Risk Management – Part 1
Risk Management – Part 1
Life is full of risks to health, safety, security, finances, and happiness. Investing in real estate adds a number of additional risks to one’s life. First, there is the risk of buying the wrong property, one that is in a bad location, in worse condition than you thought, and for which you paid way too much. Then, assuming that one purchases a good property at the right price, owning and managing that property has many categories of risks.
However, there are ways to reduce risk to acceptable levels. Reducing risk is basically a matter of having adequate knowledge and utilizing good risk management procedures.
With this article we begin a multi-part series regarding ways to manage the risks associated with rental property ownership.
Adequately managing risks of any business, including landlording, can be complex and time consuming, and can involve a number of components and potential complications. Good risk management is achieved through adequate organization and planning.
Risk management includes a variety of activities. Landlord-tenant relations, proper maintenance, adequate record keeping, formal safety programs, adequate insurance, and proper vesting of properties are some of the things that are part of a good risk management program. The goal of risk management is to anticipate and avoid future legal and other problems. When legal problems occur, the goal is to end them as efficiently as possible, which usually means obtaining an early settlement.
As for all businesses, landlords should have a risk management program in place. Some refer to such a program as asset protection. However, asset protection is actually only a part of risk management. Good risk management includes a number of issues in addition to asset protection. Asset protection becomes important primarily when all other risk management measures have not been totally effective. Considering that the goal of risk management is only to protect assets from creditors is a dangerously limited view.
Disaster planning is another part of risk management. Is your real estate investment business ready for a fire, a hurricane, a flood, or whatever other unexpected event might occur tomorrow, next week, next month, next year, and/or beyond? It is not only 9/11 or Katrina level disasters that should be of concern. Are you even prepared for a hard-drive failure that could occur at any time?
You may have already considered the most obvious risks, such as fire or injury related to your rental properties, and have bought insurance to protect against those risks. Unfortunately, there are hundreds of other liabilities with potential for loss that every landlord should consider, many of which are often overlooked or ignored.
Security deposits, lead-based paint, mold, and a bunch of fair housing items are only a few of the many potential land mines that landlords can encounter. Accordingly, it is important that, as a real estate investor, you (1) avoid being sued or becoming the subject of governmental investigation, (2) be the winner in any lawsuit or agency investigation that does occur, and (3) make sure that a potential judgment or penalty does not result in one landing in the poorhouse.
Exposure to lawsuits and governmental actions is minimized by having a good understanding of all the laws related to rental housing and following them all very carefully.
The odds of winning a lawsuit or being exonerated in a governmental investigation that does occur in spite of your best efforts are maximized by (1) not being having done anything seriously wrong in the first place and (2) having maintained adequate records to prove it.
Avoiding financial damage, even total ruin because of losing a serious lawsuit requires that one follow adequate asset protection procedures as part of a comprehensive risk management program. This includes utilizing proper vesting for all properties and carrying adequate insurance.
All risk management measures, including asset protection and disaster planning, require that you have to put things in place prior to occurrence of the catastrophe, not after the fact. Most attempts at after-the-fact maneuvering are usually ineffective. In fact, some methods of attempting to protect assets after the fact by transferring property are considered “fraudulent conveyance” and are illegal. You need to manage risks now, before the event occurs.
A few risks are predictable or at least are things that can be planned for and even controlled to some extent. Included in this category might be:
Death – “when” is sometimes somewhat controllable, “if” is never controllable
Taxes – second only to death in probability
Insurance premiums
Rents
Loan expenses
Employee costs
Operating expenses
Computer problems – backup, backup, backup
Other risks are unpredictable and usually beyond the landlord’s control. Included might be:
Illness, even permanent incapacity
Changing tastes in rentals
The local economy and its impact on the rental market
Actions taken by neighboring landlords
Actions taken by various levels of government or agencies thereof
Some events affect day-to-day operations only, others reduce profits, yet others result in hassle and stress, and still others can cause serious financial losses, even result in bankruptcy.
Risk management can be divided into the four approaches of:
Avoiding risks completely,
Controlling (minimizing) risks that can’t be completely avoided,
Transferring risks to other parties, and
Retaining risks of low probability and/or low maximum potential cost.
Some risks can be avoided or eliminated, others can be controlled or minimized, still others can be transferred to someone else, and some can and should be retained. However, before you can decide what to do about which, you need to identify and analyze them.
We will discuss each of the four approaches in future newsletters. A detailed discussion of risk management is provided in our “9 Steps to Managing Risks” Mini Training Guide.