The New Prospectors:

Buying Tenant Occupied Foreclosed Property Under The San Francisco Rent Ordinance

San Francisco Apartment Magazine

By Jeffrey Woo

Banks were not, and are not, prepared to dispose this number of properties all at one time. As a result, REOs have hit the market at rock bottom prices not seen in a generation or more. Among the REO properties on the market, many will have existing tenants.

While purchasing an REO property from a bank works mechanically the same as purchasing property from any other seller, there are differences. The selling bank prob­ably knows nothing about the property it is selling. When a bank forecloses, its first priority is getting the property sold quickly in order to recover its loan losses. If that property has a tenant in it, the bank will know little or nothing about the tenant or the tenancy. The bank will likely not have a copy of any leases or tenant applications. It may not even know the tenant names or the rent amounts they pay. Many banks will not even bother collecting rents from ten­ants in their rush to get the property sold.

Why so little information? There are two reasons. The first goes back to their pri­ority of getting the property sold. While it would enhance the marketability and value of the building to gather this infor­mation about tenants in the property, the time and expense of acquiring the infor­mation is not justified in the bank’s mind because of the sheer number of properties it is seeking to dispose. It does not want to manage property for any longer than it must. The second reason is a bank’s experience with REO properties is going to be primarily in areas without rent or eviction control. In those areas, a bank need only serve a 60 or 90 day notice on tenants to clear the property. For that rea­son, a bank will see no reason why it or a buyer should worry about the details of a tenant or tenancy.

However, in eviction control jurisdictions like San Francisco, that can’t be done. Tenants of foreclosed properties maintain all of their rights under the San Francisco Rent Ordinance (“Ordinance”). Under the Ordinance, it is not permissible to evict a tenant simply because the property has been foreclosed upon. Because a ten­ant maintains all of his rights under the Ordinance, it is critically important that a buyer understands the risks he faces in buying an REO property without clear information about a tenant or tenancy.

So what can be done if the bank does not know the tenant’s name or the amount of rent he is suppose to pay? Assuming the tenant will not admit what rent he pays, it is possible to that a Rent Board petition based upon Extraordinary Circumstances under Rule 6.11 can be filed which seeks to have a rent established. The petition allows a landlord to seek a rent increase “where, because of . . other extraordi­nary circumstances unrelated to market condition, the initial rent was set very low or the rent was not increased or was increased only negligible amounts during the tenancy,. . . “If prevailed upon, the Rent Board will establish the rent as the fair market value rent as of the date the tenant first moved in plus any lawful rent increases that could have been taken. By filing this petition, the owner is hoping to get the tenant to admit what the actual rent he was paying.

Also, if the property is a single family home (with no in law unit) or a condominium, and it can be shown that the tenancy began after 1995, a State law called Costa Hawk­ins allows a landlord to raise rent to market rent at anytime. As many REOs are single family residences, this may be a much sim­pler way of getting the tenant to admit to the real rent and who they are. It may also give the buyer leverage in negotiating the tenant out of the property.

If the property is being purchased to live in, one of the first issues is going to be whether the tenant has a lease. While the Ordinance allows owners of property to evict tenants for owner move-in (“OMI”) or under the Ellis Act, a tenant with a lease with a remaining term may not be evicted under these grounds until the lease expires. Whether the lease is valid after the foreclosure will depend upon whether the lease was entered into before or after the loan documents were signed.

If the loan commenced before the lease, then a foreclosure of the loan will act to terminate the lease and an OMI or Ellis Act eviction can be commenced. If the loan was entered into after the signing of the lease, the owner may not be able to evict for OMI, Ellis Act, or any other grounds for eviction under the Ordinance which does not constitute a breach of the tenancy until the lease expires.

Further, there has been enacted Federal and State laws regarding foreclosed properties that may extend the time it take to lawfully evict a tenant. Under the Federal law, if the loan foreclosed upon was federally-related, a landlord is required to give 90 days notice of eviction. Under State law, tenants are given a minimum of 60 days to vacate whether or not the foreclosed loan was federally-related. A number other bills at the State level have been, or are anticipated to be, presented before the legislature which may effect an owners right to evict tenants from an REO. Thus, the risk of future legislation on REOs is much higher than the same risk to non-foreclosed rental property.

It may be useful to know if the tenant claims to be “protected.” Under Section 37.9(i) of the Rent Ordinance, a tenant may be served a questionnaire in which he is obligated to disclose whether he is ei­ther “protected” or that he believes within the next 12 months he will become “pro­tected.” If the tenant fails to return the questionnaire within 30 days, the tenant will be deemed as not “protected.”

A “protected” tenant is defined as a person who is either (i) 60 years of age or old and has resided in the premises for 10 years or more; (ii) disabled, qualified to receive SSI/SSP payments and has lived in the premises for 10 years or more; or (iii) disabled, has a life threatening illness or condition, quali­fied to receive SSI/SSP payments and has lived in the premises for 5 years or more. It should be remembered that all disabled persons are not “protected” and the ques­tionnaire under 37.9(i) will not tell you if they are disabled. Yet, if a tenant is dis­abled, the eviction of that tenant will result in higher relocation expenses, a longer evic­tion time if the Ellis Act is used, and the loss of condominium conversion rights.

If the buyers intend is to keep some or all of the tenants, finding out the terms of each tenancy may be difficult depending upon the cooperation of the tenants. If the ten­ants provides you with a copy of the writ­ten lease or signs an estoppel certificate (a declaration by the tenant stating basic terms of the tenancy and other information), you will be fortunate. However, many tenants find it in their interest to not provide such information. It allows them to allege that that the foreclosed prior owner agreed to a variety of things such as allowing a pet or a roommate, or storage in the garage, or park­ing a car, or exclusive use of common area or a reduction in rent or the like. While the only proof this tenant may have to his claim is his word, you will have no evidence to the contrary. And because the Ordinance restricts how you can amend the tenancy, this is a risk that must be recognized.

So is the lesson that a buyer should never buy a tenant occupied REO property? No. The lesson is that in evaluating what it is worth to buy the property, this risk must be calculated into your estimation of value. As an example, I recently had a client come to me after he had entered into a contract to buy a tenant occupied REO property. He had put $10,000 down and the contract provided for no contingencies. He learned after entering into the contract that the house had been previously owned by ab­sentee landlords who cut up the house into a series of rooms which were each rented room by room. Through some documen­tation found at the rent board, we learned that there were at least five tenants in the property and that there were a total of eleven separate rooms. This client wanted to take back the house to live in and asked that we do an assessment of the cost of re­moving all tenants. After providing a writ­ten assessment, the client was willing to breach the contract and lose his $10,000 deposit because he could not afford to both buy the house and evict the tenants. He presented our estimate to the bank, which in turn agreed to lower the price of the house by $130,000 to induce my client to close escrow. My client assessed that the reduction in price was worth the risk of the unknown. The bank assess that the reduc­tion in price was worth not having the risk of having to find another buyer and leav­ing the property on the market.

REO properties are plentiful and tempt­ing, but it is important to recognize that the diamond in the rough you may be looking at may have some hidden flaws. Like buying used cars, be sure to under­stand that the tenants in San Francisco come with a unique set of challenges that may not be apparent to the unwitting buy­er. Buying tenant occupied REO proper­ties requires more due diligence and an understanding that what may seem cheap, can quickly become expensive is you have failed to account for risk of the unknown that tenants can bring. The converse is also true that knowledgeable buyers of tenant occupied REO can find enormous returns in the face of such risks.

Jeffery Woo heads the Complex Rental Property Group at Sedgwick, Detert, Moran & Arnold. He is a past president of the Chinese Real Estate Association of America. He also currently serves as a director of the San Francisco Association of REALTORS® and of the San Francisco Apartment Association. He has been named as a Super Lawyer by his peers in 2006, 2007, 2008 and 2009. He lectures widely on the topic of real estate and has published dozens of article on the topic of Rent Ordinance and Real Estate. Jeff welcomes your comments and can be con­tacted at 415-627-3706 or via email at jeff.woo@sdma.com. His website can be found at www.mypropertyrights.com

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