Don’t Get Caught

We’re all born wet, naked and hungry and uneducated.  Our parents supply food, shelter and clothing but we personally are responsible for our own education as we continue our journey through life.

Therefore  I would like to examine some of the issues of the day about which investors should educate themselves.

As an investor you need to be the best generalist you can possibly be.  Let me help you with your continuing education.

Insurance Traps
Danger of under insurance.

Let’s say you bought an investment property 20 years ago and still own it. When you purchased the property you insured the house on it for $250,000, which was its replacement value at the time of its purchase. You’ve had tenants in this house over that time, undertaking little maintenance on it and simply renewing the insurance policy each year for the original value of $250,000.

Twenty years on it would cost $500,000 now to replace the house and, in addition, the value of the land has tripled over that time. Because of the massive increase in the value of the land you’re more than relaxed with your cover of $250,000 and you appreciate that the property is under-insured.  You’re comfortable in the knowledge that even $250,000 will go a long way towards the cost of a new house.

A cyclone hits your area, your home is destroyed and you now make a claim for the $250,000 under your insurance policy. Your insurer brings to your attention an averaging clause in the insurance policy (common in modern policies) whereby the payout is reduced according to the following formula:

$250,000 (max amount of cover)
$500,000 (cost of new house) = 0.5 x $250,000
= $125,000

The payout on your claim therefore is reduced by half.  How can this be, you ask?  You always knew your house was under-insured but until now you operated under the genuine but mistaken belief that you still would receive $250,000 under the policy.

Your insurer refers to you the following insidious comments about the effect of the averaging clause, which are set out in the explanatory booklet accompanying the original insurance policy:

“This type of clause requires you to bear a proportion of each loss or claim if the sum insured is inadequate to cover the full potential loss.  In effect, you are taken to have self-insured a proportion of the risk, because you have not insured the full value of the risk.”

The moral of the story is that if you don’t want the averaging clause to apply, you must ensure that the level of your insurance is adequate so that your property is always covered for its real replacement value.

You should review your cover therefore every year or two to make sure it is up to date with replacement costs for the property. Do not over-insure either as this will usually get you no extra benefits, since the maximum amount of the cover will be the value of the property, and not the amount you have it covered for.

What loss does your insurance policy actually cover?
Many insurance policies have what appears to be an exhaustive all-inclusive list of events for which your insurance company offers cover.  Don’t be fooled by the apparent all-encompassing cover.

Unless your loss occurs because of one of the items in the list, you are not covered at all.  A better way to go is to take out insurance cover for ‘accidental loss or accidental damage.’  This style of policy will then usually go on to state that you  are not however covered for loss resulting from certain specified or excluded events eg. Terrorist attacks, bomb explosions, war.

In real terms your cover is greater under this style of policy, as the insurance company can only decline the claim if it falls under one of the specified exclusions.  That means it would be harder for the insurer to wrangle out of the claim because to do so, they will need to show that the cause of the loss was because of one of the list of specified excluded events.

Risk of damage passes early
Investors should appreciate that with most real estate contracts in Australia, the risk of damage to the property passes to the buyer on or very quickly after the contract of sale is entered into.

An investor should always, therefore, effect interim insurance cover over the property as soon as possible after a contract is formed and this is usually done by taking out a cover note with a reputable insurer.

Most real estate agents and solicitors acting for buyers can place that cover for you with most sales, but not in every circumstance.  For example, if you’re a buyer of a commercial or industrial property where some business use is being carried on, for example, wood manufacturing or sale of pool chemicals.

In that situation an insurance company will want to send out an inspector to view the premises to assess the risk before agreeing to place the cover, and may even decline to do so because they assess the risk as being too high, eg. A wooden backpackers’ accommodation complex.

If you find yourself in this situation you will need to alter the contract of sale before you sign it to ensure the contract provides that the risk of any damage to the property before settlement remains with the seller.  A suggested clause to be added to the contract is:

“Regardless of any other clause in this contract, the property is at the seller’s risk until settlement date.”

Two insurance policies over one property
Once an investor places a cover note over a property, does this mean that the property is protected by two policies, that is, it is over-insured?  Should not the seller in these circumstances cancel their insurance policy, as the property will be covered by the buyer’s interim insurance cover? The simple answer is no. But, why not?

What if the buyer has failed to disclose to their insurer their appalling claim history under other policies in the past?  This failure to disclose such a material matter would correctly entitle the insurer to dishonor a claim for damage made to the property before settlement.

If the seller had erroneously cancelled their policy in these circumstances, they might find that their property is not covered by insurance at all.  The wise approach then is for a seller to keep their cover current until settlement date.

Tips to give you a head start
For the renovator.  Time is money.  Over-runs can cost you thousands of dollars.  Delays in commencement of renovation work can severely eat into your profit.  You must be ready then to start work immediately after settlement takes place.  It’s also important that you don’t buy now and sell later in a falling market.  You must therefore move quickly.

You should add a clause then to the contract which provides that the seller will give you access to the property before settlement at reasonable times and upon reasonable notice to allow you to measure-up and get quotes from trades people and suppliers, but not to do work.

Will a seller agree to such a clause?  In most cases they will.  A suggested clause would be the following:

“The seller will allow the buyer or the buyer’s trades people and manufacturers access to the property, at reasonable times and upon giving reasonable notice to the seller in writing before settlement, to allow the buyer and its trades people and manufacturers to take measurements and obtain quotes for the cost of carrying out work for the buyers following settlement.”

With the benefits of such a clause, once settlement has taken place you’re “out of the blocks” and up and running with your renovation, with no loss of time.

For the investor. If you buy a property as a “buy-and-hold” investment and the seller is an owner-occupier of that property, on settlement you’ll be looking for a tenant.  Don’t start that search after settlement.  It may take you four to five weeks or even longer to find a tenant.  In the meantime, the mortgage payments are coming out of your own funds.

Give yourself a head start by adding a clause to the contract that provides that the seller will allow you or your rental manager reasonable access to the property at reasonable times to show the property to prospective tenants.  With a bit of luck you will secure a tenant before settlement with no loss of rental income.  A suggested clause would be the following:

“The seller will allow the buyer or the buyer’s rental manager access to the property at reasonable times upon giving reasonable notice to the seller to show the property to prospective tenants of the buyer following settlement.”

A practice that can backfire on you
The practice of using conditional clauses in contracts to drive the price of the property down is common amongst the hard bargaining brigade.  This “Old Russia” style of negotiator, for example, will sign up to buy a property subject to a building inspection.

Following the inspection the buyers will then say to the seller that they will sign off on the building inspection (and proceed to settlement) provided that the price is reduced by, for example $15,000 on the basis that the builder advises substantial work needs to be carried out to repaired the property.

But that claim is simply untrue and the seller knows it.  The street-smart seller was at home the day the building inspector called and when asked by the seller if there were any building problems, the builder replied, “No mate.  Your house is in pretty good shape for its age.  I’ve got no real problems with it.”

Your strategy is now transparent and will create a lot of ill will with the seller.  This style of negotiation could damage you in the future, especially if, for example, the seller plans to rent the property back from you following settlement for a year.

In other words, they will be looking after your half a million dollar investment for the next year.  So beware of this strategy of using conditional clauses to drive the price down.

No seller would be happy with that approach but it will not create the ill will that the other phony approach mentioned above generates with sellers.

Some commentators believe that the same result can be achieved in a much softer way by making the contract subject only to finance approval.

This will be more palatable, they say, to the seller as such a clause is far more common that a valuation clause.

If the financiers’ lender values the property at less than the purchase price, then the commentators believe you can use this to negotiate the price down as well.

The problem with this approach is that you won’t be able to back up your claim about the low valuation by providing a copy of the valuation to the seller, as lenders will generally not give you a copy of their valuation.

Hidden “stings” of buying off the plan
Investors are lured to the purchase of units and houses off the plan by the prospect of big capital gains or the ability to buy a property at wholesale price.

In October this year, during a court case on the Gold Coast involving a prominent local developer, the developer made an amazing admission under oath.  He told the court his property contracts to buy units off the plan come with a hidden sting.

He said in every contract he prepares, he places clauses that favour him as a developer and it was up the buyers’ solicitors to identify those clauses and ask for them to be removed.

The clause in question in the court case was one that allowed the developer to cancel signed contracts three and a half years after they were entered into.

So in a rising market, such a clause gives the developer the right to terminate the contract and retain the benefit of the increase of value in the property.

If the market had not moved during that time, or only moved moderately, then the developer can still insist that the settlement takes place.

It’s vital therefore that when you purchase a property ‘off the plan’ that you obtain independent legal advice as well as read the contract documentation yourself.

State of unit and the complex
It’s very common for developers to give maximum effort to getting the title for the units registered with the Government Titles Office, so that settlement of the sale of the units can take place, and then leave the general tidy up of the unit and the complex, including building defects within the unit, to be finalised in the months after settlement.

From an investor’s point of view this can be fatal, as the unit and the complex might be left in such a poor state for weeks, and even months, following settlement that it’s unable to be rented.

It’s for this reason that I always recommend to clients when buying off the plan that they insert the following self-explanatory clause in the contract.

Without such a clause you may be left to pick up the tab for cleaning and repairing the unit yourself, or wait until the developer gets around to it.

In the meantime you’ll be left to meet the mortgage payments on the loan yourself without the benefit of the rental income from a tenant.

The clause is:
State of unit and complex

The seller guarantees that the lot, complex and all facilities within it will be in a clean and tidy condition on the date of settlement, and available and fit for use and occupation by the buyer, and in particular and without limitation, the lot and carpets will be professionally cleaned and all building work completed in the lot.

In addition, all common areas and facilities within the complex will be professional cleaned and in a tidy condition and available for us by occupants of the complex on settlement and, in particular, all debris, rubble, scrap and surplus building materials will be removed and electricity and gas services will be available to the lot and the complex.

This guarantee is a fundamental term of this contract and has been included in this contract for the benefit of the buyer and may be waived by the buyer by notice in writing to the seller on or before settlement.

A trap with sole/exclusive agencies
In a soft real estate market it may be that you need to engage a second real estate agent to market the sale of your property because the previous agent had not been successful.

You may have given the prior agent an exclusive or sole agency which, in most cases, will provide that at the expiration of the sole/exclusive agency, if the property is sold by you or another agent to someone who is introduced to the property during the term of the first agent’s appointment, commission will be payable to the first agent.

This will usually result in double commission being payable.

It’s therefore essential to ensure that a clause similar to the one set out below is inserted in any contract of sale by the second agent:

The buyer guarantees that [insert the name of the agent who finally makes the sale] introduced her to the property and that no other person has introduced or made knowing to her that the fact that the property was for sale.

The buyer indemnifies the seller for any financial loss suffered by him in the event that this guarantee is incorrect.

This article appeared in Australian Property Investor Magazine and was written by Rob Balanda the author of the ‘Made Simple’ series of publications available from our online bookstore.


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Rob Balanda


Rob is a partner in the Gold Coast based law firm MBA Lawyers. He is a highly regarded educator of property investors and estate agents and the author of the "Made Simple" series of books and CD's.

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