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Lesson 7
Post-Acceptance Analysis & Inspections
Legal Issues
Although you
should have checked into as many issues as possible prior to
even writing the offer, you must now do some serious investigation.
Title Insurance Report
If not available prior to writing the
offer, obtain the preliminary title report or chain
of title report as soon
as possible. Also obtain legible copies of all documents referred to in
the report. Title reports often contain errors, so question any items that
weren't expected or don't make sense.
Zoning &
Building Codes
If not done prior to writing the offer as
recommended in Lesson 5, you should now check into zoning and Building Code
& Permit matters.
Licenses & Permits
Depending upon the city, county, and/or state in
which the property is located, it is possible that a variety of licenses and/or
permits might be required for rental properties. Some jurisdictions
require rental property certification or business licenses, with the cost usually depending upon number of units
or the gross income. While these items are not legally your problem until
close of escrow, it is best to know what's required and have your all your ducks
in a row prior to closing. You also need to know whether any inspections
are required to obtain the certification or license and, if so, have the inspection done prior to
closing in case there are problems.
Some locations have a rental tax or fee at the city,
county, or state level, some locations have it at two or even all three levels. Some tax
only commercial properties, while others also tax residential at the same or a
different rate. The frequency of reporting and paying taxes owed often
depends upon gross income. For example, under a certain total gross rent
for the property requiring quarterly reports and payments and over that amount
requiring monthly. Unless all leases provide for the tenants paying for
the tax, you need to know the correct numbers in order to do your financial
analysis. It is not impossible for all levels of tax to total 3 to 5
percent, so it can significantly affect the bottom line when not paid by the
tenants.
Financial
Your purchase contract should
have required that the
seller provide financial records that show income and expenses for at least the
past 12 months. These records should be detailed enough so that you can
determine expenses in the various categories. While income will
be somewhat verified by the leases, verification of expenses can be more
difficult. The best verification is from the check register along with
cancelled checks. You can instead require copies of the associated parts
of federal income tax returns for the past one or two years, (Schedule E and
perhaps Schedule C) but you have no way
to be sure that these are the same as filed with the IRS. You can
also determine realistic expenses on your own.
Use rent data from the leases themselves.
Take into account any increases that take effect within the year after expected
close of escrow.
Get insurance quote from at least two agents and
use their recommendations regarding needed coverage. Do not use the
sellers insurance expense amount without knowing exactly what coverage was
purchased.
Get latest tax info directly from the
county. If the assessed value is available for a year subsequent to the
year for which tax amount is available use the future value and current value
and current tax to calculate the future tax amount. While this won't give
an exact number without knowing the future tax rate, it should provide a better
number to use for your analysis.
NOTE: Property taxes may be increased
substantially based on your purchase price. Make sure you understand
the local tax assessment policy and use the likely new tax amount
for your proformas.
Be sure to obtain accurate and true data for all
other expenses. Verify the data to the degree possible. For example,
if landscape maintenance is a monthly expense verify from the existing vendor
what the total annual cost is. Don't us the amount for a winter
month. Don't forget snow removal expense where that is a factor. Be
sure that the amount used from rubbish collection is the cost for realistic
collection frequency. If the location is serviced by more than one
company, get quotes from them all.
Remember that you will want to consider changing
vendors after you own the property anyway, so each quote that you obtain at this
point will be one fewer that you will need to get later.
You should also take a look at the conditions of
the roofs, parking lot, heating/cooling systems, and any other major components
to determine (1) whether there is deferred maintenance that will need immediate
attention (lender may even require it) and (2) what type of annual reserve payment
you need to include in your analysis (lender may do so).
Although you came up
with the price that you were willing to pay when you wrote the offer, you have
to re-analyze the value, using the same procedures with perhaps more complete
and accurate data. Also, if you structured your contingency
periods properly, you will have the results of whatever
inspections you performed.
If you now come up with a value of less
than you offered, it should only be because of (1) information from full
documentation was different than from that originally provided before
writing the offer or (2) previously undisclosed physical or
environmental defects were uncovered during inspections. In either
case, you can exercise the appropriate contingencies and try to
negotiate a lower price or, if the seller is unwilling to renegotiate,
cancel the deal.
Documentation
Leases
You should be sure that you are provided copies
of all leases and related documents, including
amendments, guaranties, checklists, and house rules. Be sure that all pages of every
document are of good readable quality - you may need to provide copies to the
lender and/or for a lawsuit. Read these documents very carefully. Be sure that you
can live with terms of all leases until they expire, at which time you can
replace the documents with your own better ones.
One reason lease documents are important is to verify rent
income. While income verification is not as important for a duplex at a
location where you are certain of the market rents, for larger income
properties, particularly somewhat unusual ones, it is important to verify actual
rents. This is particularly important regarding unique commercial
properties for which it is difficult to independently determine market rents.
Be sure that you have all
leases and amendments to leases. Read them through carefully,
looking for all issues that affect the net operating income or value of
the property both now and in the future. For commercial
properties, look for the the following issues:
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Any lease that gives the tenant an option to or a first right of
refusal to purchase the property or to lease other space in the future -
make a note to renegotiate the issue at the time of future extension or
renewal.
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Any lease that has remaining terms of more than one year or
option to renew beyond that date - the terms can be important for future
cash flow and property value.
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Any lease signed by an entity having limited liability such
as corporation, limited partnership, or LLC - make a note to require a
personal guaranty at the time of any future extension or renewal.
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Is tenant or owner responsible for maintenance of major
components such as plumbing and electrical systems within tenants' premises
and heating/cooling systems for individual tenants.
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Are leases gross, NNN, or some variation in between.
Be sure to notice differences among units.
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Must the owner contribute to the cost of future tenant
improvements.
For residential property, the first four items could appear
even though not common, but the last two items would be very unusual.
Lead-based Paint Disclosures
For Tenant
For residential property constructed before
1978, verify that the lead paint issues are fully covered, as discussed in
Lesson 5.
Other Tenant Info
Since the value of leases is dependant upon the
financial strength of the tenant and/or guarantor, it is of value to obtain
copies of applications, credit reports, financial statements, and/or other documentation upon
which the decision to lease was based. You should also require copies of
written complaints from current tenants, any police reports regarding current
tenants, and any notices (e.g., inspection reports) regarding violation of laws
or regulations.
Estoppel
Certificates
Although often not utilized unless required by
the lender, as they usually are for larger properties, estoppel certificates
should be used for every purchase of a tenant occupied property. An
estoppel certificate is a statement signed by a tenant (1) affirming his lease
documents (attached to Certificate) and the deposit/rent amounts; (2) confirming
that there are no agreements outside of the attached documents; and (3)
confirming the date to which rent has been paid. The document is
sometimes called a Certificate of No Defense. A sample basic Certificate
is available in our members-only Forms
Web.
Without an estoppel certificate, you may
find out after closing that (1) a tenant had a first right of refusal or option
to purchase that he'd not been given opportunity to exercise or (2) there is a
lease amendment that the seller had neglected to provide which extends the lease
for 3 years of the unit that you planned to move into after close of
escrow.
If closing is delayed, it might be necessary to
get updated amendments to the certificates to cover rents collected since the
previous versions were executed or certain other special changes in
circumstances. It is even possible that a lease could have been amended or
a new lease executed. On this subject, be sure that your purchase contract
gives you control over any lease changes after its acceptance.
Inspections
Every offer to purchase real estate should be
contingent upon a thorough inspection of the property. Whether you need
the inspection performed by someone other than yourself depends upon your
knowledge and experience. If you are new to
real estate investing, and/or building construction, DO NOT try to do an
inspection on your own. Even experienced investors usually take some qualified, but
disinterested, third party along when they check out a property before
purchase. Homebuyers often fall in love with a home because they like the
trees on the lot, or the pool, or even the wall paper. Investors cannot
afford to do that.
If there is any doubt after you and a qualified
assistant have gone over the property, hire a professional, particularly for
those items that your inspection raised concerns about and for complex
components of a complex property. In the latter category would be a
central air conditioning system in a 16-unit apartment building.
While one should be concerned about physical
inspections when purchasing a personal residence, it is usually of greater
importance when purchasing income property. There are several reasons why
this is so.
First, rentals are often mistreated by tenants.
Second, many landlords do minimal maintenance, often for only things that break,
and do little or no preventive maintenance. Third, some income properties,
particularly the larger complexes, have types of equipment not found in a
single-family home.
Be sure that your purchase contract makes
contingencies out of all inspections and allows adequate time to get the results
of the inspections taking into account inspector scheduling, holidays, weekends,
weather, time to analyze the reports, and time to utilize a contingency if
necessary.
Physical
Hopefully, you have written a good contingency
clause regarding physical inspections into your purchase contract. Now you
have to decide how to use it. There are a lot of things that are
candidates for close inspection, and what is important depends upon the type and
size of the property as well as the complexity of some of the systems. The
ones that are often of concern are as follows:
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Roof - Depending upon the type and age of the
roof and your technical qualifications, you will want to either do your own inspection or hire a roofing
contractor or other qualified inspector to check it out.
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Heating/cooling systems - If you're looking at a
4-plex and each unit has its own individual system, each of which is 5
years old, you are probably at low risk if you simply verify the
approximate age by calling the manufacturer with the model and serial
numbers. However, if you're buying a 16-unit building with 30-year
old central heating and air conditioning systems, you should definitely
hire a licensed heating/cooling contractor to thoroughly inspect the system.
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Electrical - The degree to which the electrical
system might require inspection depends upon the age of the
property, but can also depend upon property type and size,
and. For residential property built in the past 20 years, there is
probably little of concern except to determine that the electrical
service for each unit is of adequate amperage and if there is aluminum
wire, things that you can easily check yourself. However, if the property is 60 years old, you should have an
electrician check out the panels and wiring. If the property
utilize aluminum wiring, you should also consider having it inspected by
a qualified electrician to verify that connections of the aluminum wire
are in conformance with code. For certain
commercial properties, inspection by a qualified person can be important
no matter what the age of the property . For example, consider an
industrial building. You want to be sure that it has both adequate
voltage - at least 240V and maybe even 480V, depending upon possible
uses - and sufficient amperage - this being extremely variable,
depending upon possible use. You would want to utilize an electrical contractor
with applicable high-power experience to analyze the system.
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Plumbing - Lead pipes, polyethylene pipes
MORE
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Gas - properly vented water heater and other
gas appliances MORE
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Pests - This inspection is relatively inexpensive
and is usually required by a lender anyway, so you will probably want to
require it. While often referred to as a termite inspection, the
inspector will also be interested in evidence of other insects,
particularly other wood eating ones such as carpenter ants, as well as
in rot and conditions conducive to insects. For example, for a wood
siding building, they usually want to see dirt at least 2 inches below
the bottom edge of the siding. They may also note things such as a
inadequately caulked bathtub that allow moisture to enter the
surrounding walls.
You can either hire
individual specialized contractors for each component or hire a property
inspection service to cover the entire property.
Whether you hire a single property inspector or a separate inspector for
each of various components depends upon the type and complexity of
property. Read RHOL's Selecting
a Property Inspector page. Having independent inspections by
professionals can sometimes give you more leverage in re-negotiating the
deal when problem are found.
We
all know that it's a good idea to have a property inspection when
we're buying a 50-year old property with questionable plumbing,
electrical, and roof and with 25-year old appliances, but what about
when buying a brand new property directly from the builder with new
plumbing, electrical, and roof and with latest-model appliances.
In reality, the most important time to enlist the services of a
property inspector can be before closing escrow on new construction.
In fact, older properties can even have the advantage of defects having
long ago been discovered and repaired.
Many buyers assume that because the home
is brand new, city or county inspectors and the builder will have found
any problems and rectified them before the property is ready for
occupancy. However, City or other government building-inspectors are
sometimes overworked and routine inspections are completed quickly. Most
building departments have little time to thoroughly inspect each
property. While inspectors look for code violations, differences between
the approved blueprints and actual installations may vary greatly and
seldom are checked by inspectors, much to the surprise of most buyers.
These buyers close escrow without having
the property inspected, even though the cost of the inspection is
negligible when compared to the price of the property. New construction
is never absolutely free of defects, regardless of the quality of
construction or the reputation of the builder. There are always problems
that show up only after the property is being lived in. Some problems
surface to create problems after the first occupant has just moved in,
while others surface only years later when the property is offered for
sale and the seller or buyer has the home inspected. By this time, the
one-year guarantee has expired, the two-year deadline to file a
complaint with the Registrar of Contractors has passed, and the seller
is stuck with repair costs.
It's an unfortunate fact that many city
and county building departments will issue a building permit to a
contractor without checking to see whether the contractor's license is
in good standing with the Registrar of Contractors. As a result, some
contractors with suspended or revoked licenses or who submit license
numbers belonging to other contractors end up constructing new property.
How can a buyer check to see whether a
contractor is properly licensed? You should determine if any complaints
have been filed against the contractor, current license status, and the
"qualifying party" to whom the license was issued. You
should make sure
the qualifying party contractually responsible for constructing your
home matches the license number on the building permit. For additional
information, visit our Selecting
a Contractor page.
Environmental
General
This is another subject that is seldom of much
concern for a personal residence, except for lead-based paint and radon issues, but can be important for income properties,
particularly commercial properties.
Soil & Ground Water Contamination
Although you should have checked whether the
property is in a super-fund site before writing the offer, if you didn't, do it
now. While
this is not necessarily a reason to eliminate it from consideration, you
should be sure that you understand the ramifications, if any.
For commercial properties in particular, you need
to be concerned about (1) current tenant practices on the property, (2) previous
tenant practices on the property, and (3) the history of the site prior to
construction of the current improvements. For commercial locations, the
lender will usually require a Phase One Report, but you should have made the
Report a contingency in your purchase anyway. A Phase One Report is
relatively inexpensive, in the range of one to two thousand dollars. You
can write the purchase contract to require that the seller pay for it.
Otherwise, if the lender requires the Report, you, the buyer, will have to pay
for it.
Lead-Based Paint
For pre-1978 residential properties, you, as
buyer, must be provided with the legally required lead paint pamphlet and
disclosure form. This is in addition to receiving copies of the
tenant-signed forms mentioned in the earlier paragraph. Your
purchase contract should require that this be provided to you almost immediately
after contract acceptance so
that you have time to deal with any questions. If the form indicates that
the seller has had a lead paint inspection or has had remedial work performed, be sure to get
copies of the reports and/or certificates.
If there are any concerns, you might want to consult with an expert. You
don't want to be stuck with many thousands of dollars worth of required
abatement work after you own the property.
Asbestos
If applicable, have the property inspected for
asbestos.
Radon
If applicable, have the property tested for
radon.
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