Buying and Selling: September 2012 Archives

Is there any problems with having all your money in only real estate?

That was a question I saw.

The answer is YES there are problems!

1) No diversification. The real estate market tanks, like it has right now, and you are hosed. The more so because of the leverage attaching to most real estate investments. If you own five properties with a total value of $3.5 Million maximally leveraged, and the market loses 20% of value, you may have lost more than the entirety of your equity. If you need to get out now for some reason, the fact that prices are down hurts you much worse in real estate than any other investment except maybe commodities. If you had other investments, you likely would be able to hold on until market recovery and still make money.

2) Most people who do it get too strongly leveraged. Leverage is great, it makes your money work harder. But you've got to do some heavy thinking about how much leverage you're going to accept. If your cash flow is positive or tolerable, you can last out downturns. If you get into a situation where you can only make the payments for a certain amount of time, that can create desperation, and force you to accept an offer that leaves you owing money to the lender, and money to the IRS.

3) Real Estate is not liquid. This is the real kicker that drives the first two. You can't just call your stockbroker and get cash in seven days or less. You have to find the right buyer to get a decent price. If you need money in a hurry, this can force you to sell property for less than it's worth. If there are no good offers but you need to sell, you can find yourself forced to accept a bad one.

4) Landlord issues. The more properties you have rented out, the more likely that either blind chance or one of your tenants is going to do something to one of your properties which requires a lot of money in a hurry. If you're maximally leveraged and have no money anywhere else, where are you going to get that money? Particularly if the nature of the damage renders the property uninhabitable, in which case you're not likely to get any new loan on the property until it is fixed, and your lender might just decide to keep any insurance money in order to cut its losses.

If they're not rented out, of course, you're flushing cash every month.

Don't get me wrong. Real Estate is a great way to make money. In fact, given the phenomenon of leverage, you can make more in real estate with less risk than in practically any other investment field. But you've got to have some money somewhere else, and the larger your investment in real estate, the more money you need in other investments.

Caveat Emptor

Original here

Unpermitted additions are popular in California because of property tax implications. You see, due to Proposition 13 back in 1978, taxable assessments are based upon purchase price plus no more than 2% per year since acquisition (although if you bought prior to 1975, it's based upon the taxable basis in 1975). Let me say that this is a very good thing, because someone who buys property today has a reasonable assurance they won't be taxed out of their property, something you could not say prior to the passage of Prop. 13, where the legislature had more than tripled property taxes in the three years before it passed. Indeed, Prop. 13 has been one of the background factors leading to the elevated values today. If you bought a property for $40,000 in 1975, your taxable assessment 33 years later would be a little shy of $77,000. In the open market, it would probably be about a $500,000 property, perhaps even $600,000, even with the market having taken its recent tumble. People who bought in the early nineties are sitting around $200,000 assessments for the same property, and even those who bought back around the time of 9/11 have assessed values of perhaps $300,000.

However, one exception to Proposition 13 is if you build an addition. New additions are assessed based upon the value it adds to the property when it is built. So in the case of the person who bought in 1975, expanding the living room or putting in a new bedroom could double the owner's property taxes. A new master suite could go much further than that. Building a second story to add multiple rooms could make your tax bill resemble a new purchase.

But if the county never finds out about it, and never updates their records, they don't make the new assessment, and the property taxes don't go up.

The way the county keeps track of all of this is via building permits. The theory is that anyone making an addition is going to get the proper permits, have all the inspections done, and happily pay their newly increased taxes.

Yes, I'll wait until you're done laughing, but it works out to be the intelligent thing to do, as we'll discover.

This is aside from all the usual headaches of dealing with your self-interested bureaucracy. Predictably, a lot of people decide that they will do anything they can to keep the county from finding out about that addition. No permits, no plans, no inspections, no bureaucracy, just do the work and enjoy the results.

Well, not quite. Licensed, insured contractors have legal and insurance based requirements to make certain any work they're involved in has all the necessary permits, inspections, etcetera. Go to Bureaucracy, Go Straight to Bureaucracy, Do Not Pass Go, Do Not Collect your nice little tax evasion. So this also encourages the use of unlicensed contractors, who as a group aren't precisely known for their unswerving dedication to high standards of construction and repair. Their work may or may not adhere to code, it may or may not do what it was supposed to, it may not continue to do so even if it does initially, and it may or may not even be structurally safe. Not to mention you're going to need Divine Intervention if someone gets hurt building it, or even on that portion of the property at a later time. Homeowner's Insurance companies have been known to be sticky about such details, and for excellent reason.

But if the county finds out about it, you've got all the issues you were trying to dodge right back at you with penalties and compound interest. I said if, but it's really more a matter of when.

You see, most folks want to sell the property at some point in time. When they sell it, they want to get a price appropriate for the property. They've got a 4 bedroom 2000 square foot property now, so the owners want the price 4 bedroom 2000 square foot properties are bringing in the market, not a 3 bedroom 1400 square foot price. When that happens, somebody usually notices that what they're trying to sell doesn't match county records for the property. It's one click on MLS to find out. The Era of Transparency bites everyone with something to hide. An agent I know told me he once asked someone in the assessor's office how they found out about cheaters. The answer? Mostly Real Estate Agents, but the context and way he told the story leads me to believe that the real answer is more properly "people unhappy with some other party to a transaction that may or may not have come off." It doesn't take much. Given even an anonymous tip, there isn't a judge in the world that's going to deny the assessor the right to investigate, especially given that you're on record trying to claim it had something more in order to sell it for a higher price. It's not like MLS records are private, or that the county assessor doesn't subscribe. Unless you've got some trick to make the extra room vanish when the tax man knocks on the door, they're going to find out the truth.

If the addition happens to be to code - current code that is - you can get a retroactive permit. The process isn't too horribly much worse than if you'd done everything legal in the first place. But you're still going to pay all those back taxes, plus penalties and interest.

However, it's rarely to current code. Building codes get updated all the time, and when you get a permit legally and dot all the i's and cross the t's, you almost always get grandfathered into any code updates along with everyone else. It was fine and to code when you built it, so unless it has somehow become unsafe, you're still cool as far as the code goes. I see stuff every time I go looking at property which couldn't get approved now, but because the permits were obtained, the work was done, and everything was legally signed off however many years ago, it's still legal today.

Grandfathering doesn't apply, though, if you didn't do things the legal way. It's the code now that's important, and if it's not to code now, they can and will make you bring it up to current code standards. This often entails completely demolishing it and starting over, or simply putting things back to the way they were originally, if anyone can figure out what that was. Whatever happens, you're going to have the county inspectors looking over your shoulder every minute until the situation is resolved, and the licensed contractor you're going to have to retain isn't going to have much sympathy for what you did to yourself without paying a member of his brotherhood (most contractors are male). Upshot: It's going to be a lot more expensive and time-consuming than if you did it correctly in the first place.

It can be, and often is, worse than that. If the addition is unsafe, if you don't bring it to code within a specified period of time, they can make you demolish it. Actually, they can make you demolish the entire structure if it's bad enough. Suppose there's other stuff done there that was legal at the time, but there were no permits needed then? Nobody believes liars and cheats, and that's you at this point.

Sometimes, the additions are not compatible with zoning, set back regulations, etcetera. In that case, they're coming out, end of story, and the entire structure may be condemned. Granny flats are one common issue that often impacts setbacks and or zoning. I may not like it, but it's not like I've been elected dictator for life. We've got to deal with the law as it is, not how we would like it to be. We can work to change it, but in the meantime, it is what it is.

Now, about buying such a property: Are you really comfortable plonking down your hard earned cash (or worse, borrowing money so the seller can have cash) for a property where part or all of it may be at risk of being demolished, when (not if) the county finds out? Particularly the same price the your new neighbor paid for his fully permitted property? I don't think that's likely. Not many inmates of insane asylums are purchasing real estate, and when they do, they need to get their trustee involved. I can't see any trustee agreeing to it either.

There is one potential loophole: If you can show the property was as it is when you bought it, then the addition will be treated as part of the sales price, and you can potentially get forgiveness as an innocent purchaser, but it's still got to be to current code. See above for issues with that. There's a also time limit on this, usually two years is my understanding. The issue is this can be difficult to show without the cooperation of the former owner, who's going to be assessed for the difference, plus penalties and interest, and is therefore unlikely to cooperate! I understand there are other limits upon this loophole, but these are the most important ones.
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Even if you manage to unload one of these white elephants upon some unsuspecting fool, you're not in the clear. It can come back to bite you. I heard about one case not too long ago where the seller bought in 1986 and sold in 1999, and they swore it was like that when they bought, that they had no reason to suspect it was unpermitted. All to no avail. The judgment was rendered against them, and they're going to have to find the people who sold it to them to get any satisfaction in return. Good luck with that, especially if they're dead.

One final issue: In the era of make believe loans, anything went, but lenders are once again balking at lending at properties with unpermitted additions. In particular, they're not willing to lend based upon the current configuration, but based upon what's in county records if at all. As one lender fairly close to my office found out when they tried to sell their repossessed 1500 square foot lender owned property that the county records showed as 640, this can put the kibosh on the vast majority of potential sales. How good of a price do you think you're likely to get when the buyer can only get a loan for about fifty percent of value, and the lender wants to treat that as 100 percent financing? Result: It sat for eight months until a buyer came along with the resources to deal with it, and that buyer got a fantastic deal as the property was essentially ineligible for a loan.

(Question: How many "get rich quick in real estate" seminars mention that most of the very best deals happen for buyers willing and able to sink a lot of cash into the property for the time it takes to deal with the issue that's preventing everyone else from buying it?)

in short, unpermitted additions are a landmine waiting only some random event to explode, and it can do so years after you thought it was no longer your problem. They can be good news for buyers with the resources to deal with them, but they can cripple your ability to sell the property, particularly for a good price. They can actually cause you to be forced to sell for a price below what you'd get without doing any of the work at all. Looking at the costs, I find it difficult to believe that anyone considering things rationally would willingly do this, but in looking at MLS and visiting 20-30 properties most weeks, I see a lot of hard evidence that not everyone thinks these things through.

Caveat Emptor

Original article here