Risk Management
Risk Management
Operating any business is risky, but being a landlord appears to be more risky than operating most businesses. Landlords are sued more than any other group of business owners in America.
Many risks of landlords also exist for most other businesses, but there are many risks in the landlording business, particularly for residential rentals, that don’t exist for other business. Residential landlord-tenant laws, fair housing laws, ADA,
lead paint laws, and other laws regulate landlording at federal, state, county, and city government levels. Landlords and tenants interact regarding a very important category of life, where the landlord’s ownership and the tenant’s occupancy of the property are sometimes at odds and therefore have the potential for causing conflict. Landlords must choose their way through a minefield of risks related to these issues.
Managing risks related to rental property can be complex and time consuming. However, risk management should be at the top of every landlord’s list of priorities and be considered in everything he/she does. This is not only because there is potential for a significant judgment payable to the tenant or a fine payable to the government, but because the risk can extend to loss of the subject property and, if adequate asset protection procedures are not in place, to the loss of all of a landlord’s assets.
Every landlord should consider developing, regularly updating, and always utilizing a risk reduction plan to reduce liabilities associated with their property. By giving thought to what could happen and proactively implementing policies and
procedures for protecting the health, safety, and security of tenants and their guests and, for commercial property, the customers or clients of the tenants. By doing so, landlords can (1) avoid many management problems and (2) reduce the
risks of lawsuits and losses.
Risk management can be divided into the four approaches of:
- Avoiding risks completely (e.g., no diving board
for a swimming pool), - Controlling (minimizing) risks that can’t be
completely avoided (e.g., know and follow all laws), - Transferring risks to other parties (e.g., buy
insurance), and - Retaining risks of low probability and/or low
maximum potential cost (e.g., don’t carry collision coverage on older autos).
All risk management measures, including asset protection and disaster planning, are like insurance in that you have to put things in place prior to occurrence of the catastrophe, not after the fact. In fact, attempting to protect assets after the fact by transferring property is considered “fraudulent conveyance” and a conviction on that charge carries serious consequences. Furthermore, such attempts are usually ineffective.
However, before you can decide what to do about which risk, you need to identify and analyze them. Identifying exposures is a vital first step to risk management. Until you know the scope of all possible losses, you won’t be able to develop a
realistic, cost-effective strategy for dealing with them.
Avoiding Risks
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.
As a real estate investor, certain types of risks may be avoided completely by eliminating potential sources of a particular risk. Some
examples are:
- Buy good properties in good locations.
- Don’t provide risky amenities.
- Don’t store dangerous chemicals on the property.
- Don’t rent to unqualified tenants.
Controlling Risks
Many risks are under direct control of the real estate investor and, although not always totally avoidable, can be minimized by taking preventative actions. In other words, if you can’t avoid an exposure to risk completely, minimize it. For example, in your personal life, you can pretty much avoid the risk of drowning by staying away from water.
Methods of controlling risks so as to minimize them include:
- Know and follow all the laws.
- Provide a healthy, safe, and secure rental
environment. - Develop and follow adequate and legal written
tenant screening and selection procedures. - Have a good repairs & maintenance program.
- Use good hiring & supervision procedures.
- Document everything in writing, utilize good
forms & agreements, and retain everything. - Treat tenants fairly and respect their privacy.
- Vest ownership of each rental property in a
separate limited liability entity. - Develop a disaster plan and have it in place.
Transferring Risks
Another method of managing exposure to loss is to transfer risk. The most common method of transferring risk is to buy insurance (which transfers some or all of the risk to the insurance company).
While there are a large number of types of insurance coverages available, four kinds of insurance are most essential for both individuals and groups. They are: liability, casualty, automobile, and, for some, workers’ compensation.
Liability insurance covers payment for claims up to policy limits. Liability insurance (particularly for property damage and bodily injury) usually includes legal defense at no additional charge when the policyholder is a party to a lawsuit
that involves a claim covered by the policy. Litigation is costly, whether the claimant’s suit is valid or ridiculous, so the legal defense provision is very important.
In addition to bodily injuries, many liability policies will cover personal injuries (libel, slander, etc.) unless specifically excluded.
Liability coverage can be much more important than all hazard coverages put together. Exposure to financial loss due to physical hazards is actually limited, although the limit can be quite high. The worst case might be if the building
were completely destroyed from some hazard the day after your hazard insurance policy was cancelled and you had to pay off the loan out of your pocket. If you had no way to buy yourself out of the mess from existing assets, you could at
least sell the land and apply the proceeds toward your debt. Losses from property damage are limited by the value of the property, but loss from liability is only limited by what a judge or jury might wish to award.
Retaining Risks
A real estate investor may decide that they can afford to absorb some losses, either because the frequency and probability of those losses are very low and/or because the maximum dollar value of the potential loss is manageable.
For example, a landlord owns an old pickup that he uses in maintaining his properties. The landlord has an excellent driving record and exposure to collision is low because it is usually driven among properties over relatively rural routes with little traffic. The blue book value of the pickup is very low and the insurance company would call the vehicle totaled if it was extensively damaged and pay only a very low fully depreciated value amount as settlement.
With these factors in mind, the landlord could decide to drop the collision coverage completely. In effect, the landlord has decided to retain the risk of losing a relatively small amount of money rather than transfer the risk to an insurance
company by paying for collision insurance.
When deciding whether or not you should retain a particular risk you must (1) determine the dollar amount of maximum risk, (2) consider the probabilities of various degrees of loss occurring, including the maximum, and (3) decide
whether you can sustain the most probable loss amount without significantly damaging your financial condition.
Disaster Planning
Planning for disasters that could impact your business, both natural and man-made, is an important part of risk management. Is your real estate investment business or property management 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? Are you even prepared for a hard-drive failure that could occur at any time? Unexpected
emergencies can, in the blink of an eye, shut down operations, or even worse, put you out of business for weeks, even months.