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What you'll get from this article:
🏠 Rental property rISK MANAGEMENT INCLUDES PREVENTING, REDUCING, AND TRANSFERRING RISK
🏠 CHOOSING THE RIGHT LEGAL STRUCTURE FOR YOUR PROPERTIES
🏠 EVALUATING INSURANCE NEEDS FOR YOUR RENTAL PROPERTIES
🏠 RENTAL PROPERTY MANAGEMENT PRACTICES TO PREVENT OR REDUCE RISK
🏠 Cash flow management techniques
🏠 TRACKING FINANCIAL RATIOS AND METRICs for your real estate
Risk management in real estate financial planning is evaluating and forecasting financial risks and identifying ways that you can avoid them or minimize their impact. Every investing and business activity has inherent risks.
A risk management plan in your real estate business includes creating strategies for:
Preventing negative events from happening in the first place. A simple example of risk prevention is removing a pool from your rental property to prevent pool-related accidental injuries or drowning from occurring in the first place.
Reducing the impact of negative events when they occur. Using the pool example, a risk reduction strategy could include installing a safety fence around the pool, maintaining it in safe condition, adding safety covers on drains, and posting signs with pool rules.
Transferring the financial risk of negative events. A risk transfer strategy would include making sure you have the right insurance coverage in your landlord policy before your rent the property with the pool, as well as including a provision for tenant pool use in the lease, and what happens if the tenants do not follow the rules.
#1 - Limit liability with legal structure
Treat your rental properties like a separate business in terms of daily operations. For many rental property owners, that includes creating a separate corporate structure to hold their rentals.
The most common corporate structure for rental property ownership is the Limited Liability Company (LLC). An LLC is a type of business entity that provides protection from personal liability for business debts. Other benefits include:
- Pass-through taxation Unlike a traditional corporation, an LLC can elect to be a “pass-through” for tax purposes. Income is not taxed at the corporate level and passes through to the members (owners) of the LLC who report income and losses on their personal tax returns.
- Increased privacy An LLC plus professional property management can add an additional level of privacy for those property owners who do not wish to interact with tenants directly.
Because an LLC is a separate legal entity, this can impact the cost and process for both mortgage lending and landlord insurance. You will also need to follow corporate formalities, like keeping written records of quarterly and annual meetings of the members (even if it is just you in the LLC). While establishing and maintaining an LLC is generally low-cost, there will be some additional fees depending on the state your property where is located.
Is an LLC right for your situation?
Some property owners who only own one property and do not plan to increase their holdings may find it easier to own their properties directly while managing their liability risk with sufficient umbrella liability insurance. Direct ownership may also be preferable for homeowners who are house hacking. Remember to check with your financial planner, legal and tax advisors for guidance on your personal situation.
#2 - Transfer Risk With Insurance
All successful rental property owners utilize insurance as part of their risk management strategy. Insurance is a method of transferring certain types of financial risks from the rental property owner to the insurance company. The property owner pays premiums to the insurance company in return for the insurance company covering costs of large negative events, e.g., “bad stuff you can’t afford.”
Common types of insurance landlords use are:
Rental Property Insurance – Rental property insurance (also called landlord insurance) covers the building itself and other structures on the property in case of a covered loss such as damage from fire, wind or lightning, etc. It also provides some liability coverage in case you are found legally responsible for injury to a tenant.
Rental property insurance can include riders for additional types of covered losses, such as rent loss due to property damage which makes it uninhabitable, flood, earthquake, or other expenses to bring the building back to code after a covered event.
Rental properties require a rental property insurance policy. Your homeowner’s policy covers an owner-occupied property and generally will not cover most rental activities. For more on how to choose a rental property insurance policy, see How Much Of A Property Deductible Should You Carry?
Umbrella Liability Insurance – Umbrella insurance provides an additional layer of liability coverage above your rental property, homeowner’s, and auto insurance coverage. Umbrella insurance covers medical and legal costs of damage or injury to others for which you have been found legally liable.
Umbrella coverage does not cover losses from business activities, professional liability, or criminal acts.
Renter’s Insurance – Renter’s insurance covers damages and loss of property belonging to the tenant from events like theft, fire, flood, and weather. It is important for both the tenant and the landlord, as a rental property insurance (landlord) policy does not cover the tenant’s possessions. It also provides liability protection to the tenant if a guest is injured.
Best practice is to require tenants to obtain renter’s insurance as a component of the lease. This reduces your risk as a property owner and increases the chance that you will find a financially responsible tenant. Make sure to check at least annually for proof of rental insurance as there is the possibility of tenants allowing a policy to lapse.
Rent Default Insurance – Rent default insurance covers the loss of contractually agreed upon rent due to tenant non-payment. It may also cover eviction expenses. Consider this type of policy if you would be financially unable to pay the mortgage and ongoing expenses of your rental property during a period of non-payment of rent.
#3 - Best practices for rental property management
Leases and Rental Agreements – Every tenant should have a written legal agreement – no exceptions. A lease is a contract between a landlord and a tenant that gives the tenant the right to live in the property for a fixed period (e.g., 12 months), and outlines the responsibilities of both parties.
Creating a lease agreement that clearly defines expectations for tenants and landlord helps protect both the property owner and the renter.
Beyond the basics of identifying landlord and tenants, monthly rent, security deposit, and lease duration, a strong lease may include provisions for:
- Legal disclosures
- Maximum number of occupants
- Common areas
- Painting and other decorating
- Subletting and long-term guests
- Property damage
- Prohibited activities, such as smoking
- Unacceptable/illegal activities that are grounds for termination of the lease
Tenant screening Establish a fair, objective, and legal process for communicating and screening applications from potential tenants. You must follow the same procedures for tenant screening for every applicant. Depending on the laws of your state, the tenant screening process may include:
- Written applications for all tenant applicants. Following a strict procedure for due diligence on tenant applicants will help you document and comply with fair housing laws and avoid discrimination. Whatever standards you have, such as income requirements or credit score, must be applied equally to all tenants.
- Background check to verify the tenant’s identity, income, criminal history, and employment. Make sure to follow Fair Credit Reporting Act guidelines and use an approved consumer reporting agency. Note that the results of this screening are confidential.
- Eviction search to see if the applicant has had any recent prior evictions.
- Credit report from one of the major credit bureaus to view credit score, payment history, and negative events such as a tax lien, eviction, foreclosure, or bankruptcy.
- References from previous landlords or personal references.
Make sure you know and work within your state and local landlord/tenant laws as well as federal fair housing laws when you are establishing a policy for advertising listings or accepting/rejecting rental applications. The Fair Housing Act prohibits discrimination in rental housing and outlines applicants’ rights and landlord obligations.
Ongoing maintenance with regular inspections Inspect your property regularly. Rental property is an investment that has carrying costs of time, money, and attention. By inspecting regularly, and addressing any issues promptly that you find, you will maintain the value of your investment.
Regular inspections tasks include:
- Check to see if there are any small maintenance issues that require A leaky pipe, evidence of pests, or a hanging tree limb are examples of small things that could turn into much bigger problems if unaddressed.
- Verify that they are not any lease violations, such as additional tenants, surprise pets, landscaping neglect, or smoking in the rental unit.
- Noting items that are wearing out and require repair or replacement at some point, such as appliances, faucets, lights, carpet, paint, etc. Even if they are not urgent, offering to take care of them shows the tenant you care about their comfort in the unit and may help with lease renewals.
Remember that you cannot just drop by your rental unit whenever you please. Make sure to give your tenant notice before you inspect. Ideally, include inspection provisions and procedure in the lease.
Use licensed and insured contractors Make sure that any contractors who work on your property are licensed and insured. Do not assume that a contractor has both an appropriate license and liability insurance – you need to verify this. For major projects, such as a renovation, make sure that your contractor also has a surety bond.
Failing to use a licensed, insured contractor means that any liability for their project – including their subcontractors and employees -- remains with you. For example, if there is an accident or injury, the work is not up to code, or the contractor has damaged utility lines, you would be liable. Your landlord policy would not cover you if you knowingly hired an unlicensed contractor.
Documenting and handling tenant complaints is part of being a landlord. Think of your tenants as your customers or your clients. You need boundaries and a clear, strong lease and rental agreement, but you also want responsible tenants to be satisfied with their tenant experience.
Best practices for handling tenant complaints include:
- Include specific instructions in the lease for how tenants should handle maintenance requests and property emergencies.
- Encourage your tenants to let you know when something needs repair or attention.
- Communicate -- Respond to requests quickly and professionally.
- Take prompt action on problems when possible.
- If you have a tenant who complains constantly or frivolously, consider letting them out of their lease early.
Proactively remove or remediate risks on the property During your inspections (in person and drive-by), if you see something that could be a risk to the tenant or their guests, take care of it promptly.
#4 - Cash Flow Management
How you manage cash flow in your rental property portfolio can increase or decrease your risk, depending on what you do. With the impact of the Covid-19 pandemic, some rental property owners are confident they can navigate rent loss if they face it, while others are fearing that they may lose their properties.
To manage risk, property owners can focus on:
Robust emergency cash reserves
Building and maintaining sufficient cash reserves to pay for unexpected or large expenses is a key component of a rental property investor’s financial plan. Rental property owners need to have ongoing cash reserves for:
- Late or unpaid rents
- Maintenance & repairs
- Property taxes
- Seasonal or irregular expenses
- Insurance premiums and deductibles
- Emergency fund
- Down payment for the next property
Building sufficient cash reserves takes time for most rental property owners. If you are starting from $0, it can take 18 to 24 months with a cash flow positive property to build minimum cash reserves. See How to Build and Maintain Cash Reserves for Your Rental Property.
The risk of rent default is highest with a single rental unit. The risk of all your tenants defaulting at the same time is reduced as your number of rental units grows. Rent diversification:
- Smooths out portfolio cash flows
- Helps the rental property owner weather economic downturns (like Covid-19)
- Makes it easier to budget for vacancies
In many ways, real estate investing resembles entrepreneurship more than securities investing. One of the reasons real estate has the potential to deliver outsized returns is that most investors are concentrated in their real estate portfolio, not diversified. They own only a few properties, or they focus on a particular neighborhood, or component of the real estate sector.
Most landlords have some concentration risk. The risk is highest with the first property and typically tapers slowly as the real estate portfolio grows. Rent diversification increases by:
- More units
- Investing in different geographic areas
- Investing in different types of income-producing properties
- Adding additional revenue sources, such as paid parking, storage, or coin-operated laundry.
#5 - Use financial ratios and metrics
It will not surprise you that I encourage real estate investor clients to track their numbers. Clearly, as a CERTIFIED FINANCIAL PLANNER™ and CFA® charterholder, it is obvious I like math. Using financial ratios and metrics in your real estate ventures will:
- Set guidelines and goals for your rental property portfolio
- Define how you will measure success
- Make comparative judgments (between properties, financing choices, etc.)
- Help you make more confident financial decisions about your real estate business.
Common ratios in real estate include:
Rental return is the amount of rent you receive from a unit or property expressed as a percentage of the acquisition costs (purchase + renovations) of the property. For example, a property that generates $3,000 in gross rent per month on acquisition costs of $250,000 has a 1.2 percent monthly rental return. Successful income property investors follow the “one percent rule,” aiming for a monthly rental return of one percent or higher.
Rental Return = Gross Monthly Rent ÷ (Purchase price + necessary renovations)
Cap rate is the ratio of an investment property’s Net Operating Income (NOI) to acquisition costs (purchase + needed renovations/repairs), expressed as a percentage. Commercial real estate investors focus on cap rate, but it can also be used for rental properties to assess potential profitability.
Cap Rate = Net Operating Income (NOI) ÷ (Purchase price + necessary renovations)
Net Operating Income (NOI) = Gross Income – Operating Expenses
Operating expenses include:
- Property taxes
- Maintenance and repairs
- Utilities paid by the property owner
- Other business expenses
- Reserve for expected vacancies
NOI does not include interest costs. Cap rate looks at the property itself, without evaluating the potential use of a mortgage to purchase the property.
Return on Investment (ROI) is the ratio of your annual return (revenue -net of operating costs and interest) to your acquisition costs (purchase price + needed renovations), expressed as a percentage.
ROI = Revenue - (operating costs + interest) ÷ Acquisition costs
Vacancy rate is the percentage of time a rental or portfolio of rental units is unoccupied. Vacancy is typically projected on an annual basis.
Vacancy rate = Projected number of days vacant ÷ (Available Rental Days x Units)
Target leverage ratio is the level of financing that you plan to maintain expressed as a percentage of the total value of your properties.
Target leverage ratio = Target debt ÷ Total rental portfolio value
The higher the target leverage ratio the higher the potential risk. Leverage magnifies gains, but it also magnifies losses. Some investors are more risk-seeking than others and prefer a high leverage ratio. Others have a lower risk tolerance and prefer a lower leverage ratio.
Know your risks
All investments have risks. As a property owner – like all business owners -- a good risk management process will help you prevent those risks that you can control, reduce risks where you can mitigate them, and transfer risks with insurance.
This blog is for general financial education purposes. Information contained in this blog should not be construed as financial, tax, real estate, legal or investment advice. For educational purposes, blog posts may contain links to other websites which are not under the control or and are not maintained by Real Life Planning. Real Life Planning has provided those links for your convenience but does not necessarily endorse all the material on those sites. Please consult your financial, real estate, legal, or tax advisor for advice specific to your situation.