As uncertainty continues to loom in the real estate investing and private lending space, it may be more important than ever to be sure your borrowers maintain adequate insurance coverage to protect themselves and your assets. It is far too common for private lenders, especially, to fall short of what they require of their borrowers, with some lacking insurance requirements altogether. This puts your investment at risk in the event of a loss that is not covered, causing your borrower to default on their loan.
Today we’ll discuss some guidelines you should consider when developing your lending institution’s insurance requirements and what to do if your borrower fails to comply with them. For this purpose, we’ll focus primarily on property and premises liability coverage for single-family properties up to about 20 units at any one location. Larger complexes, commercial, or mixed-use properties require additional coverages that we can help you work through if needed.
What level of insurance should you consider requiring?
The property should (at minimum), be insured to the outstanding loan value, or more. Replacement Cost coverage (versus Actual Cash Value), allows your borrower the opportunity to recover depreciation that may be levied against the loss settlement during the claims process and should be required. This can help minimize the financial hardship your borrower may experience from not recovering enough money to make them whole again and bring the property back up to its value as an asset.
Depending on your appetite for risk and the locations of where the properties are located on which you are lending, you can consider two coverage levels: Basic and Special Form. Basic is just that; it is named peril coverage with exclusions such as Theft, Weight of Ice, Sleet or Snow, and Water Damage that can harm investors. Coverage is afforded for only the perils named in the policy. With Special Form coverage, the burden is on the insurance carrier investigating a claim to prove that the loss was caused by an exclusion – otherwise, coverage is afforded. Special Form coverage is more comprehensive but does still contain standard exclusions. Some of these can be bought back through additional endorsement, which you may consider requiring. These include, but are not limited to: Mold & Fungus, Sewer and Drain Backup, Earth Movement (earthquake shock and sinkhole), Flood, Terrorism, and Cyber Liability. If you are in close proximity to a coast, you should consider requiring Named Windstorm coverage.
Many lenders require Special Form coverage and a maximum property deductible of a percentage of the total insured value of the location (typically no more than 2%). This deductible applies to the “All Other Perils” property deductible, where there may be a higher assigned deductible for more severe perils such as Wind/Hail, Water Damage, and Theft.
With regards to liability coverage, your borrower should carry commercial premises liability with a per occurrence limit of $1,000,000 with a $2,000,000 annual aggregate. You should never allow a personal liability policy and defense costs should be outside of these limits so they do not diminish what is available to settle a loss. For locations with higher unit counts or more stories, higher limits should be required.
If you are working with a borrower who is renovating a property, it is important to know that premises liability coverage extends to slip and falls, or personal injuries, for instance, that occur on the premises, but do NOT extend to anyone hired to work on-site or the work being completed. These can be obtained through a General Contractor’s Liability policy, which should also be required.
How should I be listed on these insurance policies?
As the lender for real estate investment properties, the lender should be listed as the mortgagee on the property insurance policy. This ensures that you receive notice prior to coverage cancellation due to non-payment or any other underwriting issue, and guarantees you are listed on all claim payments for property losses at that location. This protects your interest in the property. For a liability policy, being listed as “additional insured” on your borrower’s policy serves the same purpose.
What do I do if my borrower’s coverage is canceled or does not comply with my requirements?
In the event you get a notification of cancellation of coverage for a property in which you have an interest, you can force-place insurance coverage with a Lender-Placed Insurance policy. This type of policy is intended to protect your interest in the property or the outstanding loan amount. You, the lender, will pay the premium on a policy of this nature, but collect it back from the borrower by adjusting their monthly payment. Learn more about NREIG’s Lender-Placed Insurance alternative, which offers the great benefits of our Insurance Program, just for lenders when it is needed.
Requiring your borrowers to carry adequate insurance coverage, and having a relationship in place with a trusted insurance agent who can help you when Lender-Placed Insurance becomes necessary is critical to minimizing your risks as the lender. An agent who understands the real estate investing landscape and can help you design insurance lending requirements to fit your needs is a valuable partner in uncertain times.