How to protect your investment property from liability

How to protect your investment property from liability

New investment properties can be nerve-wracking for most people. On the positive side, you can get cash flow and appreciation. On the negative side, you are taking on significant liability and run the risk of getting sued. All it takes is one tenant who slips and falls on the stairs to sue you, and you are in trouble. That’s why it makes sense to spend a lot of time thinking about how best to protect your investment property from liability.

After all, the last thing you want is to get a knock on the door from a legal server.

In this guide, I’ll breakdown exactly how you can protect yourself from liability. I’ll show you a couple of different strategies, explain my thoughts on which one is the best, and then help outline how to put this plan into action.

One thing to note right off the bat: I am not a lawyer so please don’t view this as legal advice and consult your own lawyer before doing anything. I am merely mapping out exactly what my fiancee and I do to protect our own property. Since we use this strategy, it is safe to assume that we believe it’s a good one!

Getting started with real estate investing

So, congratulations! The fact that you have picked this book means that you have the intention to work on your real estate investment game. Maybe you have even already started the journey in real life. After all, real estate is the fastest way to wealth.

According to Andrew Carnegie, a whopping 90% of millionaires have reached their financial status because of real estate. However, with any good thing, there is always risk. No, we are not talking about that old superstition that your tenants will call you for something menial, such as fixing their toilets.

In fact, if that is your only problem, then you should be alright. You can simply solve it by either doing it yourself to save costs or by hiring a regular maintenance staff or property manager.

The big problem here is having a tenant slip and break their leg because your wobbly banister did not provide them support. If you are doubly unlucky, said tenant is also old and would have suffered a broken hip. You can get sued for that.

What is worse: the tenant may be a middle-aged breadwinner whose working years are still ahead of him. You may have to pay not only for hospitalization but also for the salary that he will lose during his recuperation.

This is, without a doubt, your worst nightmare as a real estate investor.

Why could you get sued for a wobbly banister?

If you’re asking why this could lead to a lawsuit, that’s a totally reasonable question. I had similar questions as well.

The reality is a tenant can claim that you provided a non-habitable property due to the health and safety risk. Even if the case gets dismissed as frivolous, you’ll have spent significant money on a lawyer and endured stress.

Even worse, let’s imagine you got the house inspected. A good lawyer will request a copy of the housing inspection. Check out this inspection below:

Check out that red safety issue: the garage door didn’t go back up if it sensed something. The inspector flagged this as a safety issue and you thought it was silly.

However, now someone actually got hurt on the garage door and their attorney now has your inspection report.

In this case, you provided a non-habitable home AND were reckless. After all, you had written documentation stating that this was a safety issue.

Their lawyer will now argue that you knew or should have known, it was a safety risk. Now, they’re suing you for even more money.

Is it worth getting worried about being sued?

All in, your odds of getting sued are low. Let’s say there is a 0.25% chance you get sued by a tenant in a unit in a given year. It’s extremely low.

Check out the math:

Your odds of getting sued increase with every additional unit you add to the portfolio. If you have 10 units with a 0.25% chance of getting sued from each tenant, then your overall risk is 2.5%

For illustration, we have 13 units right now. Under this simple model, the odds say we have a 3.25% chance of getting sued this year.

The “this year” part is key here. After all, if you are a buy and hold investor, then you’ll own the property for more than just one year. Now let’s look at how that changes the numbers:

In this model, holding property for longer also increases the odds you can get sued. It’s similar logic to above: if you hold a single unit property for 10 years and your risk of getting sued is 0.25% per year, your total risk is 2.5% you’ll get sued over a 10 year period.

The implication is this: the more units you have and the more years you hold those properties increases the odds that you will get sued.

We own 13 units. Under this logic, it’s more likely than not we’ll get sued at some point in the next 20 years. It’s for this reason we have this system to protect our liability.

Our liability prevention strategy for our real estate investments

Our Liability Prevention StrategyWhen we invest in real estate, we use a multi-pronged strategy to protect our liability. In this post, I’ll walk through each step of the liability prevention strategy in detail.

Our strategy is:

  • Property Insurance: standard liability prevention
  • Umbrella Insurance: the enhanced option
  • LLC Protection: why a separate entity is your best friend
  • Legal Blanket: How to make sure no lawyer can sue you
  • Treating tenants right: The basics of keeping tenants happy.

Let’s dive into detail on each of these:

Tactic #1: Property Insurance

Right off the bat, you’ll need property insurance. If you ever plan to have a mortgage on the property, then you need insurance. The bank won’t give you a loan otherwise. Consider this level of liability protection the “table stakes” option.

It’s for that reason 95% of homes in America have property insurance.

That makes the more interesting question: what are the types of insurances to consider?

ValuePenquin has this nifty analysis that shows you the majority of homeowners use an HO-3 option. Don’t worry if you’ve never seen the HO-s described as HO-s before!

HO-1 and HO-2 are peril policies, which means it’s only covered if it’s explicitly mentioned in the policy. For example, if your policy doesn’t explicitly say “theft” and you get robbed, then you won’t be covered.

HO-3 policies are open-ended, which means they should cover almost everything. It’s why 78% of homeowners opt for this kind of policy. I think it’s a smart decision as well.

Now, don’t just stop at the type of insurance policies there are. You also need to know what the coverage really means. Will it provide you with the actual cash or will you be getting replacement cost?

Actual cost value vs replacement value

ACV is insurance companies usually prefer. The actual cost value, otherwise known as the market value, is equals to the replacement cost minus whatever depreciation the property has undergone.

So, you will basically get your property’s exact market value at the given time that you try to claim your benefits. To put it in a different way, it is what your property (or its part) would cost if you have to sell it at that given time.

Some insurance policies may consider outdated design as a cause for depreciating values. However, others may not. This is why you need to read the fine print

Replacement value is preferred by policyholders. Why? Well, the amount that they will get back is the amount paid for such a property when it was still new and intact. This compensation is favorable to you, especially if you have had the property for years. The amount will not be deducted based on its wear and tear.

It will, instead, depend on the materials that you will need to rebuild your structure. Anyone who is building knows that they want the finished product to look brand-new, or else what is the use of renovating?

How do I find an insurance expert to help me?

Auto, Home, Life, & More American Family Insurance

You’ll need someone to help you get your property insured. There are a lot of online marketplaces you can use to help people find different insurance policies.

I am a strong believer though in the need to have a specific person to pick up the phone and call. You want that personal connection in case you ever need to submit a claim.

Having a close relationship with an insurance expert is also part of our process of buying properties. If I see something interesting, I send it to our insurance guy at American Family. He gets me a quote back, since we send him so much business, in less than an hour.

The trick to finding a guy like this is to ask your agent. Once you have a potential deal, ask your agent to give you the names of their three favorite insurance agents.

Call all of them, and then speak to them over the phone. I don’t have any specific questions that are helpful to ask. We made our decision on who to hire based on who was most responsive on the phone with us and who we felt was a good person when we spoke via phone.

How much does property insurance cost?

Insurance is not that costly if you aren’t in a flood zone.

For our six-unit, we pay $179 a month

 

For our seven-unit, we pay $122 a month

 

All in, it’s almost exactly $300 a month for 13 units. Will take it.

Tactic #2: Umbrella Insurance

Umbrella Insurance

For any effective war strategy, you will see that there are several lines of assault and defense. In real estate investment, you have to focus on your lines of defense. To protect your property, you have to ensure that you have not just one means.

This way, if one ends up breaking down, you still have something solid standing.

What better way to protect your investment than with an umbrella policy? The very term promises protection from a rainy day.

Umbrella insurance is usually your go-to insurance when you have exhausted the limits of your other policies. If, for example, you have a $500K  property insurance policy.

If something happens that has a bill of more than $500K, you typically have to cover that. With an umbrella, the umbrella will handle that.

Here’s an example. Let’s imagine someone accidentally forgets they have a candle burning. Your property burns down, which is covered by the first line of defense in your standard property insurance. But, let’s say all the cars in the parking lot burn too. Those aren’t covered, and you are on the hook for them.

It’s no wonder that 80% of people with “considerable wealth” have an umbrella insurance policy.

That’s where umbrella insurance will kick in:

The advantages of an Umbrella policy are pretty substantial, which makes it extremely attractive to real estate investors. Here are a couple advantages that I like about the policy.

  • It has a wider scope.
  • It covers not just the policyholder, but also the rest of the household.
  • It specifically covers injury to others, such as a tenant.
  • It covers property damage.
  • It can be pretty affordable.

Why are umbrella policies affordable?

Umbrella policies are shockingly affordable. In fact, the average cost of a $1M umbrella is reported to be only $150-$300 a year.

The reason why is umbrella policies are rarely used. A customer needs to exhaust all of their other insurance before the umbrella kicks in. That means them not likely and insurance companies price them affordably.

Why do you need an umbrella policy and homeowners’ insurance?

It should be self-explanatory by now, but the umbrella is adding both depth and breadth to your coverage. The umbrella adds more stuff to your coverage and adds more coverage to the things that are already covered. Even better, it does this at a relatively low cost per year.

How do I find an umbrella insurance broker?

The insurance guy you found above for your property insurance should also be able to get you an umbrella. When I send a new property to our insurance guy, we automatically quote us for insurance and an umbrella.

How much do you pay for an umbrella? And in total?

We pay $22.92 a month for our umbrella each month.

All in, that means we pay $324 a month for both our regular insurance and our umbrella.

Even better, our umbrella is $3M so we have extra coverage there as well!

Tactic #3: The LLC

LLC

Speaking of taking all the protection that you can get, let us move on to our third level. By this time, not only do your assets have walls surrounding them, they also have a gated structure. The third layer can provide the spikes that will help serve as defense rather than assault weapons. That will be your LLC.

Should I have an LLC or Umbrella insurance for my rental property?

This is a hotly contested issue in the real estate world. Do a quick Google search and you will find passionate people who believe in both strategies. Go on to BiggerPockets and you’ll find people just going to town on each other and calling each other stupid for it.

I know the naysayers will start with the cons, so we will go down that road first, as well. Here are the “cons” of owning property in the LLC.

  • It costs money to set up an LLC
  • There is added managerial hassle on your end to ensure that you don’t compromise the integrity of the LLC
  • The LLC is not a foolproof strategy to protect yourself

All of these points are factually true. There are also completely stupid reasons to not get an LLC. Here are a couple reasons

It costs money to set up an LLC

Yes, it does. So does everything else on this list. Protection costs money. You’re not going to skip having insurance on your property because it “costs money.”

We use Legal Zoom to set up our LLC’s simply because it’s easy to do. We always do the “economy” package, which when combined with state fees, is typically around ~$300 or so. This is also a one-time fee. Remember, we’re paying $300 for our umbrellas and property insurance each month. $300 for a one-time set up fee is absolutely worth it.

To be fair, there are other fees you need to use to keep your LLC up and running. The biggest is the Registered Agent fee. This means paying someone to serve as the point of contact for you for the LLC and handle paperwork and similar. We also use Legal Zoom for simplicity, which ends up being another ~$150 bucks a year.

I don’t think it’s that much for a yearly fee when compared to what we pay each month for insurance anyways.

There is added hassle to manage an LLC

This is also true.

There are a couple of things you need to be careful about to keep the integrity of the LLC. The biggest is co-mingling funds, which essentially means you can’t keep your LLC money with personal money and you can’t pay for things in the LLC with personal money.

To do this, you need a separate bank account. This sounds like a hassle, but the bank will help you out on this. Remember, the bank makes a lot of money when you take out a mortgage. If you ask them to help you create a new bank account for you, they’ll be happy to do so.

We do this as part of our standard process of buying real estate. It typically takes us 5 minutes to sign the paperwork, but they do all the heavy lifting to set it up for us.

Once the bank account is set up, it’s a lot easier to keep funds separate than you think.  If you don’t get a debit card, then it’s hard to spend LLC money anyways.

LLC communication does matter

One step that does matter for the LLC is keeping communication separate. An LLC is a business, so you need to keep communication separate like you would a business.

For us, part of our process is to create a new Gmail account for every LLC. Let’s say we’re buying 123 Main Street in Chester, New Jersey. We might set up an LLC called 123 Main Chester LLC. I’ll set up a Gmail account called 123mainchesterllc@gmail.com, and then set up auto-forwarding to our actual email addresses.

That way, if anyone emails the LLC’s Gmail, we’ll get it sent directly to our real inbox. Then, I’ll go into the other  Gmail account and reply.

It took ~5 mins to set up, and takes maybe an extra 30 seconds when replying to emails.

So, for every negative point, we can easily find a positive. Now, let us take a better look at the perks of using an LLC.

The LLC is  not foolproof

Totally true. You could still get sued with an LLC. You could also have the LLC pierced.

But, you could also have an accident that goes above the cost of your umbrella insurance. None of these solutions are foolproof.

We personally believe it’s worth $300 in setup and $160 in yearly cost to have the extra layer.

Why you should use an LLC for your investment real estate?

The very name Limited Liability Company speaks volumes about what it can do. While corporations are recommended to bigger companies, the LLC works better for smaller ventures such as your real estate one.

  1. An LLC separates your business assets from your personal assets. When you lose as a real estate investor, you only lose the money that you have invested in it. This will not affect your personal assets, such as your vehicle or even your family house. It may, on the other hand, affect vehicles that you have bought under the business name. Perhaps these are vehicles that you have allotted to your maintenance staff. So, your personal debts remain as personal debts and your business debts remain as business debts. They are separate.
  2. An LLC does not need an elaborate setup like a corporation. With an LLC, you don’t need to have annual meetings or reports. It is a small company and there is no need to update several shareholders. You can go ahead and live your personal life without worrying about what else you need to do for your investment all the time. In fact, you can have a day job and even a second, freelance one. The setup allows you to put your eggs in different baskets.
  3. There is more ownership flexibility in an LLC, if you compare it with a corporation. There can be more or fewer owners, depending on what suits you. Start with a small group of people, though. This way, you don’t have to deal with the wants and needs of others. You can do it your own way, first. Then, there will be no other person to blame for any losses but yourself.
  4. Even as you get away from more intense liability, you are also rewarded with an easier to handle tax classification. You can, of course, classify your business a sole proprietorship. This way, you evade the double taxation of corporations the legal way. I would like to emphasize the legality of this. You are, after all, handling a smaller business.

What is the total cost of this protective stack?

  • The property insurance and umbrella added up to $324 a month.
  • For the setup cost, let’s assume we own the property for 10 years (120 total months). If it’s a $300 in setup cost, then it’s $300/120 months =  $2.50 in amortized cost to set up the LLC per month.
  • There’s also the registered agent fee of $160 a year, which is $160/12 months or $13.33 a month.
  • The total cost of our protective stack thus far is $324+$2.50+$13.133 or $340 a month.

But remember, we have 13 units. It means we’re paying $26 dollars a month for insurance, an umbrella, and an LLC.

We personally feel that cost is worth the protection. We’re also not completely done with our liability strategy.

Tactic #4: The Legal Blanket

The Legal Blanket is a sneaky strategy to prevent yourself from getting sued. It’s really sneaky actually.

I read this strategy in a book (Multi-Family Millions), so I can’t take any credit here. However, I hope it prevents someone here from being sued.

Here’s how the legal blanket works. Let’s imagine your property in Grand Forks, North Dakota. Unfortunately, this doesn’t work in a bigger metro area.

If you Google “Grand Forks Real Estate Attorney“, you’ll find 17 options in the city. This includes a dozen lawyers as well who work in other areas, like divorce law.

Now, call all of them and schedule a 10-minute consultation with each of them.

Make sure this is a paid consultation for the LLC that owns the property. In other words, the LLC is paying the lawyer here. It’s okay, these fees should be tax-deductible since the business is paying for it.

The average cost per hour is $225. For a 10 minute consultation, this means you should expect to pay $37.50

If you do a consultation with all 17 law firms in the area, your total cost will end up being $637.50.

Why do you have a paid consultation with all the law firms?

The key word here is “paid.” Since your LLC paid for the consultation, your LLC is now considered a client of that law firm.

Check out this quote from lawyers.com:

“It is not ethical for two attorneys in the same firm to represent opposing parties without the written consent of both parties to waive the obvious conflict of interest”

Said differently: you are now the client of every firm in the area. That means these firms cannot ethically represent anyone who tries to sue you.

How can someone sue you if there are no lawyers around who can represent them? Will someone keep trying to find a lawyer if the first five they contact all don’t take the case?

I told you it was sneaky.

The downsides of the legal blanket

This is some sneaky, Harvey Spectre shit right here. It can absolutely work, but there are definitely some pretty severe downsides to it.

The first is that this can obviously only work in smaller areas. If you try doing this in New York City, you’ll fail because there are hundreds of law firms. The only way this works is if you are in a smaller area.

The second is the amount of time and expense required. You only need to meet with the law firms once, but scheduling and going to all these consultations will take a significant amount of time. You also have to pay to do so, which can add up quickly.

I think the Legal Blanket strategy is sneaky, brilliant, and only makes sense if you have a lot of units concentrated within a finite area. It’s not worth the hassle. And remember, your odds of getting sued only increase if you have a lot of units.

What is total cost of protection thus far?

We own 13 units, but they are in two different states. For illustration though, let’s keep the math building.

Thus far, we’ve spent $340 a month for property insurance, umbrella insurance, and the LLC.  Now, let’s add on the blanket.

Let’s stick with $637.50 across 10 years ago (120 total months). Amortized evenly across those months means $5.31 a month.

We’re now at $345 a month for all of this protection. One more level of protection left, and it’s arguably the most important.

Tactic #5: Be a good person

This whole piece is about how not to be sued. We’ve covered a couple of different tactics on how to do so that provide a variety of different protection for different costs.

I spent time trying to find data on this, and couldn’t. But, I generally believe that being a good person will decrease the likelihood that your tenants will sue you.

Said plainly: if you’re a dick, then your odds will increase that you’ll be sued. If you are kind, then your odds will decrease.

Being a good person does not mean be a push-over either.

How to be a fair landlord without being a pushover

For example, we have a tenant at one of our properties who cuts the grass in exchange for $50 a month off of his rent. That’s a good price for us and a good deal for him.

His lawnmower broke and he asked us for $100 off rent to buy a new one.

A dick landlord would say no, tell him to buy his own, and then increase his rent $50 if hadn’t done so promptly because the grass wasn’t being cut.

We took a different approach. We told him we’d be happy to knock $100 off his rent if he buys a new lawnmower. The one follow up though was we asked for a receipt for the mower.

This is a fair situation for everyone. He gets a new lawnmower (that’s his BTW, not ours….he can use it to cut other lawns on weekends to make extra cash if he would like), and we get a happy tenant. However, we also make it clear that we need verification by asking for a receipt. You can’t just skip rent without verification!

My fiancee and I think this is a good example of how to be fair to tenants, but also standing our ground and not being a pushover.

Why being a fair landlord lowers your chances of being sued

Again, I couldn’t find any data on this. But we firmly believe that by treating our tenants as the human beings that they are prevents tenants from getting pissed off at us. You have to be pretty pissed to sue someone.

If we can keep an amicable relationship by doing right by our tenants, then we make sure we don’t get sued on the back end.

Liability protection means a multi-leveled strategy to maximize your protection

This last chapter will be looking at all the safety nets that have been discussed. Together, you can call them your protection stack.

To recap, this means having regular insurance, an umbrella policy, an LLC, a legal blanket, and treating people right. Some of you may think this is overkill. Others will think of this as too expensive.

Others may also rightfully point out that we are not lawyers and that we are missing something!

Here’s why we think this is a good strategy though.

The set up for our legal stack takes 2-4 hours a year

Our stack takes very little time to manage. We have a nice benefit in that we have existing relationships with our insurance guy and use Legal Zoom a ton.

However, managing this entire stack can be done in part of one Saturday afternoon or maybe even an evening after work. With that little time commitment, I’m absolutely okay investing this time.

The cost for our stack is minimal at $345 a month, and being a fair landlord is free

$345 a month for 13 units is really cheap when you think about it. It breaks down to roughly $26.50 per unit.

However, our average unit rents for $500 a month. That means we’re paying approximately 5% of our monthly income for protection.

I’m absolutely okay with that ratio if it lowers our odds of being sued.

Some might say that 5% of your rent is a lot. However, remember the table from the beginning: if you own enough units for long enough, then it is mathematically inevitable that you will eventually get sued. I think 5% of the rent is worth it to keep our lives stress free and lawsuit free.

It’s also an investment in not having to pay a lawyer $225 an hour for hundreds of hours to defend us!

Maybe our stack is overkill, but wouldn’t you rather be safe instead of sorry if it’s only $26 per unit?

This is the piece that many people latch onto. You’ll probably hear some investors say that this is overkill. I’m sure people will say so in the comments.

And you guys are totally okay to say that and believe that.

But, my fiancee and I project out to own 500 units over the next 5 years. We’d rather be safe instead of sorry for the investment of only $26.50 a month.

Here’s how we see the math working out in our favor:

This chart highlights the same odds of getting sued of 0.25% per unit per year. For the next 5 years, I’m showing the number of units we expect to own by the end of that year.

Our odds of getting sued per year is simply that 0.25% per unit per year number multiplied by the number of units we expect to own. Insurance cost per year is the number of units multiplied by that $26.50 number we calculated out together.

Based on our financial forecast model, we expect to own over 500 units by 2023. In that world, we expect an over 100% chance of getting sued.  In that world, we also plan to spend over $5,000 on the insurance stack that year.

$5,000 is a lot of money to spend on insurance, for sure.

But, if you are expecting to get sued due to the law of big numbers, is it really that much?

Why we hope the stack prevents or solves problems easily

Let’s say something goes wrong, we get sued, we have to dip into insurance, whatever.

Property insurance and the umbrella should cover a lot. If it doesn’t cover enough, the LLC exists to protect us personally. If someone really has a bone to pick and tries to sue us for all the money in the world, the legal blanket hopefully prevents them from doing so and leads them to drop it.

I’m willing to spend $5K on all that protection if I think it’s mathematically inevitable it  happens

Conclusion

Thank you all for following along with this very long piece and your patience in the matter. My hope is that this post will help you in your own real estate liability needs.

Please let me know in the comments if  you have any thoughts, questions, or comments!

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