Solving Problems in Real Estate Loan Transactions Part III: Real-Life Examples (11 through 15)

11)???Construction and construction completion loans requiring an “as-is value” vs. “as-completed value” appraisal.

“As-is” value.

An “as-is” real estate appraisal estimates the property’s current condition without any assumptions or estimated prices of potential improvements or repairs. ?In other words, it assesses the current market value of the property based on its existing state without considering any “hypothetical changes or improvements” made in the future. This property type is sometimes regarded as a “fixer-upper” or “fix & flip.”

An “as-is” appraisal is appropriate when the seller is unwilling or unable to make any repairs, improvements, or warranties regarding the property’s condition before a sale.

“As-Completed” Value.

An “as-completed” real estate appraisal evaluates a property’s value after it has been renovated, improved, upgraded, or modernized. ?This type of appraisal is necessary when a property owner has made significant renovations or additions and wants to know how much the property’s value has increased. The seller usually looks for a top retail price to sell on the open market.

The appraiser will typically inspect the property before and after the improvements, considering factors such as the quality of workmanship, materials used, and any other relevant factors that could affect the property’s value, such as views and superior location. ?The appraiser will report the condition to the lender.

The loan request:

“My client purchased an old dog of a property in a nice single-family residential neighborhood for a total rehab or rebuild. ?The only reason to call it rehab is for property tax assessments and easier processing through the building and safety department of the municipality. ?Otherwise, we would refer to it as scrap and rebuild a new home. ?The client paid $1,000,000 for the dog of a property.

The borrowers believe they could build a new single-family structure of about 3,000 for about $300 per square foot and have an excellent investment for resale. ?Their proforma showed a $600,000 profit, all in. They paid 60% on the purchase, leaving a first loan of $400,000.?Now want to borrow about $1,500,000 to pay off the $400,000 and provide approximately $900,000 for the construction. ?The estimated value after completion is $2,700,000. ?They have some reserves and good credit.”

Lender’s comments after reviewing the file:

“Construction to completion is a vibrant and necessary business. ?But there are multiple issues and hidden risks to look at.?The first is does the borrower have skin-in-the-game. ?They made a down payment of $600,000 for a $1,500,000 loan request, so it appears they have about 40% down. ?The answer is “yes.”

Licensed construction fund control agent to manage the distributions:

The second consideration concerns a licensed construction company that created a budget to complete the project. ?Do they have finished projects with references and drive-by comparisons? ?Do they have a contractor’s license and adequate insurance coverage for contractor liability, construction defects, and workers’ compensation for their job workers? ?Also, does the property owner have a course of construction insurance policy, an umbrella liability policy, and riders to cover workers comp if the contractor fails to cover the risks?

The next issue concerns funding the construction loan proceeds during the building process. ?Most lenders prefer to use licensed construction fund control companies, which manage the entire bookkeeping, property inspections, and lien release process. ?Can the lender anticipate that the fund control company will do their timely draws and inspections and obtain contractor lien releases??Part of this question is whether the lender will distribute the loan proceeds in its entirety or fund according to a draw schedule where the borrower only pays interest on the outstanding balance over time. ?Some lender licenses allow split funding, meaning the lender can partially fund the original draw with subsequent draws over time.

Encumbering Real Property

The next issue concerns the difference between the real property and personal property liens encumbering the property. ?Documents are drawn to cover the real and personal property permanently attached to the (fixed) real property.?The document encumbering the real property is a deed of trust or mortgage instrument recorded at a municipal recorder’s office.?Recorded loan documents place a lien on the property but do not cover the construction draws.

The recorded deed of trust does not encumber the construction fund control holdbacks.?Cash proceeds are personal property because they are not attached to the real property. ?Money sitting in the trust account, or the account of a construction fund control agent, is considered personal property, not real property.

Encumbering the Personal Property

The Uniform Commercial Code (UCC), first published in 1952, is a comprehensive set of laws governing all commercial transactions in the U.S.

The UCC laws regulate personal property transactions and provide for a public notice mechanism so that the Secretary of State can identify liens.?The public can also identify personal property liens through the Secretary of State.

A recorded UCC-1 statement filed with the Secretary of State’s office is part of the transaction’s closing. ?The UCC-1 is an encumbrance and remains a matter of public record until a recorded UCC-3 occurs, reflecting the satisfaction of the debt.

Mechanics Lien Laws

The construction lending industry’s “mechanics lien law” risks are the most draconian and punitive in real estate. ?Mechanics’ lien laws require a lawyer who can guide the property owner through the liability maze.

a)?A mechanic’s lien is a “cloud” against a property.

b) Any unpaid contractor, subcontractor, laborer, or material supplier can record a lien with the county recorder’s office for lack of payment.

c) The claimant is allowed a limited time to file a suit, begin a foreclosure action, and force the sale to pay off the lien.

d) ?The mechanics’ lien notification period begins at the point of the first drop of a surveyor’s markers, the first evidence of work in progress, the first supplies delivered to the property, or the first shovel in the ground.

12)???Loan request where the borrower has no skin in the game. ?Skin in the game means that the borrower has significant risk capital to lose in the event of default.

No Skin in the Game

When a real estate owner has “no skin in the game,” they do not have any personal investment or financial risk capital at stake in the property or transaction. ?The owner is not personally risking any of their money or assets in the deal, or they have no emotional attachment or interest in the outcome.

The phrase “no skin in the game” can also be used more broadly to refer to situations where someone is not personally invested or engaged in the outcome of a decision or action. ?In real estate, the phrase refers to an owner not actively managing or improving their properties or making significant financial investments in their real estate holdings.

The loan request:

“My client has a partially completed home with an outstanding balance of $650,000. ?His construction lender stopped funding during construction because of various delays, and the borrower defaulted. ?He needs another $300,000 to finish the project.?The borrower believes the finished value will be about $1,400,000, so your loan to value will be 68%.”

The lender’s response after reviewing the file:

“Your borrower purchased this distressed property for $499,000 and obtained working drawings and permits for rehabilitation. ?Concurrently with the purchase closing, he recorded a construction loan of $650,000. ?The borrower got a loan for 100% of the purchase price plus $150,000 above the purchase price. ?The transaction must be a fix-and-flip from a lender specializing in these high-risk transactions.

The borrower has no personal capital and minimal risk in this transaction.?The lender was sucker enough to make a loan and inadvertently assumed development partner risks, which did not work out. ?The only solution is a bail-out loan or foreclosing on a partially completed property and selling at a discount. ?A partially completed building with open construction will necessarily be sold and discounted in price to compensate for the cost to complete, plus cost contingency and speculative developer profit.?A foreclosing lender could lose their shirt.”

The lender declined this transaction because the borrower has no capital at risk and could walk away at any time, leaving a lender holding the bag with a partially completed problematic property. ?Losses would stare a lender in the face.

In an accelerating market, fix-and-flip lenders look brilliant.?In a declining market, they look somewhat foolish.

13)???Loaning on a property lacking adequate easements for ingress/egress

When a property owner has no ingress/egress into a property, they have no legal right or access to enter or exit the property through a particular route or pathway.

Ingress/egress

Ingress refers to the right to enter a property, while egress refers to the right to exit a property. ?These rights exist through law and legal agreements such as easements or rights-of-way. ?With an ingress/egress easement, the property owner may be able to enter or exit their property through a particular pathway or route, even if there are more direct or convenient ways to access the property.

For example, suppose other properties on all sides surround a property and do not have a public road leading directly to it.?In that case, the owner may be required to purchase an ingress/egress easement from one or more neighboring property owners to access their property.

It is essential for property owners to carefully review their title and deed to ensure that they have the necessary ingress/egress rights to access their property or to work with an attorney or real estate professional to create one.

The loan request:

“My client has a 3,000-square-foot industrial building that he wants to finance.

The lot is 40ft by 100 ft with adequate parking. ?I will provide data for your lender review.”

The lender comments after reviewing the file:

“We have reviewed the file. ?We have found that the parcel has a 40-foot-wide industrial building on a 40-foot-wide lot. ?There is parking at the rear of the building, but the only way to access it is to drive down a 10-foot-wide paved entrance on the parcel next door. ?We checked, and no written easement between the two owners exists that will ensure continued access to parking.?The neighboring owner could cut off access at any time for any reason. ?If not now, subsequent owners could cut off access. ?In talking to the property owners of both parcels, a solution is to record a mutually reciprocal ingress/egress easement and record it so that the easement runs with the land.”

As a matter of clarification, an easement is a non-possessory right conveyed from one property owner (#1) (left side property owner) to another property owner to (#2) (right side property owner) to use, enter, or cross over a parcel (or a portion) that is owned by the party (#1). ?Non-possessory means that party (#2) possesses a right to use, enter, or cross but does not own or have no current or future property ownership claims of the property.

A non-possessory interest in a property restricts its free use because it is an encumbrance on the property and generally runs with the land.?The non-possessory interest (easement) is usually recorded against the property in municipal public records and serves to cloud the title.

The two adjacent property owners are friends and occupy two contiguous industrial parcels. ?Each land parcel is 40 ft wide by 100 ft deep. ?The property owner on the right side owns the subject property of this loan request. ?The property was built with a zero-lot line, meaning that the property was initially built-up to the property line with no setbacks.?The left-side property owner agreed to construct his building only 30 feet wide so that there would be 10 feet available for ingress/egress of automobiles for use by both properties.?The location for ingress/egress was not on the collateral property but 10 feet on the left-side property. ?The right-side property possessed no other method of entry besides his left neighbor’s property. ?No written agreements existed, but merely two good old boys who agreed with a handshake and hopefully an occasional cold beer at the local Kelsey’s bar, maybe meeting up with Archie Bunker for a frolicking conversation.

Prescriptive Easements

Conflicts and litigation may arise to prove when a party asserts that they have claimed rights to pass over a property, although nothing is in writing.?A “prescriptive easement” is a “claim of possessory right to pass” across another person’s property acquired by continued use without permission of the owner for a legally defined period.

Usually, a claimant has the burden of proof of the elements necessary to establish that the easement has been created over time by prescription (California Code of Civil Procedures 321).?In California, a claimant must adequately prove that they have possessed the prescriptive easement by continuous use for at least five years.?Other states have similar regulations.

The statutory time for prescriptive easements varies from state to state.?Each claim is fact-specific, with the possibility of winning and losing some.?Proving the claimant’s rights can take time, resulting in litigation and the risk of losing.?A well-documented agreement will avoid all misunderstandings.

A borrower will want to review the issue of exclusive vs. non-exclusive easements.?Will the easement run with the land and bind all future owners? ?California Civil Code 1104 provides that a transfer of real property passes all easements attached to it.?In California, 2d 872 (2002).

In this real-life example, there is a strong argument for a “prescriptive easement” proving the right of access.?Proving this up could cost a future owner litigation expense and time.?The original owners and subsequent owners have operated with the condition of entry for 40 years.

The Two Adjacent Properties

In this transaction, the right-side collateral property is owned free and clear by the owner.??The left-side property owner, with the driveway, had the first lien of $300,000.?There was a suggestion that the two property owners hire a civil engineer and a lawyer to draft a reciprocal usage easement for ingress/egress.?The owners must submit the plans and a proposed agreement to the building and planning department for approval. ?Upon city approval, a recorded reciprocal easement agreement would occur. ?Once the contract was signed and recorded, the easement would remain on the property title. ?But not in this case because a defaulted borrower on the left side property would result in the easement being foreclosed and extinguished.

In this real-life example, the problem was that the recorded newly drafted easement would be in the first lien position on the right-side property but as a second or junior position on the left-side property.?The left-side property’s recorded easement would be in a second lien position behind a $300,000 first trust deed.?If the left-side borrower defaulted on his loan and the property was lost in foreclosure, the recorded usage easement would be foreclosed on, extinguished, or cease to exist.?Subsequent owners who have no access could be damaged. ?Non-access for automobile ingress/egress would drastically diminish the functionality and desirability, and the value would be severely affected.

As a result, the lender must decline this loan request.

14)?Loaning on a property with a mutual reciprocal usage agreement for ingress/egress and available parking with and between neighboring property owners.

Reciprocal Usage Agreement

Reciprocal easements are non-possessory interests conveyed between two or more property owners.?An agreement establishes the terms for easements, restrictions, and covenants between two or more parties.?The agreement is mutual between two or more parties to benefit each other, usually equally.?

The loan request.

“My client operates a body and fender repair shop. ?He has operated the business for 25 years and has a written option to purchase the property significantly under its current market value. ?He requests a purchase money first loan at the maximum the lender will consider. ?He has ‘so-so’ credit but great cash flow.”

The lender comments after reviewing the file:

“Given the borrower’s long history of operating this business and his option to purchase at approximately 40% under the appraised value, the lender will consider increasing the loan to value, perhaps up to as much as 90% loan to purchase price. Based on the current appraised market value, the loan to value would be about 54%.”

The auto body and fender shop front a busy street but needed auto access to the repair shop, parking, and storage yard.?Entry into the repair shop is only available through an alleyway spanning the length of the commercial block.?All the other commercial property owners along the street had the same issue and potential risk.

The lender’s task in processing and underwriting a requested loan was to verify that the alley right-of-way is either a publicly owned street or a written reciprocal easement agreement signed and approved by the property owners will allow for continued access through the alleyway.?The verified recorded easement proved that ingress/egress was available and did run with the land. ?There was a satisfactory shared expense agreement for upkeep and roadway capital improvements. ?Risk abated.

?A phase I environmental site assessment showed no significant contamination.

15)??Loaning to a borrower with awkward liens, encumbrances, and judgments to clear up.

What is a Lien?

A lien is a legal right or claim against real property, a security interest.?A debtor (borrower) agrees to convey the security interest as consideration for the loan. The lien is a charge or claim against the property. ?It will remain until the loan is satisfied.

A lien refers to a monetary (money) claim?that will be attached to a property by a recorded instrument and becomes an encumbrance on one or more properties. The instrument is usually a deed of trust or mortgage document.

What is an encumbrance?

An encumbrance refers to a legal claim or agreement to enforce rights and obligations relating to a property. ?The claim is against the property by an independent party, such as a mutual property association, a court-ordered lien, a municipal notification for substandard conditions, or a government agency. ?The claims restrict the unrestricted use of the property until the deficiencies are satisfied or negotiated into an equitable agreement of future actions. ?An encumbrance can be eliminated, reconveyed, or modified.?

Hundreds of instruments, agreements, or actions are recorded and become a matter of public records. ?Each creates a lien or an encumbrance particular property.

The lending industry sometimes uses the terms lien and encumbrance interchangeably. ?However, a lien is generally a recorded monetary charge against a property.?All liens are encumbrances, but not all encumbrances are liens.?

Judgments are decisions from a court of law regarding the rights and liabilities of parties in a legal action or proceeding. ?The judgment will usually explain the court’s reasoning for the court order.

A judgment decree is not self-enforcing. ?Once a judge decides and issues a verdict, the winner must act upon it. ?The legal system requires that the winner collects the money from the opponent. ?The opponent may voluntarily pay the judgment, object, or appeal the verdict to avoid enforcement actions. ?The winner must use all efforts to enforce the judgment by placing public notice and attempting to freeze assets. ?The procedure takes time, effort, and money.

The loan request:

“My client has a few properties with good equity.?However, he found himself in a bit of a jam because of both a divorce and a partnership dissolution.?He requests an interim loan to pay off his ex-wife, his ex-business partner, and a corporate tax lien. ?We may call this a fresh start loan.”

The lender comments after reviewing the file:

“There are a series of considerations in the proposed transaction.

a)?Does the borrower have a court order about the ex-wife’s payout?

b) Paying off an ex-wife is a consumer loan rather than a business-purpose loan.

c) ?Does the borrower have an executed agreement with his ex-partner to dissolve the partnership for a certain amount of consideration?

d) Paying off an ex-partner is a business purpose.

e) If the borrower has a personal tax lien, that would be for consumer purposes.

f) ?If the borrower has a corporate tax lien, that would be a business purpose to pay off the lien.”

Business purpose loans

Business purpose loans are loans on 1 to 4 units of real property where the loan proceeds are used primarily for business purposes. “Primarily used for business” is essential. ?That means that a portion of the loan proceeds, more than 50%, must be used for business purposes. A percentage of the loan proceeds (less than 50%) may be for consumer purposes.

Consumer purpose loans

On the other hand, a consumer-purpose loan is one where loan proceeds are used primarily for personal, family, and household purposes.

Why is the distinction between business and consumer purpose lending important? ?Because both federal and most state governments have created regulations that require special disclosures and notice/reporting responsibilities for lenders when dealing with consumer-purpose borrowers.??These additional requirements have extreme punitive consequences for any mistakes or deviations by the lender(s) and procuring mortgage broker(s). ?These onerous changes have caused many private money lenders to exit consumer lending altogether.

Industry participants commonly refer to the “business purpose exemption.” There is no stated “exemption” in the Truth-in-Lending regulations but rather just “not covered” under the consumer laws. ?Common practice is that “not covered” and “exempt” are interchangeable.

The greater the percentage of loan proceeds used for business, the safer for the lender and procuring loan broker in the event of default. ?What I mean by the term “safer” is whether the lender or procuring loan broker could become entangled in an accusation by the borrower that the loan was a disguised consumer loan.

Review of the Loan File

In reviewing the credit file, the borrower has sufficient equity in four properties to make individual loans or to cross-collateralize all four properties, raising the required $1,400,000.?The payoff to the ex-wife is $400,000; the ex-partner is $500,000; and the borrower’s portion of the $200,000 of the $400,000 corporate tax lien. ?Since the partnership dissolution agreement calls for both corporate officers to pay ? of the lien, the ex-partner’s $500,000 will require $200,000 to pay the IRS. ?Any remaining net loan proceeds will help the borrower reposition his business into future profitability.

The loan complies with regulations because only 28% is consumer, and the remainder, 72%, is for business purposes.

The loan is doable but will take some time to process, primarily to obtain updated demands from the IRS. ?The processing time includes a third-party appraisal, opening escrow, arranging title coverage, and closing the transaction. ?Without the IRS lien, the process would take two weeks.?But, with the IRS lien and their propensity to work in slow motion closing the loan could take as much as four months. ?All parties should be made aware of the timing and to gain consensus. Future conflicts will only frustrate the participants.

The borrower should hire a tax attorney with experience dealing with and expediting the IRS updated demand.?Hiring a specialist attorney will speed up the process.

16)??Making a loan on a land parcel that contains a manufactured home.

The loan request:

“My client has an accepted offer to purchase a property with a manufactured home on it, containing a fixed foundation on a 1/4th acre parcel. ?The property will be non-owner occupied and made available for rental. ?Similar properties are in demand because of the availability of gardening for fresh food, the ability to keep a few animals on the property, and the perception of living off the grid. ?The potential renter owns a llama named Dolly, a few goats, and chickens.?They are excited to find a home for Dolly Llama and the kids.

The property is on a paved street with available water and electricity connections.?The sewage connection is by septic tank.”

The lender comments after reviewing the file:

The first question to be determined is whether the real estate is being purchased in fee ownership or rented from a third party. ?When a modular home unit is owned by a third party on a leased parcel, the property is considered “personal property.”

Is the land parcel in a community association of similar properties subject to rules, such as covenants, conditions, and restrictions??Does the community have written bylaws?

The borrower should contact the building and planning department to verify that gardening and some animals are allowed on the property.

What is the description of the manufactured home, including size, age, and amenities, and is the home installed on a permanent foundation??Was the installation engineered and permitted by the local municipal building department?

The manufactured home will remain a personal property asset in California until the owner applies for and receives a certification referred to as a “433a permanent foundation certification”. The certificate relates to a titling document called “Installation of a Manufactured Home on a Foundation Systems” that complies with the California Code of Regulations, Title 25, Chapter 2, Section 18551.?The completed certification is recorded in county records and will be in a future title search.

Upon completing a loan transaction or conveying the property title, a title company will issue a title endorsement (ALTA 7).?The ALTA 7 is an endorsement that will ensure the reassignment of ownership of the manufactured home from personal to real property.

If the conversion process from personal to real is incomplete, the collateral property value will only be limited to vacant land value.?Appraisal of comparable neighborhood sales will be limited to similar land parcels.

Summary:

The borrower’s creditworthiness: As with any loan, the borrower’s creditworthiness will be a factor in determining whether the loan is approved and what the loan terms will be. Some in the industry refer to this type of lending as “equity-based” or “collateral-based” lending. Also, identifiable “property equity” is significant in private money loan transactions.?

The lender will obtain an application, credit report, bank statements verifying available cash flow, and escrow and arrange for a title company to issue a draft report to determine what is recorded against the property. The extra prudent lender will also obtain a background search from a vendor like Lexus/Nexus.

Assessment of loan quality will contain all the above and experienced-based judgments.?Remember, good judgment comes from experience.?But, in many cases, experience comes from past bad decisions, otherwise known as bad judgments. We should continue absorbing new knowledge and gaining valuable new experiences.

I hope you find value in the education contained in this article.

Thank You,

Dan Harkey