Insurance: Cover Your...Asset
Updated: Jun 10, 2019
Last week we were talking about real estate taxes, which is one of the more straightforward expense items. This week we’re looking at the insurance line item. Unlike taxes, you can’t simply go online to check the rates, current coverage for the seller or what coverage will be needed for you. Further, insurance is extremely property and location specific. Two complexes immediately next to each other can have drastically different policies for a variety of reasons.
There are numerous coverages you can elect to get, or be required to get, depending on the situation. Property level coverages can include the traditional property casualty insurance as well as other items like loss of rent (just because one of your buildings burned down doesn’t mean the bill collectors will give you a break), E&O insurance (watch out for what you put, or don’t put, in your leases) and general liability (just wait for someone to trip on a sidewalk crack or fall in that fancy pool). These costs can vary due to the age/condition of the property, likelihood of losses and risk factors such as pools and fitness centers. Location level coverages can include flood, wind, earthquake and other additional coverages that can be required by your lender or your investors to better protect their collateral.
When you begin your review of an Offering Memorandum’s expense items, you’ll inevitably see a line item for the insurance. Even if it’s one of those “napkin” P&L’s with only a few numbers, this is usually one of the items included as everyone is well aware that insurance is necessary and that it’s typically a larger item.
Each property and investment can be different but, for the sake of an initial review, look to see if the insurance stated is approximately 50-100 basis points of their implied value.
If it is, you may be okay for this early stage of the process without digging in too much further.
However, keep an eye out for the extremes.
You may see the stated insurance amount substantially lower than 50 basis points. If this is the case, there could be a few things going on. The owner could have an umbrella policy blanketing numerous assets to keep costs down. They could have a relationship with their lender. However, the most likely is that current owner could be under-insured. They may have elected to forgo certain items such as flood or loss of rent. This is more likely to occur when an owner holds a property all-cash as a lender would typically force the insurance coverage based on their guidelines. I have one client that intentionally self-insures for flood and wind on all his properties. It’s a risk he’s willing to take. However, in a few years when he goes to sell one of his properties, a potential buyer is going to see an artificially low expense for insurance. They will need to adjust for this or be surprised at closing.
On the other extreme, the insurance amount could be substantially higher than 100 basis points of value. This situation is not going to raise any flags on the insurance coverage itself, but it could raise some big concerns about the property being underwritten. The asset could be located in an exceptionally high-risk location for flood or wind. It could be in a location so questionable that an owner has a pay a premium to get a provider to write a policy for the property. It could also be the result of inflated policy premiums due to excessive past claims. These can come from past losses, lawsuits or any number of items that had to be paid out by the insurance company. Make sure any premium inflation is due to isolated events, and there’s no concern of trends, and ensure that you will not be penalized for past issues.
Ultimately, the insurance expense you’ll incur in the future will be dictated by the policy coverages you elect to take on your property. More likely, they will be dictated by the coverages YOUR LENDER elects to require you to take. Some of this will be based on your risk tolerance and that of your investors. Others will be based on the asset, location and lender. Just understand that the policy held by the current owner is not necessarily the policy you’ll be holding.
As you go under contract, one of the first diligence items you’ll be requesting is a copy of the current insurance policy. Once obtained, you’ll be able to know specifically what was covered and what it cost. At that time, you’ll be capable of fine-tuning your number. Until then, if it falls in the 50-100 basis point range, you should be good for initial underwriting.
If you want to be more specific at the initial assessment phase, I would encourage you to add an insurance provider to your list of professional partners.
With basic information like address, age, construction quality, etc, they should be able to do a quick desktop review give you a non-binding ballpark price for your analysis.
At the end of the day, insurance is going to be required (unless you 100% self-insured, which I’d advise against unless you’re really looking for some excitement). You’ll need to make sure you’re properly insured for yourself, for your investors and for your lender. Get the coverages necessary. The expense will be whatever it will be. Just make sure that you’re underwriting a real number and then it will not be a surprise down the road since you would have purchased the property with it in mind.
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Next Week: Utilities. They're more than just crappy purchases in Monopoly.