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Dancing with Hurricane Irma

I don’t like cold. Let me put that in perspective: if it’s less than 70 degrees, it’s cold. One of my lifelong goals was to get out of the cold and live in a place that never got below 80. I spent a few vacations during my youth in the tropics, and decided that’s where I wanted to live. Someday. I saved and invested during my 20+ year real estate career specifically for that day in the distant future when I could pay cash for my tropical home. This is the story of the decisions made with that purchase and how we fared in the recent dance with the forces of nature.

The Purchase Process

My first choice for this home was the Cayman Islands, but, as tends to happen, my children grew up and I enjoy their company too much to be so far away. Seeing as how I couldn’t keep my children forever young, my wife and I settled on the Florida Keys (the closest thing there is to tropical in the continental U.S.). In 2012, after a two-year search, we finally found a house that fit our exact needs and that we could pay cash for. We were looking forward to living debt free in the house and location of our dreams. The Find in OTA’s Find-Analyze-Close or FAC process was done, now time to analyze.

How to properly analyze a real estate opportunity.

The steps in Analyze depend on exit strategy. However, regardless of exit strategy there are two basic steps. In my wholesale class, I call these A1 and A2.

  • A1 is the step in which we estimate the after repaired value (ARV) of a property.
  • A2 is the process of establishing the profitability of the deal.

My exit strategy for this deal is own forever, which means that I need to analyze what it costs to own the property. For this article, I’ll limit the considerations of A2 to the monthly costs of ownership and ignore opportunity costs. Since I plan to pay cash for the house, this step boils down to the monthly cost of taxes and insurance.

Ownership Costs:

  • Property Taxes and Fire/Hazard Insurance – $350 per month, within expectations
  • Wind and Water Damage (hurricane and flood) Insurance – $1000 per month, ouch!
  • Required Modifications Due to FEMA and County Regulations – $15,000 Ouch again!

My first thought was that $1000 per month will finance a really nice home in New Mexico, PITI. My second thought was that, if an insurance company is willing to insure me for that price, is there a way to insure myself?

Evaluating Self-Insurance

Free Real Estate Investing WorkshopWhat if, instead of buying insurance, I took 5 years-worth of insurance premium ($60,000), together with the $15000 that it would take to bring the house up to insurable code, and bought a house in New Mexico (in New Mexico, it is possible to buy a nice rental for $75000). What if I called this house my Hurricane and Flood Insurance Policy, or HFIP. What if I created an LLC that has that property in it, a bank account solely for that property to receive rents, pay expenses and invest accumulated cash?

Why 5 years? Because that is, ignoring the time value of money and opportunity cost, the break-even point, or the point at which I would have paid out the cost of the HFIP to insure the Keys home.

Why a rental in New Mexico?  Because the risk associated with owning a rental in New Mexico is uncorrelated with the risks of owning in the Keys, and because I know the market in New Mexico very well.

A bit of research showed that, on average, an indirect hit by a category 4 hurricane will cause about $65000 in damage. A direct hit (meaning where the eye of the storm passes directly through a given location) is very unlikely. A category 5, direct hit or not, is another unlikely event but of course is a possibility. Obviously, either of these events could be catastrophic. There is a lot more to the analysis than what is in this article, but I determined that if I went 5 years without a category 4 or higher storm, it would be preferable to buy the HFIP rather than buy an insurance policy. The risks of self-insurance, however, are not for the timid investor. If a direct hit or a category 5 storm were to occur, the risk is a complete loss. That means that I MUST be willing to lose everything if all of the worst conditions occur, or if my risk assessment was faulty. It follows that some measurement of risk to reward is appropriate.

Risk/Reward for Purchasing an Insurance Policy

This equation is simple: $1000 per month, plus a deductible, plus the opportunity cost of the monthly premium is the risk, The reward is peace of mind that, regardless of what nature throws at me, my investment is safe.

Risk/Reward for Self-Insuring

If I self-insure as described above, the risk is total destruction and, therefore, total loss of the property, less whatever salvage value remains if the structure was flattened, less the equity and accrued cash of my HFIP. The reward of this strategy is worth considering. First, as with any real estate acquisition, the standard benefits of real estate ownership are mine to keep. In this case, those are (for both properties): appreciation, tax advantages (depreciation), and cash flow (the Keys home has a rentable apartment). Since I am proposing to pay cash for both properties, I won’t be able to take advantage of the benefits associated with leverage. At the time I was analyzing the deal, it was early spring and hurricane season was less than two months away. There was a tangible risk that a storm could hit within a couple months of closing and flatten my new home. If that happened, there would be no time to enjoy natural appreciation, cash flow or tax advantages.  That brings me to the crux of success in real estate, which succinctly put, is that profit in real estate is made when you buy. In the context of self-insurance, if I were to pay anywhere close to the ARV, I would have to wait for market forces and time to accrue enough advantage to make it work. That’s gambling. However, following the wholesaler’s creed, we instead need to buy at 70% – 75% of ARV in order to have enough profit margin. I can apply that premise to my situation and see what the numbers look like.

Calculating ARV

If I were to buy both properties at 70% – 75% of their ARV, including expenses to make necessary repairs, then on the first day after I acquired both properties I would have about $118,750 in total equity. This is calculated as follows: for the HFIP, the expected equity would be $75,000 times 25%, or $18,750. For the subject property, whose ARV was around $400,000, the equity would be $400,000 times 25%, or about $100,000. Of course, if the property were completely destroyed in a storm, there would be no equity. On the other hand, if it sustained average damage of $65,000, I would still have $35,000 in equity. That’s enough equity to wholesale it to a flipper and walk away with a small profit.

A final consideration in the analyze process was to evaluate how the property survived other hurricanes. The property was built in 1991, and two Category 4 storms hit the house … Georges and Wilma … and it survived. There are no records to tell what damage the house sustained, but it was standing. Further, the builder was still in business building the same style home in the Keys, so it seemed a good risk.

Spoiler Alert!:  Hurricane Irma came right at us! Look for next month’s article to find out if we suffered minor damage or total loss.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.