Risk Management – Part 2
Risk Management – Part 2
In this article we continue to discuss “risk management,” a subject that should be of interest to all landlords, considering the multitude of possible risks to which landlords are exposed.
As discussed in Part 1 of this series, some events resulting from inadequate risk management 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.
Although real estate investors should utilize both insurance and limited liability entity vesting to the greatest degree practical, they should be equally concerned with the more basic tactics related to risk management that will help protect against the many other possible liabilities with potential for loss.
There are, in general, a variety of other tools that offer protections beyond adequate insurance and proper vesting. Some are suited for an active business, but are not significantly useful for real estate investment. Others, even if useful to large investors, are costly to set up and not usually useful to the typical landlord. Some may not even work in all cases.
As mentioned near the end of Part 1, 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.
In this article we will discuss the first two approaches, avoiding risks completely and controlling (minimizing) risks that can’t be completely avoided.
One principle that is the same in business as it is in personal life is that it is a good idea to avoid activities that are hazardous. A related principle is that, if you can’t completely avoid an exposure to risk, minimize it. For example, in your personal life, you can pretty much avoid the risk of drowning by staying away from water. If you wish to go white water kayaking, you can reduce the risk of drowning by wearing a floatation device.
Similarly, as a real estate investor, certain types of risks can be avoided completely by eliminating potential sources of a particular risk and others can be reduced significantly with minimal effort, even to the level of being negligible. Short discussions of some examples follow.
Locations of Property
Certain locations have greater exposures to certain risks than do others. For example, buying a property in a forested area usually increases the risk of loss due to a forest fire. This risk can be avoided by not buying in such an area. If buying in such an area, risk can be reduced by buying property having buildings of fire-resistant construction, clearing the land around the buildings, and providing extra fire protection equipment.
Risky Amenities
There are a number of liability risks and costs connected to a swimming pool on the property. Those risks can be avoided by closing and filling in the pool. In considering whether to do so, you must analyze how important the swimming pool is to your tenants and the extra rent amount they are willing to pay for the availability of the pool. If you determine that the pool is not economically viable because the extra rent produced by its availability is less than the cost of maintaining and adequately insuring it, you could fill it in. Of course, you would have the issue of those current tenants who are there because of the amenities you’d like to get rid of. This obstacle may be surmountable, possibly requiring financial compensation and/or allowing termination of the lease.
Similar risks are related to many other amenities including playground equipment, fitness centers, and other recreational facilities. Again, the risks can be avoided by eliminating the amenities.
However, such amenities, although creating additional liabilities, are often useful, sometimes even necessary, to attract and retain tenants. When elimination of such amenities is not an option, one must take steps to reduce the risks from those liabilities. Important considerations include:
- Well-designed facilities – quality equipment, adequate signage, first aid considerations, and instruction in proper use available to tenants,
- Regular and adequate repairs & maintenance of facilities and equipment, and
- Rules and supervision – time of use and age of users with/without parental supervision issues.
It is important that your insurance company or agent be aware of all such facilities and that they are adequately covered in your policy. Insurance companies will often require certain items related to such facilities. For example, they may have requirements for pool safety equipment, signage, and fencing and they will often prohibit diving boards.
Maintenance Supplies
Whenever possible, pool chemicals, paint supplies, cleaning supplies, mower gasoline, and any other items used in maintenance of a property should be kept somewhere other than on the rental property in order to avoid risks associated with the items. When such items must be kept on the property risks can be reduced by storing the items in secured locations in order to eliminate any possibility of tenants and/or their children being injured by them.
Know and Follow All Laws
Keeping up to date with and adhering to landlord-tenant, fair housing, environmental, and tax laws greatly reduces the chances of conflict with both tenants and governmental agencies. The degree to which related risks can be avoided or reduced depends on both the knowledge of the laws and adequate procedures to ensure they are followed.
Health, Safety, and Security
Many lawsuits against landlords are related to health, safety, and security issues. Landlords are increasingly being held liable for tenant (1) health problems resulting from exposure to elements in the rental premises, (2) injury caused by physical defects of the premises, and (3) injuries or property losses resulting from lack of reasonable levels of security. Liabilities will almost certainly be greater when the landlord has not provided at least the minimum level of protection for health, safety, and security required by law.
Tenant Screening & Selection
Adequate and legal tenant screening and selection procedures are arguably the most critical factor to avoiding discrimination complaints and to minimizing tenant related problems of every type.
Repairs & Maintenance
A good maintenance program is important for a number of reasons. First, good maintenance will minimize bodily injury and property and serious injury from falls can be reduced by being sure that balcony railings and stair handrails are properly maintained.
Second, relatively minor upgrades can further reduce risks. For example, installing low-cost carbon monoxide detectors, even when not required by law, will greatly reduce the risk of poisoning as well as possibly provide a defense in the event of an incident.
Third, regularly and properly maintaining components of your property will reduce the cost of repairs and the chances of secondary damage resulting from an ignored problem.
Forth, an adequate maintenance program will help to minimize landlord-tenant conflicts. Failure of landlords to properly maintain their properties just to the low level required by habitability laws is a major source of landlord-tenant disputes. Inadequate maintenance can result in intervention by governmental agencies which will make it more costly to the landlord in the end.
Employees & Independent Contractors
Every worker hired to perform repair/maintenance work or be in any way involved in management of your properties, whether as independent contractors or employees, represents a variety of potential risks to the landlord. You may be liable for those workers’ actions if they are irresponsible or negligent or commit crimes against your tenants.
Minimizing the risks requires adequate screening and careful selection of employees and independent contractors as well as adequate supervision. If tenants complain about illegal acts by anyone, landlords must pay attention and investigate. Property owners should always make sure their insurance covers both negligence and illegal acts of their employees or contractors.
Minimizing risk of the IRS claims regarding classification of workers – employee or independent contractor – requires adequate understanding of and compliance with the law.
Adequate Documentation
Good risk management requires that you document everything in writing, utilize adequate forms and agreements, and retain everything for an adequate period. Everything means just that – everything.
Landlords need to keep records on all applicants, current tenants, and past tenants. A log should also be kept of all calls from prospective applicants, even if they never visit the property. Records should be kept that show periods when vacant properties were available. Make notes of all your phone calls including those calls from prospects. Use your prepared scripts (in writing) to convey the same information to all callers.
The retention time required varies because the time allowed for filing of a suit varies among states. It can depend on a specific state statute or by the general statute of limitations laws applicable to the
potential cause of action by a disgruntled applicant. The length of time typically varies from 2 to 5 years among states.
Tenant Treatment
Tenants want to know that landlords will enforce the rules and regulations fairly, objectively, and uniformly for all residents and not discriminate in their actions. Failure to address violations of lease agreements or house rules uniformly may cause problems for a landlord.
One of the issues that tenants often complain about is that landlords do not respect the property or privacy of tenants. Many states have enacted legislation that requires a specified minimum notice period – often 24 or 48 hours – or “reasonable” notice before a landlord can enter a tenant’s property without permission in non-emergency situations.
Being rude to others is not against the law, but doing so certainly will not do much for good landlord-tenant relations. Landlords that sincerely respect others and act accordingly will usually
experience less conflict.
Communication with Tenants
If the only time you communicate with your tenants is when the rent is late, there is a good chance that neither you nor your tenants are happy. If you ignore your tenants, you will likely be looking for new tenants sooner than you’d like. Many conflicts that lead to financial losses result from misunderstandings between parties. Good communications between landlords and tenants can reduce
risks.