In any kind of investing, making money is only half the battle. You must also expend considerable effort, time and capital on protecting your gains and making sure they aren’t stripped away from you, whether by an act of God, a criminal act on someone else’s part, or just random misfortune. After all, every successful football team has to have at least a competent defensive unit.
With real estate investing, your offense is your ability to sell properties at a decent price on a regular basis, to acquire properties at a below-market price, and to make appropriate and profitable renovations that quickly add value.
Your defense, on the other hand, is just as important. Perhaps even more so, because while a weak offense will simply make it hard for you to earn profits, a weak defense can leave you bankrupt in a flash.
For a real estate investor, your primary defense is your use of entities to separate your liability-generating assets from your personal assets, and, of course, insurance – and you had better understand both, if you plan to be in real estate for a long time. If you own property, a certain class of people will perceive you as wealthy. Attorneys are circling, trying to earn a bite of flesh for themselves and their clients.
We dealt with entities in a prior column. As an investor, it’s not enough to sit on your laurels, expecting a garden-variety homeowners policy to take care of your protection needs. Indeed, as we shall see, a standard homeowners insurance policy may not provide a flipper any protection at all, if no one is living in the home while you renovate it! Let’s take a closer look at the insurance part of the equation – particularly as it applies to short-term real estate investors.
Liability insurance provides protection and liquidity against people who claim to be injured as a result of something that occurred on your property, or a property owned by a corporation or LLC controlled by you.
It’s not just swimming pools and other attractive nuisances you have to be worried about. Consider the following:
Note that many of these claims could happen to flippers just as easily as to owners of rental properties. But a standard home insurance policy plus umbrella coverage protection – the “plain vanilla” option offered by most rookie insurance agents, may not be appropriate for your needs.
Why? Because most standard home insurance policies contain exclusions for vacant or neglected properties. To fill the gap, you will likely need a special kind of coverage called “vacant property” coverage, or to buy a rider on an existing homeowners policy, say, if you have a tenant moving out.
You may also want coverage for malicious mischief. This protects you against the kinds of things the neighborhood kids or area vandals and vagrants might commit while occupying your vacant property. Most homeowners insurance will cover this, but not if the property’s been vacant for more than two months while it’s being renovated! This is a specialty area of coverage, and you need a separate policy to protect you.
Dwelling vs. Homeowners Insurance
Generally, real estate investors should be covering their investment properties with dwelling policies, and not homeowners policies. The difference: A homeowners policy covers belongings in the home, too. Most investors don’t need that much coverage. A dwelling policy covers the building itself.
This doesn’t mean dwelling insurance comes cheaper. Typically, any policy designed to cover vacant buildings is much more expensive than a standard homeowners insurance policy would be. You can bid premiums down, however, if the dwelling has a functional fire alarm and burglar alarm system, if you have insulation and climate control in place to prevent pipes from freezing, and other basic risk mitigation measures in place.
Courts have defined a vacant home to mean one in which there is not enough furniture or appliances to reasonably allow someone to live there. So, if you have a standard homeowners insurance policy, and you have an incident of vandalism or arson that causes significant damage to the home, and it comes out that you had stripped the place bare of furniture and appliances, your insurer could well evoke the “vacancy exclusion” to get out of paying the claim. And they should! Standard homeowners insurance policies are not designed to cover the risks of vacant dwellings, which would drive premiums up for everyone.
To protect yourself, keep some furniture in the unoccupied home so it doesn’t meet the court’s definition of “vacant.” It may be worth renting or buying some garage sale furniture to do this in the short term, suggests Jack Hungelmann of Corporate 4 Insurance Agency Inc. in Edina, Minnesota, and author of “Insurance For Dummies.”
Some policies only cover the actual cash value of the structure, after depreciation. This is generally less desirable than a policy that covers replacement cost. With an actual cash value policy, the insurable value of rental buildings gradually diminishes over 27.5 years, using IRS MACRS rules. (There are other ways to calculate cash value as well.) This is a big deal to rental property investors who hold on to properties for many years. It’s not as much of a concern to a flipper, because if you unload the property very quickly, there’s not much time for the property to depreciate!
Because vacant dwelling coverage is a specialty line, there are no real industry standards. Policies aren’t written to conform to anything like a homeowners HO-2 form. So policies can vary widely in terms of coverage definition, exclusions and price.
For this reason, I would recommend going to an independent insurance broker who is experienced in this type of coverage, and who can write policies for several different insurance companies. This will save you time going over the fine print and comparing the contract language of many different policies from many different carriers, which you would have to do yourself if you went direct with a carrier, or with a captive agent representing only a single carrier.
If you have a property that’s under construction, you will also want construction insurance in place. Why? Because chances are good that you will have tens of thousands of dollars in construction supplies sitting on the property during the process – an open invitation to thieves. One of my earlier Flippin’ Insider columns deals precisely with this construction coverage.