Most investors recognize the importance of protecting themselves from unnecessary risk. But what do you do when there is little you can do to predict – or even prevent – damage that has a catastrophic effect on your investment?
Mother Nature is responsible for billions of dollars in damage every year. If you’re unprepared, you risk losing tens of thousands of dollars in repair costs at best… or being forced into bankruptcy at worst because you failed to examine the fine print in your insurance contract.
The Force Majeur Provision
The language in a real estate or insurance contract can be critical when it comes to cleaning up after a natural disaster.
One provision in particular, known as the force majeure provision, presents particular difficulties. Force majeure literally means “superior force” in French. It’s a term that refers to the liability of one or both parties in the event that extraordinary events or “acts of fate” occur. According to the law, acts of God refer to a natural or man-made event for which no person can be held responsible.
In the event of a disaster, investors are required to give notice of a force majeure as soon as possible. This is critical, since some provisions give just a few days after the occurrence to notify the other party. If you fail to do so within the specified period of time, you could forfeit your right to be reimbursed for the event.
Don’t Miss The Deadline
Some owners have inadvertently missed the deadline because they were busy trying to do damage control, so adding in a few buffer days is important when writing a lease or signing a contract.
The force majeure provision becomes even more complicated if you are in the middle of purchasing a property or worse, construction. In the former instance, the language in the purchase contract will determine how to handle damages and repairs. In the latter, however, the situation becomes more complicated.
Typically after a natural disaster, several things that directly affect construction of your property may happen.
First, material costs will go up, since most likely there is very little stock in the area, and any remaining materials will need to be brought in from outside of the disaster zone. Not only will this take time, but everyone who has sustained damage will need many of the same materials… which will inevitably create shortage, and further delay your timetable.
Second, city or state officials will most likely make changes to the building code in an effort to prevent severe damage in the future from a similar event.
Although this may be absolutely necessary – Florida, for example, escaped serious damage in many areas due to strict new building codes – it also means you will need to change the original plans for the building. This too will increase the time it takes to complete the project, and raise the cost of completing construction.
Third, you will almost certainly be faced with labor shortages, as workers local to the area are likely to be dealing with damage to their own homes, while new workers are few and far between.
Ramifications of the Force Majeure Clause
Many leases contain generic descriptions of the force majeure clause. As an investor, you’ll want to make sure to clarify exactly what types of events are covered. For example, does it cover power blackouts? Acts of terrorism? Strikes? What about if there is a software bug?
This is critical not only for insurance purposes, but also because a buyer’s lender may not be willing to appraise the property at its proper value if the insurance company will not be held liable for renovating the property completely.
If this happens to you, make sure you agree on this issue during the due diligence period; without insurance coverage banks will not close on the property, even if there is just minor damage.
Another factor that affects both the buyer and the seller is ensuring provisions are made to accommodate an inability to complete a closing or perform essential transactions, due to force majeure. For example, a hurricane in Florida would definitely prevent a buyer from transferring funds electronically, or filing electronically to any other state.
Both the buyer and seller should work out language that determines how long each side is required to wait to complete the transaction, and at what point the other party will be considered as having not completed the transaction in time.
How to Protect Yourself Whether You Are the Buyer Or the Seller
As an owner renting to a tenant, you can decrease your financial responsibility for damages to the property and business by including language in the lease that requires the tenant to have insurance.
This should include business interruption insurance, so that in case there is damage to the space, the tenant will have less of a financial claim on you as the owner.
If you are a buyer and have already put down a security deposit, then the insurance company can cancel the sale by refusing to provide insurance to you. There have been laws enacted in several states preventing insurance companies from canceling insurance until after repairs, however, so it’s worthwhile to check out the law in the state where the property is located.
Keep in mind that if the sale is canceled, you will still forfeit your deposit, even though the situation was out of your hands.
Another problem buyers may have is if zoning or other building laws or enacted that raise the cost of the property. Depending on what the lease says, you might be forced to close anyway, despite the higher price. Plus, it’s entirely possible that you’ll be forced to take the seller’s insurance, which may not be able to cover the new regulations now required by the city.
If you’re a buyer negotiating the language of a lease, the ideal situation would be to include a clause that holds the seller responsible for all repairs that need to be made on the property. The wordage of the lease would also prevent the seller from selling the property unless repairs were made.
Of course, it’s unlikely the seller would agree to this language, so at some point between due diligence and the end of the inspection period, you would have to make a decision about whether taking a risk on a damaged property is worth it.
On the other hand, if you’re the seller then you’ll want to have a clause that exempts you from making any repairs, while assigning insurance to the buyer.