The Definitive Guide to Commercial Real Estate Risk Management
Even in times when the real estate market is healthy and thriving, there are still a plethora of risks that making a career out of real estate entails. As a commercial real estate professional, you need to not only make sure that your property is protected, you also need to worry about interactions with clients, employees, tenants, investors, and a variety of other parties involved in your operations.
With so many moving parts involved in nearly every aspect of purchasing, selling, and renting property, the margin for error tends to be small while the chances of facing an expensive, time-consuming lawsuit are great.
Certainly, having the right business insurance program can help mitigate many of the risks that come with the territory, but what other steps do real estate professionals need to take when putting together a strong real estate risk management program?
Most quality real estate risk management plans are based on three general strategies; avoiding risk, controlling risk, and transferring risk.
Risk avoidance means choosing not to take part in activities that are deemed too risky. Risk control entails having a plan that is going to minimize the impact of potential risks. Risk transfer means shifting responsibility to a third party, which is where business insurance usually comes into play.
Keeping this in mind, let’s take a detailed look at some of the major risks that commercial real estate professionals face and talk about what they can do to protect their businesses and property from these common risks by putting together a strong real estate risk management plan.
Risks for Real Estate Agents and Brokers
The greatest risks that real estate brokers and agents face are intrinsically tied to the relationships that they form with their clients.
The very nature of the real estate business leaves brokers and agents subject to any number of potential lawsuits and claims, merely as a result of their daily business activities. A simple mistake or some bad advice given to a client can result in a costly lawsuit. In order to determine the best insurance products for real estate agents and brokers, we should first examine the differences between the two titles.
Even though the terms “agent” and “broker” are often used interchangeably, there is a slight difference between the two. The broker is basically the agent’s higher-up. Agents are licensed real estate salespeople and even though the state licenses them, they can’t make any sales without a broker.
The brokers are actually the people who are liable for the actions of their agents, which is why there are great education requirements that are necessary for those that want to take the step up from being a real estate agent to being a broker.
But since the two work in symbiosis, they are tied together by a specific set of risks that they face in their everyday work as both agents and brokers.
Accidents, Injuries, and Damages
Real estate agents and brokers can’t make sales from their offices. They need to go out to the property and show it to people in order to make deals and rent/sell property to interested parties. This leaves them vulnerable to many possible mishaps that could lead to lawsuits.
For example, you put together an open house for a very popular property that many people attended, and when all is said and done, you notice that the flooring has been damaged. Or your potential buyers bring their children to see a property and the child ends up slipping on a wet floor surface and breaking a leg. Even the agent could suffer an injury at an open house, it happens all the time.
There are always things that real estate agents and brokers can do to be more diligent and prevent accidents when showing property. The National Association of Realtors (NAR) even offers tips on holding safe open houses.
However, these are concerns that can be assuaged in some capacity through business insurance. A general liability insurance policy would protect you from personal injury and property damage claims, while a workers compensation policy would pay medical expenses and lost wages in the event that one of your agents is injured on the job.
Lawsuits from Unsatisfied Clients
Real estate is a very sensitive profession. Buying property is a much more serious matter than buying a toothbrush, and clients who believe that you haven’t performed your duties up to par can and will sue you and your company.
Whether you make a mistake in the contract you’ve put together or you fail to disclose an issue related to the property, you can be sued. Even if your client sues you simply because they believe that you didn’t do enough to help them buy the property they wanted, even without any concrete proof that backs up those claims, you could be in for a long and expensive lawsuit regardless of its outcome.
Being a real estate agent or broker also comes with its own set of ethical codes that need to be followed and violating them could also result in a buyer or seller wanting to take you to court.
Professional liability or errors & omissions insurance can protect you in such situations. If your client claims that they suffered damages because of an error you made, this policy will pay your defense costs and potential settlements.
As we’ve already mentioned, real estate agents and brokers are on the road quite often, traveling to open houses, viewing residences, or meeting with clients outside of the office.
Any agent or broker that spends a lot of time in their vehicle should seriously consider purchasing commercial auto insurance because if you get into an accident while driving for work-related reasons, your personal auto insurance is not going to cover those costs. If you’re looking to cover cars that your company rents for agents or the personal vehicles that your agents drive, purchasing a hired and non-owned commercial auto policy might be the best option.
No matter what type of work you do within the real estate industry, market swings are an inevitable risk associated with the profession. Being able to navigate between the boom and bust periods is essential.
There is no insurance that can protect your real estate business from market crashes, however. What is essential for combating these risks is constant diligence; always paying attention to key indicators and business trends and making financially wise decisions based on the data that is available is a very important part of any real estate risk management process.
NAR offers a directory of state and local realtor associations that members can access, which enable real estate professionals to view and follow key market statistics that are usually released on a monthly basis. National and state employment reports are often a very good indicator of real estate demand and fluctuations in the market, for example.
Risks for Real Estate Managers and Owners
The more your portfolio grows as a property manager or owner, the greater number of risks you will face. A recent Deloitte report on the state of commercial real estate preaches that successful managers and owners need to turn to data and analytics more than ever in order to stay ahead of the curve.
One of the greatest challenges today, with the rise of the Internet of Things and the overwhelming amount of data that is available to us, is being able to selectively decide what data is important and how to effectively use the data that will provide your business with the key indicators it needs to follow in order to achieve its goals.
The same can be said about putting together a proper real estate risk management program and processes. What are the top risks that every property manager or owner should be honing in on and looking to mitigate most?
Physical Property Risks
The number one issue that real estate managers and owners need to be aware of at all times is the state and condition of their property. No matter how many properties you are running, big or small, physical property damage is a constant risk.
When you are selling and renting property, having to maintain your real estate is one of your biggest concerns. Furniture will break, paint jobs will dim, and the exterior of your property will deteriorate due to weather conditions even if no one is living in it.
Repairs need to be performed regularly and should always be handled by licensed professionals, not the property managers themselves or the tenants.
Investing in maintenance is an obvious necessity, but so is investing in commercial property insurance. This insurance coverage will protect you from issues that are sometimes out of your control that can cause property damage, perils such as fires, explosions, or burst pipes.
If your property is located somewhere where earthquakes, wildfires, or flooding are common, it’s a good idea to include these perils into your coverage, which will obviously be more expensive. Because of such threats, it can also be said that climate change and other environmental issues should be deemed as very serious risks to the real estate industry.
Storm damage and property losses that are the direct result of climate variance are a very real problem for real estate managers. Likewise, so are the increased insurance premiums and lower property limits that have become a trend directly influenced by climate change.
Environmental challenges are also ever-present in real estate and increasingly expensive to both remediate and insure against. Issues such as vapor intrusion from underground storage tanks and even mold issues can have a serious impact on your property.
Even if the real estate manager believes that they have put together a strong insurance program for property protection, it is still recommended to require tenants to purchase additional general liability insurance to protect the property from damages potentially caused by their negligence.
Taking on tenants is probably the single largest risk in all of real estate, especially for owners and managers. There are so many variables involved when it comes to dealing with tenants and it’s almost impossible to account for most of them.
Whether there are hundreds of different individual tenants being managed by your real estate company or you’re dealing with a small number of large entities, such as companies renting office space, risks are plentiful and ever-present.
Property managers are often sued by tenants who are injured, claiming that their injuries were the result of the manager’s negligence. Even if your company does end up winning the case, the legal costs can really pile up, which is why general liability insurance should be purchased by all real estate professionals.
Property owners can help decrease the possibility of injuries by performing regular maintenance and repairs. Keeping good records of incident reports and performing data analysis for trends related to reported property damage issues can also help identify problem areas earlier and allow you to take steps towards resolving them.
Furthermore, screening procedures and requests for recommendations from prior landlords can also help to decrease the chances that your tenants are going to be problematic. Since this is far from a foolproof solution, property management is also encouraged to work with their legal team to put together a detailed contract that could help managers recover lost income in the event that a tenant causes property damage or refuses to pay rent.
If you’re serious about your real estate business, you’re obviously going to have an accountant that’s keeping tabs on your financials and even a full administrative staff that’s going to handle everything else that goes into managing real estate; contracts, incidents and claims, tenant information, rent rolls, maintenance tasks, and more.
Even if you’ve hired a number of professionals to handle these administrative tasks for you, there’s still no guarantee that an administrative error won’t occur. Even the smallest errors could result in serious losses for your clients, partners, and even tenants, who can take you to court in order to receive reimbursement.
This is why professional liability insurance (also known as errors & omissions) is a key coverage that all real estate professionals should have. Professional liability will cover all court costs and possible settlements related to an error a staff member has made or bad advice that you have given which led to financial losses suffered by a third party.
As mentioned earlier, employee injures on the job are not uncommon in the real estate industry. Real estate managers and owners are not only responsible for the safety of their direct staff they can also be held liable for injuries suffered by contractors or construction personnel they have hired to perform repairs on their property, which is why having robust workers compensation coverage is also a very good idea.
While workers compensation requirements in some states do allow some real estate agents and brokers to self-insure (meaning that they can cover staff injury costs themselves instead of purchasing insurance to cover potential workers comp claims), most states require owners and managers to obtain coverage for their employees.
If your real estate company is involved in more serious construction projects, it’s also a good idea to look into surety bonds. Surety bonds form an agreement between you and the construction company or contractors that you have hired which protects you from possible losses resulting from the construction company failing to make good on what was promised in the terms of the agreement.
Furthermore, the real estate industry is in no way immune to employment-related lawsuits of harassment, discrimination, wrongful termination, and failure to promote. Every serious real estate business should put together a proper management liability program that protects its top executives and officers from potential lawsuits. Having the right employment practices liability insurance (EPLI) in place is one of the cornerstones of this type of insurance program.
Real estate managers and owners keep a lot of sensitive data on their computers and are constantly exposed to a large number and variety of cybercrimes.
Cybersecurity statistics show that nearly every industry is being affected by cyberattacks, and real estate is no exception. Property managers store sensitive client, customer, and tenant information such as Social Security numbers, credit card numbers, and more, making them a vulnerable target for data breaches.
These attacks don’t always have to be spearheaded by outside figures and can be the result of social engineering in which employees were tricked into delivering sensitive information to hackers or simply staff participating in criminal activity that results in severe financial losses for your organization. In fact, a recent report by Deloitte showed that insiders provide the information needed for 37% of data attacks in real estate.
This is why real estate professionals not only need a strong cyber liability insurance policy, but also a commercial crime policy or fidelity bonds to protect them from cases of employee fraud and dishonesty.
Risks for Real Estate Investors
Investing in real estate often appears to be safer than investing in less palpable things such as stocks and bonds, since you’re buying actual, physical assets. However, the risks that are associated with real estate investment can be just as hard to predict and define as is the case with any other type of investment.
Does property investment correlate positively with your return requirements and risk tolerance? That is something that every real estate investor needs to ask themselves before putting their money towards a new property.
The best way to answer these questions is by considering some of the more prominent risks that real estate investors face, most of which, unlike the majority of risks commonly faced by brokers and property managers, can’t be mitigated with the help of insurance products.
While every type of real estate professional needs to have a very strong understanding of the market and the trends that cause peaks and valleys, real estate investors might be the ones that need to be most warry since they are usually putting a lot more money into the market at once than managers and brokers.
As we’ve already mentioned, the best way to mitigate these risks is through diligence and analysis. Understanding the macroeconomics of market risk and taking a critical approach towards evaluating the markets that you are looking to invest in will allow you to make better, less risky decisions in the long run as a real estate investor.
Making sure that your portfolio of investments is diverse in terms of the type of properties you are investing in and where they are located should help dissipate market-based risk considerably.
While we’ve already talked about protecting property from damages through commercial property insurance coverage, there are other property risks that investors need to consider more so than brokers and property managers.
Real estate investing is a long-term process and there are many things that can happen both to the property and to its surroundings that could devalue the property greatly over time. For example, what if you invested in an apartment complex because of the fantastic view that came with it, but five years later, another building is constructed that obstructs the view completely?
These types of risks are both hard to predict and hard to protect against, leaving property investors with the task of trying to compensate for what was lost (the great view) by introducing a new selling point to would-be tenants that might cost a lot to introduce and promote.
That’s why it’s always important to research not just the property, but also the entire neighborhood and surrounding area, in an effort to find out whether there are building plans of any kind in the community that could have a negative (or positive) effect on your property.
The depreciation of value over time is another thing to consider. At one point in time, your property will have to be either renovated or replaced in order for it to remain attractive to would-be tenants.
Can you afford to renovate or replace the property while continuing to stave off the competition? Or is the better investment to sell the old property and look for something new?
The definition of liquidity in real estate is your ability to sell the property at any given time. Again, this requires research on the end of the investor in order to make sure that, if something happens and they are forced to sell the property, that it will sell easily and (at least) make back the money that was invested.
Obviously, location is essential. But that doesn’t mean that a less popular location can’t turn into an excellent one in ten year’s time. Obviously, selling property in New York City is always going to be easier than selling property in Iowa. However, what if your research tells you that you would be able to make double what you invested in the Iowa property in 10 years compared to making only a 20% profit on your New York property?
Real estate investors need to always look towards the future and evaluate and identify potential trends in order to stay ahead of the curve.
Credit and Debt Risks
If you have invested in real estate that you are leasing, a credit risk always exists. This risk is defined by the fact that a chance always exists that your tenant will not pay their rent. Obviously, the credit risk is much smaller if you are leasing an office to a large corporation for a 10-year period compared to renting out apartments to individual tenants on a monthly basis.
If you are taking out loans in order to invest in property, then a level of debt risk exists as well. The severity of debt risk is measured by how easily you are able to make loan payments using the money that you are making off the property. Most experts will agree that a good loan-to-value ratio to be maintained is making sure that the debt of the property is not greater than 75% of its value.
Real estate can be a very rewarding profession for those who are willing to accept the fact that risks can sometimes be just as great as the rewards involved. And while many can be avoided through diligence and best practices and some can be significantly mitigated with the help of business insurance, not all risks can be covered and accounted for in real estate, or any other professional service for that matter.
Making sure that all of your insurable risks are covered as thoroughly as possible is one of the main responsibilities that real estate business leaders have towards their companies and something that needs to be a central part of your real estate risk management plan.
If you’d like to discuss your real estate insurance program in order to better understand your needs, don’t hesitate to reach out to one of the expert brokers in our real estate practice at any time.