Solving Problems in Real Estate Loan Transactions Part II: Real-Life Examples (6 through 10)

Part I contains an introduction and real-life lending examples as follows:

1)?The husband intentionally failed to disclose to the wife his intent to borrow against their owner-occupied residence to start a business.

2) Making a loan to the husband (only) during divorce proceedings as he represents that the soon-to-be ex-spouse will cooperate and sign the needed documents. ?But her cooperation was quite the opposite.

3)?Underwriting super complex and audacious loan transactions and sorting out complicated issues with little cooperation from the borrower about receiving material facts.

4)?Purchasing a property subject to a first lien without notifying the lender or a formal bank assumption. ?Later, the property owner wants to borrow.

5)?Borrowers fail to tell their broker/ lender that he and his wife are in Chapter 13, 11, or 7 bankruptcy.

Part II continues below:

6)?A bootlegged 10-unit apartment building where the owner wants to borrow based upon ten rather than a property zoned for six. ?They represent on their loan application that they own a 10-unit apartment building, but zoning and their public records title search say that it is a 6-plex.

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 an excellent cash flow vehicle.?A typical reference may be a “cash cow” or an investment producing a steady income or profit stream. ?Both may be correct.?

Borrowers mortgage broker comments to the broker/lender:

The lender has completed a preliminary review of this file.?The building is six 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 obtaining building permits.

California has passed multiple laws that dramatically reduce and, in some cases, eliminate real estate property ownership rights.?In the past, bootlegging was frowned upon big time.?But new rules encourage multi-tenant high-density residential apartments, even for bootlegged apartments.?Owners with bootlegged units may or may not be able to obtain permits as conforming.?Consult a real estate entitlements lawyer.

A lender will evaluate whether they can underwrite the transaction as a 6-unit building and give no value to the increased cash flow because of the illegal bootlegged units completed sometime in the past until the borrower obtains building permits. Or whether the lender considers state-mandated zoning usage and the structure under the new rules, allowing for much higher density with minimal setbacks, height restrictions, and parking requirements. ?

Conforming, non-conforming, and legal non-conforming properties have been redefined through state mandates and administrative regulations oversight at the state level.?Local cities are only able to approve modifications subject to state regulations.

7)??A Property with poor maintenance and upkeep- Borrowers have an income-producing property that they failed to maintain over many years.?As a result, the property was allowed to go into significant disrepair.?Local municipal code enforcement officers recorded a notice-of-substandard condition reflected in public records. The notice is a matter of public record and appears on the title as an encumbrance for any potential buyer or lender considering making a loan.

Borrowers mortgage broker comments to the broker/lender:

“I was unaware that the city recorded a ‘notice-of-substandard-condition’ against my client’s property. The broker suggests that for discussing this loan, let’s assume that whatever was wrong has already been fixed and is no longer an issue. ‘Let’s pretend’ is to obtain a better loan quote as though everything with the borrower and property is perfect.

The experienced and prudent mortgage broker/lender responds:

“The State Housing Laws and the Uniform Housing code define substandard housing as any condition which exists to the extent that it endangers the life, limb, property, or safety of the occupants or public. The city building department official found an infraction that one or more property deficiencies exist, which 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, ensure the subcontractor’s payments, 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 complete improvements and close a loan transaction successfully.

In both cases above, converting a bootleg building 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 a contractor’s estimates to determine the total cost.?If the borrower wants to obtain a loan for construction purposes, loan proceeds are handled by a licensed loan fund control company.

With all the above exhibits in hand, the lender would order an appraisal to be completed by a certified appraiser. The appraiser should assess the subject property in an “as-is” condition before the rehabilitation and an “as-completed value.” The new lender would consider both, including the amount of interest carried during the construction and lease-up period.?The reserve dollar amount is added to determine the total loan required.

8) A small strip/convenience neighborhood retail center owner with all mom-and-pop tenants wants to obtain a loan using his property as collateral.

Classification of types of shopping centers:

https://www.icsc.com/uploads/research/general/US_CENTER_CLASSIFICATION.pdf

Borrowers mortgage broker comments to the broker/lender:

“My client has a 12-unit retail neighborhood shopping center with all mom-and-pop tenants on term leases but has now converted to a month-to-month tenancy.?The center is a bit under-parked for peak traffic.?Also, one of the tenants is a sports bar with licenses to serve food and liquor.?The bar is a popular local hangout.?My client could not get a bank loan because institutional lenders considered the property legally non-conforming under current zoning regulations.?Can you help my client get a loan?”

The experienced and prudent mortgage broker/lender responds:

“Small neighborhood shopping centers historically begin with localized small entrepreneurs who may start with a lease, but often the lease turns into a month-to-month tenancy.??Is there a substantial vacancy as a percentage of the total units???Is it a consistent tenancy pattern with a reliable rental income cash flow??Is car parking, which may include on-site and off-site spaces, adequate for rush hour???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 there are few risks of tenants solicited away to newer, better-located commercial sites?

Small centers can often 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 the right to enter the property, while egress refers to the correct exit.

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.”

Small strip centers are generally good if the borrower and collateral property are underwritten correctly. ?

9) A small owner-occupied commercial building owned by a party who holds the title as trustee of a (family trust) and operates an ongoing retail business holding title in an (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 he owns in a revocable family trust.?Can he get a loan?”

The experienced and prudent mortgage broker/lender responds:

“Yes, however, the underwriting procedure is different.?In the appraisal process, the appraiser will determine whether the rent he 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 he pays above, at, or below-market rents.?Since his S-corporation is a pass-through entity, all profits will pass through to his tax returns.?The lender will underwrite the ability to pay by reviewing the income from both borrower 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 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) Family trust of an older adult transfers trustee responsibilities to his sons as co-trustees.?The sons and co-trustees want to borrow and encumber the property.

?Borrowers mortgage broker comments to the broker/lender:

“My client is elderly and has a family trust with substantial trust assets: He was the beneficiary trustor, trustee, and the beneficiary.?He has transferred the trustee capacity and responsibility to his sons as co-trustees—the sons are beneficiaries of the trust.?The older adult now lives in a nice retirement home.?He has enough income to pay for his living expenses.?The trustees of the trust would like to borrow money to refurbish a home for rental purposes.?The property needs a substantial upgrade since no upgrades have occurred in at least 30 years.”

The experienced and prudent mortgage 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 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 examined 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:

Mortgage brokers on both sides of the transaction may be licensed professionals.?The borrower’s broker works on behalf of the borrower to obtain the required information, verify facts, and overcome obstacles.?Full disclosure is assumed, not hidden, or treated as an avoidance game.?Sometimes too many material 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.?I will cover many of them in future articles. ?Ensure you work with experienced mortgage brokers who can understand the complexities and solve the problems.

Thank you!

Dan Harkey

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This article is for educational purposes only and is not a solicitation.?If this article has value to you and your associates, please forward it to others who may appreciate its contents. ?You may use this article in your marketing efforts, providing full and clear credit for Dan Harkey, Educator & Private Money Finance Consultant.?