HELP! New investor bought a lemon in SoCal - seeking guidance

33 Replies | Los Angeles County, California

Hey BP!

I am currently FHA house hacking a property that I purchased about a year ago just south of USC which, unbeknownst to me, had illegal construction, which caused a host of problems, in addition to other issues. None of this was disclosed to me at the time of purchase and there is reason for me to believe there may have been some funny business. After speaking with friends, family and mentors, I was strongly suggested to seek legal counsel in regards to recovering damages, but am trying to avoid a costly and drawn out litigation which may prove more trouble than it's worth.

I'm currently in talks about having my case reviewed and have gotten several quotes from architects for building plans, but the timeline is too uncertain and I am accruing steep holding costs in addition to any fees/plans/services I have to pay, etc. My biggest hurdle has been in obtaining a certificate of occupancy, which is a lengthier and more expensive process than I (and my wallet) had hoped. To further complicate things, I am in an RSO zone and have been holding off on getting tenants in the meantime to avoid paying relocation fees.

The silver lining is that the supposed DUPLEX that I bought is legally recorded as a TRIPLEX in a rapidly gentrifying area and has already gained equity, but that type of project falls outside my scope of rehab capabilities and my finances are stretched pretty tight as it is. I've called around and from my understanding, borrowing is essentially out of the question, so I'm on a deadline to get things on track or risk foreclosure...

Ideally, I'd like to keep the property and salvage my credit but am exploring other options to try and stay ahead of everything. In a nutshell, I'm out of money and short on time, but my assumption is that losing the property would destroy my credit and make me a leper in the banking world.

Should I:

Sell ---As is or with duplex/triplex plans?

Salvage ---Find a financial partner or hang on and ride out the process?

Chapter 11 ---Would anyone even touch this?

Or... cut my losses, consider it my RE hard knocks education and start from scratch?

Any ideas? I'm open to anything at this point.

Hello Juan!  I would advise you to sell ASAP and walk away and find another deal to do.  I think you were taken advantage of and the previous owner probably knew what would happen to you but did not care and will probably try to lie his way through a law suit.  It might be an expensive lawsuit for you and will probably be a waste of time and keep you from doing something else for a profit.  It might stink but that is probably the way I'd go.  Who the hell am I and what do I know?

I am a 61 year old that was born and raised in Dallas, Texas.  I was also a construction manager and held a real estate brokerage license for about 30 years so I've been in and around for a while.  I think your best way is to move on and do not take any advice from those who have never been there.  Good luck to you!

Ah, I see. The other thing is that since I’ve had the property less than 2 years I might come out just as underwater if I were to try and sell it after capital gains. Would a 1031 exchange be something feasible in this scenario? There also seems to be a number of people with a hand at fault in this one and every lawyer I’ve spoken to seems to think I have a good case. The title company has also filed a claim for me and i am waiting on their call.

Does any of that make a difference in your opinion? Also, if I do sell, do you think would it be worth the investment to buy the architectural plans or sell as is?

Juan - I can't add much here since I am not very familiar with Rent Stabilization but sounds like it may be best to sell it and try to salvage what you can from it, both financially and with your credit.  Sounds like you recently purchased it but how much equity do you think you have in it right now?

@Juan Escarcega

I don't see why you couldn't 1031 it into another property. Do you have an idea of how much you would lose altogether if you were to sell it now? Do you have an idea of rehab costs if you were to make it the triplex? I would say--pencil out the numbers of every single scenario and I feel like that will present at least a little bit of clarity on which options are even feasible and then you can go from there.

I don't have a more concrete opinion on that as it's a bit out of my wheelhouse, but one other thing is that @Jeff Greenberg holds a monthly networking meeting in Santa Monica (2nd Saturday of every month) and it's very casual and people all introduce themselves and then anyone can ask anyone questions. It might be a cool place to present this scenario and let everyone there chime in with thoughts and ideas. There are a lot of investors there and from a lot of different facets of investing, so you might have a good chance of getting some worthwhile ideas. If not ideas, someone may know a right person to talk to. Couldn't hurt to just put it out there and see what you find out.

@Juan Escarcega

This does not help the OP any but I do not understand buying an RSO property.  The primary way coastal So Cal properties have significant cash flow is due to rent appreciation.  Take away the rent appreciation then the cash flow has to be achieved via a value add.  The problems with value adds is that they are typically one-time only events.  So assume a value add such as converting a duplex to a triplex results in an extra $2k/month the first year.  Each year of holding this $2K goes up at the RSO rate (3%) so it in effect will always be worth around $2K in today's dollars.

Versus purchasing outside an RSO zone. San Diego SFR rents have gone up on average ~$700/month in the last 5 years. I suspect LA is similar outside the RSO impacted properties. This $700 helps significantly with the cash flow but San Diego has a long history of rent appreciation exceeding inflation over the long term. So the rent is likely to continue to go up on a long term basis faster than inflation and faster than the 3% of the RSO property.

I think the primary reason the OP should sell is not because of the illegal construction, the holding costs, or the lack of finances but due to the RE being an RSO property.  However, add up all of the reasons for selling and I think what the OP should do seems pretty obvious.

Good luck

I’m sorry you are in a tight situation. I would say sell or 1031 it... how fast do you need to sell? I do know a few wholesalers in LA that may be able to help...let me know I can try to put you in contact with them.

Originally posted by @Dan Heuschele :

@Juan Escarcega

This does not help the OP any but I do not understand buying an RSO property.  The primary way coastal So Cal properties have significant cash flow is due to rent appreciation.  Take away the rent appreciation then the cash flow has to be achieved via a value add.  The problems with value adds is that they are typically one-time only events.  So assume a value add such as converting a duplex to a triplex results in an extra $2k/month the first year.  Each year of holding this $2K goes up at the RSO rate (3%) so it in effect will always be worth around $2K in today's dollars.

Versus purchasing outside an RSO zone. San Diego SFR rents have gone up on average ~$700/month in the last 5 years. I suspect LA is similar outside the RSO impacted properties. This $700 helps significantly with the cash flow but San Diego has a long history of rent appreciation exceeding inflation over the long term. So the rent is likely to continue to go up on a long term basis faster than inflation and faster than the 3% of the RSO property.

I think the primary reason the OP should sell is not because of the illegal construction, the holding costs, or the lack of finances but due to the RE being an RSO property.  However, add up all of the reasons for selling and I think what the OP should do seems pretty obvious.

Good luck

 You make money by buying large studio units and converting them to one bedrooms as they vacate. You buy at low rents, make the value add, double the rent and keep going. You also get costs under control. You buy a 10 unit building with a $2,000/mo water bill, a manager that seems to be embezzling, and has three vacancies. You renovate three units, get the water bills under control, and you've got a building that you paid $90,000/dr for... that is now worth $130,000/dr.

@Seth Borman interesting idea about converting large studios to 1 bedrooms.. I don’t think I’ve heard of someone doing that before , have you done this before ? What does it usually cost per unit . I guess the thing is it seems rent control tenants rarely move especially if they are getting such a great deal .
Seems rare to find buildings with that many vacant units in L.A

Originally posted by @Seth Borman :
Originally posted by @Dan Heuschele:

@Juan Escarcega

This does not help the OP any but I do not understand buying an RSO property.  The primary way coastal So Cal properties have significant cash flow is due to rent appreciation.  Take away the rent appreciation then the cash flow has to be achieved via a value add.  The problems with value adds is that they are typically one-time only events.  So assume a value add such as converting a duplex to a triplex results in an extra $2k/month the first year.  Each year of holding this $2K goes up at the RSO rate (3%) so it in effect will always be worth around $2K in today's dollars.

Versus purchasing outside an RSO zone. San Diego SFR rents have gone up on average ~$700/month in the last 5 years. I suspect LA is similar outside the RSO impacted properties. This $700 helps significantly with the cash flow but San Diego has a long history of rent appreciation exceeding inflation over the long term. So the rent is likely to continue to go up on a long term basis faster than inflation and faster than the 3% of the RSO property.

I think the primary reason the OP should sell is not because of the illegal construction, the holding costs, or the lack of finances but due to the RE being an RSO property.  However, add up all of the reasons for selling and I think what the OP should do seems pretty obvious.

Good luck

 You make money by buying large studio units and converting them to one bedrooms as they vacate. You buy at low rents, make the value add, double the rent and keep going. You also get costs under control. You buy a 10 unit building with a $2,000/mo water bill, a manager that seems to be embezzling, and has three vacancies. You renovate three units, get the water bills under control, and you've got a building that you paid $90,000/dr for... that is now worth $130,000/dr.

 The issue with these options is 1) nothing stopping anyone from doing the items Seth indicated on non RSO RE.  2) you need to have a legal eviction which typically means cash for keys on top of relocation fee. 3) Theses items are one time only.   You convert studios to 1 BR once.  You convert to low flow water once.  You get rid of the embezzling manager once.  Then you are once again locked in on the cash flow.  

Without market rent appreciation they seem more beneficial to a flipper than a buy n hold investor.  

In a market like LA rent appreciation has beat inflation long term by a wide margin for over 60 years. San Diego SFR has had an average $700/month increase in the last 5 years. At RSO 3% annual rent increase, the average San Diego SFR rent would have increased $340, less than 50% of the market appreciation.

My preference is to do the items that Seth indicated on property that is not RSO rather than an RSO property that does not easily benefit from market rent appreciation. 

A few questions. Did your inspection mention anything about illegal construction? Is the construction not up to code or just not permitted? Have you spoken to your agent about the misrepresentation? 

BTW I had to look up what an RSO zone is. I'm so glad I don't know about those!

@Juan Escarcega I know last year the city passed something to supposedly make it easier to legalize illegal units due to the housing shortage but not sure if it would apply to your unit and you may have already heard about it , here is an article from last year

http://www.latimes.com/local/lanow/la-me-ln-illegal-apartments-20170510-story.html

Are you able to rent the vacant unit on Airbnb in the meantime to bring in some rental income ?

On the plus side prices have gone up in L.A especially the south la area since last year it seems so if you did sell hopefully you wouldn’t lose money after transaction costs .

Originally posted by @Joseph M. :

Seth Borman interesting idea about converting large studios to 1 bedrooms.. I don’t think I’ve heard of someone doing that before , have you done this before ? What does it usually cost per unit . I guess the thing is it seems rent control tenants rarely move especially if they are getting such a great deal .
Seems rare to find buildings with that many vacant units in L.A

 I haven't, but I worked for some guys that did. 

Rent controlled tenants don't move much, but it was common to buy buildings with 5-30% vacancy rates. The buildings are worth more with vacancies so if someone is planning on selling they will hold a vacant unit.

Otherwise you can negotiate cash for keys and make the vacancy.

We had a ten unit building that we got with two vacancies and a third tenant passed away a day before closing. Rents were $400-$595 before and $1400 after renovation.

Originally posted by @Dan Heuschele :
The issue with these options is 1) nothing stopping anyone from doing the items Seth indicated on non RSO RE.  2) you need to have a legal eviction which typically means cash for keys on top of relocation fee. 3) Theses items are one time only.   You convert studios to 1 BR once.  You convert to low flow water once.  You get rid of the embezzling manager once.  Then you are once again locked in on the cash flow.  

Without market rent appreciation they seem more beneficial to a flipper than a buy n hold investor.  

In a market like LA rent appreciation has beat inflation long term by a wide margin for over 60 years. San Diego SFR has had an average $700/month increase in the last 5 years. At RSO 3% annual rent increase, the average San Diego SFR rent would have increased $340, less than 50% of the market appreciation.

My preference is to do the items that Seth indicated on property that is not RSO rather than an RSO property that does not easily benefit from market rent appreciation. 

Let's say that you buy a building, improve the management, get the expenses under control, and get the CoC return with principal repayment to 10%. That, in and of itself, is really good, right? RSO goes up by 3% annually while property taxes go up by 2%. As a result, your operating expense growth is lower than your rent growth. Your position will improve every year until you sell.

Or, you can just hold it and make 10% forever.

A non rent controlled building will typically cost 15% more per door and be a lot harder to find. It's always nice to find something in the county or Huntington Park that you can do the same thing to.

Originally posted by @Seth Borman :
Originally posted by @Dan Heuschele:
The issue with these options is 1) nothing stopping anyone from doing the items Seth indicated on non RSO RE.  2) you need to have a legal eviction which typically means cash for keys on top of relocation fee. 3) Theses items are one time only.   You convert studios to 1 BR once.  You convert to low flow water once.  You get rid of the embezzling manager once.  Then you are once again locked in on the cash flow.  

Without market rent appreciation they seem more beneficial to a flipper than a buy n hold investor.  

In a market like LA rent appreciation has beat inflation long term by a wide margin for over 60 years. San Diego SFR has had an average $700/month increase in the last 5 years. At RSO 3% annual rent increase, the average San Diego SFR rent would have increased $340, less than 50% of the market appreciation.

My preference is to do the items that Seth indicated on property that is not RSO rather than an RSO property that does not easily benefit from market rent appreciation. 

Let's say that you buy a building, improve the management, get the expenses under control, and get the CoC return with principal repayment to 10%. That, in and of itself, is really good, right? RSO goes up by 3% annually while property taxes go up by 2%. As a result, your operating expense growth is lower than your rent growth. Your position will improve every year until you sell.

Or, you can just hold it and make 10% forever.

A non rent controlled building will typically cost 15% more per door and be a lot harder to find. It's always nice to find something in the county or Huntington Park that you can do the same thing to.

First I do not view a COC of 10% good. I would never choose RE if I was projecting only 10% COC. 10% is virtually same return as S&P which is a lot less effort.

Second, are you indicating “10% forever” return based on a one-time 10%?   Realize a one-time 10% is not even a 5% annual after 2 years.  

Hi Juan,

Sorry to hear about your situation.

I recommend you sell or 1031 the property.

Chalk it up to a learning experience.

FYI, if you used standard CAR purchase contracts, you are advised in multiple forms and places to do your due diligence in these areas, such as:

RPA – Section 11: Buyer is strongly advised to conduct investigations of the entire Property in order to determine its present condition. Seller may not be aware of … Property improvements may not be built according to code, in compliance with current Law, or have had permits issued.

BIA – Section 3: YOU ARE STRONGLY ADVISED TO INVESTIGATE THE CONDITION AND SUITABILITY OF ALL ASPECTS OF THE PROPERTY…

SBSA – BUILDING PERMITS, ZONING AND CODE COMPLIANCE: Buyer and Seller are advised that any structure on the Property… may have been built without permits, not according to building codes, or in violation of zoning laws…

Because of all these disclosures, it would be challenging to win in court. You would have to prove the seller had material knowledge of the unpermitted improvements and failed to disclose.

In the future, I recommend you take the time to become more familiar with all these documents. More importantly, become familiar with all the areas of due diligence for a real estate investor. That’s everything from checking into potential code violations and unpermitted construction, to conducting a camera inspection of the drain or sewer lines if the pipes are old and you suspect they may be deteriorating.

Lastly, I understand you may not be familiar with all of these things. So on future deals, work with an experienced real estate agent who can help point these areas out for you.

Good luck!

Originally posted by @Dan Heuschele :
First I do not view a COC of 10% good.   I would never choose RE if I was projecting only 10% COC.  10% is virtually same return as S&P which is a lot less effort.  

Second, are you indicating “10% forever” return based on a one-time 10%?   Realize a one-time 10% is not even a 5% annual after 2 years.  

Once you've added value you refinance out. Rents are up, you have less money in the property than you did when you started, and the 10% CoC will continue until you sell the property. At which time the property will most likely have increased in value. Cap rates can still compress in some neighborhoods. That's why people that bought in Echo Park ten years ago have made so much money...

Originally posted by @Seth Borman :
Originally posted by @Dan Heuschele:
First I do not view a COC of 10% good.   I would never choose RE if I was projecting only 10% COC.  10% is virtually same return as S&P which is a lot less effort.  

Second, are you indicating “10% forever” return based on a one-time 10%?   Realize a one-time 10% is not even a 5% annual after 2 years.  

Once you've added value you refinance out. Rents are up, you have less money in the property than you did when you started, and the 10% CoC will continue until you sell the property. At which time the property will most likely have increased in value. Cap rates can still compress in some neighborhoods. That's why people that bought in Echo Park ten years ago have made so much money...

I do not agree that 1) 10% COC is a good return for RE. I would never (and have never) purchase an RE if this was my expected return. 2) one time items (value adds as well as expense reducing items) returns such as those you listed are as beneficial as continuous long term rent appreciation. 3) that an RSO property will experience the same appreciation as the non RSO property. This explains why the RSO properties are cheaper than the non RSO properties.

The only part I agree with is the RSO properties are cheaper to acquire.  

Let’s compare:

- both RSO and non-RSO properties can have value add opportunities but which do you think provides the better initial return on the value add?  If you do not know, it is not the RSO RE. 

- both will have property appreciate but which will have more property appreciation?   You answered this yourself when you noted RSO are less expensive.  They have gotten to be less expensive because they have had less property appreciation. 

- the RSO property is capped at 3% rent appreciation which is far less than the historical market appreciation in LA and less than 50% of the market rent appreciation of San Diego (I assume LA market appreciation has been similar) for the last 5 years. 

I stand by my statement that the biggest issue with the OP’s purchase is that it is RSO.  

Add in the illegal construction issue, the holding costs, and his limited finances and the OP should sell.  Ideally his next RE purchase is better.  

Hi and welcome to BP Juan. This place is an amazing forum for all financial questions. For your case specifically, I feel I may be able to provide some advise.

I run a mortgage/real estate brokerage in Los Angeles. Please feel free to reach out to me in a PM. Happy to help even if we do not end up working together.

Originally posted by @Dan Heuschele :
Originally posted by @Seth Borman:
Originally posted by @Dan Heuschele:
First I do not view a COC of 10% good.   I would never choose RE if I was projecting only 10% COC.  10% is virtually same return as S&P which is a lot less effort.  

Second, are you indicating “10% forever” return based on a one-time 10%?   Realize a one-time 10% is not even a 5% annual after 2 years.  

Once you've added value you refinance out. Rents are up, you have less money in the property than you did when you started, and the 10% CoC will continue until you sell the property. At which time the property will most likely have increased in value. Cap rates can still compress in some neighborhoods. That's why people that bought in Echo Park ten years ago have made so much money...

I do not agree that 1) 10% COC is a good return for RE. I would never (and have never) purchase an RE if this was my expected return. 2) one time items (value adds as well as expense reducing items) returns such as those you listed are as beneficial as continuous long term rent appreciation. 3) that an RSO property will experience the same appreciation as the non RSO property. This explains why the RSO properties are cheaper than the non RSO properties.

The only part I agree with is the RSO properties are cheaper to acquire.  

Let’s compare:

- both RSO and non-RSO properties can have value add opportunities but which do you think provides the better initial return on the value add?  If you do not know, it is not the RSO RE. 

- both will have property appreciate but which will have more property appreciation?   You answered this yourself when you noted RSO are less expensive.  They have gotten to be less expensive because they have had less property appreciation. 

- the RSO property is capped at 3% rent appreciation which is far less than the historical market appreciation in LA and less than 50% of the market rent appreciation of San Diego (I assume LA market appreciation has been similar) for the last 5 years. 

I stand by my statement that the biggest issue with the OP’s purchase is that it is RSO.  

Add in the illegal construction issue, the holding costs, and his limited finances and the OP should sell.  Ideally his next RE purchase is better.  

 We are going to have to agree to disagree.

Agreed that the OP is probably in over his head.

I'm curious about what "illegal construction" is. In many cases the city has permits that they don't have online. Have to go to the office on Figueroa to find out.

Originally posted by @Seth Borman :
Originally posted by @Dan Heuschele:
Originally posted by @Seth Borman:
Originally posted by @Dan Heuschele:
First I do not view a COC of 10% good.   I would never choose RE if I was projecting only 10% COC.  10% is virtually same return as S&P which is a lot less effort.  

Second, are you indicating “10% forever” return based on a one-time 10%?   Realize a one-time 10% is not even a 5% annual after 2 years.  

Once you've added value you refinance out. Rents are up, you have less money in the property than you did when you started, and the 10% CoC will continue until you sell the property. At which time the property will most likely have increased in value. Cap rates can still compress in some neighborhoods. That's why people that bought in Echo Park ten years ago have made so much money...

I do not agree that 1) 10% COC is a good return for RE. I would never (and have never) purchase an RE if this was my expected return. 2) one time items (value adds as well as expense reducing items) returns such as those you listed are as beneficial as continuous long term rent appreciation. 3) that an RSO property will experience the same appreciation as the non RSO property. This explains why the RSO properties are cheaper than the non RSO properties.

The only part I agree with is the RSO properties are cheaper to acquire.  

Let’s compare:

- both RSO and non-RSO properties can have value add opportunities but which do you think provides the better initial return on the value add?  If you do not know, it is not the RSO RE. 

- both will have property appreciate but which will have more property appreciation?   You answered this yourself when you noted RSO are less expensive.  They have gotten to be less expensive because they have had less property appreciation. 

- the RSO property is capped at 3% rent appreciation which is far less than the historical market appreciation in LA and less than 50% of the market rent appreciation of San Diego (I assume LA market appreciation has been similar) for the last 5 years. 

I stand by my statement that the biggest issue with the OP’s purchase is that it is RSO.  

Add in the illegal construction issue, the holding costs, and his limited finances and the OP should sell.  Ideally his next RE purchase is better.  

 We are going to have to agree to disagree.

Agreed that the OP is probably in over his head.

I'm curious about what "illegal construction" is. In many cases the city has permits that they don't have online. Have to go to the office on Figueroa to find out.

 Which of my 3 bullets do you disagree with?   

Bullet 2 and bullet 3 can be verified in a couple minute search.  You basically showed bullet 2 when you pointed out the RSO properties are currently cheaper.  How do you think they got cheaper?  It is because the RSO appreciation has not been as great as the non-RSO Properties.  

Bullet 3 can be verified easily by just selecting a time from the distance past and verify that the appreciation has been greater than 3%.  It is a verifiable fact that rent appreciation in LA has exceeded 3%.  

I view bullet 2 & 3 as indisputable and very easy to verify. 

@Dan Heuschele I don't know why I'm having this talk with you. You clearly have a line on deals that make you plenty of money.

The fact is that you can make a lot of money in rent controlled apartments if you know how to work the system. People have shown that time and again in various cities across the United States. The monthly checks that my last employer mailed to their investors was proof of that.

Rent controlled apartments are undervalued because the tenants don't pay much. If you can change the tenants you can change the value of the apartment. Pretty simple concept.

If you decided to buy only NRC buildings in Los Angeles you wouldn't be able to find a lot of them. The ones that you do find usually don't have the same upside.

Originally posted by @Seth Borman :

Dan Heuschele I don't know why I'm having this talk with you. You clearly have a line on deals that make you plenty of money.

The fact is that you can make a lot of money in rent controlled apartments if you know how to work the system. People have shown that time and again in various cities across the United States. The monthly checks that my last employer mailed to their investors was proof of that.

Rent controlled apartments are undervalued because the tenants don't pay much. If you can change the tenants you can change the value of the apartment. Pretty simple concept.

If you decided to buy only NRC buildings in Los Angeles you wouldn't be able to find a lot of them. The ones that you do find usually don't have the same upside.

Nothing you stated changes the fact that on average RTO has less property and rent appreciation than non-RTO properties on average.

>If you can change the tenants you can change the value of the apartment. Pretty simple concept.

True but that is a big if. Each tenant turn over that does not meet RTO eviction qualifications requires cash for keys as well as RTO relocation costs. So is your thought to continuously flip tenants via cash for keys? Otherwise you are once again trying to compare a one-time value add to an on-going profit generator of property and rent appreciation.

>Rent controlled apartments are undervalued because the tenants don't pay much.

They do not pay much rent because the 3% capped rent appreciation has been historically less than the market rent appreciation of the non-RTO properties. It is one reason the RTO properties historically on average return less profit

>If you decided to buy only NRC buildings in Los Angeles you wouldn't be able to find a lot of them. The ones that you do find usually don't have the same upside.

You state the NRC do not have the same upside but the facts show this not to be true. The non-RTO property has on average experienced significantly more property appreciation and rent appreciation In addition, on average value adds provide better return on non RTO. The average property and rent appreciation being greater on non RTO properties is easy to verify; it is verifiable fact.

>People have shown that time and again in various cities across the United States. The monthly checks that my last employer mailed to their investors was proof of that.

All my comments are all on average. It does not mean that you cannot make money on RTO but it does mean on average, historically, more money has been made on the non-RTP Properties. This is easy to verify simply by analyzing the rent and property appreciation of the non-RTO properties versus the RTO properties. It is fact and is easy to verify. There are many investors who avoid RTO. This is one reason that RTO properties cost less, the demand is less because many investors avoid RTO properties. If the demand was the same there would not be a discount for RTO properties. RTO properties sell at a discount to non-RTO properties for a reason.