Monday, March 25, 2013

Flooding and Liquidity on the Bayou: The Capitalization of Flood Risk into House Value and Ease-of-Sale
The existing literature focuses on how perceived flood risk affects house value. Search theory, however, implies that flood risks will be capitalized into both house price and liquidity. This article draws on search theory to develop an empirical approach for estimating flood risk capitalization into both price and selling time. The results show the mix of price and liquidity capitalization varies by level of flood risk as well as across housing market phases. Regardless of the specific capitalization pattern, the results illustrate that focusing solely on price without allowing for concomitant liquidity capitalization can yield estimates that understate the full impact of flood risk on house transactions.
All of the base model estimates exhibit the expected signs and the estimates for the base model variables are robust across the extended models. Following Kennedy (1981), the coefficient estimates imply that houses in the Highest Risk Zone exhibit significant price discounts of about 2.8% and longer expected selling times. The price discount is consistent with the bulk of the existing empirical literature (except Morgan (2007)) concluding that flood risk reduces property value. Nonetheless, the estimates reported here clearly illustrate that focusing solely on price capitalization understates the full impact of being in a higher flood risk zone, as it overlooks the significantly greater difficulty of selling property so situated. In any case, the estimates are consistent with the notion that if flood insurance benefits are underpriced, they are not sufficiently underpriced to fully compensate for the perceived costs of flooding in the highest risk areas of Baton Rouge.

In order to examine the extent to which price and liquidity effects vary across the housing market cycle, the authors apply the repeat sales method to identify weak and strong housing market phases. The resultant price index shows the movement in house prices for the period 1984 (base year) through 2005... In the weak market phase, for both models properties in the highest risk zone sell at a less than 1% discount—less than one half of the discount reported for the full sample in Table 2—with no significant liquidity effect. The Medium Risk Zone coefficients are not significantly different from zero in either the price or selling time equations, the same as for the full sample estimates. Similarly, the Bayou coefficients are insignificant in price and selling time equations. The Near Bayou coefficients in the price equation are significantly negative in the price equation and insignificant in the selling time equation regardless of estimation method. Overall, these results are consistent with those found for the full sample.

In contrast with high-flood-risk properties, the Medium Risk Zone coefficient estimates are insignificant in both price and selling time equations in all of the model versions. This is consistent with flood insurance priced equal to the risk premium of risk-averse homeowners living in this zone.
The empirical literature is also clear about the general effects of flood risk on property value but unsettled about how the market responds to specific flood events. Barnard (1978), Shilling, Benjamin and Sirmans (1985), Skantz and Strickland (1987), Speyer and Ragas (1991), Harrison, Smersh and Schwartz Jr. (2001), Bin and Polasky (2004) and McKenzie and Levendix (2010) use house sales data to estimate the impact of flood zone location on housing prices. All find that flood zone location reduces price, as expected.
Barnard (1978) uses elevation as the key variable to measure flood risk to distinguish the possible degrees of variation in risk within flood zones that a simple zone designation ignores. The results show that higher elevations have higher property values, indicating that there may be some variation of flood risk and housing prices within the 100-year flood plain. McKenzie and Levendix (2010) use pre- and post-hurricane Katrina data and similarly conclude that homes with higher elevation command a premium over lower elevation homes in New Orleans. Their results also indicate that Katrina increased the premium for higher elevation homes, suggesting a greater flood risk discount for frequent or recent events.

Other studies focus on different aspects of flood zone heterogeneity, particularly the extent to which differences in flooding frequency affects house values. The empirical evidence concerning whether flood events alter perceived risks is mixed. Skantz and Strickland (1987) show that flood zone home prices are lower relative to comparable houses outside the flood zones and also that the discount does not change after a flood event. Bialaszewski and Newsome (1990) argue that flood plains have different histories of flood events and that homeowner attitudes may be more strongly affected by the realized flooding frequency rather than predicted values. Yet, they find that location within a flood zone has no significant price effect. On the other hand, Bin and Polasky (2004) use a dummy variable for the post-hurricane landfall time period to pick up price effects of changing homeowner risk perceptions. The estimates indicate that the hurricane changed risk perceptions of homeowners; it appears that recent flood events tend to increase the perceived risk and depress housing prices further.

Morgan (2007) examines whether a flood event adjusts the market downward. The empirical results show that houses located in a designated flood zone sell at a premium indicating that the benefits of living next to water outweigh the flood risk. In contrast with Bialaszewski and Newsome (1990) and Skantz and Strickland (1987), Morgan finds that a flood event does change homeowners’ risk perceptions and mitigates some of the amenity value of living next to water.

Finally, Harrison, Smersh and Schwartz Jr. (2001) examine the price effects of changes in the national flood insurance program itself. They include in their hedonic price function a dummy variable for transactions after the National Flood Insurance Reform Act of 1994.1 Their results show that the program changes increased the price discount associated with flood zone locations.

by Geoffrey K. Turnbull 1, Velma Zahirovic-Herbert 2 and Chris Mothorpe 3
American Real Estate and Urban Economics Association
Volume 41, Issue 1; Spring 2013; pages 103–129

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