All about earthquake insurance

Potential apartment building owners occasionally ask me about earthquake insurance, which is not included in a standard property insurance plan. It’s kind of scary for owners with commercial mortgages, because recourse loans require you to pay up, even in the event of the building being seriously damaged or destroyed.

 

I’ve never bought EQ coverage on any of my properties, mostly because of a vague sense that it was unaffordable (and because we don’t use recourse leverage). But I thought I’d dig into this a little to learn for myself and for you, my dear readers.

 

I therefore arranged to interview John Place, from Winston Insurance via email. I met John when I was buying my first deal and realized literally on the day of closing that I had not arranged any insurance coverage. In a panic, I called him because he had arranged coverage on the building for the previous owner. John got us covered that day, which was amazing. And he’s had all my business since.

 

He doesn’t know this (well, now he does!), but I occasionally shop around to see if his quotes are legit and no one has ever beat him by a material amount.
That said, here’s the interview:

 

Can you get earthquake insurance for a 4 to 12 unit apartment building in Los Angeles?

 

Commercial earthquake insurance is available for habitational risks of four units and up, however, some carriers have a minimum requirement of five units.

 

Is there a good way to estimate the cost based on the number of units or the square footage? (Would appreciate as much detail as possible on this one.)
There are many risk factors underwriters consider to determine pricing; they include the buildings age, construction type, location, if its secured to the foundation, the total insured value, etc.  The biggest price determinant being what EQ zone the property is located in.

 

Do you sell much earthquake insurance to LA apartment building owners? Why or why not?

 

We insure quite a few clients with multiple unit dwellings.  While the potential catastrophic damage that may occur from an earthquake is a concern for most of our clients, it does not appear to be a strong motivator for acquiring earthquake coverage.  For many, the cost is prohibitive.  I also believe the longer we go without a major earthquake the less important the coverage seems to be.
Is there anything in particular a building owner should know before he goes shopping for earthquake insurance?
An owner should understand that the decision to obtain coverage is a personal one.  There’s no right or wrong answer…the coverage is not required by law.  Earthquakes are inevitable, however, they’re unpredictable in both their magnitude and destruction.  The decision to obtain coverage is simply a matter of affordability and ones own risk tolerance.
Can you give me a ballpark quote on earthquake coverage the following building:
  • 8 units
  • 4800 sq ft
  • Zip code 90026
  • 1960s
  • Stick / stucco construction
  • No tuck-under parking
  • Rents of $1,000 / month each, so $96,000 / year
Including loss of rents of $96,000 for the example given and depending on the deductibleselected; the pricing  ranges from $0.74 /$100 of property value ($8,100 pure premium at 15% deductible) to $1.12/$100 of property value ($12,300 pure premium at 5% deductible).

 

The insurer  would then add taxes/stamp fee (3.25% of premium) and any inspection/policy/broker fees to the premium.

 

These property rates may fluctuate slightly from carrier to carrier.

If someone wants to buy insurance through you, how should they get in touch with you?
For a quote [MK: on EQ insurance or any other type], I can be reached at 909.581.7218, or email me at john@winstonins.com.

Why you get the rents buttoned-up BEFORE listing a property

Recently, I closed on a deal where the seller inflated the rents in the marketing materials. It was an unpleasant experience for everyone involved, including the buyer, seller, agents and tenants. Here’s what happened:

One of the tenants had applied to the landlord for permission to move a new occupant into his unit. Per LA rent control, the landlord can increase the rent by 10% for each new occupant who is not a minor dependent of the existing tenant. One important caveat is that the landlord must issue the tenant a notice of increased rent within 60 days of “actually or constructively” learning about the new occupant. Obviously, this creates some wiggle room for the tenant, who can claim that the landlord knew but didn’t issue the notice in time.

The seller did not accept the tenant’s application officially, but he did market the property with the rent for that unit increased by 10% (which worked out to roughly $200 per month). The listing agent didn’t know the rules; otherwise, he would have insisted that this problem be buttoned up BEFORE putting the property on the market.

Not knowing anything about this, we offered roughly 10x annual rents to buy the property and we agreed to a deal at 11x. Then we began our due diligence process, which included looking at all the leases and estoppels for each of the tenants. (This is where I beat the dead horse: ALWAYS REVIEW THE ESTOPPELS!!)

Can you see what the problem was? At 11x annual rents (the contract price), that $200 / month accounted for $26,400 worth of the value! If we bought based on the higher number and then the tenant turned around and claimed that the 60 days had elapsed and that the rent increase was void, there would be a good chance that LAHD would side with the tenant and the $26,400 would evaporate.

So, not wanting to take that chance, I requested that the seller get a signed document from the tenant agreeing to the rent increase. Obviously, the tenant didn’t want to sign it.

We were willing to walk from the deal over this, so we told the seller to get the doc signed, reduce the price by $26,400, or sell the property to someone else.

The tenant therefore had the seller over a barrel. And he used the opportunity to extort the seller for a check equal to two years worth of increased rent, or $4,800 ($200 x 24 months). The seller paid the tenant because it was better to do that than to reduce the price by $26,400 or have the deal fall apart. In my opinion, the tenant let the seller off lightly; he had a lot more leverage than he realized and could have exploited it more ruthlessly.

In the end, it all worked out. But this was another reminder of the importance of diligence and experience when it comes to apartment building transactions.

Beware of laundry leases!

When you first buy a building, you’re likely to be approached by someone, often the management company you hire, about signing a laundry lease. It will be pitched to you as a convenience for your tenants and an opportunity for you to make some extra cash. Be careful!

What’s a laundry lease? It’s an agreement whereby a laundry company agrees to place, operate, and maintain coin laundry machines in your building. In exchange for allowing them to do this, they offer to give you some share of the revenue. Sometimes they even kick in a few grand as a bonus. Sounds good right?

Here are the problems:

  1. The contracts are usually very long and very, very hard to cancel. You need to send them a cancelation notice written in lamb’s blood on third full moon after Easter seven years from now. If you forget, the contract renews for another 10 years. Etc., etc.
  2. There are usually monthly minimums below which you get nothing. The contract might say something like, we (the laundry company) get the first $100 of revenue and the rest is split 50-50 with you. If this number is set too high, you may never see a penny from the machines.
  3. Auditing the revenue is almost impossible. You’ll get a a statement every month or quarter showing how much the machines brought in and how much you’re entitled to, along with a check (hopefully). But you’ll get very, very suspicious that you’re not getting your fair share. And there’s no way to audit the numbers, because it’s all cash coming in to them.
  4. You usually can’t put any other laundry machines in the building. If you later want to raise your rents by adding washer / dryers to the units, too bad. The lease usually stipulates that you can’t put any competing machines (coin operated or free) in the property.

I’ve got two good ones about laundry leases:

  1. On our first building, the contract was short, so we were able to buy it out for around $3k and replace the company’s machines with our own. Cool, right? Well, it turned out that the company had been shorting us by roughly $150 / month, a fact which we discovered once our new machines were installed and we started collecting the money ourselves. Turned out to be a very good deal.
  2. In order to get another laundry company out of one of our buildings so that we could put washer / dryers into the units, we had to pay (I’m not making this up) $16,000 in order to get them to cancel the agreement. Do you know how much they had been paying us per month up to that point? Around $50. Bastards.

My advice: Don’t ever, ever sign one of these things without reading it carefully. Insist on a short period without automatic renewals. Insist on a low monthly minimum. And pay attention to the reporting. A 16-unit building ought to produce $200 / month or so in laundry income, maybe more. If your company’s reporting much less to you, they’re probably stealing.

Passive real estate investing part 2: Syndicated deals

As discussed in this post, one of the ways to invest in real estate without working on it full time is to put your money into a syndicated deal. Here’s how that works:

A syndicator is a professional investor who finds a property to buy and then arranges to obtain both the debt and the equity (the downpayment) from others. In exchange for his effort, he gets a piece of the profits.

Here’s how it works:

  1. The syndicator finds an appropriate property;
  2. He makes an offer which is accepted by the seller;
  3. He contacts the relevant banks and figures out how to get a loan on the property;
  4. He sets up an LLC to own the property;
  5. He solicits private investors to put up equity (cash for the downpayment) in exchange for ownership stakes in the LLC;
  6. Assuming he’s successful, the money comes in and the deal closes;
  7. The syndicator then manages the LLC and (if all goes well) upstreams the profits to the investors according to their ownership stakes.

Here’s how the investors typically get paid:

  1. A preferred return of somewhere between 6-9% / year on money invested. Initially, this is in the form of an “IOU” from the LLC. Once the cashflow starts coming in from the asset, it’s begins to be paid in cash;
  2. A portion of the profits on sale. Usually, the investors get 60-75% of the profits, with the syndicator taking the rest. For example: If you put up half the money in a 70-30 deal, you would get 50% x 70% = 35% of the profits.

Here’s how the syndicator gets paid:

  1. He often serves as the broker for the LLC buying the property and therefor receives the buy-side brokerage commission on the way in;
  2. He usually receives a series of fees from the LLC, including fees for acquiring the property, arranging the loan(s), and managing the asset (which usually means overseeing the management company that does the actual work). These fees come before the investors’ profits are determined.
  3. He often serves as the listing broker when the property is sold, thereby receiving the sell-side brokerage commission on the way out.
  4. He usually receives a share of the profits (see above) of between 25-40%, depending upon how the deal with the investors was structured. This share of the profits is paid only after the investors get their preferred return and their share of the profits.

Many investors seem to prefer syndicated deals to investing in funds, mostly because they can see the deal itself before deciding to invest. But there are a few reasons why I don’t love this model.

First, the fee model above does not allow syndicators to make a lot of money on each deal. Therefore, they make their money on volume by doing a large number of deals. That means they usually just pay whatever the asking price is in their preferred area, meaning that they accept whatever the “market” return is (since the return is a function of the relationship between cashflow and the price). If you want to just take the market return, you might as well buy the property yourself.

Second, sellers usually aren’t in love with the idea of doing deals with syndicators, because there’s no guarantee the syndicator will be able to come up with the money to close. Syndicators in effect say to sellers: “Let me tie up your property for 60 days while I try to raise the money to buy it”. Some sellers are ok with this, but only if they are receiving a very good price. So, almost by definition, syndicators are going to pay top dollar for assets, which is not a great recipe for high returns.

Despite the above, some investors just love these kinds of deals. So, as a practical matter, I am usually open to syndicating if the numbers make sense on a particular property.

Reunions!

Today’s post is short and sweet (at least, sweet for me)… I’m back at Princeton for the weekend for my 10th Reunion.

I plan to catch up with some old classmates, drink some really cheap, awful beer, and bore the hell out of a few people by droning on about real estate while they’re just trying to have a good time.

Back on Monday with another substantive post. Meanwhile, hope you enjoy your own weekend, wherever you are!