If you are a real estate investor, or if you have ever remodeled an existing property, the chances are better than not that you have either purchased or heard of a ‘Builder’s Risk’ insurance policy. The question; however, is whether or not you were ever really protected with any insurance at all.
You see, contrary to its name, a Builder’s Risk policy may not be applicable in many remodeling and construction projects and this is the most commonly mis-sold policy in the market – which means that thousands of people each year pay for insurance which they never really even have.
Some Important Facts to Know
(1) Builder’s Risk policies can often be written in terms of three-months, six-months, or 12-months. If the project is not completed by the end of the initial policy term, it can often be extended, but only one time;
(2) While there are exceptions, it is also important to know that many Builder’s Risk policies may not provide coverage for any existing property undergoing structural changes or renovations such as foundation work, movement or alteration of load-bearing walls, roof trusses, or new property additions. While this is often the exact nature of the work being performed on existing structures; these items are often specifically excluded and any claim filed on a property which has had this work performed may be immediately denied and the policy declared null and void. In essence, you’ll have no insurance.
(3) Third, all Builder’s Risk policies are considered ‘earned premium’ due the high-risk nature of insurance. What this means in laymen’s terms is that the entire premium for the policy must be paid for up-front and in full at the time the policy is issued. Also, this premium is immediately considered fully ‘earned’ by the company, which means that even if you cancel the policy three days after it is issued, you will get no refund whatsoever as the premium has already been ‘earned’.
(4) Also, unlike a normal homeowner’s policy, Builder’s Risk is not designed to protect against personal liability nor does it cover any losses which occur before the project is actually started or after it is completed. This means that if anyone, such as a neighborhood child, is inadvertently injured on the property and the parents or others choose to file a lawsuit, the insured has absolutely no liability protection unless he is also covered by a completely separate General Liability policy.
(5) Finally, a Builder’s Risk policy automatically cancels and ceases coverage either 90 days after the project is completed or 60 days after the property is put to its intended use (whichever comes first), such as in the case of a rental property in which a new tenant signs a lease and moves in. In the event of a claim after the project is completed, the insuring company can request copies of tenant leases, occupancy permits, or other official documents in order to establish when the project or construction was completed.
Why Do Agents So Often Mis-Sell Builder’s Risk Policies?
The reason so many agents incorrectly write and issue Builder’s Risk policies under the wrong conditions is not because of anything intentional, more often than not it’s simply because the agent you are working with has little or no experience in real-estate investing or anything construction-related. In addition, many agents who have developed their business around selling traditional home and auto policies have seldom, if ever, read through a Builder’s Risk policy to actually understand what is really covered and what isn’t. Therefore, they naturally assume that a Builder’s Risk policy is a one-size-fits-all policy for anything and everything construction-related. It’s only when the unexpected occurs that you find out you weren’t properly insured.
What is a Builder’s Risk Policy for?
Generally speaking, Builder’s Risk Insurance covers buildings and structures under brand-new ground-up construction or minor remodeling of existing structures, such as interior remodels and ‘gut rehabs.’ It typically covers the same types of things as regular property insurance, such as damage from theft, fire, vandalism, wind, hail, and other accidental loss or damage to the property. A Builder’s Risk policy also provides coverage for theft or damage to materials not yet installed, such as uninstalled windows, cabinetry, lumber etc.
As already mentioned, there is no liability coverage and coverage usually extends until 90 days after the building or structure is completed and/or 60 days after it is put to its intended use.
What It ISN’T Used For
A Builder’s Risk policy is not intended to be used for long-term coverage. It is also not intended to be used for properties which are occupied during the course of construction (except minor remodeling work). Finally, they are not intended for use on vacant or properties actively held for sale..
Who Needs It
Who should purchase a Builder’s Risk policy? Anyone with a financial interest in a major construction, remodeling, or repair project, including general contractors, real estate developers, and property owners. In addition, some trade associations and lending institutions may require Builder’s Risk Insurance, especially on projects worth a million dollars or more.
Other Things To Take Into Consideration
Builder’s Risk policies don’t cover damage arising from earthquakes or floods, so if you need this coverage you will have to purchase it separately. Also, as already mentioned, most Builder’s Risk policies do cover loss or damage to construction materials in transit and in storage, so if you plan on storing or transporting construction materials, make certain that this coverage is provided.
Additional Coverages You Need To Be Aware Of
Contactors’ equipment and tools typically aren’t covered by the owner’s Builder’s Risk policy and these risks will usually require separate coverage. One caveat to this is that many policies do actually provide a limited amount (usually $5,000) for tools and equipment which are stolen or vandalized, but they must be within 100 feet of the property at the time of the loss itself. They may or may not also cover “soft costs” associated with other aspects of a project such as financing charges, marketing, legal, permitting, and loss of income resulting from property damage.
SUMMARY
In closing, Builder’s Risk policies are very different and the coverages they contain can vary greatly from one insurance company to the next and it is very important that when needing a Builder’s Risk policy, you work with an agent who is knowledgeable with regards to these coverage types.
InsuranceForInvestors is extremely experienced in real estate investing as well as all matters relating to Builder’s Risk coverage. For a free quote or to discuss the insurance needs of your particular project, call us at (512) 510-4010 or (800) 299-8994 for more information.
Almost everyone who has ever had any dealing with or around real estate has heard of title insurance at one time or another – but few people actually know and understand what it really is and why it is so important; they just seem to think that it is a customary charge on the closing statement that they must pay.
In reality, title insurance is probably the single most important, and most misunderstood, aspect of the real estate transaction and NOT having it could cost you tens of thousands of dollars! Although you may have never had to make an actual claim against a title insurance policy, others (including myself) have. It is important to know that title insurance, while an insurance product, is only available from licensed title officers ad agents (ie: title companies) and that normal property and casualty agents cannot sell or offer this product.
What Title Insurance Really Is
As its name implies, title insurance is just that – insurance. A more textbook definition might be “insurance which protects the lender and the homeowner against any loss resulting from any defects, errors, or omissions in the title or claims against a property that were not previously uncovered in the title search.” This happens much more often than you may realize.
In short, title insurance protects the policy holder from any financial loss resulting from previously undiscovered liens (mechanic’s liens, utilities, lawsuits, etc) that were not found and/or otherwise satisfied during the title search when the property was being purchased. Without a title insurance policy, the owner of the property may be directly liable and financially responsible for any and all liens that appear later on – even of they have nothing to do with the current owner and were filed years prior to ownership.
Title insurance will pay for defending against any lawsuit attacking the title as insured, and will either clear up title problems or pay the insured’s losses. For a one-time premium, an owner’s title insurance policy remains in effect as long as the insured, or the insured’s heirs, retain an interest in the property, or have any obligations under a warranty in any conveyance of it. Owner’s title insurance, issued simultaneously with a loan policy, is the best title insurance value a property owner can get.
The Reason For Title Insurance
The reason for title insurance is described above – to protect the property owner AND lender from financial loss resulting from undiscovered liens prior to purchase. Some of the things that a title insurance policy protects against include:
- False impersonation of the true owner of the property
- Forged deeds, releases, or wills
- Undisclosed or missing heirs
- Instruments executed under invalid or expired power of attorney
- Mistakes in recording legal documents
- Misinterpretations of wills
- Deeds by persons of unsound mind
- Deeds by persons supposedly single, but in fact married
- Liens for unpaid estate, inheritance, income or gift taxes
The TWO Types of Title Insurance
It is important to note that title insurance is NOT a one-size-fits-all product. As it is, there are two types of title insurance polices, the owner’s policy (# 1) and the lender’s policy (# 2).
Whenever you purchase a property, you will need to ensure that you also obtain title insurance which will cover your interest in that property (the ‘owner’s policy’). The limit of this owner’s policy will generally be for the actual market value of the property at the time of the purchase.
If, like most buyers, you plan on utilizing a mortgage loan for the purchase, your lender will also require a second type of title insurance (known as the lender’s policy) in order to protect their interest in the property. As opposed the covering the market value of the property, the lender’s policy is written to protect and cover the lender for the actual amount of the mortgage.
Which One Do YOU Pay For?
Now that you understand that there are two types of title insurance policies usually involved in a real estate transaction, you are probably wondering:
#1 – why two different policies are necessary to insure the same piece of property; and,
#2 – whether or not you have to pay for two separate title insurance premiums.
In answer to question number one, (and this is a semi-long answer), the owner’s policy will cover losses or damages you (as the buyer) suffer if it is found that the property has a latent title defect such as the fact that it actually belongs to someone else, there is a defect or lien on the title, the title is unmarketable for some reason, or any other similar issue. This owner’s policy will have a section setting forth exactly what is covered as of the effective date and it will also guarantee that your ownership is free from defects or encumbrances, except any listed as exceptions in the policy, it will guarantee your right to have access to the land, and it will guarantee that you have the legal right to sell the property and convey marketable title to a new owner. So, if you purchase the property for $175,000.00, then the owner’s policy will be written for the full amount, $175,000.00.
On the other hand, the second policy (the lender’s or mortgagee policy), protects the lender for the amount of their loan to the buyer. If they loan you $150,000.00 for the property (with you putting down the other $25,000.00 as a down payment), then their policy will only be for the amount of $150,000.00. This type of policy is called the ‘ ALTA’ policy (since it is a standard policy approved by the American Land Title Association). It is issued to banks and other institutional lenders. Also, in addition to covering the lender for the losses included in the owner’s policy, the lender’s policy includes coverage for any losses that the lender would incur if another creditor were first in line. If, for example, you were to take out a second mortgage and had managed to keep this second loan hidden while refinancing your first mortgage, the second mortgage would take first place in the event of a foreclosure action. The lender’s title insurance policy would cover the mortgagee of the first loan if this were to occur.
Now, in answer to question number two, the fact is that in most cases, the two policies are actually purchased and paid for together, although the issuing title company usually provides for a discounted price.
The reason for this discounted price is due to the fact that when an owner’s and a lender’s policy are issued at the same time, the title company only has to search the records once, and because the second policy doesn’t really increase the risk that much (since the records were just checked), the premium paid for both policies together is usually about 30% to 40% less than if the polices were to be purchased separately. If, as is sometimes the case, there was an actual loss due to a previously undiscovered title defect, the title company would be liable to the owner of the property for the amount of their equity, in the case above your $25,000.00 down payment, and to the lender for their value of their mortgage of $150,000.00 for a total amount of $175,000.00
How Are Title Insurance Fees Calculated?
This is a difficult question to answer as the fees and guidelines for title insurance vary widely from state to state or even county to county. In Texas for example, all title insurance rates are set and regulated by the Texas Department of Insurance and they are generally non-negotiable; however, in Missouri, each title company sets their own rates for coverage, just like home and auto policies, and you have the ability to shop around for the best deal.
Policy costs are generally calculated (regardless of who actually sets the rate) based on each $1,000 increment of coverage amount. The calculations can be somewhat complicated, but as an oversimplified example, a title company may charge a policy fee $5.00 per each $1,000 in coverage. So, if you were purchasing a $175,000.00 policy, the premium might be $875.00 (175 times $5.00 = $875.00) Again, this is an oversimplified example, but it gives you somewhat of an idea how rates are set and adjusted.
What is Meant By ‘Recording Title?”
When you purchase real property, you will receive a written document (called “the deed”) which transfers the ownership (the title) of the property to you as the purchaser. The deed gives you formal title in exchange usually for a specified amount of money. The conveyance of real property is not complete until the deed is delivered to you or your authorized agent.
When a deed is transferred, it should be recorded in public records with the county recorder in the county where the property is located. The purpose of recording the deed is to give “notice to the world” that you now have an ownership interest in that particular piece of real property.
Recording also tracks the chronological chain of title. Anyone who wants to know who owns a piece of real property can check the records of the county recorder for the county where the property is located. Before you purchase real property, you can follow the chain of sales and transfers of the property – from the original grant of the land all the way to the current owner. When title insurance is purchased, the title insurer checks the change of title to determine whether any defects occurred in prior conveyances and transfers – defects may then be pointed out and excluded from coverage. As a purchaser of property, you want to check that every time in the past, when the property was transferred, the grantor had clear title to the property and the previous purchasers obtained clear title. If someone in the past somehow purchased the property without clear title themselves, then you yourself will not get clear title either.
Prior to the 1980’s, mortgages were written differently than they are today and investors and homeowner’s purchasing new property commonly used the ‘Subject To’ method of assuming the seller’s underlying loan as a main-stream and accepted purchasing method. However, after the Savings and Loan debacle, and the subsequent removal of popular NENQ (Non-Escalating Non-Qualifying) loans, the method of using ‘Subject-To’ financing was swiftly brought to an end. That said, however, with the new ‘credit crunch’, the record-high number of foreclosures, a declining housing market, and the recent changes in loan programs; investors are locating bargains and many bueyrs cannot qualify for a traditional mortgage loan in order to purchase a home. Because of this, although technically not allowed, the ‘Subject-To’ method is again alive and doing very well.
The biggest problem with this method of obtaining property is that with the exception of a few FHA and VA loans originated before 1989, there are almost no remaining ‘assumable’ loans left in the market and the mortgage loans used today strictly prohibit another party from assuming this debt. Commonly referred to as ‘wrap-around’ mortgages, many investors still create these assumption-purchase scenarios in order to easily obtain a new bargain property and many buyers utilize it when they cannot qualify for traditional lending, however, the fact is that they are trying to ‘skirt the system’ and they are taking a calculated risk that the underlying mortgagee either won’t find out that the loan has been assumed or else they simply won’t care so long as the mortgage is being paid. In either case, it’s a gray area at best and property insurance is really not designed to be used in these types of scenarios; which only adds another complication. Simply put, there is no ‘perfect’ or ‘clean’ way of insuring these properties and many agents risk losing their license, paying fines, and losing appointments with insurance carriers because they commonly insure these properties incorrectly and actually create ‘material misrepresentations’ in the insurance policy.
Insuring ‘Subject-To’ property is often tedious because investors and buyers do not want to trigger the ‘Due On Sale‘ clause, found in current mortgages, by sending the mortgagee a new insurance declaration’s page with a named-insured different than that of the original owner (remember, this is ‘skirting’ the mortgage contract). The reality regarding this concern; however, is very, very minor. The most common question is “Won’t the underlying lender call the loan due if they find out that I now own the property“? Technically speaking, they could. Practically speaking, they won’t. Banks are in the business of making loans, not collecting houses, and as long as payments are being made they usually don’t care whose making them. As we already said, banks don’t want houses, they want payments, and as long as they have a performing asset they are not going to call the loan due in order to give up their on-time payments in return for a non-performing asset which now costs them money. This is especially true in the current market.
Unfortunately, many real estate professionals and ‘gurus’ (which know absolutely nothing about insurance laws and some of which we actually know) teach that the homeowner’s policy should be kept in place with the ‘seller/owner’ and that the investor/buyer should actually purchase a second policy for their ’new’ insurable interest. This supposedly keeps the mortgagee in-the-dark about the transaction and makes everything clean for the new investor-owner. This is wrong! Sure, it can be done, but the reality is that in the event of a claim it may (in some cases) be construed as insurance fraud (since all parties have knowingly double-insured the property and made material representations to t he insurance companies in order to avoid disclosure to the lender).
First of all, it is a direct violation of the underwriting and eligibility guidelines for every insurance company to have duplicate coverage on the same property. Just like two people cannot have two different insurance policies for the same car, you can’t have two insurance policies for the same property – especially when one of them no longer has an ‘insurable interest’.
Secondly, you cannot maintain a “homeowner’s” policy with the seller listed as the named-insured on a non-owner occupied residence no longer titled in the original owner’s name, this can be considered insurance fraud if there is ever a claim and although the seller’s name is on the original mortgage loan, you (the investor) are technically the new owner on title and unless you are living in the home as your own personal residence, this is going to require a new dwelling (not homeowner) policy.
Third, another reason you don’t want to have the seller continue to maintain his or her current insurance as the ‘named insured’ is due to the fact that he or she is no longer the actual owner. Again, this is fraudulent. It’s true that the seller is still responsible for the underlying loan because he or she signed the original Promissory Note, but the property is no longer titled in the seller’s name – hence the seller cannot legally purchase or pay for the insurance. Also, if the seller did keep the insurance in place and listed you (the investor/owner) as an ‘additional interest’, only the liability protection of the policy is extended to you and the seller still has ownership and complete control of the policy and the seller is then the only one who can make changes or file claims and he or she is legally entitled to any and all claim settlements and refunds from the insurance company.
In summary, although it’s probably not what many investors want to hear, you (as the new owner) must obtain a new dwelling policy with your name listed as the ‘Primary Insured’. There is usually no other way. While many agents and gurus may give you different information, tell you what you want to hear, or may issue policies however you want it done, the truth is that they are incorrect and, if there ever is a claim (the whole point of having insurance), it will probably be denied flat and the policy cancelled because it was miswritten and, in some cases, illegal. We’re investors ourselves and we understand what can happen.
If you have the home in the name of an LLC or other entity, this entity should be listed as an ‘Additional Interest‘ (NOT the ‘Additional Insured‘ in most cases – there is a blurry legal difference in these terms that actually matters). All property and liability coverages should carry over to the entity listed as the ‘Additional Interest’ while, in many cases, only liability protection extends to ‘Additional Insureds’. Also most carriers will not allow a policy for personal residential property to be issued with a commercial or corporate entity as the Primary Insured. Why? Because in addition to the carrier’s potential legal issues later on in the event of a claim, that defeats the purpose of it being issued as residential personal property, it would then be considered a ‘commercial venture’ and that’s what commercial policies are designed for.
We InsuranceForInvestors specialize in investment and ’Subject-To’ properties and we can help with all of your investment property and key-person insurance needs.
Report Author: Judon Fambrough (Texas A&M Real Estate Center)
Income-producing property has always played a major role in real estate. Central to much of this property is the landlord-tenant relationship. Significant legislative changes have been made in recent years.
Once basic rule of English common law was that a tenant’s duty to pay rent was independent of the landlord’s duty to repair without an agreement or a statute to the contrary. The lease was regarding as a conveyance of land, subject to the doctrine of ‘caveat emptor‘ (“let the buyer beware”.) The landlord was required to deliver only the right of possession. The tenant, in return, was required to pay rent as long as possession was retained, even if the building was destroyed or became uninhabitable.
Download a PDF of This Report: Landlord’s and Tenant’s Guide
To most people, especially investors, an insurance policy is a necessary evil that is assumed to cover just about anything that can cause a loss to a property, but this is simply not true.
To get right to the point, there is no one-size-fits-all policy and properties which are either vacant or held for sale at the time an insurance policy is applied for cannot be written with a standard-market insurance carrier and they require different types of coverages. The following information may seem overwhelming if you are not familiar with the insurance industry, but it is intended to give you a basic understanding of why coverage for vacant property is more expensive and how it differs from the other property policies you may be more familiar with.
A Note About Vacant Property Coverage
First of all, no standard ‘big name’ insurance carriers such as Farmers, Allstate, Safeco, Travelers, State Farm, etc. will issue new policies of any type on properties that are either vacant or actively held for sale at the time of issue unless they are rental properties scheduled to be occupied within the next thirty days. Their underwriting guidelines and ‘appetite’ (an insurance term indicating the risks a company is currently interested in writing business for) specifically prohibit, in very clear and precise language, these types of properties. The reason for this is that vacant properties and those actively held for sale represent a much greater likelihood of loss due to vandalism, theft, arson, unrepaired water leaks, and similar circumstances. From the insurance company’s standpoint, the best way to avoid paying for these losses is to simply not accept the business.
If an agent were to issue a new policy on a property that the carrier prohibits and the carrier learned of it through a property inspection or because of a claim, the agent could lose his appointment and contract with that carrier. In addition, if there was a loss, the carrier would legally deny the claim altogether and cancel the policy ‘flat’ since it should have never been written in the first place per their existing underwriting guidelines and the fact that the property was vacant or for sale was not revealed would be considered ‘material misrepresentation.’ The agent could then face fines and administrative action from the state’s Department of Insurance as well as errors and omissions issues from the customer. In addition, the customer would be left without any coverage for the loss and he or she would have to pay for all all repairs or property replacements out of his or her own pocket.
The Dreaded (and Often Ignored) Vacancy Clause
One caveat to vacant property coverage occures when a previously-occupied and currently insured property becomes vacant, such as when a tenant moves out. All standard-market carriers have a very specific clause, known as the ‘vacancy clause’ written into their dwelling policies which deal with this situation. Each carrier’s clause is a bit different, but they are similar in their intent to reduce the carrier’s exposure to a loss.
In short, if a previously-occupied property becomes vacant for a period of more than 30 days (60 days with some select carriers), the policy either (1) automatically cancels altogether so that there is now no insurance in place or, if the clause is written in such a way as to keep the policy in force, (2) all coverages <water damage, loss of rents, vandalism, etc> are terminated with the exception of coverage for fire and lightening only. Once the property is reoccupied the original coverages are returned.
Where to Get Coverage For Vacant Homes and Property Held For Sale
While standard-market insurance carriers will not issue new business on vacant or for-sale properties, coverage is still readily available – but you will have to pay much more for it and the coverages are greatly reduced.
Policies for these types of properties are written through the ‘Excess and Surplus Lines’ market (referred to as E&S), which many agents know little or nothing about. In addition, agents are required by law to obtain special licensing and education in order to use this market (which fewer than 3% do). Simply stated, this is huge multi-billion dollar insurance market specializing in high-risk, unusual, or hard-to-place risks such as vacant property, commercial property, general liability, and numerous other coverages that the ‘standard’ market does not have an appetite for. This E&S market is comprised of specialty domestic insurers as well as ‘syndicates’ made up of overseas companies, most notably Lloyds of London. How these carriers and syndicates work is another topic for another article, but suffice to say that it’s complicated. Also, because of the nature of their high-risk business, these companies do not advertise directly to consumers and you have probably never heard of any of them, although they are usually extremely financially-stable with hundreds of millions of dollars held in financial reserve.
In order to obtain coverage for a property that is vacant or for sale, you must find an agent that is very knowledgeable with regards to the E&S market and that already has established relationships which enable him or her to write this type business (InsuranceForInvestors has numerous E&S markets available). This is fairly uncommon as the majority of agents have limited industry knowledge and they often focus only on simple home, auto, life, and health insurance.
Also, once you have found someone who understands what it is that you need, you will probably be required to fill out paper applications and the agent will then submit them to the carriers for review.
Most of the policies cannot be quoted online by an agent and, once submitted, it may take anywhere from the same day to several days to get a quote back because the E&S market almost always requires a manual underwriting process because of the unusual and varying nature of the risks that they write – the agent has little or no control over this process. This means that there is very seldom any sort of online rating program or automation which can immediately produce a bindable quote for you.
Unique Characteristics of E&S Policies
As you may have already guessed, there is a very big difference in the actual policies for vacant and for-sale properties than for standard dwelling policies, one of the most notable being the premium. The following list represents some of the major differences that you will need to be aware of.
Premium Amount
The premium for vacant and for-sale properties is always much more expensive than a standard policy because the premium charged reflects the type of risk insured. This premium can be anywhere from 30% to 200% higher depending upon the property, prior loss history, and coverages desired. Also, because of the manner in which E&S carriers are structured, they are usually ‘non-admitted’ to the state in which the property is located, which means that they are required by law to charge state tax and filing/stamping fees. In addition, they may charge policy fees ranging anywhere from $75 to $250 or more (again, depending on the carrier, the risk, and the premium amount).
Minimum Earned Premium (MEP)
All E&S carriers also have a ‘Minimum Earned Premium’, which is normally 25% of the base premium amount not including the taxes and fees. What this means is that at least 25% of the pure base premium is considered to be ‘earned’ by the carrier at the very moment the policy is issued, even if it is only in force for one day. For this reason, all of these policies require at least a 25% non-negotiable down payment at the time of issue. For example, if a policy were issued with a total premium of $ 1,176.50 ($ 1,000 base premium + $ 100 policy fee + $ 76.50 tax), then 25% of the base premium ($ 250) would be considered immediately ‘earned’ and it, along with the fees and tax of $ 176.50 would be due as a down payment in order to start the coverage.
The earned premium, taxes, and all fees are always considered non-refundable.
Premium Financing
E&S carriers are not set up to manage regular monthly billing cycles and they require that the policy premium be paid in full, usually within 15 days of the policy issue.
To prevent having to pay the premium balance in full and to establish a more manageable monthly billing for customers, third-party companies which specialize in the financing of insurance premiums are utilized. Although they work together closely to avoid coverage lapses and billing issues, these specialty finance companies are often unrelated to the carriers themselves and they serve as a third-party intermediary managing premium payments.
Just like when purchasing a care, when the policy is issued, a financing agreement is signed and the down payment (which is paid by the customer and includes taxes and fees) is sent to the carrier issuing the insurance. The remaining balance is then provided by the finance company to the carrier (on behalf of the customer) and the customer then repays the finance company in regular installments. If the customer is late on payment or fails to pay, the finance company notifies the carrier which, in turn, sends a cancellation notice to the customer.
Policy Terms
Many policies for vacant or for-sale properties can be written in either in 6-month or 12-month policy terms, depending upon the carrier. The reason for this is simple; if a property is being sold or is currently vacant, the assumption is that it will either be occupied or sold in the near future so why should a customer have to pay for a 12-month policy if the property might reasonably be occupied or sold within the next 90 days? If you need to extend the term of a policy for any reason, this is easily done.
Differences in the Coverage Provided
There is a tremendous difference in coverages provided between standard dwelling policies and those issued for vacant properties. While the common loss of rents and loss of use coverages are not provided (because the property is not occupied and they are therefore, irrelevant), there are many other differences of which you should be aware.
Vandalism and Malicious Mischief (VM&M) – Because it is the most likely cause of loss, most E&S policies do not include coverage for vandalism and malicious mischief for any reason, though there are some carriers which will offer to include it – for additional premium. If you do have a carrier offering to provide this coverage, you can expect to spend several hundred dollars for it.
Accidental Water Damage – Very few vacant property policies include any coverage whatsoever for damage caused by the accidental discharge of water. While coverage for water damage is often included in dwelling policies for tenant-occupied properties, this coverage is specifically excluded and cannot be endorsed (added) back to pollicies used to insure vacant dwellings. Having said that, there are a few rare cases where some companies may allow you to purchase this coverage for an additional premium, but those additional premiums are often two or three times more than the basic policy premium itself and the coverage becomes cost-prohibitive for most investors.
Theft – Theft coverage is often provided in policies for vacant properties, but you will definitely want to ask the agent to be certain as it is not an absolute guarantee that it is included.
No liability – policies for vacant and for-sale properties often do not include liability coverage to protect you against legal issues and lawsuits arising from injury or other issues arising on or from the property. If you desire liability coverage, you will be required to purchase a separate liability policy or pay much more for a policy which does include liability coverage.
In summary, properly insuring vacant and for-sale properties is a very specialized and unique niche which requires a great deal of knowledge on the part of the agent issuing the policy. The coverages are greatly reduced over those afforded to normal occupied property and it requires that you, the investor, have a good understanding of the risk as well as what coverages you are, and are not, receiving with the policy that you are purchasing.
If you are an investor and you have ever purchased a rehab property using only ‘builder’s risk’ insurance – you’d better continue reading.
Few people, including investors and full-time real estate professionals, have any real understanding of what property insurance is, the various coverages used, endorsements, and, most important, exclusions. Not knowing these differences could cost you a great deal of money in the event of a loss.
First Things First
To begin with, there is no such thing as ‘full coverage’ insurance for anything, especially real property – period. Full-coverage implies that you are completely covered for any act of nature, man, or God, and that is absolutely not true as there are ALWAYS ‘exclusions’ written into any and all policies; 100% of the time.
What is an ‘Exclusion’
Exclusions are those items specifically outlined in the details of the policy (in the conveniently labeled ‘Exclusion’ section) that specifically list what your policy WILL NOT cover or indemnify (reimburse) you for. Items such as war, nuclear explosion, intentional acts, government action, environmental pollution, and several others are pretty standard although each policy differs, not to mention the difference that exists from state to state according the state’s own regulatory insurance laws. It is imperative that you read through these exclusions in order to understand what you are NOT covered for (instead of finding out when it’s too late) and then ‘endorse’ any additional coverages that you may desire to be protected against.
What is an ‘Endorsement’?
An endorsement is an ‘addition to’ or ‘change within’ the policy that affects the coverage that the policy currently contains, whether it is to increase monetary coverage limits, add additional items to be covered, change the type of indemnification from Actual Cash Value (ACV) to replacement cost, and many other items.
Using a homeowner’s policy as a simple example, let’s assume that you own a house with $200,000 property damage coverage for hail, fire, wind, etc. Generally speaking, the contents inside your house such as furniture, bedding, electronics, etc. are usually protected at a default amount of 50% of the property damage coverage limit, which in this case is $200,000, so you would be covered for up to $100,000 for your interior contents so long as they were damaged due to a covered peril (ie: one ACTUALLY LISTED in your policy as being covered and NOT contained in the ‘exclusions’ section.) However, if you decided that it would cost you more than $100,000 to replace all of your furniture, clothing, cookware, personal items and so forth (say $125,000), you could add an ‘endorsement’ to change the $100,000 coverage limit that you have by default to $125,000 – you might just have to pay a slight higher annual premium (which varies by company).
Okay, those are the two big insurance terms that we are concerned with at this point, now shall we continue?
Various types of Policies
As we continue, please know that this article is not going to delve into the various types of policies available for all situations, those are far too complex and that subject is for another article at another time.
Without going into umbrella coverage and proper limits of automobile insurance, there are only really two general types of property insurance policies that you should be aware of; Builder’s Risk and Dwelling policies, and almost every investor that I have worked with has been SEVERELY underinsured (if insured at all) and unaware of their exposure to extreme financial loss (this is what happens when you purchase policies over the phone from a licensed ‘order taker’.)
Builder’s Risk versus Dwelling Policies
A Builder’s Risk policy, which is the type most commonly used by investors, is ONLY for use by contractors performing work (hence the name “Builder”) and many investors are under the dangerously mistaken assumption that this is the only thing that they need to purchase when remodeling or ‘rehabbing’ a property. THIS IS DEAD WRONG.
A builder’s risk policy has NO LIABILITY coverage whatsoever for claims against injury, accident, animal attacks or anything similar and it is only designed to cover buildings and dwellings that are under construction an/or any building supplies that are in, on, or within 100 feet of the premesis. In other words, the contractor himself should have his own builder’s risk policy as a course of business and if you are the one purchasing it, all you are doing is paying to protect the contractor’s tools, trailers, building supplies, and materials against loss – and that’s it. He should send you a ‘Thank You’ car at the end of the job. You are NOT covered against fire, water damage, wind, hail, etc. and you have no protection against lawsuits arising from the personal injury of others. If you are acting as the contractor (by working on the property yourself), then this type of policy will protect you against loss of your own tools, equipment, and building materials that are stolen, but you still have no liability and you are wide open to financial and legal loss. Some of the basic features of a builder’s risk policy (in Texas) include:
- Building supplies of the insured (what you paid for) are included in the policy limit;
- Building supplies of others are subject to a $5,000 limit;
- Includes coverage for scaffolding, cribbing, and other temporary structures on-site
- Contains standard exclusions as other policies;
- You can insure the full value of the completed building or increase the coverage limits as work increases;
- IMPORTANT: Coverage automatically TERMINATES either 90 days after construction is completed or 60 days after the building is occupied or put to its intended use, whichever comes first.
A Dwelling Policy on the other hand is what most investors need – including while the property is being renovated. This type of coverage does contain liability coverage to help protect you and it is used mainly for rental properties and NOT for homeowners.
The key features and benefits of a dwelling policy (and there are several types depending upon what perils, ‘endorsements’ and coverage limits you desire) include:
- Contains liability insurance to cover bodily injury and property damage for which you are legally liable and it will pay medical payments incurred within 3 years of an accident (this does not cover the insured <a.k.a. ‘you’> or your tenants, just employees, guests, passers-by, and all others)
- Also contains ‘supplementary payments’ protection at no extra cost (if you chose to accept the liability coverage on the policy)
- Bonds paid with no limit (except up to $250 for bail bonds)
- First aid expenses at the scene of an accident with no limit
- Interest gained on judgments against you (also with no limit)
- A ‘loss of earnings’ feature to pay you up to $200 per day to assist in defending yourself or investigating a claim;
- Expenses incurred at the request of the insurance company (such as expert witnesses, special investigators, etc that are used when defending you against a claim), and most importantly;
- Defense (legal) and investigation costs (with no limit)
In addition, a dwelling policy protects your property against loss arising from any of the ‘covered perils’ listed in the policy such as wind, hail, fire, vandalism and malicious mischief, theft, and several more up to the coverage limit that you choose.
In order to be considered eligible, a property must be only one to four units (SFR to fourplex) and, if a mobile or manufactured home, it must be tied down or permanently affixed by means of having the wheels removed and the tongue cut off.
Again, speaking in general terms about what a dwelling policy covers in regards to property loss, the following bullets are a few standard coverages that are usually included as default amounts in the policy; although each may be increased or changed by adding and endorsement and paying a slightly higher premium:
- ‘Other Structures’ such as sheds, workshops, and detached garages are usually limited to 10% of the coverage that you have on the primary dwelling;
- Personal property (such as appliances) is also limited to 50% of the limited to 10% of the coverage that you have on the primary dwelling;
- Fair Rental Value (used to reimburse lost rental revenue) is limited to 10% of the coverage that you have on the primary dwelling;
- Loss of Use (used to cover additional living expenses required to allow the household to maintain their normal standard of living) is limited to 20% of the coverage that you have on the primary dwelling.
Unfortunately, this is one of those articles that I would like to begin in a very political way, naming names and as well as the offending political parties while espousing how it violates the very idea of personal accountability, free markets, and the limits of government intervention as well as the government’s intention of misleading the American public once again, but I will refrain myself from doing so due to the fact that this is not a political discussion. Suffice to say that our beloved Federal Government is at it yet again; quietly fast-tracking new and unnecessary regulations in the name of the ‘victim-hood of the poor illiterate masses’ which, since written and authored by those legislatures that have no actual first-hand experience in anything that they wish to control, will greatly restrict the way you, as an investor, do business and which will probably cause you to violate the new law and create a great deal of personal liability through the smokescreen of your being a ‘Predatory Lender’.
That’s right, you individually will be considered a ‘Predatory Lender’ and subject to fines and punishment if you sell more than one property in any 36-month time period.
How is that you ask? Read on.
Also known as the “Expand and Preserve Home Ownership Through Counseling Act” (a common renaming tactic used with unpopular bills to perpetrate a type of ‘victimization’ and give the bill a new and misleading name in an attempt to give the American public and those voting a ‘warm fuzzy’ so that it will pass the Senate), this bill greatly restricts your rights to sell your own property.
As an investor, if you ever plan on seller-financing your own properties, either by carrying back the full mortgage balance or even a partial secondary lien, you could be in big trouble.
What is HR 1728?
House Resolution 1728, introduced on March 26, 2009 by Representative Bradley Miller (D) was passed by the U.S. House of Representatives on May 7, 2009 with little fanfare and even less press coverage and it is now in the Senate awaiting a full review and vote. Not until it was actually referred to the Senate did it ever begin to receive the attention of everyone it will potentially affect. The full text of the bill can be read here.
What Does It Say?
In short, the proposed legislation focuses upon the predatory lending practices of the past and the resulting subprime mortgage debacle, imposing stringent requirements on mortgage brokers, loan servicers, appraisers, and almost everyone else involved in a real estate transaction. Unfortunately, owner financing also gets caught up in the dragnet, and the impact could be devastating.
The offending text of the bill is in section 101(3)(e), which defines who is actually exempt from being a ‘licensed mortgage originator’:
- does not include, with respect to a residential mortgage loan, a person, estate, or trust that provides mortgage financing for the sale of one property in any 36-month period, provided that such loan:
(i) is fully amortizing;
(ii) is with respect to a sale for which the seller determines in good faith and documents that the buyer has a reasonable ability to repay the loan;
(iii) has a fixed rate or an adjustable rate that is adjustable after 5 or more years, subject to reasonable annual and lifetime limitations on interest rate increases; and
(iv) meets any other criteria the Federal banking agencies may prescribe.
What Does This Mean?
In a nutshell, so long as you don’t provide any owner financing on the sale of your own property any more than one time every three years, you will not be in violation of the statute. However; any individual (such as an active investor) who does sell more than one property every three years via owner financing will be in violation unless they are a ‘licensed mortgage originator’. Notice that this said an ‘originator’, not a ‘loan officer’. There is a very big difference between the two. While state laws vary, it is typical that a ‘licensed mortgage originator’ must have a $25,000 to $50,000 surety bond, three years mortgage origination experience, a physical business office in the state in which the property is located, and you must maintain the required Continuing Education (CE) hours, and be governed by ‘Big Brother.’ In other words, very few, if any, individual real estate investors will ever take the necessary steps to become a ‘licensed mortgage originator’ as required in this bill.
What Kinds Of Real Estate Transactions Will Be Covered?
- Selling your own home using a land contract or owner-held mortgage with the intent of getting a faster sale, a higher sales price, or higher rate of interest than is available in other investments (the whole point of investing in the first place);
- Carrying back second mortgages on investment properties that you sell;
- Any kind of installment sale on residential properties including homes, condos, mobile homes, and even residential land lots;
The original bill presented to the House didn’t make any exceptions whatsoever to owner financing. It was only the National Association of Realtors that argued to include the exception of one owner financed property every three years. Without addressing owner financing, many in the House contended owner financing would become the ‘loophole’ for predatory lenders to continue their exploitative ways.
What’s The Problem?
Owner financed notes are not loans where the borrower receives money and must pay it back, as in the case of signature loans, cash advances, or similar. There is no transfer of money and no mortgage broker involved. They are also not created with the intent of selling them off to government-sponsored entities like Fannie Mae, Freddie Mac, or FHA. They are installment sales. The borrower receives no money that must be repaid, only a property on which periodic (ie: installment) payments must be made in order to maintain and complete ownership.
Just as egregious is the loss of private property rights. The government should have no power to legislate how property owners dispense of their properties. If a property owner is willing to finance the sale of a property to a buyer, whom is the government trying to protect by making the transaction illegal? States already have usury laws and servicing requirements that protect the purchasers. In addition, with the government’s own self-promulgated meltdown of the financial markets and the resulting inability for borrowers to even obtain new mortgage loans due to the high credit (FICO) scores necessary (minimum 700) as well as the much larger down payments now required (15% to 20%), it is going to make a bad housing situation even worse by eliminating the one viable alternative that buyers may actually have – that of purchasing individually seller-financed properties.
If passed by the Senate, this legislation will:
1. Severely limit the number of property owners who can legally owner finance the sale of their properties;
2. Make violators out of everyday Americans who, unaware they are breaking the law, are merely trying to sell their properties and/or offering financing to prospective homeowners who cannot obtain conventional financing;
3. Require obscene amounts of due diligence on the part of note investors to make sure all facets of this legislation have been complied with;
4. Give prospective homeowners even fewer options to realize the ‘American Dream’ of homeownership;
5. Cost the U.S. taxpayers over $400 million dollars to enforce.
What is Being Done About This Bill?
First notified about this bill by the diligent loan-servicing professionals at NoteWorthy they are lobbying to exempt owner financing from this legislation. Owner financing did not contribute to the subprime meltdown in any way, shape, or form. The housing catastrophe was caused by the federal government (the same government pushing this bill) forcing many lenders to make bad loans and then sloughing them off immediately to unsuspecting government agencies (the secondary market) and Wall Street, leaving them, quite literally, without a chair when the music stopped. Owner financing cannot be considered predatory by the obvious fact that the owner takes on all liability and risk of default by the borrower. Underwriting is done a lot more carefully when the lender is also the long term payee.
Who’s With Us?
Most industry associations do not want this bill to become law. In fact, the opponents of this legislation far outnumber those who support it. For a list of interests and their positions, go here. Unfortunately, many consumer groups oppose this bill for completely different reasons than we do: Namely, they don’t think the legislation is restrictive enough.
What Can You Do?
To make certain that this bill never passes the Senate and becomes law, contact your senator via phone, fax, e-mail or regular mail and implore him or her to vote NO on the bill as it is currently written. You can get your senator’s contact information by clicking here. Also, NoteWorthy has assembled some sample letters created by Vena Cox-Jones that will assist you in knowing exactly what to say and how to say it. Additionally, the people at NoteWorthy have also written a fourth letter specifically for owner-financed note brokers, all of which can be found by clicking here.
Please keep in mind that the best plan of action is to logically address how this legislation will hurt ‘the little guy’, i.e. buyers and sellers of individual properties. Although we all consider ourselves to be ‘the little guy’, the government has made it clear that anyone associated with mortgages is to be considered ‘the bad guy’ at all times and that it has little interest whatsoever in how this bill may affect your business, your family, or your livelihood. Please remember to always remain civil, cordial, logical, and intelligent in your communications with your senators’ offices.
In an order to maintain the status of the dangerous bill, NoteWorthy has also started a website in order for you to sign up to receive updates on their progress to defeat this legislation. Take action today or suffer the consequences of this legislation tomorrow.
* Information obtained from the Noteworthy Newsletter, Copyright 2009.
Don’t Shoot the Messenger…
Since we at InsuranceForInvestors have been asked many times why we need an applicant’s social security number and date of birth, I thought that I would write this brief article in order to help explain this request for personal information. Before we begin, it is important for you to know that insurance agents NEVER see anyone’s credit score, all we see is a total premium amount at the end of the quote.
Question # 1: Do I really need to provide your social security number to get a property quote?
Answer # 1: YES.
Question # 2: Why do ‘you’ need it?
Answer # 2: ‘We’ don’t – it’s the insurance companies themselves that require it for a quote or policy.
In today’s world, we all understand the need for privacy and keeping personal information confidential. We hear every week about computers being hacked into and data being stolen. We know. However, almost all insurance companies (standard and non-standard alike) doing business in the United States require both a Social Security Number as well as a Date of Birth for the primary applicant in order to receive a quote or issue an insurance policy. It is NOT up to InsuranceForInvestors as to whether or not we choose to obtain this information, it is a requirement of almost all insurance companies themselves. While you may not agree with it and you may not like it, that’s simply the way it is. You already need to provide this number to purchase a vehicle and obtain a mortgage – so it stands to reason that you also need to provide it in order to purchase insurance protection. If you choose not to provide this information, then we will not be able to provide you with an accurate insurance quote, regardless of how badly you may need or want one.
You see, the insurance industry is founded on the principals of risk management and risk mitigation, and insurance companies, as a way of rating and determining the business they insure, must make certain that they understand the risk that they are actually providing protection for. Believe or it not, people actually lie about past occurrences and this can affect the insurer’s risk position. Although you are not applying for ‘credit’ in the true sense of the word, as we already mentioned, this industry is based on statistical and actuarial risk analysis and management, statistically speaking, individuals with lower FICO (credit) scores have a higher propensity to file a higher-than-average number of claims for higher dollar amounts. This means more risk for the insuring company. Therefore, in order to create an accurate quote for the specific risk involved, the insurance carrier needs both the applicant’s Social Security Number and Date of Birth to verify identity and retrieve an insurance score (NOT a ‘CREDIT” score) in the background in order to determine a premium rate appropriate for the risk itself
Again, agents never see your credit score or personal information, just a total premium amount at the end of the quote. All premium and credit calculations occur internally (in the insurance companie’s software and servers) and agents have no access to your credit information.
In the event that there is a ‘no hit’ on your social security number (meaning that your SSN isn’t found or you refuse to provide one), you automatically get rated to the highest premium tier for whatever type of policy or coverage you are having quoted. The reason for this is simple – if the insurance carrier can’t verify your claims history or identity, they are obviously going to assume that it is a high-risk account and you are not going to get preferred rates. This is rare, but it does occur sometimes for those people with very little established credit or those individuals with a recently-issued social security number, such as recent legalized immigrants, as well as those who simply don’t wish to provide this information.
Although you may not be aware of it, many lenders violate state law on a regular basis and very few closing officers, loan officers, or mortgage bankers even know that this law exists or that they are violating it. As a professional agent, I fight this battle several times a month (usually on the day of closing) and I have witnessed numerous loans delayed, at the closing table, because the lender wants to violate state law at the last minute. Most recently (four days prior to the writing of this article), I spent the the better part of an entire morning going ‘back and forth’ with the loan officer, the loan processor, the bank Vice-President, and finally, the bank President regarding a construction loan that was set to close. All parties were physically sitting at the closing table when the lender decided to delay closing in order to request an ILLEGAL increase in insurance to cover the amount of their loan. While most agents view selling insurance as a simple ‘transaction’ (like buying a gallon of milk) and they would have made the change and charged the customer more money, we at InsuranceForInvestors care about our clients and it is our job to act as consultants and advisors in order to ensure that they are treated ethically and that we always do what is in their best interest.
This is a continual issue that we insurance professionals must face on a regular basis and it shouldn’t even exist in the first place.
Unfortunately, one of the most frustrating aspects of insurance that we deal with on a regular basis is that of lenders or mortgagees illegally requiring their borrowers (a.k.a. our customers and clients) to obtain insurance coverage in the amount of the loan rather than for the actual replacement or reconstruction cost of the property.
THIS IS 100% ILLEGAL
While lenders may understand the ‘ins and outs’ of loan-to-value ratios, mortgage structures, amortization schedules, and everything else associated with the ‘money’ part of a mortgage loan, they know absolutely nothing about insurance, yet that doesn’t stop them from creating ridiculous requirements which violate state law and then demand that the borrower meet these requirements in order to get the loan. This is wrong.
From an insurance-only perspective, insurance companies don’t care anything about the market value of a property, its appraisal value, the purchase price, or the loan amount of the mortgage. These are all irrelevant. What insurance companies care about is the RECONSTRUCTION COST (also referred to as ‘Replacement Value’) of the property; or in other words, the amount of money that it is expected to cost to rebuild the property on the same land at today’s current labor and material rates (including soft costs such as debris removal, permitting, blueprints, etc). This has nothing whatsoever to do with the loan amount, market value or anything else.
As a simple example, let us assume that a new property is purchased (with an appraised value of $300,000) for an agreed-upon purchase price of $250,000. The buyer puts down 20% ($50,000) of his or her own money and then obtains a mortgage loan for the remaining balance, which is $200,000. The purchase price the buyer has agreed to pay (the original $250,000) includes the property itself, the land that the property is sitting on, and the seller’s equity. The buyer then contacts his or her insurance professional (hopefully us) and learns that the estimated reconstruction cost of the property is only $150,000 (this means that it is expected to cost $150,000 to rebuild the property in the event of a total loss and it does NOT include non-insurable items such as the land or the equity paid to the seller in the loan). The insurance binder is sent to the lender and the loan is ready to close. Sounds reasonable, right? Wrong.
More often than not, the lender will demand (yes, demand) that the insurance coverage be increased to $200,000 in order to cover the entire loan amount – which is where the ‘illegal’ part comes in. The lender is requiring the insurance company to provide coverage for the land, the seller’s equity, the rolled-in closing costs, and everything else associated with the loan even though this has nothing at all to do with replacing the property. Not only does it cost the buyer more money in insurance premiums, but it also violates state law.
HOUSE BILL 1338 (the Law)
House Bill 1338 was enacted into law by the Texas State Legislature on September 1, 2003 and it amends the Texas Insurance Code (to be more exact, it amended: Section 2, Article 21.48A, Insurance Code, Subsection (g)). Without rehashing all of the boring and dry ‘legalese’, the important part of this change states that:
“No Lender, as a condition of financing a residential mortgage or providing other financing arrangements for residential property, including a mobile or manufactured home, may require a Borrower to purchase homeowner’s insurance coverage, mobile or manufactured home insurance coverage, or other residential property insurance coverage in an amount that exceeds the replacement value of the dwelling and it’s contents, regardless of the amount of the mortgage or other financing arrangement entered into by the Borrower. A Lender may not include the fair market value of the land on which the dwelling is located in the replacement value of the dwelling and its contents.”
So you see, it is very clearly documented that the act of requiring Borrowers to ‘over insure’ their property in order to obtain a loan is illegal, but it happens much of the time and I myself, as a professional agent, have dealt with countless lenders who choose to argue the point and demand excess coverage, even after I have sent them a copy of this law, because it’s their own ‘internal policy’.
As a consumer, you should expect your agent to take care of this problem for you and, as a Borrower, you should demand that your lender follow the law (they would expect it of you) and report any who still withhold closing a loan based upon your obtaining insurance for their full loan amount.
Thanks to excessive activism coupled with past abuses by unscrupulous investors, the 79th Texas Legislature has now made it much more difficult for investors in Texas to work within their entrepreneurial vocation.
Two laws which were recently passed have dealt a deadly blow to the use of popular lease-options. SB 629, authored by Sen. Eddie Lucio (D-Brownsville) and sponsored by Rep. Harold Dutton (D-Houston), and HB 1823, authored by Rep. Harold Dutton and sponsored by Sen. Eddie Lucio.
These laws were initially introduced as a means to protect low-income buyers and immigrants along the Texas-Mexico border as the practice of lease-options by unscrupulous builders and developers are what is traditionally blamed for the creation of ‘colonias’ (identifiable unincorporated areas located within 150 miles of the Texas-Mexico border that lack infrastructure and ‘decent’ housing), however; their effect on real estate investors extends far beyond the state’s border regions.
SB 629 and its companion HB 1823 both enter into simultaneous effect on September 1, 2005. The result of these combined new laws is to effectively eliminate the many reasons that investors use lease-options in the first place and the unintended consequence is that, while introduced to protect low-income buyers, immigrants, and unsophisticated buyers, these new laws will actually make it much harder for these individuals to purchase housing due to the fact that they, in many cases, are unable to qualify for traditional mortgage financing and builders and investors will now be less inclined to offer lease-options or ‘rent-to-own’ scenarios as a purchasing alternative under these new laws.
SENATE BILL 629:
SB 629, introduced as an amendment to another law passed in 2001 which revised part of the Texas Property Code (Chapter 5, Subchapter D, Section 5.061) and governed installment land contracts, is a silver bullet for many investors.
Under the previous law passed in 2001, installment land contracts are now considered ‘executory contracts’ and, as such, the seller is required to provide several disclosures. In and of themselves, most of these disclosures are not too great an issue for most sellers; however, the law also stipulates mandatory penalties (which are ridiculously disproportionate to the supposed harm suffered by the buyer) for non-compliance on the part of the seller. The obvious liability for the seller is the fact that any buyer looking for a payday may enlist the services of an attorney for the sole purpose of exploiting a seller’s technical non-compliance with disclosure requirements that the seller may not even have known existed at the time the contract was signed.
With the introduction and subsequent passing of SB 629, the effect is that lease-options, which were not addressed in the previous 2001 law, are now also considered executory contracts along with the installment land contracts already mentioned. This is where things get bad.
One of the primary issues with this change is the fact that investors no longer maintain the benefits of ownership in regards to taxation (as was previously possible) nor are these investors able to take advantage of the capital gains tax rates due to the fact that these lease-options are now legally considered an actual sale of real property instead of a traditional rental scenario with the option to purchase. Because lease-options are now considered a sale, there is a negative tax implication for sellers desiring to defer profits through the use of a 1031 exchange when (and if) a tenant/buyer exercises his option to purchase the property. The sale is deemed to happen as soon as the lease-option is signed and not, as has previously been the case, some time in the future when the tenant/buyer actually chooses to exercise his option to purchase.
As if this isn’t bad enough, very few investors are ‘cash heavy’, meaning that few people actually hold the property that they are selling ‘free and clear’ and that most have some sort of underlying mortgage on the property.
However; under SB 629, a potential seller cannot enter into an executory contract with a potential buyer if the seller does not own the property in fee simple, free from any liens or encumbrances. In addition, the seller also has to maintain fee simple title for the entire duration of the contract. The exception to this requirement (Section 5.085) is that it does not apply to a lien or encumbrance placed on the property that is placed on the property by the seller prior to the execution of the contract in exchange for a loan used only to purchase the property if the seller, not later than the third day before the date the contract is executed, notifies the purchaser in a separate written disclosure of the terms of the seller’s underlying loan.
In short, a buyer could agree (but is not required to do so), before the contract was executed, to accept property that was not held in fee simple if the encumbrance on the property resulted from the seller obtaining a loan in the past to purchase the property. The caveat to this is that the seller must inform the buyer, in writing, as to (a) how much the seller paid, (b) the remaining balance on the current mortgage note, (c) the seller’s monthly payment amount, (4) the seller’s mortgage loan number, and many other traditionally confidential pieces of information that seller’s would never normally release to a prospective buyer. Furthermore, a buyer also could agree (at his discretion) after the contract was executed, that an encumbrance may be placed on the property in order to obtain a loan to make improvements to the property.
HOUSE BILL 1823:
Reading in much the same manner, HB 1823 was the companion bill to SB 629 above and it, in effect, allows individuals who purchase homes under traditional contract-for-deed or rent-to-own scenarios the same rights as other buyers using any other method, including use of the standard Texas homestead exemption, the right to pass the home to a family member if the purchaser dies, and right to take advantage of tax exemptions and deductions (which the seller subsequently loses). Under this new law, lease-options and contract-for-deed purchasing arrangements are now considered ‘executory contracts’ to convey real property and, as such, it takes many advantages away from sellers and gives them to the buyer.
According to John Henneberger, co-director of the Texas Low Income Housing Information (TLIHIS) Service, a non-profit entity whose goal is to assist low income Texans; “After more than 40 years of abuse, the contracts-for-deed system has finally been fixed once and for all. For more than ten years, we have worked with Senator Lucio to curb the predatory practices of those who would take advantage of low-income residents. With this bill, Senator Lucio has ensured that residents of ‘colonias’ and low income neighborhoods all along the Border will no longer be subject to arbitrarily losing their homes under the old contract-for-deed system.”
Senator Lucio, sponsor of the bill and author of SB 629, also stated that “The Texas Senate sent a strong message to those who would prey on the innocence of our low-income Texans with this unanimous vote that we will not let the unscrupulous take advantage of our constituents.”
Under HB 1823 (similar in large part to its parent bill SB 629), some of the key points affecting investors and other sellers who may want to use a lease-option are that:
- lease-options and other contract-for-deed arrangements are now clarified and considered as ‘executory contracts’ which entitles buyers with certain protections;
- purchasers now have the option to convert their lease-options or contract-for-deeds into traditional mortgages;
- sellers are required to keep the property free of liens during the term of the contract although it allows certain prior mortgages liens with certain protection for the buyer;
What this means: If the seller already has a preexisting mortgage lien on the property (regardless of whether it contains a Demand Clause or not), the seller must notify the purchaser in writing before the third day that the new lease-option contract is executed of the lien holder’s contact information, the outstanding loan balance, the loan servicer, payment amounts and due dates, etc. which means that the purchaser will know both the seller’s monthly and overall profit – which the purchaser may use as a negotiating tool against the seller.
- a purchaser, at any time and without paying penalties or charges of any kind, is entitled to covert the purchaser’s interest in property under an executory contract into recorded, legal title.
What this means: Per HB 1823, a seller must give the purchaser legal title to the property if the purchaser provides an appropriate promissory note that contains the same interest rate, due dates, and late fees as the contract. Also, on or before the tenth day after the date the seller receives the aforementioned promissory note, the seller shall either schedule a mutually-agreeable date to execute the deed and deed of trust or otherwise deliver to the purchaser a written explanation that legally justifies what the seller refuses to convert the purchaser’s interest into recorded legal title.
In other words, if you as a seller have an underlying mortgage on the property and the purchaser provides a Note and you must then give the purchaser legal title, the ‘Due on Sale’ or ‘Demand’ clause in your mortgage loan will probably be triggered and you must pay off this underlying debt. However; as indicated in both bills, sellers are prohibited from refinancing the property (to pay off the aforementioned mortgage loan) since the seller is required to keep the property free of additional liens unless the new lien is obtain for the sole purpose of improving the property and it is authorized by the purchaser.
- sellers may not impose any provision that forfeits an option fee or other option payment paid under the contract for a late payment;
- sellers may not impose any provision which increases the purchase price, imposes a fee or charge of any type, or otherwise penalizes a purchaser leasing property with an option to buy for requesting repairs or exercising any other right under Chapter 92 of the Texas Property Code;
- property sold under contracts for deed are required to be legally platted/subdivided and contract for deed owners are now enabled to obtain information in order to determine whether their property has been properly platted;
Due to the enactment of these new laws, lease-options in Texas, which have long been a source of debate and varying legal opinion, have become even more convoluted. Because of this, low-income and credit-challenged buyers will probably find it more difficult to realize the dream of home ownership and investors, along with other sellers of real property, may be well served to invest in markets that do not generally require lease-option alternatives for buyers while actively searching for less-complicated and more mainstream sales techniques such as wraparound mortgages, seller-financing (with the subsequent sell of the mortgage note), and traditional mortgage financing.
