Property insurance for hazard and liability is often an afterthought in private money lending but should be given careful consideration in every transaction in which you participate. As a private money investor, you need to make sure that you are insured properly, for the right amount, and at the right time.
The escrow company overseeing the closing, or the Private Money Lender (PML) managing your transaction, will help you make sure the proper hard money loan insurance is in place.
Certificate of Insurance
At closing, you will need a certificate from the insurance company adding you as an “additional named insured” on the policy. Be sure the insurance agent coordinating the buyer’s policy understands you have mortgage interest in the property and that you or your firm’s address is properly stated on the certificate of insurance.
Additional Named Insured
Being an additional named insured gives the investor the same rights and responsibilities as an entity named as an insured in the policy declarations. Practically speaking, if there is damage to the property the check will be made payable to the borrower and the additional named insured. This way you can ensure that repairs are made to restore the property to the condition it was in when the loan was originated.
Make sure the amount of coverage the borrower has is sufficient to rebuild the property and/or replace equipment, personal property, and business property should a disaster strike.
Verify the Insurance Certificate
Insurance fraud is common. Be sure to call the agent and verify that the certificate of insurance was issued by the agent and the company. Make sure you have a copy of the insurance certificate several days in advance of closing so you have time to conduct your due diligence.
A certificate of insurance is not the same as a policy. Often times the actual insurance policy is sent weeks or months after closing. If you do not receive a copy of the policy, be sure to call and obtain one and keep it on file. If you did not receive one it could be an indication the name or address on the policy is incorrect.
If you or your firm have an address change, be sure to notify all insurance carriers on which you may be an additional named insured.
Forced Place Coverage
If the borrower does not maintain coverage on the property, most promissory notes or security instruments give the investor/lender the ability to advance funds to force place insurance coverage. This type of coverage is referred to as “forced place coverage” in the industry and requires advance planning for you to obtain.
Your PML likely works with an insurance broker or company that specializes in forced place insurance. Track your borrower’s policies carefully and be prepared to force place if needed.
Junior Liens and Forced Place Coverage
Force placing coverage for junior liens (e.g. a 2nd mortgage) is a bit tricky. If your note investment is a junior lien you need to consider a few things:
- Senior Lien Holder Force Places – If the first lien holder force places insurance, that does not mean your lien is covered. That means the first mortgage lien holder forced placed on their behalf and the insurance only covers their lien.
- Equity – If you do not have equity, you may not wish to force place insurance. Forced place insurance can be expensive and if you have little or no equity, force placing may do you little good. Every situation is unique, so consult with your counsel before making a decision.
Foreclosures and Insurance
If you foreclose on a property and no one bids, the property is said to “revert to the beneficiary.” In layman’s terms that means you own the property. The insurance policy of the borrower, or the forced place policy you may have had is now extinguished and you must put a new form of insurance on the property called “REO Insurance.” Most forced place carriers also offer REO insurance, but it is up to you as the lender/investor to convert your policy from a forced placed to an REO policy.
The REO policy covers properties which you take back as “Real Estate Owned.” Because you often do not have possession of these properties, you cannot obtain a standard policy. Special policies exist to cover lenders for vacant properties, or properties with former owners in possession. When requesting a policy you will decide the amount of coverage for fire and liability.
REO Policy and Junior Liens
If you take back a property as a junior lien holder, you should still obtain a REO policy to protect you from liability. If you have equity, you will want full replacement value for fire, but if you have little or no equity, consider setting your fire coverage very low (most insurance companies have a bottom limit amount) in order to get the benefit of the liability coverage.
For example, you may take back a 2nd as a REO because you wish to hang on to the property as an investment property. Let’s say the 1st was $500K and the property was worth $550K. If you sold it, you would likely have no cash proceeds. In this case, consider setting the fire policy as low as the carrier will go (e.g. $18,000). The cost of the policy will be nominal, but it usually comes with a base $1 million liability coverage. If you were to purchase the liability coverage separately, it would likely cost you substantially more than purchasing the REO policy in this manner.
Check with your insurance specialist to find out your carrier’s policies for REO forced place insurance.
Full Debt Bid and Insurance Policies
Laws vary by state, but in a foreclosure auction it is generally not a good practice to open your lender’s bid at the full amount of the debt. Why? Because if no one bids and the property reverts back to you as the beneficiary, then you are deemed to have been ‘paid in full’. This could be a real problem if the current debt is $400,000 and the property is worth $300,000 due to property damage. If you try to collect on the previous forced place policy (or any other avenues available to collect on your losses) you will have no rights to do so.
The general practice is to start the bidding substantially below the full debt, and then “credit bid” (using your current lien as currency rather than presenting cash) up to the amount, not to exceed full debt. This preserves your policy rights so if you gain possession of the property and find there was damage that occurred that is covered under the forced place policy, you can still collect upon it.
Be sure to cancel your forced place insurance policies after a borrower has either reinstated their insurance, or the property has been sold, or you no longer have an interest.