Why Non-Conforming is a Risky Strategy

My new tenant called me saying their mailbox was gone. I could not understand, so I sent my maintenance guy out to put up a new box. A week later the tenant called to tell me their mailbox was gone. So I did what any reasonable landlord would do, I put up another mailbox. This went on for a while before I finally called the post office. They told me the delivery person was taking it down because they showed my 3 unit property as 2 units, so they were "not able" to deliver mail to three locations. Are you kidding me? And to top it off, I could not get the post office to recognize the property as a three unit because the zoning was for no more than 2 units. This particular property had both a converted basement and a converted garage into livable units. Anything that does not meet your typical standards or appearance would be considered non-conforming.

These properties can be very profitable, but if you don't know what you are doing, you could make a costly mistake. Let's start by taking a look at what makes a property non-conforming.

Size: We normally see this with large additions. You don't want to be the biggest house on the block, and it is worse if there is a significant size difference to the neighborhood. If you are the biggest house, your house is worth less per sq foot, meaning you don't get the value you would expect from the size.

Appearance: I see this a lot with new construction. There might be a handful of new houses in a neighborhood of houses that were built 30 years ago. This brand new house might be worth $400,000 in a new neighborhood, but because it is surrounded by older homes, it is worth much less. You cannot compare the new house to the new neighborhood ½ a mile away. People will pay less if they are not surrounded by similar homes, and it is very difficult to appraise these, so be careful!

Something else that could fit into non-conforming appearances is under or over improvements. We have funded a house with an in-the-ground swimming pool. The pool provided no value and could potentially provide a negative value. It might cost $25,000 to put that pool in, but other homes don't have a pool, so it is not expected and people don't pay for it. I believe it might actually decrease the value, because people expect back yards and don't want the maintenance hassle. Simple things like granite counters compared to laminate are also important. I would look at other houses that are currently listed and try to copy what is on the market or over improve just a little to standout, but do not expect a higher price just because you have the higher quality. I think under improved houses is the obvious one. It is because of these houses people can fix and flip. They get a house at a big discount because it does not fit in the current condition. Once the condition is brought to standard, it can be sold at a higher price.

Use: This is the big one and the reason I thought I should write this article. I have owned several non-conforming properties because of the use. My example above is a great instance of this. What made that non-conforming is that it did not conform to city zoning. In this case, I am zoned for up to two units and this property had three. I purchased it this way, and the city is aware of the current use. The reason I purchased it was the numbers as a rental were really strong. But there are two problems you need to know about if you decide to go the route I did.

1.Management. My guess is that most of these buildings only have one electric and water meter, so if you ask that your tenant pay utilities you will need to find a fair way to divide this. Of course this creates challenges because tenants start complaining that they use less and don't want to pay as much as their neighbor. Other problems could be one furnace or water heater with one thermostat, mail getting mixed up, and of course problems if you ever need to pull permits for improvements. You heard my story of my mail problems. On that same tri-plex, I was denied a permit to build a garage that I planned to rent separately because current of the non-conforming use.

2.Exit. The big problem that I see with non-conforming investments and especially non-conforming use, is the exit is very difficult. It is challenging to finance these, so it will be difficult to refinance or sell them. If your buyer can't get financing, they may not be able to buy. Thus, reducing the buyer pool significantly; which obviously reduces the value. These need to be financed with cash, private money, or banks and cannot be financed FHA, VA or conventional. Unlike conforming properties, you need to account for your potential buyer pool when you analyze the re-sale value.

As mentioned, non-conforming buildings can be very profitable, and I have done very well with mine. They tend to cash flow well because of the lower price to get in, and they can flip well because you can add value to them easily (you still need to buy at the right price), but there is some real risk. My tri-plex netted me $2,000 a month on three units while my loan was being paid off by my tenants. Not a bad little investment.

When you do your diligence, you might want to check with the city about what they will require, as well as make adjustments to the value to justify the fact that the financing is difficult. You don't want to be surprised that it is worth a lot less than the other homes after you own it. Also, if you don't have cash or non-traditional loans, you will not be able to buy, so don't risk your earnest money until you know you can close.