There is a new set of negotiations taking place between real estate lenders and serious property investors about a subject that often seems like an afterthought — insurance.
It’s a subject that investors may skirt over in their quest to expand their real estate portfolios and start bringing in rent as quickly as possible. Why prioritize this “cost center” when they could be spending their time investing in even more rentals? Why not go with whatever risk management approach has worked for them in the past?
Mortgage lenders, too, have an interest in providing a fast and easy closing experience for every real estate investor for a competitive advantage.
But these lenders must take the long view when writing mortgages on a new set of income properties — or later, when they’re preparing to sell investors’ real estate portfolios into the secondary market. Concentrating on speed alone is not always prudent in these situations. It’s critical that both lenders and investors look more comprehensively at their risks given new complexities, such as increasingly intense storms and severe flooding. This is especially true when real estate portfolios stretch across multiple municipalities or states.
Lenders who plan to securitize and sell these loans must also ensure that all coverage meets secondary market requirements. Otherwise, they may be in violation of their investor covenants and subject to related financial losses.
For these and other reasons, lenders, investors and investors’ insurance agents are coming together to ensure everyone’s needs are or will be met.
Closing the Valuation Gaps
What makes these collaborations difficult, though, is that these parties don’t speak the same language when it comes to the value of what they are protecting. They’re basically approaching an identical question from opposite ends.
Lenders tend to care about two measures: the value of the home (such as market value), and the interest rate borrowers (real estate investors) are paying. That interest becomes their “yield pad” and if investors lose rental income, then lenders’ profits are potentially eliminated. It’s this scenario, too, that may put them in jeopardy of violating investor covenants — ultimately reducing their cash flow and the money they have to lend to others.
Investors and their insurance agents, on the other hand, are interested in the insured value — or obtaining the maximum possible payout should a loss occur.
Collectively reviewing coverage at loan origination as well as regularly afterwards can help to assure that all parties’ needs are continually met.
Illustrating the Disparity
Consider this fictional scenario: Gary is an investor from the Northeast. His LLC has purchased and refurbished five older multifamily homes, which they will market to renters when he returns from a winter vacation in Florida. While he is away, one of the houses catches fire and burns to the ground.
The market value of the home is $1.5 million. The loan balance is $1.2 million. The replacement cost has been estimated at $2 million, but the lender requires the property only be insured to the loan amount ($1.2 million), which Gary uses as the insured value of the home.
The insurance company will only pay the limit of liability on the insurance policy ($1.2 million), leaving Gary with enough funds to satisfy the mortgage, but not enough to repair/ replace the multifamily home, causing cash flow issues to his business as well as the portfolio of rental properties and associated debt/interest service expected by the lender. Gary has to delay future investments/financing. The lender is out a significant amount of interest that it would have earned had the loan remained active while reconstruction was completed, and the course of normal business is interrupted for both parties.
This kind of scenario illustrates where more deliberate collaborations between lenders and real estate investors can be especially beneficial. A lender might want to agree, in advance, to reimbursement of commercial investors for replacement costs in these situations. That way, borrowers will have more capital to deploy on more deals — helping all parties to reap the rewards.
Examining Categories of Coverage As property investors know, many insurance policies are very specific — carving out exactly what is covered and excluding everything else. Basic peril coverage is a case in point, covering only such categories as theft, ice and tree damage.
Broad peril insurance goes a little further, often covering damage from burst pipes, for instance. Even blanket coverage doesn’t really live up to its name; named storms and floods are unlikely to be included, along with war and terrorism.
Both lenders and investors need to be aware of these limitations and take appropriate action — particularly in areas with known risks. Examples are coastal properties in the Northeast, some of which must be insured through state-sponsored plans, versus private ones.
The time for both parties to empower themselves with insurance knowledge is now. The Mortgage Bankers Association (MBA) expects multifamily and commercial lending to increase again in 2023 after some cooling down this year. By aligning their individual needs with the common goal of increasing their profits, lenders, investors and insurance agents all stand to gain.
Thomas Price is president of Incenter Insurance Solutions, a provider of insurance services and solutions that help clients obtain coverage while advancing their personal or business goals. The firm’s flexibility and partnerships with dozens of carriers enable them to custom-design solutions with creative precision.
