Let's get real for a second. You are investing in real estate. You need to protect the asset, the cash flow, your business. So you buy insurance, but managing the risks you face is more than just buying an insurance policy. There are several types of risks you face. Some are insurable, some are not, but A LOT of headaches can be avoided with some simple risk management concepts. The Risk Management process is pretty simple.
- Identify Risk
- Rinse and Repeat
Let's walk through this for a moment from the perspective of a real estate investor. Let's take a look at three common risks, and how one might manage the risk.
A fire could down the home, destroying the asset and its cash flow. So let's walk through the process, we know the risk. What would the loss of the home do to your business? If you have a mortgage on the home, you would still be on the hook for the payments, but would be out the cash flow. It would probably be devastating to your business. So your best plan? In most catastrophic scenarios where the financial well-being of your business is at risk, it is best to transfer the risk. Insurance is a risk transferring mechanism. Rather than you taking on that risk, the company does. So by purchasing a dwelling fire policy that protects the asset, you insure the cash flow with business income coverage or the "fair rental value" which pays for the cash flow. Pretty simple. Then monitor, this one is pretty easy, but when it comes to insurance it is important to review. What has the market done? How much is the home insured for? Does that need to be adjusted? Do you have enough liability insurance, have you increased the rent? Remember the company will pay you the rents you lose in the event of a loss, but you need to state what you are collecting in rent. If that has increased you need to increase that coverage. So there is a little work to do, but your insurance agent or broker should be able to help you through the monitoring process.
A tenant poses all kinds of risk. They could damage the home, they could not pay rent, they could sue you and so much more. A lot of risk. For example, say we will focus on the risk that the tenant damages the home. This too can be catastrophic, and require reinvestment that eats into our profits. However, risk transfer is not an option, as damage done by a tenant is not covered by the insurance company. So how do you manage this risk? In this case your best bet is what is known as Risk Avoidance. That is, avoid tenants that will destroy the home, or in other words tenant screenings. There are a number of tenant screening services. We recommend that you use one that will not only provide the online screen, but that will do full background checks. Usually the cost of these is cheap, and if you do it right, you can have the tenant pay for the screening. That extra step may go far in deterring those would-be investment destroyers and non-cash flow payers. It's a great plan that won't eat into your profits. From there monitor the situation. Find a good screening company, and if something goes wrong review what happened. Did you ignore a red flag in your haste to get the vacancy filled? Did your screening service miss something important? Analyze, and make a new plan or continue on.
Didn't we just cover this? Yes, but they pose A LOT of situations that are scary. The risk is that you have to evict, and you get nailed with a lawsuit because you didn't follow the legal steps. Again, this is catastrophic, but again risk transfer is not an option because wrongful eviction of a tenant is not covered by the insurance company. You might notice that insurance companies don't like to pay for your lack of information. So how do you manage the risk? This time the answer is Risk Reduction. You can't really control what a tenant does or how they react. But there are ways you can reduce the risk that you are actually found to be at fault. This one is a no brainer, but too many investors fail to take the proper steps, which include education, education, education OR outsource. If this is something you plan to do on your own, education is the single most important step you can take to ensure you are following all applicable laws. If you can't or won't do that, then outsource it. This is one of the things that property managers do, so get a good one that knows the process and has done it (i.e. your brother-in-law, while a good guy, is probably not your best option). The experience or knowledge can help you avoid pitfalls and heartache and reduce the risk you face. That's the plan; now, let's hope you never have to do it. How could you further reduce the risk?
Bottom line is that we as investors run into risk all the time. The question is will you have a plan, or fly by the seat of your pants? It doesn't take long, take a few minutes, sit down, and list those things that could potentially keep you up at night and figure out a plan and how you will react. It may make all the difference in the world when it comes to your sleep habits.