Commercial real estate (CRE) assets are places where people live, work, and shop. As such, the investors who own them are exposed to some level of liability associated with incidents that happen on their premises.
In this article, we are going to define what liability is and how commercial real estate investors can protect themselves from it. By the end, readers will be able to identify where liability exists in a commercial real estate investment and use this information to guide their investment decision making process.
At First National Realty Partners, we leverage our significant experience and operational expertise to mitigate the liability risk that arises from owning commercial real estate assets. To learn more about our current investment opportunities, click here.
What is Real Estate Investor Liability?
From a real estate investor standpoint, the term “liability” refers to the risk of financial loss (short term or long term) that arises from ownership of a commercial investment property. For example, the owner of a multifamily property may be exposed to some amount of financial liability if a tenant slips on the stairs and hurts their back or if a storm causes a tree to fall onto the roof of the property. In either case, the owner could be on the hook for some amount of money to pay for the tenant’s lost income or for repairs to the property’s roof.
Clearly these sorts of large ticket, unexpected expenses are not desirable. Fortunately, there are steps that investors can take to protect themselves from this sort of unwelcome surprise.
How Real Estate Investors Can Protect Themselves and Their Investments
In real estate investing, there are a number of widely accepted strategies that can be used to protect against the financial liability associated with an unexpected event. They include, but aren’t limited to:
Limited Liability Companies
In commercial real estate investing, nearly all properties are purchased through a Limited liability Company (LLC). This is a separate legal business entity formed specifically for the purpose of owning and operating the commercial rental property. The idea behind this structure is to limit an investor’s financial liability to only the assets contained within the LLC. To illustrate how this is helpful, let’s pick up one of the examples above.
Suppose the damage from the tree falling through the roof was so significant and the financial loss so great that the LLC had no choice but to declare bankruptcy. Creditors of the LLC, like the senior lender or property management vendors, can only pursue the LLC for payment. Except under extreme circumstances, it is unlikely that they could pursue investors or property owners personally for the debts of the LLC.
As an ancillary perk, the LLC also provides investors with a number of tax benefits because it acts as a “pass through entity” where income and expenses pass through it to be taxed at the individual investor level.
Given the legal and financial implications of LLC formation and ownership, it is always a good idea for real estate investors to consult with a qualified real estate attorney and/or CPA to ensure a transaction is structured properly.
Compartmentalization of Assets / Asset Separation
Creating a limited liability company is a best practice when purchasing one property. When assembling a multi-property portfolio, it is a best practice to create a limited liability for each property separately. This practice is known as “compartmentalizing” assets.
For example, assume that an investor owns five separate office buildings. If all of them are owned in the same entity and one of them suffers a substantial loss, the other four are exposed to risk if a creditor attempts to recoup payment for something. But, if each of the five properties are “compartmentalized” in separate LLCs, the liability is limited to just the assets that the single LLC owns. In addition, this sort of separation also protects individual investors from personal liability in the event of a financial loss.
A typical commercial property carries multiple types of insurance, including:
- General Liability Insurance: To protect against loss from things like slips and falls, properties carry liability insurance.
- Hurricane / Flood / Earthquake / Wind: To protect against loss from damage caused by natural disasters like a hurricane, earthquake, or fire, properties may carry additional specialized insurance designed to protect against these specific events. In some cases, the investor may choose to purchase these policies on their own. In others, they may be required by lenders or other interested parties.
- Business Crime / Data Breach: In an increasingly digital world, it is possible that a property could suffer a loss associated with hacking or some other type of digital crime. These are insurance policies that are designed specifically to protect against this and property owners are well served to purchase one.
- Business Income: If there is a sudden and unexpected loss of rental income, for whatever reason, business income insurance can protect owners against loss. In many cases, the payout is designed to replace the lost income for a certain period of time and stabilize property cash flow.
- Commercial Umbrella Insurance: Finally, a commercial umbrella policy is designed to offer an “umbrella” of protection to help pay for the costs over and above certain policy limits.
Buying insurance allows property owners/investors to pay a little bit of money each month in the form of an insurance “premium” to protect against the loss of a lot of money due to an unexpected event. This sort of protection is critical to limiting financial liability in a commercial real estate investment, regardless of property type or asset class.
Another way that individuals can protect themselves from certain types of liability is to make investments anonymously. Typically, this is accomplished by establishing an anonymous trust through which real estate investments are made. In this structure, the names associated with the trust are not recorded upon creation of the LLC, which provides an additional layer of investor protection.
How Private Equity Firms Handle Liability
For an individual, one of the major benefits of working with a private equity firm to make a commercial real estate investment is that they have a significant amount of experience in two areas necessary to limit investor liability:
- Transaction Structure: The most experienced private equity firms know exactly how to structure a real estate investment to minimize investor liability. In most cases, this includes creating limited liability companies and compartmentalizing assets, but there are other steps that may be taken such as negotiating financing terms that limit the ownership entity’s financial liability in the event of a loan default.
- Insurance: Again, due to their experience, private equity firms know which types of insurance to purchase, how much coverage to obtain, how much it costs, and which firms to work with to ensure that a payout will be provided if needed.
Remember, private equity firms are typically investors in their own deals. As such, it is in their own best interest to limit a property’s liability in every way possible.
Summary of Real Estate Investor Liability
Real estate investor liability is the risk of financial loss associated with an unexpected event such as a storm, flood, or slip and fall.
Every commercial property exposes investors to some level of liability. It is unavoidable, but there are several proactive steps they can take to minimize it.
Loss mitigation steps include: creating limited liability companies to compartmentalize assets, purchasing adequate insurance coverage, and investing through anonymous trusts.
When working with a private equity firm, much of this liability mitigation work is completed by the firm itself. In doing so, they are able to leverage their experience and expertise to minimize investment liability for both themselves and their investors.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.