Due Diligence on illegal units

[Brendan Chisholm]

Last month, I changed up the content to discuss closing on a home with a Fannie Mae Homestyle loan. This month, I thought I put in another little twist on conducting proper due diligence with acquiring property. I will use a responder from my direct mail campaign to discuss in further detail.

For the past four months, I have had a direct mail campaign for my city and neighboring city. I started to see in an influx of responders around the fourth touchpoint for each respective campaign. The fifth and sixth touchpoints also had a ~5% response rate. Notwithstanding the foregoing, the property owner called me not to discuss that specific property, but rather the “triplex” she owned next door.

During the conversation, we discussed the income and expenses for both properties. She mentioned that she has long term tenants and has not raised rents in some time. As we were nearing the end of the conversation, she advised that she should only wanted to sell this triplex at this time. She provided me with the amount she wanted for the “triplex” as well. At the end of the initial conversation, I asked her to give me a few days to think it over and do some more research. I started looking at triplex comps in this part of the city, and her offer was below market. Although I was not looking to acquire a triplex, I thought this could be the inside track to getting the nine unit. I then thought to myself, get the “triplex” under contract and then negotiate a purchase price for a first right of refusal to the neighboring nine-unit apartment. This would give me the inside track to owning two properties, and more importantly the nine-unit apartment I was initially targeting.

After I started looking at the comps and rental prices for each unit type, I looked at the tax assessor’s website. I wanted to see the public records for the home. I then noticed that the “triplex” was only permitted as a two-family / duplex. After noticing that, I went online to the city’s planning and zoning department to research further. I found in the city’s public documents that in this specific zone, the city only allowed single family, two families, and had special exemptions for apartments up to 12 units. I thought I could use this as leverage. But first I wanted to hear from the horse’s mouth (the city).

The next morning, I spoke to city planning. I told them the zone the address was located (not the actual address). The gist of the conversation was that there is "no way" the city would permit this to be classified as a triplex. It would have to remain a duplex. This presents a bunch of problems for me in trying to acquire the property. Not to be immediately let down, I had a conversation with my insurance broker. A similar response came from him. The brokerage could find someone to insure the property, but only at the appraised value of a duplex. I did not need to make a call to my residential lender.

I spoke with some trusted friends who have been investing for decades. They told me there is no need to pursue this further. If you do take ownership and buy it, you will encounter a few problems. I would need to evict the tenant in the illegal third unit, or request that the owner do so prior to me taking ownership. In turn, I can promote a 2 bed 1 bath, and 3 bed 2 bath duplex (eventually). I immediately lose out on rental income on the illegal unit. I would not be able to rent the "new" 3 bed 2 bath until I find a new tenant, from the current tenants of the 2 bed 1 bath, to fill those two combined spaces. The rent prices for a 3 bed 2 bath would offset the loss of the illegal unit. And best-case scenario, I would be losing out on this revenue for a minimum of 12 months. The deal penciled for a triplex; at a duplex it does not make sense.

I was also advised that buying properties with illegal units is not a practice one should get into. My friend advised me that he knows of people that cities have made examples of these owners. The headache involved is not worth the potential revenue and tarnishing your reputation with the city.

There are several lessons learned from this experience. One lesson stands out above all else, due diligence is critical. You need to understand the property and/or asset you are inquiring. To finish off the blog with the words from the late, great Kenny Rogers, “You’ve got to know when to hold ‘em, know when to fold ‘em, know when to walk away, and know when to run.”

Stay Safe & Healthy!