Insuring an investment property is something every investor will want to do.
In truth, it’s probably an expense an investor would like to skip, but seeing your hard work and money go up in smoke is a nightmare that can ruin years of work. Here’s how to avoid that, or at least insure against it.
Actual Cash Value Policy vs. Replacement Cost Policy
How do you choose the right insurance?
For homes that will need some fixing up, the choice may be partially made for you, because you may be limited to an actual cash value (ACV) policy. That means the insurance company will give you only enough insurance to cover what you paid for the property, minus the value of the land it sits on. This often occurs when the house is older and the plumbing, electrical, and roof have not been fully updated.
The downside for those insured with an ACV policy is that if the structure sustains major damage, there likely won’t be enough money paid out to rebuild. In a worst case scenario, you may have only enough money to pay off the loan and be left with a vacant lot or a damaged building. But an ACV policy is still better than nothing and will often be sufficient for small losses, especially if you are prepared to pay a bit more than the deductible (because of depreciation) or do some of the work yourself.
An important note about ACV policies is this: about one-half of them don’t cover water damage from frozen or broken pipes. In some cases, you just can’t get it because of age or something else. But at least it’s good to know that up front or get it endorsed to the policy if you can.
On the other hand, a replacement cost policy is the preferred option if you can get it. The coverage is better, and it will pay for the full cost of a covered loss (minus your deductible) or even to fully rebuild the house, if necessary. To qualify, the property must be in good condition, with the roof and paint in good shape. I can’t tell you how many times over my years in insurance I’ve come across houses that couldn’t get a good policy because of the condition of the roof or siding. Other problem issues include a lack of gutters, no handrail on the stairs, and debris left in the yard. Don’t let your renters leave an old appliance or broken-down vehicle in the yard. An insurance inspector will usually cancel the policy if they see that.
When looking at a replacement cost policy, make sure the dwelling coverage (Coverage A) involves enough of a payout to rebuild, based on what contractors are charging in your area. In some cases, this number may not be even close to what you paid for the property. It could be much more or much less, and a lot of people are surprised by that. It does not matter what you paid; it matters what a contractor will charge you to rebuild that same home in the same construction style on the same lot.
With most policies, if you are more than 20% under market costs, you will be subject to a coinsurance penalty. This means that if the home would cost $200,000 to rebuild, and you are insured for less than 160,000 (80% of value), any claim you have will be paid out at the same ratio. For easy math, if the value is $200,000, and you insure for $100,000, you are at 50%. If you have a toilet overflow that causes $8,000 in damage, the insurance company would pay only 50% of the cost—$4,000, minus the deductible. This is because you were only insured at 50% value on the home. Watch for this, and make sure your house is insured to full replacement value. (Note that with an ACV policy, you can usually get one that will pay 100% on partial losses, even though the home coverage is not at replacement value.)
Next, make sure your policy includes outbuildings (garage, shop, etc.), if you have any. Also look for “loss of rents coverage.” If your renters have to move out after a fire or other covered damage to the home, this will pay you the rent you would have collected from them during that time.
Lastly, make sure you have liability coverage on the home. Common limits are $300,000, $500,000 and $1,000,000. It doesn’t cost much to get the higher coverages here, so it’s almost always worth it. If someone gets hurt and sues you, this coverage is a lifesaver. I recommend requiring your renters to carry their own renter’s insurance as well. It’s very inexpensive for them in most cases, and if they are found liable or negligent in an injury, it’s good to have a policy for that claim to go against rather than having your insurance be the only option. And while we are talking about tenants, don’t let them have dangerous dogs or other pets. If you’re a serious investor, you don’t want a dog bite claim on your record. Insurance companies hate those.
I hope that helps you out on your journey toward real estate success. And keep in mind, having a good agent who can look things over for you is always a plus, but being armed with at least basic knowledge is extremely valuable for every real estate investor.