Buying Rental Property
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There are a number of factors that must be considered when purchasing income property in addition to those of concern when purchasing a personal residence. Some of these are related to existing tenants and would not be of concern if purchasing a new never occupied property. Most of these additional concerns should be written into the purchase offer and should constitute contingencies to the purchase. Subjects of special concern for rental properties include:
Legal Rental
You (or your agent) should verify that all units are legal, both as to zoning and to building codes. Were improvements done with building permits? Are electrical and plumbing to code? If not, are they grand-fathered? Living with illegal items in your personal residence is one thing. Having non-code items in a rental unit leaves you open to violation citations and/or lawsuits by injured tenants or their survivors. Keep in mind that a disgruntled tenant can file a complaint that results in a special inspection of your property.
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. Many jurisdictions require business licenses, with the cost usually depending upon number of units or gross income. While these items are not legally effective for you 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 license.
Some locations have a rental tax at the city, county, or state level, some 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.
Documentation
You should be sure that you are provided copies of all leases and other documents, including amendments, checklists, and house rules. Be sure that all pages of every document is of good readable quality - you may need to provide copies for a court action. 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 this is 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.
You will also need copies of the leases for your lender.
If the property was built before 1978 be sure that the seller has executed lead-based paint disclosure forms on file and that you receive copies. Your purchase contract should require that the seller to get them if he doesn't already have them and provide them soon after acceptance of the contract You, as the new owner could become legally liable due to violations of the law by the previous owner. The required pamphlets and forms are available on the members-only Forms Web.
Financial Records
Your purchase contract should require 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 statements 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, but you have no way to be sure that these are the same as filed with the IRS.
Physical Inspections
While one should be concerned about physical inspections when purchasing a personal residence, it is often 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.
Environmental
This is another subject that is seldom of much concern for a personal residence, but can be important for income properties, particularly commercial properties.
Is the property in a super-fund site? 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.
For pre-1978 residential properties, you, as buyer, should 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 Documentation section above. Your purchase contract should require that this be provided to you almost immediately after contract acceptance rather than wait to the latest date allowed by law so that you have time to deal with any questions. If the form indicates that the seller has had a lead paint inspection, be sure to get a copy of the report. 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.
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, the buyer 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, the buyer, 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.
Insurance
Before committing to purchasing a property, be sure that you will be able to obtain the required insurance. Premiums can easily turn out to be a significant operating expense and need to be taken into consideration when analyzing the property. Worse yet, it is possible that a particular property and/or landlord will turn out to be uninsurable.
A property may be rejected for a variety of reasons. As examples, the building is sitting on an earthquake fault line, near a toxic waste dump or in an area subject to flash floods, hurricanes or fires. The physical condition of a building might make it uninsurable.
Similarly, investors might be turned down for insurance if they have a history of making too many insurance claims on a homeowner's policy or even for having a bad credit record.
The types and amounts of insurance coverages the landlord buys must also be based on the requirements of the lender.
The more tenants, the more insurance must be purchased to cover the risks. The best insurance package for a landlord is usually the commercial liability policy, or a scaled-down version of that for smaller buildings.
Such a policy covers damage to the building and to tenants' personal property, injured residents and guests, any kind of equipment used to maintain or heat the building, workman's compensation for anyone doing upkeep and storm or earthquake coverage in areas prone to such disasters.
Also, you need to keep your insurance agent up to date on the value of the property to make sure you're covered. Insurance policies coverages are generally automatically adjusted annually to insure that they keep up with replacement costs. In other words, as your properties increases in value, so do your premiums.
While the lender will usually require that insurance be in place prior to closing, if you are buying with seller financing or cash you may not be reminded. The insurance required by the lender will be of minimum coverage needed to protect the lender's position. You will want a number of additional coverages beyond those minimums, as well as perhaps higher levels on some coverages. A good insurance agent can advise you on this matter.
Using an independent broker rather than a company agent (such as Allstate, State Farm, and Farmers) gives access to a number of competitive companies. It doesn't hurt to also get quotes from the company agents, since they are often competitive with the independents. Because there are so many varieties and levels of coverages available, be sure that the quotes are for the same coverages and dollar limits.
Holding Title
It is extremely important to give serious thought to the potential liabilities associated with owning rental properties and to take the necessary steps to minimize your risks. There are dozens of ways in which it is possible to lose your entire net worth if ownership is not properly vested.
Investors should research the subject themselves and/or seek competent legal advice regarding the tax and legal implications of the various vesting options. For many investors, it is currently recommended that the Limited Liability Company (LLC) provides the best tax benefits and risk management, with a separate LLC used for each separate property.
Pre-Closing Statement
As for any real estate transaction, you should be sure that you check over the pre-closing statement. It is much easier to have corrections made before closing than after. Of particular interest for rental properties are pro-ration of rents and transfer of security deposits.
Although escrow agents often do not do so, there should be a formal assignment of all leases from the seller to the buyer, so be sure to ask about this issue before closing. The assignment can be a part of some other document rather than be a separate document, but there should be a formal assignment of some kind.
Transfer of Services
Discontinuance of utilities or other services by the seller before you have them turned on in your name can create havoc with your relations with your newly-acquired tenants. Cover this issue in your purchase contract and make arrangements for transfer of services with electric, gas, water/sewer before close of escrow. Unless you are already a large customer, expect to put up deposits for gas, electric, and maybe even water, the amounts often equal to or 1-1/2 times the historical monthly bill.
There may be services other than utilities that must be considered. Find out from the seller if he has contracted services of pest control, landscape maintenance, or other service and remind him to terminate those services at close of escrow. Be sure to set up the necessary services in your own name, using your own new vendors or those of his you'd like to use at least until you have time to evaluate them and/or get other quotes.
After Closing
Check the closing statement carefully. In particular check pro-rations of rents, property taxes, and interest and be sure that you received credit for deposits, as you will be responsible to the tenants for them.
Contact the tenants - meet them in person and give them a written notice.
Prepare new leases and other documentation for tenants whose leases expire in the near future. If you are buying pre-1978 residential property and the seller did not have required lead paint disclosure documents for each tenant, get them executed immediately. The required pamphlets and forms are available on the members-only Forms Web.
Summary & Conclusion
When buying rental property, there are a number issues that you should be concerned about if you wish to avoid problems both during escrow and after close of escrow. Most of these issues should be properly written into your purchase offer.
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