Homeowners Insurance on a Real Estate Investment Property from a Lender’s Perspective

[John Jacobs]

Re: Homeowners Insurance on a Real Estate Investment Property from a Lender’s Perspective

I am a private money lender.  Amongst other things I always instruct the insurance agent that the property will be vacant. I always request a Builder’s Risk Policy.

My question has to do with what I need to tell the Insurance Agent in terms of how much property insurance I want.

Here is an actual deal that I lent on. I lent $225,000 of which $185,000 was for the purchase of the property and $40,000 is going toward renovations.

As a lender I just want to get back my loan amount back (in this instance $225,000) if there is a total loss with the property.

I have seen where a lender tells the insurance agent how much property insurance he/she wants based on a price per square foot calculation.

On the other hand I have also seen where a lender tells the insurance agent that the amount of property insurance should be the loan amount in this instance $225,000. I myself have done this and when I have the insurance agent comes back to me to ask me how much the purchase price is and how much in renovations are.  I provide to the insurance agent the breakdown in this instance $185,000 (purchase) and $40,000 (renovations).

How should I best communicate to the insurance agent how much property insurance that I want (and communicate it in such a way that they he/she clearly understands)?

Thank You

John

[John Mocker]

John,

As a private money lender you are acting as the Mortgagee.  You have an economic interest in seeing that the property is correctly insured.  You want to see both Building coverage and Liability coverage.  You want to make sure you are listed as the Mortgagee on the policy.  This is important because you want your name to appear on any claims checks.

The following are some general terms that you can use with your Agent, Attorney and CPA to determine the proper form for the coverage.  Which is proper will depend on the property and on what is going to happen on the property:

1. Fix and Flip with work begining within 30 days

    That will most likely be a Renovation Builders Risk policy

2. Fix and Flip where work will not begin for more than 30 days.  

    That will most likely be started on a vacant dwelling policy and then switched to a

    Renovation builders risk when they are ready to start

3. Buy and hold (unoccupied) 

    The Vacant dwelling policy is most often used unless it will be occupied within 30 days

4. Buy and Hold (occupied)

    most common policy for that situation is a Dwelling Fire policy (some companies call

    them a Landlord policy)  

In terms of how the value of the coverage there will be on the building, the main two types areL:

1. Replacement Cost:  the cost to rebuild the structure from the foundation up with the same kind and quality.  Most Insurance companies have estimating programs that calculate the amount needed.  If the cost to rebuild exceeds the Replacement Cost that is calcutated the Insured is out of pocket for the addtional.  Because of that, some companies offer Guaranteed Replacment Cost or Replacement Cost Plus 25% or 50% if needed.  

2. Actual Cash Value:  The definition is the Replacement Cost minus depreciation.  Again, the coverage is for the structure excluding the foundation and land.   This limit is harder to determine than Replacement cost as it depends on condition, market value, etc.  The big problem on this type of coverage, for you as the Mortgagee, is that depreciation will be applied to any partial loss.  So if they have a $100,000 loss and there is 40% depreciation, the claim check will only be made out for $60,000 (less the deductible).   Many Renovation Builders Risk policies will only write Actual Cash Value for the existing structure.

Lastly, policies differ on what is covered (called Perils in the industy).  The best coverage is generally called "Special Form".  It is sometimes incorrectly called "all risk".  The next best is Named Perils.  Here, only those perils (causes of loss) that are named in the policy are covered.  

The least coverage on a Named perils form is a Fire policy.  This is often refered to as a "DP1" form.  Better Named Perils forms add more coverage and can be refered as DP2 or DP3.  Here you should get your agent to spell out what is covered on one of these forms to see if it is acceptable to you.

[John Jacobs]

@John Mocker   John,  Thank you for such a comprehensive and informative Email.  John Jacobs

[Jaron Walling]

@John Jacobs Fun fact; the vacant dwelling policy is also the most expensive. 

[John Jacobs]

@Jaron Walling  Hi Jaron,  Yes that was my understanding as well.  Thank You John

[Chris Seveney]

@John Jacobs

Curious why are you communicating with the insurance company ? We never do. Our loan agreements state specifically the insurance requirements and the borrower must comply.

[John Jacobs]

@Chris Seveney    I do not talk to the Insurance Company directly.  I talk to the borrower and the Insurance Agent.