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The Simple Microeconomics of Adapting to Real Estate Damage Caused by Flooding

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 The New York Times has published a good opinion piece by a Professor of English on the unintended consequences of federal subsidies and regulations for living in flood plains.

In this brief piece, I am not talking about surviving a flood.  Instead, I will discuss how flood risk (ex-ante) and flooding affects the real estate market and the distribution of income.   In an increasingly risky economy, who should own the risky assets?

When one owns an asset, there is uncertainty about how the price of the asset will change over time.  A share of Tesla can either rise or fall over time.  A home’s value can go up or down over time.  The asset’s owner is not guaranteed that “nothing bad” will ever happen to the home.   Under the logic of the efficient markets hypothesis,  expected future risks to a specific property will be reflected in the value of the asset today.

For example, if crime is expected to rise in the year 2024 in a Los Angeles neighborhood because the police have announced that they will no longer patrol there — economics predicts that home prices for such homes in April 2022 in these areas will decline now to compensate buyers for the emerging risks as crime rises. Those who buy the homes today are “adults” and know what risks they are taking on.  Economics predicts that self-selection will arise. Those with an edge at defending themselves (so think of Clint Eastwood or Bruce Lee or the Terminator) will be more likely to buy these homes due to comparative advantage in self-defense.  A home buyer can buy one of these discount homes and install security cameras and use a private car to drive one around to avoid contact with potential robbers.

This same logic applies in flood zones.   Professor Rush gives some quotes of home owners who are frustrated that the value of their home has declined because of increased flooding.  Are they victims who the rest of society should subsidize?  These individuals chose to own when the opportunity cost is that they could have rented and held a more diversified portfolio.  Most poor people are not home owners.  This means that middle class and richer people own these at risk to flood homes are they really the “vulnerable” people who deserve federal handouts for choices they voluntarily made?

I think the answer is no for several reasons.  First, none of us flip “one sided coins”. If their homes had tripled in value, they would not have given 50% of their equity gain back to us.  These home buyers want to keep their capital gains and nationalize any losses.  This subsidy of risk taking creates moral hazard effects.  

These home owners could have sold their homes previously and rented in the same area to reduce their risk exposure and to keep their social network and commute.  These home owners can sell housing equity in their home to outside investors to diversify their portfolio.   If home owners do not engage in any of these risk diversification strategies, are they victims?

Note that up until now I have focused on the incumbent property owners who are increasingly aware of the flood risk they face both from their past experience and because of new entities such as First Street Foundation’s Flood Score.

As I argue in my 2021 Yale University Press book Adapting to Climate Change, we will be better able to adapt to flood risk if society agrees on evolving flood risk maps such as First Street’s that show property by property the expected risk.  Banks and insurers should be allowed to risk price based on these such that riskier properties face higher interest rates, lower loan to value ratios and higher insurance premiums.    Home buyers who are quoted these interest rates and insurance premiums will quickly figure out that the property is risky and these Bayesians will update their beliefs and bid less for the home.  The owner of the home will receive a lower sales price for the “common knowledge” that the home is riskier due to climate change.  

The Banks and Insurers will act as the “adults in the room” nudging real estate buyers to reduce their demand in risky places and increase their demand for housing and real estate in safer places.  If we change our zoning codes to up zone in safer places featuring less fire risk, flood risk and extreme heat then a more elastic housing supply curve emerges there and prices of real estate will reflect demand and increased supply. Worries about climate gentrification on higher ground will be muted.

Will flood zones be emptied out?  No, I predict that in beautiful and productive locations that happen to be flood zones, single family homes that are adjacent to each other will be purchased and knocked down. They will be replaced with wetlands and tall buildings that have empty lower floors to reduce building damage.  Civil Engineers will figure out how to have productive real estate assets that are acclimated to the risks.

The key to this smooth adaptation dynamic is for government to retreat.  Government is taxing people on higher ground to subsidize people taking risks.  Why is that fair?  Mancur Olsen  asymmetric interest group logic can explain this political equilibrium but I believe that reforms will occur as tax payers realize the size of the subsidies we are paying to the risk takers.

The next steps in the climate change adaptation research agenda is to focus on induced innovation. As more home owners face flood risk, this creates a demand for solutions and this creates profit opportunities for innovations that offset this damage.  Do you doubt that capitalism will deliver here?

Finally, note that at no time in this piece did I discuss major engineering projects.  Such projects can protect an area from flood risk but I argue in my 2021 book that they should be funded locally. Such projects protect local land and home owners own those and thus should pay for their own defenses. The central government can provide the expertise and human capital but local public goods should be funded locally.

One More Point!   Those who cry that climate change is lowering the value of homes in areas that now face flood risk ignore that there are other homes on “higher ground” whose values rise because they are relatively safer. It is an exaggeration to call this a “zero sum game” but even good economists ignore this cross-elasticity point.  General equilibrium effects always exist.  


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