Real estate investing can be considered the business of anticipating the future. Take for example deciding to remodel a kitchen in a fix and flip. The investor anticipates the value that future buyers will see in that new room. Buying a property along a commuter rail line that is under construction anticipates the future desirability of that location as a place to live. This skill is not limited to positive developments. This skill needs to include negative ones like property insurance to protect from storm damage and other natural disasters.
Property Insurance Basics For Rental Investors
The most common way of anticipating property damage is to buy insurance on the structure. This is technically defined as a risk transfer. A risk transfer is one of the four methods of dealing with the risk of financial loss. Risk transfer is used most appropriately in situations where the loss will occur infrequently but will have a significant financial impact when it occurs. Keep this in mind when considering the impact of a deductible on the premium for a property insurance policy.
Property insurance follows some basic forms commonly accepted by insurance commissioners in every state. The forms standardize the coverage that is provided by the policies. These policies are commonly referred to as “landlord policies”. The technical name, though, is a Dwelling Protection policy, or DP policy form. They differ from a Homeowner’s (HO) form in that they do not require the owner of the property to live there.
Like all property insurance, DP forms can be broken down into two basic kinds of insurance. The first type is referred to as a “named peril” policy. This form of coverage lists the kinds of causes of damage that are covered by the policy. Policy forms DP-1 and DP-2 are named peril policies. They specify that policy will pay for damage caused by fire and vandalism, for example. The DP-3 policy form is an “all risk” policy. Under this policy they which will pay for damages caused by anything unless it is specifically excluded in the policy.
Exclusions of Property Insurance
Property insurance companies exclude certain causes of damage because these causes may result in a ruinous financial loss to the company. Keep in mind that property insurance is sold through local agents. Therefore, it is very common for an insurance company to provide coverage to a significant number of properties in a specific location. A common disaster that damages or destroys all the houses in that location could bankrupt the insurance company.
It is absolutely critical for anyone investing in real estate to understand that even an all-risk policy does not insure the property against everything that could happen to it. Although water damage is covered, water damage caused by “(f)lood, surface water, waves, tidal water, overflow of a body of water or spray from any of these, whether or not driven by wind” is specifically excluded in the DP-3 policy form. Again, this is because flood losses could be so large they could bankrupt the insurance company.
The same is true for damage caused by earthquakes. At first this might seem to be a concern only for real estate investors on the west coast. The fact is that earthquake that hit New Madrid, Missouri on February 7, 1812 was larger than any that has ever struck the state of California. The area around the quake was undeveloped so property damage was minimal. That same area is still prone to earthquakes, and is not insured under the standard policy form.
The flood exclusion is the reason around 80% of property owners in the Houston area are not insured against the significant damage caused by Hurricane Harvey. Even though it is likely that the Federal Government will come to the financial rescue, counting on Uncle Sam is not a prudent strategy for real estate investors. A more prudent approach is for them to understand and manage property insurance for these large losses.
