Legal Issues
Although
you should have checked into as many issues as possible prior to even
writing the offer, you must now do some serious investigation.
Title Insurance
Report
If not available prior to writing
the offer, obtain the preliminary title
report or chain of title report as soon as possible. Also obtain
legible copies of all documents referred to in the report. Title
reports often contain errors, so question any items that weren't expected
or don't make sense.
Zoning & Building
Codes
If not done prior to writing the
offer as recommended in Lesson 5, you should now check into zoning and
Building Code & Permit matters.
Licenses & Permits
Depending upon the city, county, and/or state
in which the property is located, it is possible that a variety of licenses and/or
permits might be required for rental properties. Some jurisdictions require
rental property certification or business licenses, with the cost usually depending
upon number of units or the gross income. While these items are not legally
your problem until close of escrow, it is best to know what's required and have
your all your ducks in a row prior to closing. You also need to know whether
any inspections are required to obtain the certification or license and, if so,
have the inspection done prior to closing in case there are problems.
Some locations have a rental tax or fee at the
city, county, or state level, some locations have it at two or even all three
levels. Some tax only commercial properties, while others also tax residential
at the same or a different rate. The frequency of reporting and paying
taxes owed often depends upon gross income. For example, under a certain
total gross rent for the property requiring quarterly reports and payments and
over that amount requiring monthly. Unless all leases provide for the tenants
paying for the tax, you need to know the correct numbers in order to do your
financial analysis. It is not impossible for all levels of tax to total
3 to 5 percent, so it can significantly affect the bottom line when not paid
by the tenants.
Financial
Your purchase contract should have required that
the seller provide financial records that show income and expenses for at least
the past 12 months. These records should be detailed enough so that you
can determine expenses in the various categories. While income will be
somewhat verified by the leases, verification of expenses can be more difficult. The
best verification is from the check register along with cancelled checks. You
can instead require copies of the associated parts of federal income tax returns
for the past one or two years, (Schedule E and perhaps Schedule C) but you have
no way to be sure that these are the same as filed with the IRS. You
can also determine realistic expenses on your own.
Use rent data from the leases themselves. Take
into account any increases that take effect within the year after expected close
of escrow.
Get insurance quote from at least two agents and
use their recommendations regarding needed coverage. Do not use the sellers
insurance expense amount without knowing exactly what coverage was purchased.
Get latest tax info directly from the county. If
the assessed value is available for a year subsequent to the year for which tax
amount is available use the future value and current value and current tax to
calculate the future tax amount. While this won't give an exact number
without knowing the future tax rate, it should provide a better number to use
for your analysis.
NOTE:
Property taxes may be increased substantially based on your purchase
price. Make sure you understand the local tax assessment policy and
use the likely new tax amount for your proformas.
Be sure to obtain accurate and true data
for all other expenses. Verify the data to the degree possible. For
example, if landscape maintenance is a monthly expense verify from the
existing vendor what the total annual cost is. Don't us the amount
for a winter month. Don't forget snow removal expense where that
is a factor. Be sure that the amount used from rubbish collection
is the cost for realistic collection frequency. If the location
is serviced by more than one company, get quotes from them all.
Remember that you will want to consider changing
vendors after you own the property anyway, so each quote that you obtain at this
point will be one fewer that you will need to get later.
You should also take a look at the conditions
of the roofs, parking lot, heating/cooling systems, and any other major components
to determine (1) whether there is deferred maintenance that will need immediate
attention (lender may even require it) and (2) what type of annual reserve payment
you need to include in your analysis (lender may do so).
Although you came up with the price that you were
willing to pay when you wrote the offer, you have to re-analyze the value, using
the same procedures with perhaps more complete and accurate data. Also,
if you structured your contingency periods properly, you will have the results
of whatever inspections you performed.
If you now come up with a value of less than you
offered, it should only be because of (1) information from full documentation
was different than from that originally provided before writing the offer or
(2) previously undisclosed physical or environmental defects were uncovered during
inspections. In either case, you can exercise the appropriate contingencies
and try to negotiate a lower price or, if the seller is unwilling to renegotiate,
cancel the deal.
Documentation
Leases
You
should be sure that you are provided copies of all leases and related
documents, including amendments, guaranties, checklists, and house rules.
Be
sure that all pages of every document are of good readable quality -
you may need to provide copies to the lender and/or for a lawsuit. Read
these documents very carefully. Be sure that you can live with
terms of all leases until they expire, at which time you can replace
the documents with your own better ones.
One reason lease documents are important is to
verify rent income. While income verification is not as important for a
duplex at a location where you are certain of the market rents, for larger income
properties, particularly somewhat unusual ones, it is important to verify actual
rents. This is particularly important regarding unique commercial properties
for which it is difficult to independently determine market rents.
Be sure that you have all
leases and amendments to leases. Read them through carefully, looking
for all issues that affect the net operating income or value of the property
both now and in the future. For commercial properties, look for
the the following issues:
-
Any lease that gives the tenant an option to or a first
right of refusal to purchase the property or to lease other space
in the future - make a note to renegotiate the issue at the time
of future extension or renewal.
-
Any lease that has remaining terms of more than one
year or option to renew beyond that date - the terms can be important
for future cash flow and property value.
-
Any lease signed by an entity having limited liability
such as corporation, limited partnership, or LLC - make a note to
require a personal guaranty at the time of any future extension or
renewal.
-
Is tenant or owner responsible for maintenance of major
components such as plumbing and electrical systems within tenants'
premises and heating/cooling systems for individual tenants.
-
Are leases gross, NNN, or some variation in between. Be
sure to notice differences among units.
-
Must the owner contribute to the cost of future tenant
improvements.
For residential property, the first four items could appear
even though not common, but the last two items would be very unusual.
Lead-based Paint Disclosures
For Tenant
For residential property constructed before 1978,
verify that the lead paint issues are fully covered, as discussed in Lesson 5.
Other
Tenant Info
Since the value of leases is dependant upon the
financial strength of the tenant and/or guarantor, it is of value to obtain copies
of applications, credit reports, financial statements, and/or other documentation
upon which the decision to lease was based. You should also require copies
of written complaints from current tenants, any police reports regarding current
tenants, and any notices (e.g., inspection reports) regarding violation of laws
or regulations.
Estoppel
Certificates
Although often not utilized unless required by
the lender, as they usually are for larger properties, estoppel certificates
should be used for every purchase of a tenant occupied property. An estoppel
certificate is a statement signed by a tenant (1) affirming his lease documents
(attached to Certificate) and the deposit/rent amounts; (2) confirming that there
are no agreements outside of the attached documents; and (3) confirming the date
to which rent has been paid. The document is sometimes called a Certificate
of No Defense. A sample basic Certificate is available in our members-only Forms
Web.
Without an estoppel certificate, you may find
out after closing that (1) a tenant had a first right of refusal or option to
purchase that he'd not been given opportunity to exercise or (2) there is a lease
amendment that the seller had neglected to provide which extends the lease for
3 years of the unit that you planned to move into after close of escrow.
If closing is delayed, it might be necessary to
get updated amendments to the certificates to cover rents collected since the
previous versions were executed or certain other special changes in circumstances. It
is even possible that a lease could have been amended or a new lease executed. On
this subject, be sure that your purchase contract gives you control over any
lease changes after its acceptance.
Inspections
Every offer to purchase real estate should be
contingent upon a thorough inspection of the property. Whether you need
the inspection performed by someone other than yourself depends upon your knowledge
and experience. If you are new to real estate investing, and/or building
construction, DO NOT try to do an inspection on your own. Even experienced
investors usually take some qualified, but disinterested, third party along when
they check out a property before purchase. Homebuyers often fall in love
with a home because they like the trees on the lot, or the pool, or even the
wall paper. Investors cannot afford to do that.
If there is any doubt after you and a qualified
assistant have gone over the property, hire a professional, particularly for
those items that your inspection raised concerns about and for complex components
of a complex property. In the latter category would be a central air conditioning
system in a 16-unit apartment building.
While one should be concerned about physical inspections
when purchasing a personal residence, it is usually of greater importance when
purchasing income property. There are several reasons why this is so.
First, rentals are often mistreated by tenants. Second,
many landlords do minimal maintenance, often for only things that break, and
do little or no preventive maintenance. Third, some income properties,
particularly the larger complexes, have types of equipment not found in a single-family
home.
Be sure that your purchase contract makes contingencies
out of all inspections and allows adequate time to get the results of the inspections
taking into account inspector scheduling, holidays, weekends, weather, time to
analyze the reports, and time to utilize a contingency if necessary.
Physical
Hopefully, you have written a good contingency
clause regarding physical inspections into your purchase contract. Now
you have to decide how to use it. There are a lot of things that are candidates
for close inspection, and what is important depends upon the type and size of
the property as well as the complexity of some of the systems. The ones
that are often of concern are as follows:
-
Roof - Depending upon the type and age of the
roof and your technical qualifications, you will want to either do
your own inspection or hire a roofing contractor or other qualified
inspector to check it out.
-
Heating/cooling systems - If you're looking
at a 4-plex and each unit has its own individual system, each of
which is 5 years old, you are probably at low risk if you simply
verify the approximate age by calling the manufacturer with the model
and serial numbers. However, if you're buying a 16-unit building
with 30-year old central heating and air conditioning systems, you
should definitely hire a licensed heating/cooling contractor to thoroughly
inspect the system.
-
Electrical - The degree to which the electrical
system might require inspection depends upon the age of the property,
but can also depend upon property type and size, and. For
residential property built in the past 20 years, there is probably
little of concern except to determine that the electrical service
for each unit is of adequate amperage and if there is aluminum wire,
things that you can easily check yourself. However, if the
property is 60 years old, you should have an electrician check out
the panels and wiring. If the property utilize aluminum wiring,
you should also consider having it inspected by a qualified electrician
to verify that connections of the aluminum wire are in conformance
with code. For certain commercial properties, inspection by
a qualified person can be important no matter what the age of the
property . For example, consider an industrial building. You
want to be sure that it has both adequate voltage - at least 240V
and maybe even 480V, depending upon possible uses - and sufficient
amperage - this being extremely variable, depending upon possible
use. You would want to utilize an electrical contractor with
applicable high-power experience to analyze the system.
-
Plumbing - Lead pipes, polyethylene pipes MORE
-
Gas - properly vented water heater and
other gas appliances MORE
-
Pests - This inspection is relatively inexpensive
and is usually required by a lender anyway, so you will probably
want to require it. While often referred to as a termite inspection,
the inspector will also be interested in evidence of other insects,
particularly other wood eating ones such as carpenter ants, as well
as in rot and conditions conducive to insects. For example,
for a wood siding building, they usually want to see dirt at least
2 inches below the bottom edge of the siding. They may also
note things such as a inadequately caulked bathtub that allow moisture
to enter the surrounding walls.
You can either hire individual
specialized contractors for each component or hire a property inspection
service to cover the entire property. Whether
you hire a single property inspector or a separate inspector for each
of various components depends upon the type and complexity of property. Having
independent inspections by professionals can sometimes give you more
leverage in re-negotiating the deal when problem are found.
We
all know that it's a good idea to have a property inspection
when we're buying a 50-year old property with questionable plumbing,
electrical, and roof and with 25-year old appliances, but what
about when buying a brand new property directly from the builder
with new plumbing, electrical, and roof and with latest-model
appliances. In reality,
the most important time to enlist the services of a property
inspector can be before closing escrow on new construction. In
fact, older properties can even have the advantage of defects
having long ago been discovered and repaired.
Many buyers assume that because the home is brand
new, city or county inspectors and the builder will have found any problems and
rectified them before the property is ready for occupancy. However, City or other
government building-inspectors are sometimes overworked and routine inspections
are completed quickly. Most building departments have little time to thoroughly
inspect each property. While inspectors look for code violations, differences
between the approved blueprints and actual installations may vary greatly and
seldom are checked by inspectors, much to the surprise of most buyers.
These buyers close escrow without having the property
inspected, even though the cost of the inspection is negligible when compared
to the price of the property. New construction is never absolutely free of defects,
regardless of the quality of construction or the reputation of the builder. There
are always problems that show up only after the property is being lived in. Some
problems surface to create problems after the first occupant has just moved in,
while others surface only years later when the property is offered for sale and
the seller or buyer has the home inspected. By this time, the one-year guarantee
has expired, the two-year deadline to file a complaint with the Registrar of
Contractors has passed, and the seller is stuck with repair costs.
It's an unfortunate fact that many city and county
building departments will issue a building permit to a contractor without checking
to see whether the contractor's license is in good standing with the Registrar
of Contractors. As a result, some contractors with suspended or revoked licenses
or who submit license numbers belonging to other contractors end up constructing
new property.
How can a buyer check to see whether a contractor
is properly licensed? You should determine if any complaints have been
filed against the contractor, current license status, and the "qualifying party" to
whom the license was issued. You should make sure the qualifying party
contractually responsible for constructing your home matches the license number
on the building permit.
Environmental
General
This is another subject that is seldom of much
concern for a personal residence, except for lead-based paint and radon issues,
but can be important for income properties, particularly commercial properties.
Soil & Ground Water Contamination
Although you should have checked whether the property
is in a super-fund site before writing the offer, if you didn't, do it now. While
this is not necessarily a reason to eliminate it from consideration, you should
be sure that you understand the ramifications, if any.
For commercial properties in particular, you need
to be concerned about (1) current tenant practices on the property, (2) previous
tenant practices on the property, and (3) the history of the site prior to construction
of the current improvements. For commercial locations, the lender will
usually require a Phase One Report, but you should have made the Report a contingency
in your purchase anyway. A Phase One Report is relatively inexpensive,
in the range of one to two thousand dollars. You can write the purchase
contract to require that the seller pay for it. Otherwise, if the lender
requires the Report, you, the buyer, will have to pay for it.
Lead-Based Paint
For pre-1978 residential properties, you, as buyer,
must be provided with the legally required lead paint pamphlet and disclosure
form. This is in addition to receiving copies of the tenant-signed forms
mentioned in the earlier paragraph. Your purchase contract should require
that this be provided to you almost immediately after contract acceptance so
that you have time to deal with any questions. If the form indicates that
the seller has had a lead paint inspection or has had remedial work performed,
be sure to get copies of the reports and/or certificates. If there are
any concerns, you might want to consult with an expert. You don't want
to be stuck with many thousands of dollars worth of required abatement work after
you own the property.
Asbestos
If applicable, have the property inspected for
asbestos.
Radon
If applicable, have the property tested for
radon.
