A cautionary tale when investing in rental property…

I was attending a get-together dinner recently for members of my curling club, as curling season begins in earnest this month.  Jackie, one of our esteemed  board members (and the most ebullient curler in our group) was recounting her rather unfortunate recent tale of woe.  It  involved a small, but rather intense kitchen grease fire that she accidentally started in her apartment.  Of all the possible worst-outcome scenarios, she has to consider herself lucky – she, nor anyone else in her building, were harmed.

Her apartment was not so lucky.

To her credit, she had the foresight to have a kitchen fire extinguisher on hand in case of emergency, and coupled with her staying calm under pressure, she was quickly able to extinguish the flames caused by the fire.  (Note to  landlords:  provide fire extinguishers for all your tenants….you know – an ounce of prevention and all…)  Unfortunately, smoke damage to her unit was extensive, and while the local fire department did not have to put any fire out, the local building inspector pronounced her unit uninhabitable, forcing her to seek temporary lodging.

Several key issues arise from this accident…

Since she as the tenant was responsible for damage to her unit, what exactly is she responsible for?  Does the landlord have to make the necessary repairs (utilizing a specialized fire-damage contractor, for example).   What time frame must the repairs be done?  Doe the landlord have to allow her back into his building after the repairs are made?

To make matters even more complicated, Jackie mentioned this little addendum to her tale of woe:  the landlord was set to close on the sale of the building in a few days.  So, what happens to that sale?  Can it go forward as planned?  What liability, if any, does the current owner have to the buyer, since they are under contract?

A bit of a pickle, right?

Let’s start with the basics – that is, Jackie’s rights and responsibilities as a tenant.  She apparently did not have a lease, and was on a month to month tenancy arrangement with the landlord.  Very common…but alas, very unfortunate for her and her landlord.    So when investing in rental property, know that without a lease, the landlord has no requirement to reinstate a tenant in his building after repairs are completed to the unit.  In this case, Jackie most probably will have to look for another living arrangement.

Liability issues

Next – what is the extent of Jackie’s liability in this case?  She started the fire, so landlord negligence is not applicable here.  Most leases have traditional damage clauses in them. For example, a standard Blumberg lease calls for the tenant to make all repairs at their own expense when a fire is started due to their negligence or act.

But if the tenant has no renter’s insurance, it is doubtful they will be able to cover all related repair expenses.  So in reality, the limit of financial liability for any tenant  is the full amount of their security deposit.  If there is no lease, then the security deposit is all the landlord can recover.   (Though legal action to recover further damages can be sought in the court system, it’s usually quite difficult and pointless for landlords to attempt to recover from most cash-strapped tenants.)

How to best protect yourself

Obviously, you as a landlord need to protect yourself.  So the three basic rules to be learned here when investing in rental property are:  You must always have a lease.  In that lease you must always require the tenant to carry renter’s insurance.  And that lease must also require that you be named as a co-insured on the tenant’s policy.

Now,  if the tenant has a tenant’s insurance policy, then the tenant’s insurance carrier would be in the first position to pick up the tab for all repairs due to the tenant’s negligence.  However, if the tenant has no renter’s insurance, then the landlord’s building insurance policy would come to the forefront, and would pay for the requisite repairs (less the deductible of course).    And the landlord could use the tenant’s security deposit to defray the cost of his deductible, for example.

Either way, the tenant is still responsible for their rent up till the time the unit was damaged.   If the unit becomes uninhabitable, the tenant cannot be charged rent.  Of course, the tenant usually wants to move back in after repairs are completed.  So it behooves the tenant to aid the landlord in finding a contractor quickly to make those repairs as soon as possible.  In this case, without a lease, it becomes the landlord’s option whether to allow Jackie back in as his tenant again.

If other tenants in the building were affected by the fire as well, the landlord can’t demand the tenant make restitution for the other tenants’ rent roll, or repairs to their units. In that case, the landlord’s insurance policy would cover both the lost rent revenue from other tenants, as well as  increased expenses due to the additional repairs from the fire damage.  However, any time a claim is made on a landlord’s insurance policy, obtaining subsequent coverage for future buildings may be much harder to get.  In addition, premiums may rise on existing policies as a consequence of a claim.  That’s why it’s also so important to require your tenants to carry their own insurance, with you named as the co-insured on that policy.

The hard part

When there is an existing contract of sale in effect between the landlord and a buyer for the rental property and  then disaster strikes prior to closing – whether through an act of nature, or an act of God… or an act of  Jackie…the seller is required to put the building back to the condition it was in when the contract was signed.   This does not mean they are required to make everything new.  De facto, some repairs require new materials  – for example, new sheetrock being installed due to a small amount of fire damage.  Or, in the case of a total destruction of  a building due to flood, fire, tornado, etc. the buyer is not entitled to a new building.

As such, most real estate contracts cover this rare possibility by allowing the buyer to either accept the seller’s insurance company’s amount for replacement coverage, thereby taking the building damaged, as is, along with the settlement cash,  or they can walk away from the deal with their deposit returned to them.

Renegotiating

In the case of a smaller amount of damage, like oh, say… a small kitchen grease fire, then it is common for some amount of renegotiation to occur.  The buyer will usually be presented with several scenarios:  if they want a quicker closing, they can wait for the seller’s insurance company to present an amount they are willing to offer the seller for the repairs, as mentioned above.  The buyer could then accept that amount, take the building as is, then close and make the repairs themselves.

Another alternative is for the seller to make the repairs to the building, in concert with their insurance company.  While this is common, it will also take much longer to close, as everyone must wait for not only the insurance company to send an adjuster out, but also a claim amount must be approved with the seller, and then a contractor has to be hired and he must then make all the repairs prior to the closing being set.  Yet another option is for the seller and buyer to renegotiate the price of the building immediately, not waiting for the insurance adjuster.

Delays abound

In all cases, it ain’t pretty.  And if the buyer had his financing set to go for the original closing date, he might lose it if the closing were to be delayed by more than a month or two.  And usually a sales contract would spell out a buyer’s rights in event the seller has to delay a closing.  (The norm would be that the buyer unilaterally would then have the right to exit the deal if he chose not to wait.)

The bottom line

So while poor Jackie has to wait for all these issues to sort themselves out,  including finding temporary housing, she also wonders if she can be locally “blacklisted” by area landlords for her accident.  And the answer is yes, she can.  When subsequent landlords ask for her prior landlords contact information to check her references as a tenant, they may disqualify her as a prospective tenant for purely economic reasons:  she has unfortunately made herself a higher-risk tenant due to this one accident.

But there will always be landlords who don’t do their homework, and don’t check references when selecting tenants.   In a more positive light, some landlords may be more understanding of a prior accident, and not be so rigid, if they can be financially protected.  As mentioned above, a solid lease which calls for a tenant to have renter’s insurance, and which names the landlord as co-insured, should be adequate protection for anyone investing in rental property.

photos courtesy of  biancoinsurancepittsburgh.com, glogster.com, recipetips.com, floridarealestatelawyerblog.com, intowner.com, startribune.com, home.howstuffworks.com, insurancequotes.com, ehow.com