Real Estate 024: Rental Property Insurance

One of the most important things that I have learned as a Real Estate Investor is risk mitigation. One of the ways to mitigate risk, both tenant related vs external, is to maintain proper insurance. When you are financing a rental property, a conventional lender, if not all, will require that you maintain a certain level of insurance to protect their loan. However, even cash investors should consider purchasing adequate insurance as it will be an additional line of defense between you and the liability. 

According to my insurance broker,  owner occupied insurance is underwritten differently compared to non-owner occupied, or rental property insurance. Non-owner occupied properties have different types of exposures in regard to liability as a result of the tenant. Further, there may be break-ins to the property during rehabs or vacancies that require additional consideration when understanding coverage. There are two types of policies when it comes to insurance, actual cash value and replacement cost. Lets take a deeper dive into each of these topics further below:

Actual Cash Value

Also known as the "fair market value", is what an insurance company would consider the replacement cost of the property - depreciation. It represents the actual dollar amount you would expect to receive for the item if you were to sell it on the market. Actual cash value policies are typically cheaper than its counterpart, replacement costs, however you may be placed in a tricky situation when trying to rebuild from a covered peril, such as fire damage, as it may cost significantly more to reconstruct a home than what you would be receiving from the insurance company after depreciation. This type of insurance may be beneficial for investors who are purchasing homes at a significant discount (e.g. $32/sq ft) but replacement cost at current market rates to rebuild may be $80/sq ft. In these situations, it may behoove the investor to cut their losses and take a cheaper policy, knowing that they will not be able to rebuild in case of major damages.

Replacement Cost Value (RCV)

Replacement cost insurance means that you are insuring the property for the amount to rebuild the property like new. In a situation where you have a total loss (e.g. fire burned down your building), your insurance provider will cut you a check to repair or rebuild the property. It is considered to be superior to the ACV as it puts the owner back into the same position prior to the covered peril. Typically, the replacement cost coverage is based on a formula on the sq footage of your home, location, and type of home, and can be adjusted by the investor to increase coverage based on the condition of the property. However, note that some insurance policies include a cap to the amount of replacement cost coverage, so be sure to check with your insurance broker. Although the premiums may be slightly higher than ACV, RCV policies provide enhanced coverage for the average real estate investor.

Types of coverage

Once you have determined between Actual Cash Value and Replacement Cost Value, the next step is to determine your carrier will provide necessary coverage:

Dwelling Coverage

Similar to homeowners insurance, rental property insurance covers physical damage to your dwelling, meaning damage to the structure of the home or apartment itself. For example, it will cover damage to your your walls and your roof, but not personal items of your tenant. Coverage will only extend to damage caused by a covered peril, and you should make sure to understand what type of perils, such as fire or lightning damage, are covered by your particular policy.

Liability & Medical Coverage

Liability and medical coverage will protect you from the legal and medical costs associated with someone being injured on your rental property. If your tenant or a visitor is injured on your property, and you are deemed responsible for the injury, rental property insurance can cover these costs up to your policy limits. If you're someone for whom the limits of this coverage are not sufficient to cover potential liabilities and you wish to increase your coverage, you could also purchase umbrella insurance for your rental property.

Loss of Rent Coverage

Loss of rents coverage provides protection against lost rent payments if the property you rent is uninhabitable due to a covered peril. For example, If the tenant is forced to move out as a result of a covered peril, a fire burns down the kitchen and living room and the tenant physically can’t inhabit their property, the insurance company would pay the monthly rent until the home is reconstructed back to a habitable condition. Coverage will generally extend up to a defined period of time, such as 12 months. Loss of rental income does not always come standard with rental property insurance, so you should check your policy before purchasing it if this type of coverage is important to you.

Personal Property 

Personal Property coverage provides protection against the loss of damages or theft to your personal property inside the home and vehicle.

Perils (Examples):

Building Ordinance/Law, Loss of Rents, Fire & Lightning, Vandalism & Malicious Mischief, Falling Objects, Weight of Ice, Snow, or Sleet, Theft, Windstorm or Hail, Mold, Power Failure, Water Damage (Sewers/Drains), Earthquakes.

Whichever method you decide to pursue, make sure that you are getting adequate coverage to protect your interests in the property. Although we hope for the best, insurance is there to protect us when unforeseen damages or liability occur. 

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!

Real Estate 023: Real Estate Partnerships

You may be wondering if you should have a partner to help build your real estate portfolio. This is a valid question as some asset classes such as multifamily is well-known for being a team sport. But what about single family, note investing, or other asset classes? This is not an easy decision and it requires looking at your temperaments, the skills that you bring, and goals in forming the partnership.

I have met investors who formed partnerships from the beginning of their real estate careers through meetups, conferences, and even online. I have also met investors who began on their own and partnered up on specific deals where it made sense. Lets take a look into some of the pros and cons of using a partner or going solo in building your real estate portfolio:

Advantages

“If you want to go quickly, go alone. If you want to go far, go together" - African Proverb

Teamwork: Investing in real estate will require you to have resources, whether that be capital to purchase the home and make renovations, knowledge to structure/negotiate a deal, or time and hustle to underwrite the deal, communicate with your team members, and oversee the project. By having a partner, you are able to share the workload and also select tasks according to the strengths of each person. If you love to work with spreadsheets and look at the numbers, and your partner loves to network, build relationships, and find deals, there is a natural compatibility and chemistry between the deal finder and the analyzer. In another example, one person may have the money from a high paying W-2 job, but the demanding hours may not allow them to fly to the different markets, meet with the team, and underwrite/pursue leads. This person may benefit from teaming up with a person who may have low funds, but more time to perform the aforementioned tasks. This also works for people with poor credit, maximum Fannie Mae loans, and other commitments.

Shared Networking: You may have heard the idea Six degrees of separation, where all living things and everything else in the world are six or fewer steps away from each other so that a chain of "a friend of a friend" statements can be made to connect any two people in a maximum of six steps. By having a partner who is well connected, you instantly become two steps away from finding the next person who may be able to help you in your business, whether that be a realtor, contractor, property manager, private lender, or mentor connection. Real estate investing is very well a relationship business and having a strong network will certainly provide huge dividends down the road.

Increased Accountability: Assuming that you have found a partner who is equally motivated, capable, and willing to do the work, you will have won yourself an accountability partner for the long haul. Although you can find large profits in a relatively short period of time, real estate investing is generally not a "get rich quick" scheme. As such, there will be moments where you lose focus, motivation, and need someone to help you get back on track and keep your eyes on the prize. Further, as the saying goes, two heads are better than one, or 1+1 = 3 (synergy). When you encounter a roadblock, you and your partner will be able to put your heads together to come up with a better solution than just you alone. 

Disadvantages

"No deal is good enough, to take down with a bad partner"

Multiple Captains: When driving to a destination, it becomes difficult to stay on course when there are several people trying to take control of the steering wheel, each believing they know the best route. Compared to a solo investor, where each decision starts and stops with them, having a partner (assuming 50/50 equal general partners) means that you have to listen and respect the opinions of others. This may result in compromising even though you disagree with their strategy or decision in pursuing or passing on an opportunity.

Division of profits: While an advantage of a partnership is division of risk, the flip side means that any upside is also divided amongst the partners. Assuming all things equal, you may have found a home-run deal that brings a 100% return over 5 years ($100K --> $200K) through forced appreciation and improved management, but the overall returns are split in half with your partner. Contrarily, if you would have purchased this deal by yourself by utilizing debt for the other $50K seed money, you would have realized all $100K in gains (less debt service) which may be significantly higher than the partnership scenario. 

Partner problems: Whether you partner up with a stranger or your best friend from childhood, its very important to vet them and understand their finances, goals, and temperaments. I have seen people's situation change in the blink of an eye through death, divorce, health complication, gambling habits, etc. and these things can impact your partnership. There are numerous case studies online where partners sued each other alleging theft of assets, not fulfilling their part of the contract, and other types of fraud. Further, there may be cases where outside liability (e.g. car accident) of your partner results in the loss of your asset as they may be forced to liquidate the property to settle their debts. Make sure you protect yourself by engaging a real estate attorney to draft up the operating agreement or joint venture agreement that secure your interests.

To create a successful partnership, make sure that you and your partner have clearly written goals that align before you start to look for deals. For example, if you want to be a long term buy and hold investor and your potential partner only wants to do fix and flips for 2 years and get out of the game, there is clearly a conflict of interest. Next, remember that consistent communication is key. After identifying your goals and business plan on how to get there, make sure you communicate issues (without personal emotion) and offer solutions to the problem - no one likes a complainer. There may be times where one partner needs to concede to another, and other times where you stand firm. If partners learn to respect one another and compromise for the benefit of the group, then the relationship will become even stronger and you will be one step closer to your goal. 

As mentioned above, there are both advantages and disadvantages for partnerships, and as an investor I have gone both solo and partnered up for deals on a case-by-case basis. Remember to carefully review how they apply to your situation, your personality, and the deal. There are many successful investors who have done it both ways and have reached their goal, so do not fear one or the other, and maintain an open mind. 

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!

Real Estate 022: Using a Home Equity Line of Credit (HELOC) or Refinancing your Property

During the upswing of a market cycle, homeowners may be wondering if it is a good idea to tap into their home equity, or the difference between the market value of the property and remaining balance of the loan. There are three popular ways (other than selling) a homeowner extracts the equity portion of their property: refinance, home equity loan, and home equity line of credit. 

1. Refinancing your Home

We often hear it on the news, radio, or online advertisements, "take advantage of low rates, refinance and lower your monthly payment!" I know I have received dozens of mail from mortgage lenders offering me to take their deals. In short, refinancing means taking a new loan to replace your existing loan. This is usually done to either take advantage of lower interest rates, remove private mortgage insurance (PMI), or better terms (5, 15 vs 30 year amortization), to take cash-out, or both. People may benefit from taking the equity in their home which fluctuates with the market and putting that money to other use: consolidate debt, make necessary purchases, or even invest in real estate. In addition, without taking cash out of the property, you can use the lower interest rate to lower your monthly payments (assuming the gain is higher than the closing costs involved in the transaction). 

2. Home Equity Loan (HELOAN)

A home equity loan is another type of equity stripping used by homeowners to take advantage of a lower LTV (loan to value) which is experienced during times of appreciation. Equity loans are available in both fixed or adjustable rate mortgages where a financial institution (typically a bank or credit union) has 2nd lien position on the home. This means that in addition to your original mortgage which is in 1st lien position, or first in line to be paid out when there is a sale, refinance, or other action on the home, there is another mortgage that is on top of the 1st lien note. As 2nd lien position requires the 1st lien position holder to be paid in full before the 2nd lien holder sees a dime, this is seen as higher risk, as such there is more scrutiny during underwriting and may be more difficult to qualify. 

3. Home Equity Line of Credit (HELOC)

A HELOC, or home equity line of credit, is similar to the home equity loan in that it is a 2nd mortgage (home serves as collateral), but a HELOC is a form of revolving debt, like a credit card with simple interest (not amortized). This means that you are able to withdraw money up to an approved limit, using a bank transfer, card or check, repay it and draw it down again within the predefined terms of the loan. As a HELOC is a secured loan, you are able to obtain a lower interest rate than the average credit card (around 22-25%) or personal bank line of credit (typically 8-12%). 

A limitation to the HELOC is the draw schedule, typically 5-10 years, variable interest rate, and the loan to value requirements (e.g. 80-100% LTV). For example, if your house is worth $500,000 and you currently have a $300,000 mortgage balance, you are at a 60% LTV. If a lender decides to limit the LTV to 90%, that means the maximum amount your HELOC can be is $150,000 ( = $500,000 * 90% - $300,000). 

Depending on the usage of the HELOC it may be beneficial to consolidate debt or use the funds to purchase necessary items that otherwise may have carried a higher interest rate (e.g. 20% consumer credit rate vs 5.5% home equity line of credit rate). However, as this line of credit is secured by your home, you want to ensure you have a plan to pay off the debt so that you do not put your primary residence at risk of foreclosure.

In addition to purchases and debt consolidation, savvy investors use a HELOC to purchase a rental property all cash and refinance out their money to pay back the HELOC, or take enough funds for a 20% downpayment on a turnkey property. If the rental property is achieving double digit returns (i.e. 12% conservatively), against a HELOC rate of 5.5%, then you have created a 6.5% spread on the borrowing cost and increased passive income without using any of your own money (read: leverage/other people's money).

In conclusion, before you go out and apply for one of the three aforementioned products, please remember each bank and credit union have different rates and terms as well as conditions (draw schedule, etc.). Further, they will also have different programs that will incentivize a new customer such as paying for closing costs, appraisal, and introductory rates at 1.99% for 6 months. Make sure you watch out for any hidden fees such as annual maintenance fees and draw fees that may build up quickly. There are always risks involved when using other people's money and using debt to create income producing assets, however, if you know your numbers and have a solid plan of repayment, you will be able to scale up your property safely and quickly than other methods.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!