Solving Complex Problems in Real Estate Loan Transactions -Examples (6 through 10)
By Dan Harkey
Business & Financial Consultant
cell 949-533-8315 email [email protected]
Note: My last article contained examples (1 through 5). This article contains examples (6 through 10). ?
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6)??Property owner with a bootlegged 10-unit apartment building. They represent on their loan application that they own a 10-unit apartment building.?
Borrowers mortgage broker comments to the broker/lender:
“My client has ten apartment units and wants to refinance and pull cash out for investments. The property is a great cash flow vehicle. A common reference may be a “cash cow,” or an investment that produces a steady stream of income or profit.”?
The experienced broker/lender responds:
“The lender has completed a preliminary review of this file. The building is 6-units with four bootlegged units made by separating the 2-bedroom units into one-bedroom units and adding small bathrooms and kitchenettes. The owners constructed illegal units without getting building permits.
The lender can only underwrite this as a 6-unit building and give no value to the increased cash flow because of the illegal bootlegged units until building permits are obtained and the building becomes conforming under today’s building and zoning standards.
The borrower must approach the local building and planning department to obtain approval for a new configuration! The municipality will not be pleased that the property owner modified the building secretly and operated it for personal cash flow for a period.?Circumventing an approval process has its consequences. The municipality, most likely, will require a personal inspection of the entire building and require it be brought up to code. The owner may need to go in and tear up walls and remove drywall and paneling so that the city can inspect for compliance. If the owner added kitchens or even kitchenettes, he might be required to replace or create an electrical panel with higher amperage.
The borrower would most likely get stuck complying with Title 24.?California Building Standards Code is a broad set of requirements for “energy conservation, green design, construction and maintenance, fire and life safety, and accessibility that applies to the structural, mechanical, electrical and plumbing systems in the building. This borrower would likely need to hire a consultant to prepare a California Title 24 report as part of the approval process.
Guide To Title 24:
https://www.library.ca.gov/wp-content/uploads/2021/08/GuideToTitle24.pdf
The entire illegal conversion of the 6-unit building could cost be big dollars to modify and upgrade the building to today’s building standards.
The terms conforming, non-conforming, and legal non-conforming have all been redefined through recent state legislation and state administrative regulations.???
Over the last couple of years, a group of new laws has been passed with the idea of eliminating single-family zoning and up-zoning properties to create more high-density multi-tenant residential apartments. Removing single-family zoning and allowing high-density multi-tenant buildings in residential neighborhoods is now a law and a fact of life in California from now on. Promoting low-cost housing is in vogue.
Primary changes include replacing local municipality’s control and oversite for building, planning, & zoning with state-level bureaucracies managed by state public employees who are labor union members.
Localized planning tends to focus on protecting the peacefulness and tranquility of neighborhoods.?Newly created state-run bureaucracies may or may not make decisions with the idea of maintaining or improving neighborhood lifestyles or having a vested interest in you, your family, and other families.
I bring this up because local control and local bureaucracies are not just going to lay down and go away.?There will be competing power structures between local and state to deal with. Between Zoning Codes, Building Codes, and administrative staffing, a process will still be necessary to obtain building permits to complete code compliance.?All the above means more hassle and frustration trying to bring non-conforming buildings into today’s more flexible standards.
Planning and Land Use in California:
Building codes in California:
Bills passed include AB 3088, SB-6, SB-8, SB-9, AB -15, AB-946, AB 989, AB 1401, SB-10 SB-12, SB 330, AB 816, and SB-1079. These new laws expand government involvement in the ownership and operation of real property.
7)?Borrowers have an income producing property that they did not maintain.?As a result, the property went into disrepair.?The code enforcement officers recorded a notice-of-substandard condition in public records.
Borrowers mortgage broker comments to the broker/lender:
“I was not aware that the city recorded a ‘notice-of-substandard-condition’ against my client’s property. For discussing this loan, let’s assume that whatever was wrong has already been fixed and is no longer an issue.”?
The experienced broker/lender responds:
“The State Housing Laws and the Uniform Housing code defines substandard housing as any condition which exists to the extent that it endangers the life, limb, property or safety of the occupants or public. There was an opinion of a city building department official that one or more property deficiencies exist that need to be repaired and brought up to current zoning and building standards.
The notice of substandard conditions may require adjustments, modifications, or partial or entire building demolition. The borrower should contact the building and safety representative to pick up copies of any reports to evaluate the extent of the required changes or alterations and the total cost of mitigation. The property owner must be willing to conform to what the city will accept before they release the notice. Has the borrower obtained any engineering reports, cost estimates, or building permits to complete the repairs and improvements? The city must approve a plan.
The lender may need to hold back a portion of this loan and deposit the proceeds into a licensed construction fund control company. The fund control company’s job is to confirm the construction progress, maintain an accounting of the money, make sure the subcontractors are paid and obtain lien releases. There is not just a simple fill-out and check-the-box solution.?It is a complex issue that requires a competent lender who understands the problems and the strategy to carry out the completion of improvements and a successfully closed loan transaction.”
The entire conversation about repair and upgrading for Number 6 (Bootlegged property) also applies to number 7 (property with notice of substandard condition).
In both the above cases of converting a bootleg building corrected back to conforming or upgrading a building that was in disrepair will require a building permit, a set of plans, possible engineering reports, cost estimates, and contractor’s estimates to determine the total cost.?If the borrower wants to obtain a loan for this purpose it will be handled like a construction loan.?With all the above exhibits in hand the lender would order an appraisal to be completed by a certified appraiser.?The appraiser should provide an appraisal of the subject property in an “as-is” condition before the rehabilitation and an “as-completed value.” The new lender would use consider both appraisals’ calculations including an amount for interest carry during the construction and lease up period.?This amount would be added to come up with a total loan required.
8)?Borrower with small strip/convenience neighborhood retail center with all mom-and-pop tenants wants to obtain a loan using his property as collateral.
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Classification of types of shopping centers:
Borrowers mortgage broker comments to the broker/lender:
“My client has a 12-unit retail neighborhood shopping center with all mom-and-pop tenants. The center is a bit under-parked for peak traffic. Also, one of the tenants is a sports bar with licenses to serve both food and liquor. The bar is a popular local hangout. My client could not get a bank loan because institutional lenders considered the property legal non-conforming under current zoning regulations. Can you help my client get a loan?”
The experienced broker/lender responds:
“Small neighborhood shopping centers are characterized by localized small entrepreneurs who may start with a lease, but often the lease turns into a month-to-month tenancy. Is there a consistent tenancy pattern with a somewhat reliable rental income cash flow? Is the parking, which may include on-site and off-site spaces, adequate for rush hour periods??Is there a substantial vacancy as a percentage of the total units??Are there professional service providers if the lender were to take the property back in foreclosure? Also, is the location a stable commercial area, meaning that there are little risks of tenants being solicited away to newer, better-located commercial sites?
Most many cases, small centers can be upgraded and repositioned by a few physical changes, including re-slurry sealing and striping the parking lot, repainting, reconfiguring the ingress/egress structure, and improving the monument signage. Ingress refers to rights of enter to the property, while egress refers to the rights of exit leaving the property.
Upgrades and reconfiguration can be complex when considering adjacent properties’ rights and agreements between the other business owners. The borrower can get estimates for these improvements and include the cost in the loan.”
This type of property is generally good collateral.
9)???Small owner-occupied commercial building owned by a party holding title in one form as trustee of a (family trust) and operating a retail business holding title in another form (S-Corporation).
?Borrowers mortgage broker comments to the broker/lender:
?“I have a client who is a dentist and provides dental services for low-cost and credit-based customers. He operates his dental practice as an S-Corporation. His practice operates out of a building that he owns in a revocable family trust. Can he get a loan?”
The experienced broker/lender responds:
“Yes, however, the underwriting procedure is different. As far as an appraisal of the property, the appraiser will determine whether the rent the is paying from his one entity to his other entity is market rent. The valuation would rely on comparable commercial rents in the geographic area rather than what he is paying himself.
Part of the appraisal process is a rent survey. The appraiser will determine whether the tenant pays above, at-or below-market rents. Since his S-corporation is a pass-through entity, all net profits will pass through the borrower (personally) and will reflected on his personal tax returns. As a result, the lender will underwrite the ability to pay by reviewing the income from the borrower (individually), his family trust and his S-corporation.
Lastly, if the subject loan is a second trust deed junior to a first the business entity may need to sign a subordination agreement to ensure that it is junior to the recorded deed of trust. If the lender were to foreclose on the property ownership entity, meaning the family trust, the lender would not want to keep the s-corporation tenancy of a related defaulted party.”
10)??An elderly trustee of a family trust wishes to transfer trustee responsibilities to his sons and wants a loan to encumber the property. ??
?Borrowers mortgage broker comments to the broker/lender:
“My client is elderly and has a family trust with substantial assets: He was the beneficiary trustor, trustee, and the beneficiary. The elder now lives in a nice retirement home. He has enough income to pay for his living expenses. He has transferred the trustee capacity and responsibility to both his sons as co-trustees. The sons are beneficiaries of the trust. The trustees of the trust would like to borrow money to refurbish a home for rental purposes. The property needs a substantial upgrade since it has not been upgraded in at least 30 years.”
The experienced broker/lender responds:
“The lender will need to review the entire trust agreement and any amendments to determine who has the authority to sign and encumber the property.?Also, the lender will need substantial documentation that this is a business purpose loan rather than a consumer purpose loan. Upon reviewing the file, the lender may also request that the borrower’s attorney submit a letter that they have reviewed the transaction and that all parties agree that the transaction is for business purposes and beneficial to the trust.
Is there a list of upgrades to the property with contractor estimates? There is substantial equity to make a first trust deed loan.?There will be no need to withhold the proceeds and place them into a licensed construction fund control company trust account.”
Summary for examples (6 through 10).
Mortgage brokers on both sides of the transaction may well be licensed professionals. The borrower’s broker works on behalf of the borrower to obtain required information, verify facts, and overcome obstacles.?Full disclosure is assumed, not hidden, or treated as an avoidance game. Sometimes too many facts are conveniently avoided or intentionally withheld.
Understanding how to analyze complex underwriting issues can make or break a transaction.
There are dozens of complex issues that arise in new proposed loan transactions. ?Make sure that you work with knowledgeable and experienced mortgage brokers who can understand the complexities and solve the problems.
Supporting articles written by Dan Harkey intended to help interested parties gain knowledge of private party real estate lending.
?Any of these articles will be forwarded upon request.
Business vs. Consumer Purpose Lending.
1)???Solving Complex Problems in Real Estate Loan Transactions-Examples (1 through 5).
2)???Property Insurance coverages During Inflationary Times.
3)???Private Money Real Estate Loans-An Overview of Good Reasons.
4)???An Overview of Private Money Lending & Trust Deed Investments.
5)???The Capitalization Approach to Income Property Valuation.
This article is intended for educational purposes only and is not a solicitation.
? Dan Harkey. This material’s unauthorized use or duplication without express and written permission from this author or owner is strictly prohibited. Excerpts and links to the articles may be used in marketing efforts, provided that full and clear credit is given to Dan Harkey. The credit displayed when you forward any article must include Dan Harkey, Business & Finance consultant. You are not authorized to modify the content or the articles title.