Asset Protection: A Rational Approach

“You’re going to lose everything you own,” the speaker solemnly warned the audience at a recent real estate investment program.  “We live in a very litigious society,” he continued; “you need asset protection.”

Real estate investors, as a group, will flock to hear speakers talk about the need for what is commonly known as “asset protection.”  They will spend hundreds, if not thousands of dollars setting up elaborate business entities (the LLC – “Limited Liability Company” – being the most popular), in an effort to avoid “losing everything.”  Ironically, many new investors spend more money on “asset protection” than they do on real estate.  Sometimes they end up with all sorts of asset protection entities, but no assets to protect.

There is a more rational and practical approach to asset protection.  Setting up the correct business entity to allow you to achieve your real estate investing objectives is both important and necessary.  The correct entity will allow you to take full legal advantage of tax benefits and provide a structure for running the business.  Properly established and registered, the entity will allow the investor to work with investment partners, obtain financing, and provide a basis for determining the relative percentages of ownership and allow for succession and continuity for a successful operation over a period of time.  And yes, the entity will provide a measure of “asset protection” for the benefit of the principals, if the entity is properly established and capitalized, and has complied with the appropriate level of corporate formalities.

However, no form of entity is a substitute for good risk management.  The fundamental components of a good risk management program are (1) good management practices, (2) adequate insurance coverage, and (3) regular review and oversight.  For real estate investing, good management practices include using the services of a reputable, licensed, professional property management company.  The relatively small cost (usually 6 – 8%) will be more than justified by the savings from avoiding disasters.  Good management includes proper screening of tenants; regular and thorough inspection of the investment property, arranging for prompt and competent repairs, and if necessary, timely initiation of eviction proceedings.

In addition to standard form “all risk” fire insurance policies, adequate insurance coverage should include, where appropriate, flood, earthquake and other forms of disaster coverage.  I recommend that tenants be required to carry renters insurance, which can cost as little as $12 per month, but will cover the tenant’s personal belongings, relocation costs (if necessary), and injuries sustained by their guests.

Last, but not least, good risk management practices includes regular review and oversight.   “File and Forget” is not a smart way to manage anything.  Prudent owners make sure they manage their property managers, and take steps to ensure that their expectations are met.  Do not just sit back and hope the checks roll in every month.  Be proactive. Pay attention.  Ask questions.

But what about “asset protection.”  What if something “bad” happens, the tenant sues, and the investment property is in your name and not buried under an onion’s worth of layers of special entities?  What can happen?  Indeed, what DOES happen?

First and foremost, the type of liability that owners need to be concerned about involve claims resulting from personal injury, either to the tenant or their guest.  Injuries can range from a sprained ankle caused by a crack in the walkway to serious brain injury (or death) resulting from a collapsed balcony or similar structural failure.  There are also potential claims based on acts of discrimination, for example, but in terms of monetary damages, the “big ticket” issues usually arise from personal injury cases.

In such cases, the first and best line of defense is good property management, as discussed above.  In terms of avoiding catastorphic loss, investing in good prevention can yield a very high rate of return!  The next line of defense is your insurance policy (or policies), which should include comprehensive general liability coverage.  In the event of a claim, the insurance company will provide legal counsel and will pay for investigation and other costs arising from the incident.  If early settlement does not resolve the issue, and the matter proceeds to litigation, your insurance company is most likely under an obligation to provide a defense in most cases.  There are general exceptions, such as for willful or deliberate acts, and specific exceptions, such as where the policy does not cover certain types of loss unless a special “rider” has been obtained; i.e. flood, earthquake, etc.

Statistically speaking, it would be extremely rare if you found yourself facing a full-blown lawsuit with a prospect of a large jury verdict that might exceed the limits of your insurance coverage — the type of catastrophic “lose everything” outcome that promoters of “asset protection” programs use to sell their services.

Let’s look at the reality — not the hype.  It is fairly well established that close to 90% of all lawsuits that are filed will settle before going to trial.   So, if your insurance company has not been successful in resolving the claim and the plaintiff (i.e., your tenant) proceeds to file a lawsuit, the probability of the matter going to trial before a jury is 1 in 10.  Arbitration, mediation and other forms of formal dispute resolution are mandated by most State rules governing litigation.   In California, the parties are required to participate in a Mandatory Settlement Conference the week before the start of trial.  Statistics vary, but in one County, the Court noted that one-third of all remaining cases settle at the Settlement Conference, usually held on the Wednesday before the start of trial; another one-third settle on the Friday before trial, and a percentage settle even after the jury has been seated.  Again — as a statistical fact — very, very few cases make it all the way to the end of trial.  And even after the Jury renders a verdict, there are appeal procedures, that work to modify the outcome.  Many headline-grabbing jury awards are often reduced — drastically — by these types of procedures.

Real estate investors should consider the actual threat of “losing everything” in considering how best to protect their investment and their personal assets.  Sadly, many new investors spend more time focused on so-called “asset protection” measures than they spend doing their due diligence in relation to the investment itself.  Investors pay money to set up elaborate LLC entities only to find themselves locked into a bad investment with other partners they did not take time to know.  If one added up all the personal injury jury verdicts that exceeded insurance policy limits over a 10-year period in the United States, I wonder if the total amount would come close to matching the losses caused by Bernie Madoff and his scheme.

This is not to say that forming a LLC or a C-Corporation is not a good idea.  Properly done, the appropriate business entity provides the means to manage your investment assets, entitles you to certain tax benefits, and manage your investment partners.  But a business entity should never, ever be a substitute for good management practices.

Get Legal Advice BEFORE You Invest

Why should you seek legal assistance as part of your due diligence when considering an investment opportunity?  For starters, it might be a lot less expensive than seeking legal assistance after something goes wrong.  To be perfectly honest, I would really prefer not to hear a client tell me “I wish I’d talked to you sooner.”  Actually, there are several ways an attorney can be a valuable member of your real estate investment team.  Here are a few points to consider when making the decision how to maximize the return on your legal dollar.

For starters, you need to focus on your goals.  Most successful real estate investors have a clear focus on their financial objectives.  If you have a plan and are focused on clearly defined and realistic objectives, you’ll be able to communicate these objectives to your investment team.  By staying focused, you can avoid distractions and concentrate on your goals.  How can you expect your advisors to help you get where you’re going if you don’t know where you want to end up?

The next step is to make sure you consult with an attorney familiar with real estate issues.  Not all attorneys are equally knowledgeable in all areas of the law.  You wouldn’t hire a plumber to do your electrical work, or consult with a foot doctor for a head injury.  For the same reason, a brilliant patent lawyer may not be the best choice for evaluating a real estate investment opportunity.   If you are not sure — ask.  It will save both you and the attorney time — and money.

Next, heed the age-old maxim:  “You get what you pay for.”  Don’t start the conversation “Do you give free advice?”  The right attorney is going to provide you with valuable advice that will be worth the cost.  The attorney – client relationship is not only privileged, and over a period of time your attorney can become a very valuable and trusted member of your investment team.  Work on developing a long-term professional relationship with your attorney, and you will realize a good return on your investment.

Spend wisely.  Let the attorney know your budget.  Most attorneys will work with you, so long as you have realistic expectations and take a reasonable approach.  At the same time, recognize that the true measure of value of professional advice is avoiding the loss of your investment.  If you are investing $50,000 in a project that promises to yield a 10% return, you need to measure your legal costs against the risk of losing the entire $50,000, not as a percentage of your profit.  Remember, you will hopefully be able to apply good legal advice over and over — thus maximizing your return on your legal investment.

Avoid litigation.  One of the reasons to do your due diligence is to avoid situations that will result in litigation.  Unfortunately, there are many:  poorly drafted investment contracts; easement disputes; zoning violations; and overzealous promises, to name a few.  No one benefits from litigation except trial attorneys.  Aside from the costs, there are the inevitable delays, fractured relationships, and lost opportunities.  Again:  Avoid litigation.

Follow the advice.  You paid for it — so use it!  Of course, it’s your choice.  But you should at least give the legal advice some consideration before you take action.  Many times, an attorney cannot unequivocally state that a particular real estate investment complies 100% with all applicable state and federal laws, tax codes, SEC regulations, etc.  Each investor should recognize that there is no such thing as 100% certainty, and adjust their risk tolerance accordingly.

Ultimately, the decision whether to proceed with an investment is up to the individual investor.  Seeking advice from financial planners, tax advisors, real estate professionals and attorneys, as well as from experienced investors, is all part your due diligence.  Getting legal advice before you invest is often a smart investment strategy.

Arbitration: Be Careful What You Ask For

In the past I’ve written about the importance of reading and understanding the Arbitration Clause in your contracts, and warned you not to sign until you fully understood the consequences. I also noted that the U.S. Supreme Court had granted certiorari to hear arguments in a case that raised the question whether the arbitrator had interpreted the parties” contract in determining that the parties had authorized a class action.  The case, Oxford Health Plans LLC v. Sutter, 675 F.3d 215, was affirmed on June 10 by the U.S. Supreme Court.

Dr. Sutton is a pediatrician who provided medical services under contract with Oxford Health Plan.  The contract included a binding arbitration clause for any contractual disputes. Alleging that Oxford had failed to fully and promptly pay him and other physicians with similar contracts, Dr. Sutton filed a proposed class action.  Oxford moved to compel arbitration, and the court granted the motion. The parties agreed that the arbitrator should decide whether or not the contract authorized class arbitration, and the arbitrator concluded that it did. Oxford then filed a motion to vacate the arbitrator”s decision, claiming he had exceeded his powers under Section 10(a)(4) of the Federal Arbitration Act.

While the case was pending, the U.S. Supreme Court issued a ruling in the case of Stolt-Nielson S.A. v. AnimalFeeds Int”l Corp., 559 U.S. 662 (2010), which held that an arbitrator may employ class procedures only if the parties have authorized them.  In Stolt-Nielson, the parties stipulated they had never reached an agreement on class arbitration, so the arbitrator”s decision approving the class action in the Stolt-Nielson case was held casino online to be in excess of his powers.  Based on the ruling in Stolt-Nielson, Oxford asked the arbitrator to reconsider his decision. The arbitrator issued a new opinion saying that Stolt-Nielson did not apply; in the Oxford case the parties disputed whether the contractual language authorized class actions, whereas in Stolt-Nielson, the parties agreed they had not established intent.  The arbitrator in the Oxford case reaffirmed his conclusion that class arbitration was permitted based on the intent of the parties.

The key lesson of Oxford is the extremely limited scope of judicial review available to vacate arbitration rulings. Under the Federal Arbitration Act (FAA), courts may vacate the arbitrator”s decision “only in very unusual circumstances.” The Court goes on to note that FAA Section 10(a)(4) authorizes a federal court to set aside an arbitration award where the arbitrator exceeded his powers, but declares that a party seeking relief bears “a heavy burden.” “It is not enough … to show that the arbitrator committed an error–or even a serious error.”  The Oxford Court went on to declare that “the sole question … is whether the arbitrator (even arguably) interpreted the parties” contract, not whether he got its meaning right or wrong.” (Oxford; emphasis added.)  In other words, The arbitrator”s decision, even if he committed a serious error or got it wrong, will withstand a legal challenge to vacate unless the aggrieved party can show that arbitrator”s actions were outside the scope of his contractually delegated authority.

Driving home the point, the Court ruled that Oxford chose arbitration, and “it must now live with that choice.” Even if the arbitrator made a “grave error,” it would not be sufficient to vacate the award. “The potential for those mistakes is the price of agreeing to arbitration.” Agreeing to submit a dispute to arbitration is a bargained-for risk.

In other words – be careful what you ask for!

Flippers and Rehabbers Beware

The primary goal of flipping houses is to make a profit. Investors seek out properties with the intent of making basic improvements and reselling them. An experienced flipper with a skilled crew can turn a distressed property into an attractive turn-key investment opportunity. However, there are several traps that await the investor/flipper. Even a technical violation of state contractor licensing requirements could expose the investor to substantial risk of serious financial consequences.

In addition, if the contractor you hired is not licensed, or does not have workers” compensation insurance, the workers brought onto the job site might be classified as employees of the property owner! Check – and double-check – whether your contractor is currently licensed and has proof of workers” compensation insurance!

Many states, such as California, require anyone who does any improvement work on real estate that requires a permit must declare they are licensed as a contractor, or demonstrate that they are exempt from the licensing requirement. Some investors seek to take advantage of the “Owner-Builder” exemption and bypass the need to hire a licensed general contractor, doing some of the work themselves and hiring subcontractors as necessary. For those investors with the required skills and know-how, this could result in significant cost reductions and boost the profit margins. For those whose experience is limited to watching a few episodes of “Flip this House,” it could result in a disaster.

Qualifying for the Owner-Builder exemption is not easy. The Contractors State License Board (CSLB) division of the California Department of Consumer Affairs provides a checklist for Owner-Builders in a brochure appropriately titled: “Owner-Builders Beware!” Among the requirements is that the Owner-Builder must register with both the State and Federal Government as an employer, and be responsible for complying with various payroll withholding requirements. Most importantly, the Owner-Builder must provide Workers’ Compensation insurance. The Owner-Builder is responsible for supervising the job, obtaining building permits and all inspections, and making sure that all workers and material suppliers are paid.

Moreover, in order to qualify for the exemption, the Owner-Builder must sign an affidavit, under penalty of perjury, affirming they have read, understood and agree to comply with the applicable provisions of State law. The declarant must affirm that the property is your personal residence that you have occupied for 12 months prior to completion of the work; that the work must be performed prior to the sale of the home; and the exemption can only be used twice in any three-year period. For those flippers who seek to turn properties more often, the exemption is not available.When hiring a general contractor or subcontractor, investors, flippers and homeowners are cautioned to check and casino online confirm that the contractor is licensed and in good standing before signing the contract, and should recheck to ensure that the contractor remains in compliance at all times for the duration of the work. This can be done by checking the CSLB website ( and checking the name and number provided by the contractor. It is very important to confirm that the name the contractor is using on the contract is the same, exact name registered with the CSLB. Also, check to confirm that the contractor has a workers’ compensation policy in full force and effect for the full duration of the contract.If a contractor’s workers’ compensation policy expires and is not renewed, the contractor’s license is automatically suspended. Although this would prohibit the contractor from recovering any compensation under the contract, it may also expose the property owner to liability for any claims from any of the contractor’s workers or subcontractors.

Private lenders involved with rehab projects should be aware that if a contractor’s license expires or is automatically terminated for technical reasons (i.e., expiration of a worker’s compensation policy; improper transfer to a different entity, etc.), the contractor may be required to disgorge all compensation received under the contract. (B&PC 7031) Having an experienced contractor can make a big difference in the success of a rehab project. Taking a few minutes to confirm that your contractor or subcontractors are properly licensed and in compliance with state requirements can be the best investment in your investment project.

Taking Stock of The Fools Advice

The Motley Fool provides a wealth of information and tips for stock market investors.  In a recent article, “Stock Market Risk Reduction,” offered some excellent tips for reduce risk in the stock market.  These same tips would easily apply to real estate investors.

1.  Be a long-term investor, not a short-term speculator.  The Fool warns that holding stock for only a short period of time is “not investing – it”s gambling.”  The same is certainly true of real estate. Building wealth in real estate takes time. Even Flippers soon realize that the real value of their business model is doing many deals over a longer period of time, some of which will make more than others. The law of averages will catch up.

2.  Increase your knowledge.  The Fool puts it well:  “The more you know, the fewer mistakes you”ll likely make.” So true!  The Fool cautions against relying on the “tips from friends or strangers.”  Many novice investors jump at prospects based on what they heard from their buddy or a promotional event they attended.  Due diligence is the process of obtaining relevant information in order to reduce the risk of loss. You need to take time to understand the market, the area, and the factors that will impact your investment. Attend a real estate investing association that provides educational programs and training, not sales pitches.  Read books and articles, and topical blogs such as those provided by The Bigger Pockets.

3.  Limit your downside.  The Fool recommends that in investing in stocks, you need to consider the valuation of the company. The same applies to real estate. Learn to assess the true value of real estate that you are considering. Experts often say you make Du kan l?se om dem alle her pa online. your money on the purchase, not the sale. Spending too much on a property, compounded by failure to control rehab costs, can quickly wipe out your return and even result in a loss!

4.  Avoid futures, commodities, option, penny stocks, shorting and margin – at least until you”ve learned a lot about them.  Good advice for stock investors! In real estate, there are numerous examples of complicated investment schemes that are extremely risky, and should be avoided until you understand and accept the risk involved. Unfortunately, there are a lot of promoters who make a lot of money selling program packages for the novice real estate investor with promises of quick riches that involve complex schemes that are at best risky, and at worst, might be illegal in some states! Stick to the basics and learn the fundamentals before you venture into the deep end!

Don”t be a Fool – learn before you earn!