ESSENTIAL LEGAL ISSUES IN PURCHASING MULTI-FAMILY INVESTMENT PROPERTIES
Investing in multi-family property is a great way to build wealth. Multi-families are also great first investments for new investors looking to make a smaller purchase to get their feet wet before buying something bigger. However, when buying a multi-family property there are a number of legal issues that every real estate investor should be aware of that do not arise when purchasing a condominium or single-family home. I have outlined three important issues to consider when purchasing a multi-family property.
1.ZONING: IS THE PROPERTY A LEGAL MULTI-FAMILY PROPERTY?
One of the first things I advise clients buying multi-families is that they need to understand whether the property is a legal multi-family. This comes in two forms: it must be either a permitted use under the current zoning regulations or a “legally non-conforming” property. If it is neither, then the purchaser may be in for serious problems down the road. That is why every investor should understand the zoning issues that can arise when purchasing multi-family property and how to navigate through them.
If the multi-family property is a permitted use under the zoning regulations, then you can rest comfortably that the property’s use does not violate the zoning regulations. However, what if the multi-family is in a zone where multi-family property is not a permitted use? Is it an illegal use and therefore a buyer should shy away from the purchase? Not necessarily.
The multi-family property may be a legally non-conforming use. In the world of land use law, a property may not be a permitted use under the current zoning regulations but multi-family may have been a permitted use in the past. A property is considered legally non-conforming if the use complied with the zoning prior to the date that the town changed the zone to remove such use from the zone. For example, if a multi-family was a permitted use in the R2 Zone in 1999 and the town thereafter removed multi-family from the R2 zone, as long as the property was in use as a multi-family prior to the change of zoning it can continue as a multi-family property after the change of zoning as a “legally nonconforming” property.
However, it is possible that an owner illegally converted a property to a multi-family property in a zone that does not permit it. This would mean the property is an illegal multi-family and a property you do not want to purchase. This is why it is important to explore the zoning and the history of the property to make sure you do not purchase an illegal property. As long as the property is in a zone that permits multi-family or the property is legally – nonconforming, you can safely purchase the property. Make sure you ask your attorney these questions during your due diligence.
2.PROTECT YOURSELF: CREATE A LIMITED LIABILITY COMPANY (LLC) TO LIMIT YOUR LIABILTIY
Buying a multi-family, or any property with tenants, is a transaction that comes with risks and potential exposure to liability that are not inherent in purchasing a residence for you and your family. For example, what if a tenant slips and falls and files a lawsuit against you arguing that her injuries are a result of you failing to comply with your obligations under the lease? What if a tenant accidentally starts a fire that spreads and causes damage to other homes in the surrounding neighborhood? These are examples of the inherent risks in buying multi-family properties. This is why it is imperative to do everything you can to minimize your liability if something goes wrong. One important thing you can do to limit your liability is to create a Limited Liability Company (LLC) and take title in the name of the LLC.
Taking title in the LLC instead of individually will limit your liability to the value of the real estate and will insulate you from personal liability (there are several narrow exceptions to this not discussed in this post). Since the LLC is the owner of the property, any lawsuit concerning the property properly names the company as the defendant and not you individually. Since the LLC's only asset is the real estate, the maximum exposure from any lawsuit is the value of the real estate. In other words, any judgment obtained by a tenant, neighbor, or other potential plaintiff may only look to the company's assets to satisfy the judgment which is the real estate. If the property was owned by you individually, a plaintiff could look to the real estate and other personal assets (bank accounts, other real estate, etc.) to satisfy the judgment.
Setting up the LLC may seem like a simple process but there are various things to consider. For example, if you are creating the LLC with more than one member, you should think about creating an operating agreement which will delineate the authority of each member; whether authority to manage the property will be vested in a manager; the process that more significant decisions are made (for example, will major decisions like whether to sell require a unanimous vote?); the process that the company should utilize in taking on new members; and how the company will decide a tie vote. Drafting a detailed operating agreement will prevent problems between members in the future.
In short, every investor should strongly consider setting up a LLC and taking title in the name of the company to minimize liability. If your LLC has more than one member, creating a detailed operating agreement will prevent problems between the members in the future.
3.TENANTS AND LEASES: DO YOUR DUE DILIGENCE
When buying any property with tenants, it is essential to do your due diligence with respect to the tenants and the leases. As an investor, you want to make sure that the tenants are current on the rent. You do not want to purchase the property only to learn that the tenants are six months behind on the rent and are vigorously fighting an eviction lawsuit. Therefore, it would be prudent to request that the seller sign a document called an estoppel certificate. This document will require the Seller to make a representation that the leases are in full force and effect and that the tenant is current on the rent. This will provide you some assurance that the tenants are not behind on the rent. Moreover, having estoppel certificates signed by the Seller will give you an additional cause of action for misrepresentation if in fact the tenants are not current on the rent.
It is also prudent to review each lease with your attorney. You should be aware of the termination date of each lease and whether the tenant has the option to renew. If the leases are to terminate a month after closing, you should be prepared for the possibility of vacancies. Moreover, if the tenants have an option to renew, this may interfere with plans to lease to other tenants. Similarly, some leases have options to purchase or lease to own arrangements. This type of provision is problematic for any investor as the tenant would have the option to purchase the property after you closed. You would likely not want to move forward with the investment if there was such a provision in any of the leases. This is why it is imperative to review each lease thoroughly to make sure you know what you are getting into.
In summary, it is in your best interest as a real estate investor to carefully review each lease before purchasing an investment property. In addition, having the seller sign estoppel certificates will provide you additional protection in the event the tenants are in fact behind on the rent.
