The Federal Reserve's plan to slowly raise interest rates in2017 could have the unintended effect of driving up property andcasualty claims and insurance costs for middle market commercialreal estate investors and owners.

The Fed's decision on rates reflects a positive view that theU.S. economy is recovering and no longer needs to be supported byartificially low rates. For the real estate industry, however,there's another side to this issue: Critically needed capitalexpenditures such as upgrades to heating and air conditioningsystems, roofing, flooring, as well as major electrical andplumbing work could be tabled as real estate companies seek to trimcosts and save money in an environment that makes borrowing moreexpensive.

Over the next five to 10 years, the pressure for real estatefirms to meet cash-flow projections will result in further capitalexpenditure reductions and increased insurance premiums, eventuallyimpacting net incomes and long-term valuations as I wrote in arecent whitepaper titled, “Interest Rates, Capex, and theInevitable Real Estate Conundrum.”

Many real estate firms are likely to find themselves in thisconundrum given the considerable capital required to buy an asset,maintain that asset and hopefully grow and remain competitive.Several real estate executives cited in the whitepaper share thisview.

For instance, Shelby Christensen, a senior vice president atLiberty Property Trust, said higher interest rates, combined withchallenging financial conditions, “would certainly cause many realestate investors, especially those who lack deep capitalization, tothink twice about certain Capex.” Less-capitalized or highlylevered real estate investors are disproportionately at riskbecause they don't have deep cash reserves like larger real estategroups.

Jerry Sweeney, president and CEO of Brandywine Realty, alsoagrees that the effect on smaller, highly levered real estatedevelopers and investors could be significant. “Capex,[specifically] maintenance and building improvements, is likely totake a hit to counter higher costs across the board,” Sweenysaid.

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Impact on insurance claims and costs

In 2016 a Mid-Atlantic based apartment group suffered adevastating loss when boiler exhaust pipes, likely due to rust andcorrosion, leaked carbon monoxide and killed several residents. Thereal estate company involved in this ongoing case is facingmillions of dollars in defense costs.

The importance of depreciation could take on a whole new meaningif your firm finds itself in this situation. Not only will yourannual insurance costs increase as a result, but it could lead toeven greater inflated or unrealistic valuations, which could have aripple effect in the industry if you factor in marketuncertainty.

Consider another potential area of vulnerability: In the eventof a catastrophic storm, a real estate company that has deferredroof repairs typically conducted every 10 years could find itselffacing a million-dollar repair bill rather than a $100,000 claimfor roof damage.

Meanwhile, as claims mount against the real estate company,insurance brokers or consultants could lose leverage regardingtheir ability to negotiate favorable terms and pricing withinsurance carriers.

Increased claims resulting from deferring capital expendituresalso would shrink the market as many carriers will deny quotingcertain risks. For most companies, it will most likely take threeto five years for insurance costs to level off since that isusually the length of time the average loss is counted against acompany.

Over time, a reduction in Capex will lead to faster degradationof asset quality due to increased competition and consumer demandschanging, all of which would affect long-term cash flow andinsurance costs.

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Solutions for real estate companies

Property owners should resist the temptation to reduce Capexreserves when rates increase. A slight increase in Capex will, infact, give most real estate groups an edge over their competition.It also bodes well for their insurance program and correlatedpremiums.

Documenting your ability to increase your Capex allocationslightly or maintain current Capex levels is also important.Presently, the property insurance market remains competitive, but acompany that can manage to at least maintain its current Capexlevels, and improves or maintains a good loss ratio, would have acompetitive advantage over its peers.

Also, instead of reducing Capex your company should seektailored insurance programs, comprehensive coverages andcost-effective risk management programs – with the help of anexperienced broker.

Whether you're a property manager, investor or insurer, thepotential impact of rising interest rates on Capex, insurance costsand valuations are too significant to ignore.

The key to future success for middle market commercial realestate investors and owners is to have proactive, internalconversations regarding strategy and capital allocations, and makesure they have an experienced insurance broker by their side tohelp them better evaluate the potential impact of any difficultdecision they may have to make.

Related: The importance of checking insurance provisions ina commercial lease

Geoffrey Pope is vice president, USI Insurance Services. Toreceive a copy of the whitepaper, “Interest Rates, Capex, and theInevitable Real Estate Conundrum,” or to learn about USI'ssolutions for real estate companies, contact [email protected].