or, How to Avoid Legal Problems in Real Estate Investments
(c) 2009 by Jeffrey B. Hare, Attorney at Law
The only sure way to avoid legal problems associated with real estate investments is do nothing. However, if you want to get involved in real estate investing, you need to follow Rule Number One: do your Due Diligence. Although many investors and real estate professionals are familiar with the term “due diligence,” they don’t always follow through. Many real estate agents limit their “due diligence” to a series of checklists concerning the property, such as confirming the zoning, evaluating the condition of the buildings, and looking for evidence of hazardous chemicals, earthquake faults, or underground tanks. These are important considerations, but for the real estate investor, “due diligence” involves a lot more.
To keep this simple and easy to follow, I have summarized the key points into a program that I call the “Five P’s of Prudent Real Estate Investing.” The Five P’s are: Plan, Property, People, Payment, and Patience. If you take the time to understand what each of these five stages involves, you will have taken a major step towards avoiding most of the legal and financial problems that can overwhelm the real estate investor. Let’s get started.
There are two aspects of the planning stage: Personal and Financial. You should carefully evaluate your Personal Goal — what do you want to be doing in a few years? Stop. This is a critical step in the process. What do you envision yourself doing in, let’s say 8 – 10 years from now. If you don’t know where you’re headed, you won’t know how to get there. Form a mental picture of what you see yourself doing in a few years, and hold that vision while you proceed with this article. Then come back and re-evaluate your vision. Ask yourself, “Is it realistic?”
One additional note about the importance of having a clearly defined and realistic personal goal is that it will help you quickly and efficiently identify and eliminate distractions that will NOT get you to where you want to be. Thanks to the Internet, you will be quickly overwhelmed with opportunities, options, and deals, each one promising to be “The Deal You Can’t Miss!” If you know where you’re headed, you will be able to quickly evaluate and eliminate many of these distractions and focus your energy and resources on those deals that will help you reach your goal.
The second aspect of the Plan stage is looking at your Financial Goal. Part of the process of evaluating your Personal Goal is figuring out how to make sure you can afford to do what you want to do: cover the cost of your lifestyle, provide financial security for your family, earn enough to live comfortably. You need to plan for contingencies, medical conditions, and of course, changes in the economy (if the recent downturn wasn’t enough of a lesson!). You should consult with a qualified, professional financial planner. Each and every person’s situation is different, but your Financial Goal should be designed to support your Personal Goal.
STOP: Keep in mind that you should periodically reevaluate your personal and financial goals. They are targets, not prison sentences. You can modify them to suit your circumstances. But you should keep them both in focus, and know if you are on track to reach them. If you stray from your path, make the necessary course corrections or reconsider your Plan.
As I mentioned earlier, most real estate agents focus their due diligence on the property, which is important. The investor should also evaluate the property as well. There are three key aspects to consider. They are Purpose, Location, and Condition.
Let’s start with “Purpose.” Is the property you want to invest in suitable for the intended purpose? Does it comply with existing zoning regulations? Does it meet building and fire code requirements for the intended occupancy? Is the lot large enough to allow for sufficient parking, ingress and egress, signage, and even expansion? Does it have adequate sewer, water and access to utilities? Just because a property is available at a good price does not mean it is suitable for your investment purposes!
Next, let’s consider the all important “Location, Location, Location.” Here, you should consider both the environmental and economic factors. While it is important to consider such factors as the proximity to transportation routes, good schools, convenient shopping, and other amenities, do not overlook the importance of other significant factors. For example, is the property subject to natural hazards, such as flooding, wildfires, tornados, or other extreme weather? Equally important (for the success or failure of your investment objectives) are factors such as the diversity of the local job market, stable housing prices, and rental rates. Does the area have a history of relatively low unemployment based on a diverse economy, or is it overly focused on a single industry that could suddenly collapse? (think Detroit). Is there an overabundance of housing driven by development rather than housing demand? (think Stockton). As the saying goes in the Music Man, you “gotta know the territory.”
The third aspect of the Property consideration is, of course, the Condition. Here, you should focus on the cost to bring the structure to “rent ready” condition, whether the improvements will be paid by the owner or the tenant. One word of caution: many older residential and some commercial properties may be eligible for listing on local, state or national historic registers, and may be subject to strict regulations governing modifications of historic buildings. Modifications can be exceedingly expensive, and local officials may require that the structure be restored rather than remodeled. Last, but not least, do not rely on disclosures. Always insist on conducting your own inspection as a contingency under any purchase and sale agreement. Watch out for mold, asbestos, vermin, termites, dry rot, and other evidence of deterioration that can be very expensive to repair. Don’t forget to look for nearby drainage channels, sewer or septic hookups, possible easements, overhead high voltage wires, and possible neighborhood nuisances (under a flight path? backs up to a shopping center or night club?).
STOP: Reality check — this is real estate investment property, not your dream home. It doesn’t have to be perfect. If it was perfect, you wouldn’t be getting such a deal, right? Also, at the right rental rate, your tenants will be happy to have a safe, secure and clean place to live — they probably don’t expect or want to pay for a Palace! Be practical — but keep your eyes open and be prepared to deal with these issues.
As an investor, your intention is somewhat different than that of a property owner. You probably own your own home (or are making payments towards that goal). In making decisions about your home, you most likely consult with your Spouse or significant other. However, when you act as an investor, you need to consider putting together your team. That’s correct —teamS. One team will consist of yourself and your Investment Advisors or consultants. The other team will consist of yourself and your Investment Partners.
First, if you are just starting out as a new investor, you should assemble a team of individuals with the professional expertise to provide you with competent advice on different aspects involved in real estate investments. I previously mentioned you should consult with aFinancial Planner, someone who can provide an objective and professional perspective on your financial situation and goal, and advise you on how best to structure your financial plan. You should also use the services of a Certified Public Accountant, commonly referred to as a CPA. This individual can provide important advice as to the impacts of capital gains taxes, depreciation, deductible expenses, and other financially critical matters that will affect your decisions. You will need Brokers, both for real estate transactions and to help you get financing for the acquisition phase, and whenever you seek to sell investment property. The right Broker can be worth many times their commission if they help you get a better understanding of local economic conditions, know the neighborhoods, and even help you get financing. You will also need a Property Manager, a very critical element in the success of your investment structure. Property Managers help you find and screen tenants, help maintain your property, and keep the value of your investment intact. Last, but not least, you need an Attorney. Keep in mind that your family attorney may be great with wills and trusts, but may not have a background or training in land use or real estate issues. Also, they may or may not be licensed to practice law in the same state where your investment property is located. Together, the primary function of this Team of Advisors is to provide assistance to you in helping you achieve your investment goals, not theirs! As you become more experienced in real estate investment issues, you will quickly become more selective in both who you have on your team, as well as to how you will use their services.
Second, you need to consider assembling a team of Investment Partners. Many investors lack sufficient capital funds when they are starting out, and need to line up equity partners, lenders, and other investors in order to make their deals work. This is probably where your Attorney can prove to be the most valuable — helping you determine how best to organize these individuals so that in the end, you achieve your goals. For example, you will need to determine the correct form of entity to use when different people are involved: will it be a partnership, corporation, Limited Liability Company (LLC), or a Tenancy in Common (TIC) arrangement? Who will control the decision-making process? How will expenses and profits be allocated? What happens if one of the partners refuses to contribute their fair share of an emergency repair? Is your system set up so you can add additional investment partners in the future? Is the investment structures so that it can take advantage of tax deferral strategies, such as a “1031 Exchange?” (Note: if it is held in an LLC, it may not be possible for an individual member to use this common but effective tax-deferral method).
Last, but certainly not least, you must include your Spouse, if you are married. Perhaps nothing is as catastrophic to an investment plan if the Spouse is left out of the loop, or not involved when they should be. More important than providing legally-required signatures and consent, your Spouse often serves as your closest and most trusted investment advisor, someone who knows your goals better than anyone, and can provide a critical “reality check” when you might otherwise get carried away in the passion of “the deal.”
At some point in every investment decision, there is a bottom line. You will have to make payments (mortgage, insurance, taxes, fees), and in order to do so, you need to receive payments (rent, sale price). The total amount of the first type must be covered by the second, or your investment goals will not be realized.
To purchase real estate for investment purposes, you need to get financing that is different than the type of financing that you need for “owner-occupied” property. For the new investor, especially someone who just purchased their first home, it often comes as a surprise that financing for investment property may include very different terms and conditions than what they expected. At the same time, you may have resources that were not available to you when purchasing your home. For example, you may be able to use a Home Equity Line of Credit (or HELOC), or a loan from a relative, or even funds from a Self-directed IRA (”SDIRA”). A qualified Mortgage Broker can provide you with options and opportunities. However, in general, you should expect to have to come up with between 30 – 40% down payment, plus pay a slightly higher interest rate on any loan you may be able to secure.
A quick note about using SDIRA funds to purchase investment property: It is perfectly legal to use your IRA funds to purchase investment property; in fact, it is uniquely suited to such transactions since regulations prohibit you from using SDIRA funds for any property that you would use (such as your home, your office building, or your vacation property). However, in order for you to successfully use a SDIRA for investment purposes, you need to take steps to set up the account, roll over your exisiting 401(k) or other eligible Pension Plan fund, and work with a Plan Custodian, like Pensco Trust, that will allow you to use SDIRA funds held by them to invest in real estate.
To make the payments, you will need INCOME. Of course, the ideal situation is an investment property that produces both positive cash flow (rental income is greater than mortgage payments, interest, insurance, property taxes, maintenance, emergency repairs, vacancies, and property management fees), and appreciates in value so that the net proceeds from the eventual sale of the property are more than any existing encumbrances on the property. To ensure the highest probability that you will receive steady and sufficient rent, you will need to consider all of the factors (and more) mentioned under the Property section, above. Just because you can get a great price on a property in the central valley of California or in a downtown area of Detroit does not mean you will be able to find qualified tenants willing to pay sufficient rent. Again, you “gotta know the territory.” And, you have to plan for contingencies … you will experience unexpected maintenance costs, emergency repairs, and periods of vacancy. Plan accordingly.
As the old prayer goes, “Lord grant me patience, but grant it NOW!” The importance ofPatience, the 5th “P” in this article, is underscored by the need to dispel the myth of the “get rich quick” scheme. Many individuals were, and some still are, successful doing “flips,” where they acquire title to property, do some quick repairs, then turn around and sell the property for a substantial profit. Is this possible? The answer is yes, but more and more it is exceedingly difficult. One reason is that with the credit crunch, not many individuals are able to get financing, so the “flippers” are finding themselves holding onto property much longer than they planned. Since they often used “hard money” loans or other types of “borrowed” funds, they often find themselves owning more and more of the anticipated profits from the planned “flip,” and often must drastically reduce the selling price or start renting it out. The true “value” of a real estate investment is built over time, both from incremental rental increases and from appreciation in value over time. The smart strategy is to be patient, build a solid investment portfolio, and let it grow in value over time.
The foregoing Five “P”s are intended as a short-hand checklist of the key elements to be considered as part of your overall investment strategy and to help you do your “Due Diligence.” Of course, you cannot eliminate risk, and you cannot guarantee that you will never have legal issues. But you reduce the probability of legal problems by taking the foregoing steps.