Calculating Insurable Value and the Limits of Liability for Rental Properties

It’s not easy to find a rental apartment these days. Vacancy rates for residential apartments in Canada’s largest cities are at record lows. The country’s 10 most populated metropolitan areas saw their average vacancy rates decline by a collective 10% in 2018 compared to the previous year.

How does this tie in with the Canadian property and casualty insurance industry? These dynamics affect how underwriters determine rental income coverage for a residential apartment building. Assessing the appropriate insurable value (e.g. a limit of liability) for rental income coverage for residential apartment buildings is a much simpler exercise than, say, assessing the business interruption values of a manufacturing business. For example, when assessing rental income coverage, results tend to be more stable, and the business itself is relatively simple.

But pitfalls remain. How can you avoid them? Consider asking the following questions:

What is the annual potential rent for the entire building?

The monthly income statements for an apartment building operation will typically show the total potential rent amount as a line item (assuming a 100% occupancy rate); it will then deduct an amount for ‘vacancies’ to arrive at the net rent collected. This can be a quick way of calculating rental value.

It’s possible that this ‘potential rent’ information is not readily available from the financials. If so, then take the number of units in the building and multiply it by the market value of rent for these units based on current lease agreements in place. If the building has different-sized units (i.e. one bedroom, two bedroom, etc.), you will need to consider this when applying the market rate to the number of units.

Note that Ontario has rent control regulations for occupied rental units; a similar rent control system is legislated in British Columbia. Ontario landlords can increase rents on existing tenants at a government-prescribed rate. The rent increase guideline for Ontario is 2.2% for increases between Jan. 1 and Dec. 31, 2020; this inflationary increase should be factored into assessing the potential annual rent for a building for a future year.

Finally, in addition to revenue for the actual apartments, check for ancillary revenue streams such as parking spaces, laundry, etc.

What is a typical occupancy rate (or inversely, vacancy rate) for the building?

Once the total potential annual rent revenue is established, it may be necessary, depending on the type of policy, to examine the building’s historical occupancy rate.

If the building typically has a high occupancy rate (or if you want to avoid any potential co-insurance issues for an insured if a claim arises), then using an occupancy rate of 100% would be appropriate for the purposes of placing values. However, if the building has demonstrated a prolonged period of vacancy, it may be appropriate to decrease the potential annual rental value to factor in this vacancy.

What are the saved variable costs that the building would experience during times of low occupancy?

Estimating normal vacancy rates can be done on a building-specific basis. The best indicator is often the subject building’s historical vacancy rate. Statistics Canada publishes geographic data on vacancy rates; this data can be useful in adjusting historic rates to consider changes in the local market. For industry-driven boomtowns, for example, things like commodity prices can be a driver of vacancy rates.

What is an appropriate income rate for rental revenues?

To put the question another way: what are the saved variable costs that the building would experience during times of low occupancy? In our experience, income rates for residential apartment buildings are quite high, often in excess of 90%.

In summary, a simple and effective method for assessing an appropriate insurable value for a rental income stream is as follows:

Rental Income Value = (potential annual rent for the subject building) x (typical occupancy rate for the subject building) x (income rate)

Okay, time to get back to my apartment search.

By Cameron McQuaid. Published in the August 2019 edition of Canadian Underwriter Magazine.

The statements or comments contained within this article are based on the author’s own knowledge and experience and do not necessarily represent those of the firm, other partners, our clients, or other business partners.