Tuesday, May 6, 2008

Why Extended Home Warranties are Bad for Investment Properties

Over the years I have had this conversation with many clients, but the basis is that Prime Properties generally does not support the use of “extended home warranties” (I will call them EHW’s) for investment properties. There are exceptions, which I will discuss, but for almost all of our clients a EHW puts less money in your pocket over time. The root of our opinion that EHW’s are bad for the investor owner is our strong emphasis on our understanding of fiduciary responsibility and Prime Properties implementation of this obligation to our clients.


Let me lay the groundwork:

The idea of an EHW is where, by paying a fee each year, the homeowner will be protected from extraordinary and unforeseen expenses. The two parallels you find in your life are the extended warranty you may buy for a car or insurance. There are good reasons why someone may buy an extended home warranties and I will discuss why they are popular.

EHW’s exist as an industry because there is a need generated by popular America, but the product is designed for the owner occupied home. The need exists, I believe, because of these two main conditions 1) when American’s buy a home they buy the most home they can afford and do not allocate a reserve to make ordinary repairs or maintain a prudent reserve of funds and 2) American’s are less “handy” with items around a house and the end result is they a) forego basic home maintenance and b) they feel vulnerable to getting ripped off by service people who may be called on to repair their home infrastructure when an item fails.

An EHW solves these two dilemma’s by 1) limiting the top exposure in most cases to less than $1,000 for any major item (this is in spite of their literature which implies a limitation to a $50.00-$75.00 co-pay) and 2) providing access to a pool of vendors/sub-contractors which have been vetted and measured to provide value in a manner so the homeowner is not cheated.

If you are a single professional, with a limited pool of friends who are in a trade and/or don’t have access to friends or family who can provide references to reputable service providers then a EHW should be strongly considered for your personal residence.

Let me now talk about how an investor owner is different than the person who an EHW is designed for. This profile fits 95% of our clients. The 5% who it does not fit is those who are temporarily renting out their home while they live somewhere else (I will address you folks later).

Our client’s primary goal is to see a product (the house) deliver the most income at the least cost over the time period they own the product. An investor, making a knowledgeable informed investment decision knows, understands and allocates (sets aside) about 1% of the value of the investment each year for expected repairs and maintenance. You can do this because you have an asset which generates revenue. These expenses are generally tax deductible. The owner who lives in their home 1) may not have funds available for any repair because they mismanage their finances and 2) if they are fortunate enough to have a year with no expense blow the money on a Disneyland vacation, leaving no money available for the next year’s repairs. Additionally, in these dynamic times, unforseen events like job loss or medical expenses can make even the best financial plans go awry.

In the markets where Prime Properties manage homes the investor should to expect to hold onto the asset for 10-15 years to realize the maximum benefits of 1) appreciation 2) increasing rents and 3) tax benefits of a depreciation schedule. All repair/expense costs should be looked at on a basis of 1) what is the cost/benefit over 10-15 years and 2) how will this impact the ability to maximize the benefit at time of sale. The average ownership in our market for owner occupied homes is 5 years so it is more logical for these owners (and the EHW companies) to make stop gap repairs and let the next buyer deal with the long term problems.

The investor owned home is different than the owner occupied home because the investor has obligations to maintain their home as required by 1) a lease contract 2) Federal, state and local law. Most common are federal laws regarding delivering products as expected (deceptive trade practice or “bait and switch” laws), state and local laws regarding residential tenancies and local laws specifically designed to regulate housing conditions on rental properties. HOA’s may provide additional reason to make repairs. The motivating factors of an owner occupied home are conditional on their personal goals and their personal finances and more flexibility due to less stringent code enforcement.

So, the investor owners are definitely different than the owner’s of homes which this EHW is designed for. Here are examples/reasons why an EHW is not in the interest of most investor owners.

The basic idea of shifting expense does not limit or reduce your expense it actually increases your expenses. Each year Consumer Reports tells car buyer to not buy an extended automobile warranty at time for purchase and the same reasons apply to owners of investment properties. An extended warranty must supply the company who offers the warranty with enough revenue to 1) make any needed repairs (including a profit for the repair company) 2) pay for the cost of administering the offering and 3) include a profit for the warranty company. If you buy an extended warranty for you car or your home you are paying for all three of these items. If you do not buy an extended warranty you are only paying for item #1 above.

EHW’s are designed to repair items whenever possible and avoid replacement. If an EHW company can put a stop gap repair in place which will delay a replacement it is in their best interest to do so. If someone is in their third year of ownership and they can make a $100.00 repair last three years, they will perform the stop gap repair and the person three years down the road (the next owner) will inherit a $600.00 replacement. During this time frame they are collecting $400.00-$600.00/year in premiums from the home owner. You as the investor owner may want to do a one time fix at a cost of $600.00 in order to keep your overall expense down. Additionally having items in a home which work and are not requiring constant repair/attention has positive impact tenant retention. So you are now in a situation where the EHW company’s interests are contrary to your interests. The EHW company has no obligation to look out for you are to even try to be flexible to your desires as they may be different then the owner occupied residence which the product is designed for.

The investor owner has a legal obligation to make certain infrastructure repairs in a timely fashion. The biggest issue is when HVAC systems are failing in the summer. From both a legal requirement and tenant satisfaction goal the investor’s goal is a timely, efficient and cost effective repair. Our experience is the EHW company’s use a small, select group of vendors which will keep the EHW costs low. As these vendors get backed up the time to visit a property can extend to 2-3 weeks. In these circumstances Prime Properties ends up having to use other vendors in order to make the repairs and the EHW is not used at all.

Additional problems which lead to client dissatisfaction include the fact that consumable items are not covered. The biggest and most obvious “consumable” which comes into play is refrigerant used in HVAC systems. There is no control on what the service company charges for this specific consumable and we have seen bills which are twice the typical charge for this expense. The other item which is not covered is the expense of “refrigerant recovery”. Federal law requires that all refrigerant be removed from an HVAC system using special procedures to prevent free release into the atmosphere. The net result is that after paying $400.00 for your warranty, you pay an additional $500.00 to cover the costs of your co-pay and services and consumables not covered in order to replace an HVAC evaporator coil which would only cost you $900.00 to replace if you did not have the warranty.

I can add to this with many more examples, but I hope you understand that when we say we will not support EHW’s you understand the reasons are based on doing everything we can to keep more money in your pocket. There are exceptions to this rule. Exceptions include if you are a new client and already have an EHW in place. If this is the case we will work with you to extract the value of what you have already paid for. The other obvious exception is if your situation is you have tenants in your “home” as a temporary situation because you are 1) temporarily living elsewhere or 2) you are waiting out a temporary market lull and expect to sell the home in the next two years. Please make your property manger aware that you are not the “typical” investor owner and that your goals are different. Every one of our clients has goals which vary, and change, for themselves and each specific property they own. Please let us know what you are trying to achieve then allow us to use our experience to help you make good decisions to maximize the results from your investment.

There is a comment section on this blog - I will be glad to answer any questions you may want to bring up in an effort to provide more insight into this issue as needed.

2 comments:

Anonymous said...

Keven,

Really appreciate the time you spend writing the blog to share your thoughts. Did not take home warranty, agreeing with the contents.

But now I am having second thoughts. Had major repairs in two rental properties over last 3 months. Latest being a leakage in condensor coil that is requiring us to replace a HVAC unit at a cost of about $2200 (Jeff King is property manager). Last month I had another issue that was over $1k to repair at a different property.

Just wanted to share to know your thoughts as I greatly respect your opinion.

Thanks,
Gade Harish Reddy

Property owner with Prime Properties

Unknown said...

Harish,

I understand why you would have had second thoughts on this. It is harder to be blase about this when you have had back to back issues. The analysis would have less relevance if you were only holding the homes for 2-3 years, but I know you are planning to hold the homes for 5-10 or even 15+ years. The analysis takes into account factors which play out over time. Your short term financial damage will in fact save you money over the next 5 years. Even if you had paid $400/year for your home warranty your out of pocket expense for replacing an HVAC unit would be an additional $400-$500 because removal and replacement of the refridgerant is not covered nor is other consumables. Your real out of pocket for this year would have have been $800-$900 with a warranty, so you only paid $1,300 more because you did not have a warranty. You will make this up by avoiding additional major expenses over the next ten+ years and not paying the $400/year for the warranty ($4,000 in savings over ten years).

The other unknown is you stated you replaced the system because of a coil leak. If it was a simply coil leak the warranty company would have only replaced a coil even if the whole system was on it's last legs. You replaced the whole system and you did this because of a desire to be proactive and eliminate an additional expected repair in the near future due to the age of the system. The warranty company would not have replaced the system at this time, they would have simply replaced the coil, and when the rest of the system failed they would have another repair, at an additional $400-$500 cost on top of your annual warranty premium.

It appears you are making good decisions that will leave more money in your pocket over time. Again, these discussions assume you are holding onto a property for 5+ years. Our experience (based on managing over 2,000 homes) shows you should expect annual repair/maintenance expense at 1% of the value of the house, so on a $150,000 home you should expect about $1,500/year in repair/maintenance. You will have often have 2-3 years with no mor than $250.00 in repair/maintenance expense but that will be balanced by the carpet replacement in year seven and another HVAC replacement at year twelve.

Kevin Martin