Real Estate Fundamentals (National Portion) Student Manual

Transcription

1 Real Estate Fundamentals (National Portion) Student Manual For Use with the PowerPoint/Audio Course Format Recommended Textbook: Real Estate Principles Roy L. Ponthier, Ph.D., Ed.D., CDEI, DREI Executive Director 10/11

2 Table of Contents 1. An Introduction to Real Estate The Nature of Real Property Real Property Ownership Transferring Ownership Encumbrances Public Restrictions on Property Rights Contract Law Types of Real Estate Contracts Real Estate Agency Law Regulation of the Real Estate Profession Real Estate Financing Applying for a Mortgage Loan Real Estate Appraisal Closing Real Estate Transactions Income Taxation and Real Estate Civil Rights and Fair Housing Property Management Home Ownership and Construction Real Estate Math

3 1. An Introduction to Real Estate An Introduction To Real Estate The Real Estate Industry Real estate industry includes: Real estate brokers and salespersons Property managers Inspectors Title company employees Developers Investment counselors Appraisers Etc. The Real Estate Industry Real estate industry divided into two branches: Residential real estate (single-family homes, condominium complexes, etc.) Commercial real estate (retail property, office buildings, industrial property, etc.) It s common for agents to specialize in either residential or commercial property, and to focus on either sales or rentals. Real Estate Transactions Real estate transaction may be: Sale Lease Exchange 3

4 Real Estate Transactions Most basic real estate transaction is the sale of a home, which often involves: Listing property Showing property Submitting and considering offers to purchase Negotiations between seller and buyer Execution of the contract Property inspections Real Estate Transactions Transactions involved with sale of a home (cont.): Financing arrangements Property appraisal Closing preparations Buyer s walk-through Closing Real Estate Transactions Listing Most sellers put home on market by listing it with a real estate agent. Seller signs contract agreeing to pay agent compensation (commission) in exchange for agent s efforts to find a buyer. Agent (listing agent) submits property information to multiple listing service (MLS). Real Estate Transactions Showing the Property Prospective buyers tour home with their own agents, with the listing agent, or with another agent from the MLS. 4

5 Real Estate Transactions Offers A buyer submits written offer to purchase, stating: Price buyer is willing to pay Closing date Other terms of sale In active market, multiple competing offers are common for desirable property. Real Estate Transactions Offers An offer is usually accompanied by a deposit: money tendered to a seller to show the offer is serious and in good faith. If offer is rejected, deposit is returned to buyer. If offer is accepted but sale later falls through, deposit may be returned to buyer, depending on circumstances. Real Estate Transactions Negotiations Seller may want to negotiate changes in the terms presented in buyer s offer. Seller uses a counteroffer to present his or her changes to the offer. Buyer may then respond with another counteroffer negotiations then go back and forth. Real Estate Transactions Contract When offer (or counteroffer) is accepted, a legally binding contract is formed. Typically, contract is contingent on the fulfillment of certain conditions specified in the contract (such as satisfactory inspection results). 5

6 Real Estate Transactions Inspections Buyer may order a home inspection to have home s construction and condition evaluated. Other professional inspections may be arranged as well: pest inspection, soil stability test, etc. Real Estate Transactions Financing Unless buyer can pay for property in cash, financing must be arranged. Usually buyer comes up with some cash (downpayment) and borrows most of the purchase price from a mortgage lender. Real Estate Transactions Appraisal Since property will serve as collateral for loan, lender will require an appraisal. Appraiser evaluates property and provides estimate of its market value to lender. Real Estate Transactions Closing Preparations After contract is signed, many tasks must be completed before sale closes: Arrange for seller s mortgage to be paid off Order title insurance policy Have deed and other documents recorded Etc. 6

7 Real Estate Transactions Closing Preparations May be handled by the parties or by closing agent (escrow agent, broker, attorney, lender, or title company). Real Estate Transactions Walk-through Buyer may make one final visit/inspection before closing to ensure all required repairs have been completed properly, and that property is in condition it s supposed to be in. Real Estate Transactions Closing Closing (settlement) is final step in real estate transaction. Closing may take place at meeting attended by parties, agents, and representatives from lender and title company. Real Estate Brokerage Broker: Acts as intermediary in a transaction, helping to arrange the purchase or sale of goods, services, or other commodities on behalf of others. 7

8 Real Estate Brokerage Brokers and Salespersons Real estate salesperson s license: allows salesperson to work with members of public in real estate transactions only if supervised by real estate broker. Requirement of state license laws. Broker s license requires additional education and/or experience. Real Estate Brokerage Brokers and Salespersons Real estate agent : generic term for person who sells real estate (broker or salesperson) Realtor real estate agent REALTOR : member of National Association of REALTORS Brokerage Services Seller s Agent Services for sellers: Pricing property Preparing home for showing Effective advertising Showing to prospective buyers Negotiations and paperwork Monitoring closing Brokerage Services Pricing Property To help seller set realistic listing price, agent uses competitive market analysis (CMA). Requires agent s knowledge regarding: area/neighborhood, recent sales/listings, and which factors matter most in determining market value. 8

9 Brokerage Services Preparing the Home Agent can instruct seller which steps to make home more attractive are worth the time and money. Some agents specialize in staging homes for showing. Brokerage Services Effective Advertising Types of advertising: classified newspaper ads mailed flyers display ad in Homes for Sale magazine Most important: listing in MLS database Brokerage Services Showing the Property Agent can hold open house: scheduled time when home is open for viewing and agent is available to answer questions. Agent can also show home to prospective buyers and other agents, using keybox provided by seller. Brokerage Services Negotiations and Paperwork Agents help parties negotiate offer and acceptance. Seller often relies on agent to provide necessary disclosure forms and help fill them out. 9

10 Brokerage Services Monitoring the Closing Process Agent acts as liaison between seller, buyer, and other parties. Helps resolve any problems that may arise. Brokerage Services Buyer s Agent Agent can help buyer with: Finding the right property Entering into contract Obtaining financing Completing transaction Agent working with buyer may actually represent seller. Brokerage Services Buyer s Agent Buyer can find selling agent by: Referral Visiting brokerage Contacting agent after seeing For Sale sign Open house Brokerage Services Buyer s Agent In initial interview, buyer s agent determines what buyer wants (and can afford). Agent then searches MLS and takes buyer to see properties. Agent typically helps buyer fill out offer form and presents offer. 10

11 Real Estate as a Career Working as a Real Estate Agent Real estate agents work for themselves. Brokers expect agents to get new listings and find prospective buyers. To earn a good living, agent must be selfmotivated and disciplined. Real Estate as a Career Working as a Real Estate Agent Agents usually set their own schedules. Agents may be able to work part-time, but must be able to manage their time. Agents must often work evenings, weekends, and holidays. Real Estate as a Career Working as a Real Estate Agent Agents must have good people skills. Agents must work closely with clients. Real transactions can be stressful and the parties can be short-tempered and demanding. Agent must be able to tolerate rejection. Real Estate as a Career Real Estate Companies Types of companies: Single broker firms vs. very large firms Local or national franchises Specialized vs. multi-service 11

12 Real Estate as a Career Real Estate Companies Support for agents: Training (formal program, mentoring, etc.) Facilities and services (desk, computer, phone, access to fax and copier, etc.) Memberships (MLS, trade associations) Real Estate as a Career Real Estate Companies Agent s responsibilities (depending on brokerage s requirements): Floor duty: must be at office to handle calls and drop-in visits from prospective clients Sales goals Real Estate as a Career Agent Compensation Most agents compensated by commission. Commission split: Listing brokerage typically splits commission with selling brokerage. Listing broker shares commission with listing salesperson. Selling broker shares commission with selling salesperson. Real Estate as a Career Agent Compensation (Commission Split) Percentages in commission split are set by agreement. Salespersons may receive smaller percentages in exchange for more support (better facilities, etc.) Some brokerages give agents 100% of commissions, but charge desk fee. 12

13 Real Estate as a Career Employment Status and Tax Withholding Agent may be classified as either: Independent contractor: Hired to perform specific job; uses own judgment in completing job. Employee: Hired to perform whatever tasks employer requires; follows employer s instructions. How agent is classified depends on degree of control broker exercises over agent. In most cases, agent is independent contractor. Real Estate as a Career Employment Status and Tax Withholding If agent is employee: Broker must withhold social security and taxes, etc. Agent is eligible for unemployment and worker s compensation. Real Estate as a Career Employment Status and Tax Withholding For federal income tax purposes, real estate agent is independent contractor if: 1. agent is a licensed real estate salesperson, 2. substantially all compensation is commission-based, and 3. agent and broker have written contract providing that agent is independent contractor. Real Estate as a Career Professional Associations Professional organizations: Provide members with information, training, and networking opportunities. Sometimes offer professional designations. May adopt codes of ethics for members. 13

14 Real Estate as a Career Professional Associations Code of ethics: Sets standards of conduct for dealing with public and other members of profession. Provides guidance on handling ethical dilemmas. Real Estate as a Career Professional Associations Largest and best-known professional association: National Association of REALTORS (NAR) Only members of NAR can call themselves REALTORS. Real Estate as a Career Professional Associations Other associations: National Association of Real Estate Brokers (NAREB) National Association of Exclusive Buyer Agents (NAEBA) National Real Estate Buyer s Agent Council (REBAC) the Appraisal Institute Real Estate as a Career Professional Associations American Society of Appraisers (ASA) Building and Office Managers Association (BOMA) Institute of Real Estate Management (IREM) American Society of Real Estate Counselors (ASREC) Real Estate Educators Association (REEA) National Association of Real Estate License Law Officials (NARELLO). 14

15 Real Estate and the Law Types of laws: Federal, state, and local laws Statutes Administrative regulations Case law (judicial rulings) Constitutional law Real Estate and the Law Laws Regarding Real Estate Agents Laws affecting real estate agents: License law Agency law Real Estate and the Law Laws Regarding Real Estate Agents Each state has real estate license law with: requirements for obtaining real estate broker or salesperson license rules for brokerages and other real estate businesses grounds for disciplinary action Real Estate and the Law Laws Regarding Real Estate Agents Real estate agents also impacted by: General agency law: usually combination of state statutes and case law Specific real estate agency law: in some states 15

16 Real Estate and the Law Laws Concerning Transactions Real estate contracts governed mostly by contract law. Also affected by state and federal civil rights laws. Real Estate and the Law Laws Concerning Property Property law includes rules about: what constitutes real property owner s rights (and limitations on those rights) different forms of ownership non-ownership interests transferring ownership and other property interests from one person to another 16

17 2. The Nature of Real Property The Nature of Real Property Real Property vs. Personal Property Two types of property: Real property ( realty ) Personal property ( chattels or personalty ) Real Property Bundle of Rights Real property ownership Possess Use Enjoy Encumber = A bundle of property rights Will Sell Do nothing Real Property Inverted Pyramid Imagine a parcel of land as an inverted pyramid 17

18 Real Property Appurtenances Appurtenance: Something that goes with or pertains to ownership of a piece of real property, but isn t necessarily a physical part of the property. Air rights Water rights Mineral rights Support rights Real Property Appurtenances Air Rights Air rights: Landowner has the right to use the airspace above the property, within limitations imposed by law. Example: Aircraft flight paths Air rights can be sold separately from the land (makes condominiums possible). Real Property Appurtenances Air Rights Restrictions on air rights Federal aviation laws Local laws and private restrictions Real Property Appurtenances Water Rights Two systems for allocating water rights: Riparian rights system Prior appropriation system Either system can be applied both to surface water and to subsurface water. 18

19 Real Property Appurtenances Water Rights Riparian rights: Landowner has the right to use the water that touches her property. Two types of water in riparian rights system: Riparian water = flowing water Littoral water = standing water Water may be used only on the riparian or littoral property itself. Real Property Appurtenances Water Rights Prior appropriation system was developed to address needs that were not served by the riparian system, particularly in arid areas. In some states, it has largely replaced the riparian rights system. Permit required for appropriative rights. Permit holder can take or divert water from a particular source for a specified reasonable and beneficial use. Example: Irrigation Real Property Appurtenances Mineral Rights Mineral rights: A landowner has the right to extract any solid minerals located within the property s inverted pyramid. Minerals are: Real property when in the ground Personal property once extracted and brought to the surface There is a special rule for oil and gas Rule of capture Real Property Appurtenances Support Rights Support rights: Natural support provided to a piece of land by the surrounding land. Subjacent support provided by the underlying earth. Lateral support provided by the neighboring land. 19

20 Attachments Attachments: Things that are permanently attached to the land. May be natural or manmade Are considered part of the real estate Attachments Natural Attachments Natural attachments: Growing things that are attached to the land by roots, such as trees, bushes, and other plants. Doctrine of emblements: Crops produced by cultivated plants are classified as personal property, even before they are harvested. Applies to crops planted by a tenant farmer. Attachments Fixtures Fixtures: Manmade attachments to real property. Items that were once personal property. Now attached to or connected with (annexed to) real property in such a way that they have become part of the real property. Attachments and Severance Physical annexation: Permanent, physical attachment of item to land or improvements. Constructive annexation: When item is a necessary or working part of real property. Severance: Natural attachments can be severed from the land and sold separately. 20

21 Attachments There are four common legal tests for distinguishing fixtures from personal property Method of attachment Adaptation of the item Intention of the parties Relationship of the parties If a written agreement exists, it normally controls whether an item is considered a fixture. Attachments Fixture Tests Test #1 - Method of attachment Is the item attached to the realty in some way, and if so, how? Is the item movable? Test #2 Adaptation of the Item Has the item been specially adapted to the realty in some way, or specially designed for it? Attachments Fixture Tests Test #3 Intention Test Did the person who installed the item intend it to become part of the realty? Test #4 Relationship Test Did the person who installed the item own the property or was he just a tenant? An item installed by a tenant is typically considered personal property. An item installed by an owner is typically considered real property. Attachments Fixture Tests Trade fixtures: Equipment and other items that a commercial tenant installs to carry on a business. Trade fixtures aren t considered part of the real property, no matter how they re attached. 21

22 Attachments Mobile Homes In many states, a mobile home is personal property until permanently attached to a piece of real estate. Once attached to a piece of real estate, the mobile home is a fixture and part of the real property. Characteristics of Real Property Physical characteristics: 1. immobility, 2. indestructibility, and 3. uniqueness. Characteristics of Real Property Economic characteristics: 1. scarcity, 2. improvements, 3. permanence, and 4. area preference. Methods of Legal Description Legal descriptions allow precise identification of a piece of real property. Descriptions are typically based on a property survey performed by a state-licensed surveyor. Three main methods of legal description: Metes and bounds Government survey Recorded map 22

23 Methods of Legal Description Metes and Bounds Metes and bounds description: Describes a piece of land by specifying its boundaries. Monuments Natural or manmade objects that mark a fixed point. Courses Compass directions. Distances Length of each boundary. The point of beginning must always be described by reference to a monument. Methods of Legal Description Metes and Bounds Reading a Metes and Bounds Description Starts with point of beginning, then gives course (direction) and distance for each leg of the boundary, until it has described a full circuit and arrived back at the point of beginning. Methods of Legal Description Metes and Bounds Example: Beginning at the old oak tree, go South 15 East 200 feet. Then go North 90 West 310 feet, more or less, to the centerline of Smith Creek. Then go northwesterly along the centerline of Smith Creek to a point due west of the old oak tree. Then go North 90 East 430 feet, more or less, to the point of beginning. Methods of Legal Description Metes and Bounds Discrepancies between elements of description are resolved in this order: 1. Natural monuments 2. Man-made monuments 3. Courses 4. Distances 5. Names 6. Areas 23

24 Methods of Legal Description Government Survey Government survey description: Property is identified by its location in a particular section, township, and range on a U.S. government survey map. Also called a rectangular survey description. Methods of Legal Description Government Survey The government survey system uses a series of very large survey grids covering much of the United States. Methods of Legal Description Government Survey In Government Survey Descriptions, each grid has its own: Principal meridian (main north-south line) Base line (main east-west line) Methods of Legal Description Government Survey Each survey grid is identified by the name of its principal meridian. For example, in California: Humboldt Meridian Mount Diablo Meridian San Bernardino Meridian 24

25 Methods of Legal Description Government Survey Each grid has grid lines running parallel to the principal meridian and to the base line at intervals of six miles. Methods of Legal Description Government Survey The north-south lines are called range lines. Range lines divide the land into columns called ranges. Each range is six miles wide. Methods of Legal Description Government Survey The east-west lines that parallel the base line are called township lines. Township lines divide the land into rows called township tiers. Methods of Legal Description Government Survey Each individual square is called a township. A township is identified by its position in relation to the base line and principal meridian. Township = 6 miles 6 miles 36 square miles 25

26 Methods of Legal Description Government Survey The location of the township above is Township 4 North, Range 5 East. It s the township created by the intersection of the fourth township tier north of the base line, and the fifth range east of the principal meridian. Methods of Legal Description Government Survey Each township is divided into 36 sections. Each section is one mile on each side, or one square mile. Each section is 640 acres. (An acre contains 43,560 square feet.) Methods of Legal Description Government Survey The sections within a township are numbered from 1 to 36. Most individual parcels are only part of a section, so they are described in terms of fractions, such as quarter sections or quarter-quarter sections. NW ¼ 160 Acres SW ¼ 160 Acres Methods of Legal Description Government Survey A complete government survey description must include the section, township, and range. It must also include the name of the principal meridian to identify the grid. NE ¼ 160 Acres NE ¼ of SE ¼ 40 Acres 26

27 Methods of Legal Description Government Survey Government lots are partial sections of land with irregular shape or non-standard size. May be caused by body of water or other obstacle. Government lots are referenced by assigned numbers. Methods of Legal Description Lot and Block Lot and block description: The standard method for describing property in towns and cities. Also called the recorded map method or the plat map method. When land is subdivided, the subdivision is surveyed and a map is drawn up that shows the precise location and dimensions of each lot. Each lot is assigned a lot number. Groups of lots separated by streets within the subdivision may also be assigned block numbers. Methods of Legal Description Lot and Block Plat: A map showing the lots and blocks in a subdivision. Once the plat map is recorded, a parcel can be described by its lot and block numbers, the name of the subdivision, and the county or city in which it is located. Example: Typical lot and block description: Lot 7, Block 2, in the Lowland Heights subdivision, according to the plat thereof recorded at Vol. 22, Page 16, in the records of Butler County, State of Pennsylvania. Methods of Legal Description Other Methods Other methods of describing land: A reference to a description in an earlier recorded document. A reference to a survey or tax assessor s map that has been recorded. A generalized description, such as all my land in Oak County. Street addresses should never be used to describe land. 27

28 3. Real Property Ownership Real Property Ownership Introduction This lesson will discuss: the different types of estates in land the different ways of holding title to property Estates in Land Interest: An interest in real property is a right concerning the property or a claim against it. Interests may be: possessory interests (also called estates) nonpossessory interests Hierarchy of Estates Two basic categories of estates: Freehold estates (include title) Fee simple estates Fee simple absolute Fee simple defeasible Life estates Leasehold estates (do not include title) 28

29 Freehold Estates Fee Simple Fee simple: the most common type of estate the highest and most complete form of land ownership can potentially last forever A fee simple estate is perpetual, transferable, and inheritable. There are two types of fee simple estates Absolute Qualified Freehold Estates Fee Simple Fee simple absolute owner is not subject to any special limitations. Fee simple absolute estate is the default estate unless it is completely clear that the grantor intended otherwise. Freehold Estates Fee Simple Fee simple defeasible: Fee title with a condition or qualification attached Interest will end if a specified act or event occurs at some later date Freehold Estates Fee Simple Fee simple determinable: Ends automatically if condition is violated; property reverts back to grantor without legal action by grantor. 29

30 Freehold Estates Fee Simple Fee simple subject to condition subsequent: Doesn t end automatically when condition is breached; grantor must take legal action to terminate the estate. Freehold Estates Life Estates Life estate: limited in time lasts only as long as a particular person is alive Example James donated his farm to the Children s Aid Society, but he retained a life estate in the farm. James has exclusive possession and use of the farm until he dies, and then the farm will belong to the Children s Aid Society. While James is alive, he is the life tenant. Freehold Estates Life Estates Measuring life: The life on which a life estate depends. In the example, James s life is the measuring life for his life estate. The life estate will end when James dies. Freehold Estates Life Estates Future interest: The ownership interest that will begin when the life estate ends. When a life estate is created, a future interest in the property is created at the same time. Two types of future interests: estate in reversion estate in remainder 30

31 Freehold Estates Life Estates Estate in reversion Margarita grants a life estate to John, and stipulates that the property will come back to her (or to her heirs) at the end of the measuring life. Margarita and her heirs have an estate in reversion. They are called reversioners. Freehold Estates Life Estates Estate in remainder On the other hand, if Margarita stipulates that the property will go to Sam (not back to her or her heirs) when John dies, then Sam has an estate in remainder. Sam would be called a remainderman. Freehold Estates Life Estates Duties of a life tenant A life tenant must pay any taxes, assessments, and other liens on the property. A life tenant must allow holders of future interests to inspect the property periodically. A life tenant must not commit waste. Hierarchy of Estates Leasehold Estates Leasehold estate: A limited, temporary estate created by a lease contract. Parties landlord and tenant. Tenant gets the right to exclusive possession and use of the property. Landlord retains title to the property. 31

32 Leasehold Estates Types of leasehold estates Estate for years Periodic tenancy Tenancy at will Tenancy at sufferance Leasehold Estates Estate for Years Estate for years: A leasehold estate that lasts for any fixed term. Also called a term tenancy. Created by express agreement only. Ends automatically when term expires. Neither party needs to give notice to the other party. Leasehold Estates Periodic Tenancy Periodic tenancy: A leasehold that is not limited to a specific term. Also called a periodic estate. Automatic renewal: continues from rental period to rental period until terminated by either landlord or tenant with proper notice. Required notice period equals rental period. Leasehold Estates Tenancy at Will Tenancy at will: A tenancy that is neither a term tenancy nor a periodic tenancy. Also called an estate at will. No specified termination date No regular rental period Rent may be paid on an irregular basis or not at all Can be terminated at any time by either party 32

33 Leasehold Estates Tenancy at Will Differences from other leasehold estates: a tenancy at will cannot be assigned to another person a tenancy at will ends automatically upon the death of either party Leasehold Estates Tenancy at Sufferance Tenancy at sufferance: Not a true estate; tenant does not have a leasehold interest. Tenant holds over after lease expires, contrary to landlord s wishes. Sometimes called an estate at sufferance or holdover tenancy. Ways of Holding Title All property has at least one owner, who may be an individual, an organization, or a group of individuals. Depending on the number and type of owners involved, title to the property can be held in different ways. Ownership in Severalty Concurrent Ownership Business Ownership Ways of Holding Title Ownership in Severalty Ownership in severalty: Ownership by one individual (often called separate or sole ownership). Individual owner may be: a natural person (a human being) an artificial person (a legal entity such as a business) 33

34 Ways of Holding Title Concurrent Ownership Four types of concurrent ownership (or coownership): tenancy in common joint tenancy community property tenancy by the entirety Concurrent Ownership Tenancy in Common Tenancy in common is the most basic form of co-ownership It s the default form of ownership if: the co-ownership arrangement doesn t fit into one of the other categories the co-owners did not specifically choose another type Concurrent Ownership Tenancy in Common Tenants in common have undivided interests in the property as a whole. Shares don t have to be equal. A tenant in common is free to sell, will, or mortgage his or her interest without the consent of the other tenants. Concurrent Ownership Tenancy in Common A tenancy in common can end if: all of the co-tenants agree to sell the whole property to someone else they all agree to partition the property one of the co-tenants files a suit for partition 34

35 Concurrent Ownership Joint Tenancy In a joint tenancy, two or more persons are joint and equal owners of a property. Requirements for creation or continuation of a joint tenancy: unity of interest unity of title unity of time unity of possession Concurrent Ownership Joint Tenancy Right of survivorship is the key feature of a joint tenancy. When a joint tenant dies, her interest: automatically passes to the surviving joint tenants is not part of her estate cannot be willed Concurrent Ownership Community Property In certain states, community property is property owned concurrently and equally by a husband and wife. In community property states: Everything owned by a married couple that isn t the separate property of one spouse is the community property of both spouses. There s a legal presumption that all property acquired by a spouse during marriage is community property. Concurrent Ownership Community Property Separate property: all property owned before marriage any gift or inheritance acquired during the marriage anything purchased with separate property funds profits or proceeds from separate property 35

36 Concurrent Ownership Community Property Community property: Any property (including money) that a spouse acquired during the marriage: through skill or labor, or using community funds or community credit. Concurrent Ownership Tenancy by the Entirety Tenancy by the entirety: A form of co-ownership similar to joint tenancy. Can only be created by a married couple. Used in non-community property states. Tenant by the entirety cannot convey his or her interest without the spouse s consent. Concurrent Ownership Dower and Curtesy Dower rights: Give wife an interest in husband s real property. Curtesy rights: Give husband an interest in wife s real property. Most states have eliminated dower and curtesy rights (use community property system or probate rules instead). Ways of Holding Title Business Organizations The way in which a business is organized affects how title to business property is held. Businesses may be organized in any of the following ways: General partnership Limited partnership Corporation Limited liability company Joint venture Trust 36

37 Business Organizations Partnerships An association of two or more persons to carry on a business as co-owners and divide the profits. Types of partnerships: general partnership limited partnership Business Organizations General Partnerships In a general partnership, each partner has: an ownership interest in the partnership a voice in management of the business a right to share in the profits an obligation to share in its losses Business Organizations General Partnerships Property is considered to be partnership property if it s: acquired in the partnership s name acquired in the names of one or more of the individual partners and the deed makes reference to the partnership Business Organizations General Partnerships A partner is not a co-owner of the partnership property and has no transferable interest in it. However, a partner s interest in the partnership itself may be transferred. Each partner may be held personally liable for the debts and obligations of the general partnership. 37

38 Business Organizations Limited Partnerships A limited partnership is more structured and regulated than a general partnership. A limited partnership has at least one general partner, plus one or more limited partners. Limited partners have: limited liability no control over partnership property passive role in management Business Organizations Corporations A corporation: is a legal entity (an artificial person) can enter into contracts or own property has corporate liability (stockholders have limited liability) has perpetual existence (cannot own property in joint tenancy) Business Organizations Corporations Stockholders: own shares in the corporation own only a right to share in profits Shares in a corporation are: securities regulated by the Securities and Exchange Commission (blue sky laws) Business Organizations Limited Liability Company (LLC) The LLC is a relatively new form of business organization. Combines advantages of a partnership with advantages of a corporation: ability to manage the company no double taxation limited liability 38

39 Business Organizations Joint Venture Joint venture: Two or more individuals or organizations join together for one specific project. Not an ongoing business endeavor No formal requirements for creation. Business Organizations Real Estate Investment Trust Real Estate Investment Trust (REIT): A business association that invests primarily in real estate or real estate financing. Qualifies for special tax treatment Regulated by SEC Investors have limited liability Strict requirements: at least 100 investors must distribute almost all of its income to investors Business Organizations Syndicate A syndicate is simply a business association in which investors pool money to establish and carry out an enterprise. May be established as a partnership, corporation, etc. Common Interest Developments Properties that combine aspects of individual ownership and concurrent ownership: condominiums townhouses planned unit developments cooperatives timeshares 39

40 Common Interest Developments Condominiums Condominiums are usually residential and look like an apartment complex. Residents: own individual units in fee simple also share ownership of common elements Common Interest Developments Condominiums Common elements: The parts of the condominium property that may be used by all of the residents. Examples of common elements include the grounds, lobby, elevator, hallways, and swimming pool A specific undivided interest in the common elements is assigned to each unit in the condominium. Legal description of a condominium unit might read: Unit 20, together with a 3.5% undivided interest in the common elements. Common Interest Developments Condominiums Limited common elements: Features that are designed to serve a single unit, but are outside the unit s boundaries. Owned by all of the unit owners. Reserved for the exclusive use of a specific unit. Examples of limited common elements include parking spaces and balconies Common Interest Developments Condominiums The buyer of a condominium unit: receives a deed for the unit finances the purchase with a separate loan obtains a separate title insurance policy pays separate taxes If a lien against one unit is foreclosed, the other units are not affected. Management of condominium complex is usually by a unit owners association. Association collects assessments (called dues) used to pay for maintenance, repair, and insurance of common areas. 40

41 Common Interest Developments Townhouses A townhouse development consists of multistory, single-family homes built on small parcels. may or may not share walls with neighboring units individual interest in unit and shared common interest in common areas may have owners association Common Interest Developments Planned Unit Developments A buyer in a planned unit development (PUD) receives a single-family home and the land it s on, plus a shared interest in the common areas. Common areas might include parks, open areas, playgrounds, recreational facilities, shopping center, etc. Common Interest Developments Cooperatives A residential co-op might look exactly like a condominium, but the ownership structure is very different. Title is held by a corporation. The corporation owns the property. Residents: own shares in the corporation, and have a long-term proprietary lease on a unit Common Interest Developments Cooperatives A cooperative project is: financed with a single mortgage taxed as a single property The rent paid by shareholder-tenant to the corporation is a proportionate share of the cooperative s operating expenses. 41

42 Common Interest Developments Timeshares In a timeshare, multiple owners purchase interests in a property (usually a vacation property). Buyer purchases a time slot: right to use property for specified amount of time each year. Common Interest Developments Timeshares Timeshare estate vs. timeshare use Timeshare estate: Buyer receives fee simple ownership in property for specific time period. Buyer shares maintenance and repair costs, as well as profits and appreciation. Also called interval ownership. Timeshare use: Buyer only receives right to use property, and does not share in costs or profits/appreciation. 42

43 4. Transferring Ownership Transferring Ownership Title Title: Abstract concept referring to real property ownership rights. Cloud on title: Problem with real property owner s title (such as an interest claimed by someone other than the current owner). Also called a title defect. Alienation Alienation: Process of transferring real property ownership (title) from one party to another. May be voluntary or involuntary. Alienation Voluntary alienation: Owner voluntarily transfers an interest in his or her land to someone else. Examples: Patents Deeds Wills 43

44 Voluntary Alienation Patent: Instrument used to convey government land to a private individual. Deed: Instrument which, when properly executed and delivered, conveys title to real property from a grantor to a grantee. Voluntary Alienation Deeds Parties to a deed Grantor: One who grants an interest in real property to another. Grantee: One who receives a grant of real property. Voluntary Alienation Deeds Types of deeds General warranty deed Special warranty deed Grant deed Bargain and sale deed Quitclaim deed Deeds executed by court order Voluntary Alienation General Warranty Deed General warranty deed contains grantor s covenants to grantee: covenant of seisin - promise that grantor actually owns the property interest being transferred covenant of right to convey - promise that grantor has legal power to make conveyance covenant against encumbrances - promise that property is not burdened by undisclosed easements, liens, etc. 44

45 Voluntary Alienation General Warranty Deed General warranty deed contains grantor s covenants to grantee (cont.) covenant of quiet enjoyment - promise that grantee will be able to enjoy property in peace, free from lawful claims by third parties covenant of further assurance - promise that grantor will take any necessary steps to make grantee s title good covenant of warranty forever - promise that grantor will defend grantee s title against claims that existed at time of conveyance Voluntary Alienation General Warranty Deed If a covenant is breached, the grantee can sue grantor for compensation. However, grantees tend to rely on title insurance or another form of title protection rather than on covenants in deed. Warranty deeds convey after-acquired title: if grantor s title was defective at time of conveyance but good title is later acquired by the grantor, the additional interest passes automatically to the grantee. Voluntary Alienation Special Warranty Deed A special warranty deed contains the same covenants as in a general warranty deed, but the scope is limited to defects that arose during grantor s period of ownership. Special warranty deed conveys after-acquired title. Voluntary Alienation Grant Deed Grant deed warrants that grantor has not: conveyed title to anyone else caused any undisclosed encumbrances to attach to the property Both warranties apply even if not stated in the deed. Grant deed conveys after-acquired title. 45

46 Voluntary Alienation Bargain and Sale Deed Contains no warranties or covenants. does not convey after-acquired title rarely used Voluntary Alienation Quitclaim Deed A quitclaim deed: contains no warranties does not convey after-acquired title conveys only the interest held by the grantor at the time it is given A quitclaim deed is often used to cure clouds on the title. Voluntary Alienation Quitclaim Deed Should use the words: release remise quitclaim Should NOT use the words: grant convey Voluntary Alienation Deeds Executed by Court Order A deed executed by court order is used to convey title after a court-ordered sale. Example: sheriff s sale after court-ordered foreclosure 46

47 Requirements of a Valid Deed In writing Identify the parties Signed by competent grantor Living grantee Contain adequate description of the property Recite consideration exchanged Contain words of conveyance (granting clause) Define interest conveyed (habendum clause) State any reservations or exclusions Requirements of a Valid Deed In Writing Under statute of frauds, deed to real property must be in writing. Statute of frauds: Law requiring certain contracts and other legal transactions to be in writing and signed in order to be enforceable. Requirements of a Valid Deed Identify Parties Both the grantor(s) and the grantee(s) must be identified in the deed. Grantee could be described rather than referred to by name. Example: Conrad Adams hereby grants and conveys title to his only son. Requirements of a Valid Deed Signed by Competent Grantor Deed must be signed by the individual(s) who will be bound by the transfer and he, she, or they must be legally competent. Competent: Of sound mind for the purposes of entering into a contract, and having reached the age of majority (18 in most states). Illiterate or disabled grantor can sign the deed by making his or her mark, but the mark must be accompanied by the signatures of witnesses. 47

48 Requirements of a Valid Deed Grantee Must Be Alive Deed recipient must be alive, but need not be competent. Child (or mentally incompetent person) can receive title to property but can t convey title. A corporation can receive title to property because it exists legally. Requirements of a Valid Deed Power of Attorney Power of attorney: Document authorizing another party (attorney in fact) to act on behalf of the grantor. For attorney in fact to sign deed on grantor s behalf, the power of attorney must: specifically authorize attorney in fact to do so, and be recorded in the county where the property is located. Requirements of a Valid Deed More Than One Grantor All grantors must sign deed. A deed lacking a necessary signature is invalid. An unnecessary signature does not invalidate the transfer. Signatures of both husband and wife are required to convey community property. Requirements of a Valid Deed Transfer by Corporation Deed transferring title to property owned by corporation must be signed by an authorized corporate official, with the signature accompanied by the corporate seal. Authorization must come from a resolution by the board of directors. 48

49 Requirements of a Valid Deed Adequate Property Description Legal description of the property is not an absolute requirement, but including a legal description will ensure the description is adequate. Requirements of a Valid Deed Recital of Consideration Deed usually must state the consideration given to the grantor by the grantee in exchange for the property. Consideration may simply be a nominal dollar amount (transfer is a sale) or love and affection (transfer is a gift). Requirements of a Valid Deed Contain Words of Conveyance Words of conveyance in a deed are often referred to as a granting clause: the words indicating the grantor s intent to transfer an interest in property. Requirements of a Valid Deed Habendum Clause Habendum clause describes the interest being transferred. Typically begins with the words to have and to hold. 49

50 Requirements of a Valid Deed Exclusions and Reservations An exclusions and reservations clause lists encumbrances the grantee will be taking title subject to. (Valid encumbrances may still remain in force even if they aren t listed in the deed.) Requirements of a Valid Deed Acknowledgement, Delivery, Acceptance For a conveyance to occur, the deed must be acknowledged and delivered by the grantor, and then accepted by the grantee. Requirements of a Valid Deed Acknowledgement Acknowledgment: Grantor declares to authorized official (i.e., notary public) that he signed deed voluntarily. Official then attests that signature is voluntary and genuine. Official cannot have an interest in transfer. Without acknowledgment, deed may be valid but cannot be recorded. Requirements of a Valid Deed Delivery Delivery: Legal transfer of deed from grantor to grantee resulting in transfer of title. Delivery must take place while grantor is alive. Grantor must intend to immediately transfer title to grantee. 50

51 Requirements of a Valid Deed Acceptance Conveyance is completed when grantee accepts deed. Deed may be accepted by an agent. Voluntary Alienation Wills Will: A written instrument disposing of property upon the death of the maker (the testator). In most states, will must be: in writing signed by testator with legal capacity attested to by at least two competent witnesses Voluntary Alienation Wills Holographic will: A will written, dated, and signed entirely in the testator s handwriting, and which was not witnessed. Only recognized in certain states. Any typewritten or pre-printed provisions in a holographic will be disregarded. Voluntary Alienation Wills Nuncupative will: Oral will made when testator is near death, in front of at least one witness. Witness writes out what testator said, and signs document. If testator recovers, will is invalid. Only valid in some states. 51

52 Involuntary Alienation Involuntary alienation: Transfer of property interest against the will of the owner, or without action by the owner. May occur through: rule of law adverse possession accession Involuntary Alienation Alienation by rule of law includes: dedication intestate succession and escheat condemnation court order Involuntary Alienation Dedication Dedication: Private party transfers land to the public. Sometimes voluntary, but is typically required by a public entity. Statutory dedication: Involves recording a subdivision map identifying areas dedicated to the public (such as parks and streets). Example: Land developer is required to indicate on her subdivision map where dedicated parks and streets will be located before subdivision is approved. Involuntary Alienation Intestate Succession Intestate succession: When someone dies without a valid will, the decedent s property passes according to the laws of descent. When there is no will, the decedent s lawful successors are called heirs instead of beneficiaries. 52

53 Involuntary Alienation Escheat When property owner dies without will or any surviving heirs, property ownership escheats (reverts) to the state. State is ultimate heir when no other rightful heirs to the property exist. Involuntary Alienation Condemnation Condemnation: Taking private property for public use through power of eminent domain. Use must be a public use. Owner must be compensated. Power of eminent domain may be exercised by government, or it can be delegated to quasi-public entities. Inverse condemnation: If a property owner feels his property has been taken or damaged by a public entity, he may sue government for compensation. Involuntary Alienation Court Order Transfer of interest in property against the owner s will can also occur under court order. Most common examples: quiet title actions suits for partition foreclosures bankruptcies Involuntary Alienation Court Order Quiet title action: Court action intended to settle dispute about title to a particular property. Partition action: Lawsuit brought by a coowner to have property divided. Once divided, each co-owner will own his or her part in severalty. Co-owners may also partition property by agreement. 53

54 Involuntary Alienation Court Order Foreclosure - Judicial foreclosure: Sale of property pursuant to court order to satisfy a lien (may be any type of lien). Deed of trust foreclosure: sale of property at a trustee s sale under a power of sale (only available for deed of trust liens). Bankruptcy: Court may order distribution of debtor s real property to satisfy claims of mortgage lenders or other creditors. Involuntary Alienation Adverse Possession Adverse possession: Person other than owner of record can acquire title to real property through a long period of continuous possession. Adverse possession typically must be: actual open and notorious hostile to the owner s interest exclusive continuous and uninterrupted for a specific period of time Involuntary Alienation Adverse Possession Actual possession: Occupation and use of the property in a manner appropriate to the type of property. Residence is not required unless that is the appropriate use. Open and notorious possession: Must put true owner on notice that his or her property interest is being threatened. Involuntary Alienation Adverse Possession Hostile possession: Possession without the owner s permission. The adverse possessor must intend to claim ownership of the property and defend that claim against all parties. Exclusive possession: True owner must be completely excluded from possession. 54

55 Involuntary Alienation Adverse Possession The adverse possessor must: have continuous and uninterrupted possession for statutory period (5 to 30 years, depending on state law) pay the property taxes during this period (in some states) Involuntary Alienation Adverse Possession Intermittent use of the property may sometimes be sufficient (such as when property is only used seasonally). Tacking: Successive adverse possessors can add together their periods of possession to satisfy the time period. Involuntary Alienation Adverse Possession In some states, adverse possessor must have claim of right/color of title: title that appears to be good, but which in fact is not. Example: Deed s legal description incorrectly indicates the boundary extends ten feet further than it really does. The owner believes the additional 10-foot strip of land belongs to her, so she fences it in. Involuntary Alienation Accession Accession: Addition to real property from natural or man-made causes. May involve involuntary alienation of another s property. Causes: Accretion Reliction Erosion Avulsion 55

56 Involuntary Alienation Accession Accretion: When waterborne soil (called alluvion or alluvium) is deposited on land beside a body of water. The process must be virtually imperceptible. Reliction: When water recedes from stream or lake, exposing new land. Like accretion, process must be extremely gradual. Involuntary Alienation Accession Erosion: Wearing away of land by natural processes (wind, rain, flowing water, etc.). Soil that moves becomes part of land where it settles. Avulsion: Sudden movement of land by heavy rain, flowing water, waves, etc. (unlike the other gradual processes). Does NOT automatically result in involuntary alienation: original owner still has title to it, if there is a way to claim it. The Recording System Recording: Placing document in public record so its information is available to the general public. Whenever interest in real property is transferred, new owner should record deed or other transfer document. The Recording System Documents transferring title, establishing an interest in property, or creating or removing encumbrances should be recorded. Including lis pendens: document stating that a pending lawsuit may affect title to a piece of property. 56

57 The Recording System Procedures Recording procedures are specified in state recording act. Typically, document is recorded by filing it at recording office in county where property is located (document is copied/scanned and returned to person submitting it). The Recording System Procedures Recording office may have rules regarding physical format of documents (paper size, margins, etc.). Taxes may need to be paid before deed can be recorded. Recorder's office maintains grantor and grantee indexes in which all recorded documents are indexed according to grantor or grantee s last name. The Recording System Title Searching Grantor and grantee indexes are used for title searches. Title search: used to determine who holds what interest in a particular piece of property. Tracing chain of title back through several owners establishes validity of seller's title. Some recording offices maintain a tract index in which all documents affecting a particular parcel (tract) are listed together. The Recording System Notice Legal rights often depend on whether a party had notice of a particular fact at a given time. Actual notice: Person has actual notice of a fact if she is aware of it. Constructive notice: A person has constructive notice of a fact if she should be aware of it, even if she is not. 57

58 The Recording System Notice Recording a document provides constructive notice of the property interest contained in it. Anyone who later acquires an interest in property is considered to have constructive notice of the earlier recorded document (even if he didn't have actual notice of it). The Recording System Notice Recording a document concerning a property interest establishes priority of that interest. General rule: First to record, first in right. If deed isn t recorded, grantee may lose title to a subsequent good faith purchaser without notice (a later, good faith buyer who has no notice of the earlier conveyance). The Recording System Notice Sometimes a document has been properly recorded but still doesn t turn up in a title search this is a wild deed. Subsequent purchaser isn t expected to have constructive notice of a wild deed. The Recording System Notice Inquiry (implied) notice: When red flags exist signs of a problem that a prudent person wouldn t overlook. Someone on inquiry notice is required to make a reasonably diligent effort to obtain more information. 58

59 Title Protection Seller is typically required to deliver marketable title to buyer at closing. Marketable title = free from serious defects and seller has unrestricted ability to convey Title Protection Title Search Title search: Examination of public records in county where property is located, looking for all recorded documents and other records that may affect property s title. Chain of title is traced for any missing links that may invalidate seller s title. Encumbrances are also important. Some states have Marketable Title Act: invalidates claims against property if they have been inactive for certain amount of time. Title searches thus only need to be performed back to a certain date. Title Protection Type of title protection: Abstracts of title Opinions and certificates of title Title insurance Title Protection Abstracts of Title Abstract of title: Chronological summary of all documents that may affect title to the property. Contains each document s source and location. Prepared by attorney or abstractor (licensed specialist). 59

60 Title Protection Opinions and Certificates of Title Opinion (certificate) of title: Formal opinion as to who true owner of property is and who else holds legitimate interests in property. Often passed on from one owner to the next. Title Protection Title Insurance Title insurance policy: Title insurance company agrees to reimburse policyholder for financial losses resulting from title defects covered by policy. If someone makes adverse claim against title, title company will defend against claim. A title policy issued to a buyer is called an owner s policy. A title policy protecting a lender s security interest is called a lender s policy. Title Protection Title Insurance Title company first performs title search. Based on title search, company issues title report. All defects and encumbrances found in public record are listed in report and excluded from coverage when policy is issued. Title Protection Title Insurance If the title report reveals unexpected problems, buyer or lender may require seller to clear them up before transaction proceeds. Title insurance policy lasts as long as the policyholder has legal interest in property. Subsequent defects or encumbrances will not be covered. 60

61 Title Protection Title Insurance Standard coverage title insurance policy insures against defects in title, including hidden risks such as forgery. It doesn t insure against claims by parties in possession, defects known by the owner, or encroachments. Extended coverage policy (ALTA policy) covers the same things as a standard policy, plus matters not of public record (such as rights of parties in possession, etc.) Title Protection Title Insurance Neither type of title insurance policy insures against losses due to government action, such as condemnation or zoning changes. Title Protection Torrens System Certain states use the Torrens system of land title registration. Torrens certificate of title provides evidence of ownership and condition of title. To register in system, owner submits application. Title Protection Torrens System Quiet title action is filed and if court determines applicant has valid title, a Torrens certificate is issued. Subsequent changes and encumbrances must be noted on Torrens certificate to provide constructive notice 61

62 Security Interests in Fixtures Fixtures are often financed, with fixture serving as security. Security interests in fixtures are governed by the Uniform Commercial Code (which has been adopted in some form in all 50 states). Security Interests in Fixtures Creating Security Interest To create a security interest in personal property, buyer must sign security agreement describing property purchased. Creditor then records financing statement (chattel mortgage), giving the public constructive notice of security interest. Security interest survives even if ownership of real property changes hands. 62

63 5. Encumbrances Encumbrances Encumbrances Encumbrance: A nonpossessory interest in real property, held by someone other than the owner. Does not give ownership or right to exclusive possession. Financial vs. Non-financial Encumbrances Encumbrances are either: financial (liens) or non-financial (easements, private restrictions, etc.) Liens Security interest Security interest: A creditor s interest in property based on a lien, which makes the property security (collateral) for the owner s debt. If property owner fails to repay debt, secured creditor may foreclose. Property burdened by lien may be sold, but new owner takes title subject to lien. 63

64 Liens Security Interest Attachment: when a lien becomes legally effective. Can affect a lien s priority. Liens Voluntary vs. Involuntary Voluntary lien: Property owner voluntarily grants lien to creditor. Example: mortgage Involuntary (statutory) lien: Lien given to creditor by operation of law, without property owner s consent. Example: tax lien Liens General vs. Specific General lien: Lien attaches to all of the debtor s real property. Example: judgment lien Specific lien: Lien attaches only to a specific piece of real property, not to everything debtor owns. Example: mortgage Types of Liens Mortgages Deeds of trust Mechanic s liens Judgment liens Attachment liens Tax liens Special assessment liens 64

65 Types of Liens Mortgages Mortgage: A lien created by contract between a property owner and a lender. Owner (Borrower) = Mortgagor Lender = Mortgagee Borrower gives lender mortgage as security for repayment of loan, with property serving as collateral. Types of Liens Deeds of Trust Deed of trust serves same purpose as mortgage but has different foreclosure procedures. Borrower = Trustor or Grantor Lender = Beneficiary Neutral third party = Trustee (Trustee handles foreclosure, if necessary.) Types of Liens Mechanic s Liens Mechanic s lien: Lien attaching to real property on which construction work was performed. Can be claimed by anyone providing labor, materials, or services. If owner fails to pay as agreed, lienholder can foreclose on property. Also called a construction lien or materialman s lien. Types of Liens Mechanic s Liens Generally, claim of lien must be filed for recording in county where property is located within a certain time period. Varies from state to state 30, 60, or 90 days 65

66 Types of Liens Mechanic s Liens Claim period may start on: date contract for work is signed; date work began; date work is completed; or date specified in the state statute. Types of Liens Mechanic s Liens Lien statutes set deadline for foreclosure, requiring owner to file a court action within a certain period of time. Types of Liens Judgment Liens Judgment lien: A lien that results from a financial judgment against the losing party in a lawsuit (the judgment debtor). Attaches to judgment debtor s property. If judgment is not paid, court may order debtor s property sold, to satisfy judgment. Types of Liens Judgment Liens A judgment lien: attaches automatically to all the debtor s property in county where lawsuit took place can attach to new property acquired by the debtor can attach to property in other counties if the creditor files an abstract of judgment in those counties 66

67 Types of Liens Attachment Liens Attachment lien: A lien used to prevent a defendant from selling property that could be subject to a future judgment. Court issues writ of attachment. Writ is recorded so that anyone buying the property takes title subject to plaintiff s lien. Types of Liens Attachment Liens Lis pendens: Legal document filed by plaintiff in lawsuit, notifying anyone who purchases specified property about a pending lawsuit that may affect title. Just provides notice; doesn t create lien. If property is sold, new owner is bound by any resulting judgment. Types of Liens Property Tax Liens Property tax lien: The lien created by general real estate taxes. Attaches only to the property being taxed. Allows government to foreclose and collect delinquent taxes from the proceeds of the foreclosure sale. Types of Liens Special Assessments Liens Special assessment lien: A lien based on a special assessment levied to pay for specific improvements such as street paving or sewer lines. Attaches only to properties that are subject to the special assessment (because they will benefit from the project). 67

68 Types of Liens IRS Liens IRS lien: A general lien that attaches to all property belonging to a taxpayer who has failed to pay federal income taxes. Lien Priority Lien priority: Determines the order in which lienholders will be paid if one lienholder forecloses on a property with multiple liens. Foreclosure sale proceeds are paid to each lienholder in order of priority. Any surplus goes to foreclosed property owner. If proceeds aren t enough to pay off all liens, lienholders with lowest priority are not paid. Lien Priority Recording date: The date a lien was filed for recording in county s public record. Determines lien priority except for: tax and assessment liens (always have higher priority) mechanic s liens (priority based on date work began) Homestead Laws Homeowners have limited protection against judgment lien foreclosure. Homestead law does not apply to: voluntary liens (mortgages, deeds of trust) mechanic s liens liens resulting from failure to pay child support or spousal maintenance 68

69 Homestead Laws Homestead: Dwelling occupied by the owner, plus land and any attached buildings. In some states, protection is automatic. Other states require owner to record a declaration of homestead. A person can have only one homestead at a time. Homestead Laws Homestead protection terminates when: owner files declaration of homestead on different property original property is sold declaration of abandonment is filed If the homestead owner dies, protection continues for family members still living on the property. Homestead Laws Exemptions Homestead makes part of homeowner s equity exempt from claims. Judgment creditor can t foreclose unless property s net value exceeds the exemption. Net value = Market value minus amount of higher-priority liens Exemption amounts vary from state to state Homestead Laws Homestead protection may also cover sale proceeds 69

70 Non-financial Encumbrances While liens usually affect only owner s title (not use of property), non-financial encumbrances commonly affect both title and use. Non-financial encumbrances include: easements profits private restrictions Non-financial Encumbrances Easements Easement: A right to use someone else s land for a particular purpose. Easement holder may use property in some specific, limited way, but may not take possession of the property. Two basic types of easements: easements appurtenant easements in gross Types of Easements Easements Appurtenant Easement appurtenant: Burdens one piece of land (servient tenement) for benefit of another piece of land (dominant tenement). Owner of dominant tenement is dominant tenant. Owner of servient tenement is servient tenant. Types of Easements Easements Appurtenant Easement appurtenant runs with the land. It continues to exist even if either the dominant or the servient tenement is sold. The benefit and the burden are automatically passed on to all subsequent owners. 70

71 Types of Easements Easements in Gross Easements in gross: Benefits particular person rather than parcel of land. No dominant tenement, only servient tenement (parcel burdened by easement). Benefit is considered a personal right, cannot be assigned to someone else. Burden of easement in gross still runs with the land. Types of Easements Easements in Gross Commercial easement: Easement in gross held by a company for business purposes. Exception to rule: Commercial easement in gross can be assigned from one entity to another. Example: Easement to install and maintain utility lines. Creating Easements Easements are created by: express grant express reservation implication prescription dedication condemnation Creating Easements Express Grant Property owner deliberately grants someone else an easement on her property. May be purchased by the person needing the easement. May be created when one part of a larger property is sold. 71

72 Creating Easements Express Grant Grant of easement must be in writing and signed by grantor (required by statute of frauds). Document creating easement should always be recorded to provide public notice. Creating Easements Express Reservation Owner selling part of her property may reserve easement against parcel she s selling, to benefit parcel she s keeping. Easement by express reservation must be in writing, and the document should be recorded. Creating Easements Necessity Easement by necessity: Arises when property can t be accessed by its owner (i.e. property entirely surrounded by other privately owned land). Created automatically in some states. Other states require owner to file a court action to obtain an easement. Creating Easements Implication Easement by implication: Arises when a property is divided, and part of it is transferred to another owner. Can be an implied grant or an implied reservation Example: Part of a larger parcel is sold, but grantor neglects to create easement in deed, leaving one of the parcels without an access route. An easement would be created by implication. 72

73 Creating Easements Implication Requirements for an easement by implication: must be reasonably necessary for enjoyment of dominant tenement apparent prior use of the easement Easement by implication is similar to easement by necessity. In some states, the law has evolved so that there is no significant difference between the two. Creating Easements Prescription Easement by prescription: An easement established by using someone else s property without the owner s permission. Also called a prescriptive easement. Requirements: Open and notorious (conspicuous) use Hostile use Continuous and uninterrupted for statutory period (ranges from 5 to 20 years) Creating Easements Prescription Unlike adverse possession, prescriptive easement doesn t require exclusive use of property. Owner can record a notice of consent, which gives express permission for certain uses of the property. Protects against prescriptive easements. Creating Easements Dedication Dedication: Private property owner transfers interest in property to government. Example: Philanthropist dedicates his land to city for a park, or dedicates an easement across his land for access to the park. 73

74 Creating Easements Dedication Dedication may be: voluntary (easement should be put into writing and recorded), or involuntary (by implication) If public uses private property over a long period without owner s permission, easement may be created by implied dedication. Creating Easements Condemnation Condemnation: Legal process used to force private owner to sell land or an easement to the government. Property or easement must be used for a public purpose. Property owner must be compensated. Terminating Easements Easements can be terminated by: release merger failure of purpose abandonment prescription Terminating Easements Release Release: When someone who has a specified interest in a property gives it up to someone else. Easement holder gives a quitclaim deed to owner of servient tenement. 74

75 Terminating Easements Merger Merger: When two adjacent properties come under the same ownership. If the same party becomes owner of both the dominant and the servient property, easement terminates by merger. You can t have an easement against your own property. Terminating Easements Failure of Purpose Failure of purpose: Easement is a right to use another s property for a particular purpose, and once that purpose no longer exists, easement is terminated. Terminating Easements Abandonment Abandonment: Easement holder (dominant tenant) does something indicating intent to stop using easement forever. General rule: Non-use is not sufficient to indicate abandonment. Exception: Servient tenant can sue to have a prescriptive easement terminated after statutory period of non-use (usually 5 years. Terminating Easements Prescription Prescription: Easement is terminated by prescription if servient tenant takes action to prevent dominant tenant from using easement, and is successful for the statutory period. 75

76 Nonfinancial Encumbrances Profits Profit: The right to take something from land belonging to someone else. Generally must be created in writing or by prescription. Nonfinancial Encumbrances Related Concepts Related Concepts Licenses Encroachments Nuisances These are not classified as encumbrances. They affect someone else s property, but aren t considered interests in real property. Licenses License: Right to enter and use land belonging to another person. Does not need to be in writing Revocable Does not create a property interest Not assignable Does not run with the land Encroachments Encroachment: Occurs when a physical object from one property intrudes onto neighboring property. Most encroachments are unintentional. Landowner who believes her property is being encroached upon can sue neighbor. Called an ejectment action. Court may order defendant to remove encroachment or pay damages. 76

77 Nuisances Nuisance: Activity on or condition of property that interferes with neighboring owner s use of her property. Private nuisance: Affects a few people, like smell of neighbor s pet pigs. Public nuisance: Affects many landowners, like pollution from nearby factory. Nuisances Property owner affected by a private or public nuisance can sue for: an injunction to stop the nuisance compensatory damages Nuisances Attractive nuisance doctrine: If property has feature that is dangerous and attractive to children, owner will be liable for any harm resulting to trespassing children. Example: an unfenced swimming pool. Nonfinancial Encumbrances Private Restrictions Private restrictions restrict how an owner may use her own property. Commonly created when transferring title, to restrict all subsequent owners. New restrictions may be stated in deed or recorded at county recorder s office Private restrictions often called deed restrictions or restrictive covenants. 77

78 Private Restrictions Private restrictions may also be imposed when there s no change of ownership. Sometimes owner will impose restriction on own property in return for payment. If put into writing and recorded, private restrictions run with land, just like easements. Private Restrictions CC&Rs Stands for covenants, conditions, and restrictions. Usually imposed by original developer of residential subdivision. Recorded, and a reference included in first deed for each lot in subdivision. Provides constructive notice to subsequent owners of the lot. Private Restrictions CC&Rs CC&Rs allow homeowners to prevent neighbors from doing things that will have a negative effect on property values. If one owner violates CC&Rs, other owners can file a lawsuit against the violator. Private Restrictions In Conflict with Zoning Private restrictions may be stricter than public land use controls, such as zoning laws. If two restrictions (one public and one private) both address same issue, the more restrictive one usually applies. 78

79 Private Restrictions Illegal or Unconstitutional Private restrictions that violate law or constitutional provisions are not enforceable. An unenforceable restriction in a deed does not make the deed void. Only the restriction is void. Any restriction on property owner putting up For Sale signs is typically void. Private Restrictions Covenant vs. Condition Covenant: Legally enforceable promise to do or not do something. Violation can result in injunction or damages. Condition: Ownership of property depends on compliance with restriction. Violator may actually forfeit title to property. Conditions are rare today because this result is so harsh. Private Restrictions Enforcement Restriction may not be enforceable if: owners in subdivision failed to enforce it against other violators character of neighborhood has changed drastically property owner suing to enforce restriction is also in violation Private Restrictions Termination Private restrictions may terminate if: subdivision residents fail to enforce particular restriction in the past; or purpose of the restriction is not reasonably achievable. 79

80 6. Public Restrictions on Property Rights Public Restrictions on Property Rights Introduction Private property ownership is affected by public restrictions on land (land use controls): comprehensive plans zoning ordinances building codes subdivision regulations environmental laws The government s powers of eminent domain and taxation also affect property. Land Use Controls Police Power Police power: State s constitutional power to adopt laws necessary for protection of public s health, safety, morals, and general welfare. Allows government to place restrictions on owner s use of private property. State delegates its police power to local governments. Land Use Controls Constitutional Limitations To be constitutional, land use regulation must: 1. have a reasonable relationship to public health, safety, morals, general welfare 2. not discriminate between similarly situated property owners 3. not reduce property value so much that regulation amounts to confiscation 4. prevent harm to the public that prohibited use of property would cause 80

81 Land Use Controls Types of Land Use Controls Different types of land use control laws: comprehensive plans zoning building codes subdivision regulations environmental laws Land Use Controls Comprehensive Planning City or county must prepare general plan for development (also called comprehensive plan or master plan). The plan should: set long-range development goals ensure land is developed in orderly fashion address population density, building intensity, housing, traffic patterns, transportation systems, noise control, etc. Land Use Controls Comprehensive Planning General plan is implemented by city and county governments through zoning ordinances and other land use regulations. Land Use Controls Zoning Zoning ordinance: Divides community into land use zones with only certain types of uses allowed in each zone. Areas zoned for incompatible uses may be separated by undeveloped areas (buffers). Areas with overlay zoning permit a mixture of different uses in a specific area. 81

82 Zoning Use Categories Modern zoning laws typically have numerous subcategories. Examples of possible residential zones: R 1: allows detached single-family houses R 2: also permits row houses and duplexes R 3: also permits apartments and condominiums R 4: permits any type of housing, including mobile homes Zoning Enforcement Zoning is enforced through building permits, which are required before a structure is built or altered. Failure to comply with permit requirement may result in fines and other penalties. Zoning Land Use Limits Zoning ordinances may: set minimum lot sizes limit building height require minimum distances from property lines for buildings (setback and sideyard rules) limit how much of the lot can be covered by a building Zoning Exceptions Special provisions for exceptions to zoning: nonconforming uses variances conditional uses 82

83 Zoning Exceptions Nonconforming Use Nonconforming use: Existing use that becomes a violation when new zoning is imposed. May be because of buildings, lot size, or use. Example: Grocery store opens in developing area with no zoning. Town council later zones area for residential use. Zoning Exceptions Nonconforming Use To require nonconforming uses to be immediately brought into compliance with new zoning laws would: cause too much financial hardship for owners discourage land development (most property owners expect to be able to continue their present use) Zoning Exceptions Nonconforming Use Nonconforming uses are usually allowed to continue, but with restrictions. They cannot be: expanded rebuilt after destruction resumed after abandonment Zoning Exceptions Variances Variance: Special authorization to build structure or use property in way that is generally prohibited. Used where enforcement of zoning would result in substantial harm to owner without providing any real public benefit. 83

84 Zoning Exceptions Variances Owner can apply to the local zoning authority for a variance. Must show severe practical difficulties or undue hardship. Variance will not be granted just to make property more profitable. Variance usually authorizes only minor deviation. Zoning Exceptions Conditional Uses Conditional use: Zoning authority may issue special permits for certain uses that are inconsistent with a neighborhood s overall zoning, but necessary or beneficial to community. Examples: schools, hospitals, churches, and cemeteries. Zoning Exceptions Rezoning Property owner may apply for amendment of zoning ordinance. To get a rezone: public hearing must be held and surrounding landowners notified Zoning Exceptions Spot Zoning Spot zoning: zoning/rezoning a parcel of land differently from the surrounding properties; illegal in many jurisdictions Example: Rezoning a property in a residential neighborhood to allow a business. 84

85 Zoning vs. Private Restrictions General rule: When private restrictions and zoning laws conflict, the more restrictive requirement must be met. Land Use Controls Building Codes Building codes: establish minimum standards for construction require builders to use particular methods and materials protect public against dangers caused by unsafe design, substandard materials, or poor workmanship Building Codes Permits Compliance with building codes is enforced through the building permit system. Permits usually required from city or county before constructing, repairing, improving, or altering a building. Building Codes Construction Inspections Once building permit is issued and construction begins, inspector can stop work on project if it conflicts with plans or building codes. After construction is completed, finished building is inspected; certificate of occupancy issued if every aspect of building complies with codes. 85

86 Land Use Controls Subdivision Regulations Local governments also implement general plans by regulating new subdivision development. Subdivision: division of parcel of land into two or more parcels or lots Subdivision Regulations Types of Subdivisions Subdivisions are usually residential. Traditional subdivision: separately-owned lots with single-family homes But common interest developments (condos and PUDs) are subdivisions too. Subdivision Regulations Procedural Laws Typically, when land is subdivided, a preliminary plat map must be approved by city/county officials before work begins. Usually contains specific requirements for utilities, streets, sidewalks, etc. Subdivision Regulations Consumer Protection Laws Some states have laws that: regulate how subdivided land is advertised to buyers, require certain disclosures, and impose other rules on sale of lots (such as rescission rights). 86

87 Subdivision Regulations ILSFDA Interstate Land Sales Full Disclosure Act: federal consumer protection law that applies to subdivisions offered for sale or lease in interstate commerce. Generally applies to subdivisions with 25 or more vacant lots. Subdivision Regulations ILSFDA Requires developers to give buyers property report with disclosures regarding: title payment and conveyance terms utilities soil conditions easements and restrictions Floodplain Restrictions Floodplain: low-lying area of land located near waterway or body of water that is prone to flooding during severe weather. If populated, periodic flooding can cause deaths and property destruction. Public often bears costs. Floodplain Restrictions To discourage additional development in floodplain areas, some local governments have banned construction in designated floodplain districts or flood hazard zones. 87

88 Environmental Laws Federal and state environmental laws can impact ways in which a private property owner can use land. Environmental Laws NEPA National Environmental Policy Act (NEPA): federal law requiring federal agencies to prepare environmental impact statement (EIS) for governmental actions that would have significant environmental impact. EIS summarizes potential impacts and possible alternatives to proposed project. Many states have little NEPAs that can be more restrictive than the federal law. Environmental Laws CERCLA Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA): concerns liability for environmental cleanup costs. Current owners may be liable for cleanup even if they didn t cause contamination. Environmental Laws Pollution Control Laws Federal government sets standards for air and water quality. States are required to implement standards. Permits are required to discharge into air or water. 88

89 Environmental Laws Other Laws Various other federal, state, and local environmental laws can affect a property s use or development. Buyers should research laws before purchasing land for development. Eminent Domain Eminent domain: Power of government to take private property for public use, upon payment of just compensation to the owner. May be used to help implement general plan. Eminent Domain Normally, the government first offers to buy the property. If the owner refuses to sell or demands too high a price, the government can file a condemnation lawsuit and force a sale at fair market value. Taxation of Real Estate Three types of real estate taxes: 1. General real estate taxes 2. Special assessments 3. Conveyance taxes 89

90 General Real Estate Taxes General real estate taxes are taxes on ownership of real property. Used to pay for government operating costs and services. Determined based on the value of the property. Also called ad valorem taxes (ad valorem is Latin for according to value ). General Real Estate Taxes Assessment Assessment: Valuation of property by city or county assessor s office to determine tax basis. Owners may appeal assessment to board of appeal/review. General Real Estate Taxes Tax Rates Taxing body usually sets tax rate annually, by: adopting budget to determine needed tax revenue, and passing law authorizing taxation (appropriation). Tax rate often expressed in mills: one mill equals one-tenth of one cent ($.001). Rates also expressed in dollars per hundred or dollars per thousand. General Real Estate Taxes Collection Taxes are levied annually, although payments may be spread over the year. Property tax year is not necessarily the same as the calendar year. 90

91 General Real Estate Taxes Foreclosure Typically a lien attaches automatically to property when taxes are levied and remains in force until taxes are paid. If taxes aren t paid, penalty, notice of impending default, and tax sale may follow. General Real Estate Taxes Foreclosure Delinquent taxpayer may redeem property before sale. Otherwise, buyer at the tax sale receives a certificate of sale and eventually a tax deed. General Real Estate Taxes Exemptions Property tax exemptions: publicly owned property, property used for religious purposes, and property owned by certain nonprofit organizations. Partial exemptions: owner-occupied homes and homes owned by veterans, senior citizens, and the disabled. Taxation Special Assessments Special assessment: Tax levied against properties benefiting from public improvement (also called an improvement tax). Examples: street paving, sidewalk addition. Special assessment creates lien against taxed property. Government can foreclose on lien if property owner fails to pay assessment. 91

92 Taxation Special Assessments Special assessments differ from general real estate taxes in the following ways: One-time charge Pay for a particular project, not ongoing government operations Levied only against properties that benefit from the project Tax based on project s cost, not property s value Property owners may pay in installments Taxation Documentary Transfer Tax Conveyance tax: Tax on transfers of real property based on the selling price (also called excise tax). Payment of tax is usually seller s responsibility. No conveyance tax is paid on amount of assumed loan. 92

93 7. Contract Law Contract Law Legal Classifications of Contracts Contract: An agreement between two or more persons to do, or not do, certain things. Contracts may be classified according to certain basic characteristics. Every contract is: express or implied unilateral or bilateral executory or executed Legal Classifications of Contracts Express vs. Implied Express contract: One that is put into words, whether oral or written. Implied contract: One not expressed in words, but implied by the parties actions. Most contracts are express, not implied. Legal Classifications of Contracts Unilateral vs. Bilateral Unilateral contract: Only one party promises to do something and is legally obligated to perform as promised. Bilateral contract: Both parties promise to do something and are legally obligated to perform as promised. Most contracts are bilateral. 93

94 Legal Classifications of Contracts Executory vs. Executed Executory: Contract is in the process of being performed. Executed: Contract has been fully performed; both parties have fulfilled their promises. Note that executed may also refer to a contract that has been signed. Elements of a Valid Contract Valid contract: A legally binding contract. Valid contract will be enforced by a court if one party fails to comply with agreement. A valid contract must have: parties with legal capacity mutual consent lawful objective consideration Elements of a Valid Contract Contractual Capacity Contract is not legally binding unless all parties have legal capacity to enter into it. Two requirements for legal capacity: (1) age (2) mental competence Contractual Capacity Age of Majority In most states, 18 is the age of majority: person must be at least 18 to enter into a contract someone under 18 is a minor parent or legal guardian may enter into a binding contract on minor s behalf contract signed by minor is not necessarily void may simply be voidable by minor 94

95 Contractual Capacity Age of Majority In some states, a real estate contract in which one party is a minor is void (No legal effect; neither party can enforce it against the other). Exception: Emancipated minor may freely enter into any type of contract. Minor may be emancipated by: marriage military service court order Contractual Capacity Mental Competence Mentally competent: Of sound mind. If one party has been declared mentally incompetent, contract is void. Legal guardian can enter into contracts on behalf of incompetent person. If someone enters into a contract while temporarily incompetent, contract may be voidable. Contractual Capacity Necessities Exception If minor or incompetent person enters into contract to buy necessities (food, medicine, etc.), the contract may be valid. Housing usually not considered a necessity for minor, unless minor is emancipated. Contractual Capacity Representing Another Parents, court-appointed guardians, corporate officers, executors, etc. all able to represent another person/party in a contract. 95

96 Contractual Capacity Corporations and Partnerships Corporation may enter into contract through individual authorized by the board of directors. Partnership may enter into contract through general partner in his/her name or in name of partnership. Contractual Capacity Aliens Aliens may enter into real property contracts, but may be subject to certain property transfer reporting requirements. Contractual Capacity Convicts Convicts are not prevented from owning, acquiring, or transferring land. However, an imprisoned felon may not be legally competent to enter into a contract. Elements of a Valid Contract Mutual Consent Contract is legally binding only if both parties have consented to its terms. Mutual consent arrived at through offer and acceptance: Offeror makes offer to offeree. If offeree accepts offer, contract is formed. 96

97 Mutual Consent Offer and Acceptance Offer must : express an intention to enter into a contract be definite and certain To be definite and certain, offer must specify basic contract terms. Vague offer is illusory. If accepted, contract is enforceable. Offer and Acceptance Termination of an Offer Offer terminates if before acceptance: offeror revokes offer too much time passes offeror dies or is declared insane offeree rejects offer offeree makes counteroffer If offer terminates before it is accepted, no contract is formed. Termination of an Offer Revocation Offeror can revoke offer any time before acceptance is properly communicated. Offeror must notify offeree of revocation before acceptance. Even if offer was supposed to remain open until a particular date, offeror can revoke it before that date arrives. Termination of an Offer Lapse of Time Offer that states deadline for acceptance expires automatically when that date or time arrives. Offer without deadline expires after a reasonable amount of time has passed. Reasonable depends on circumstances. Issue sometimes decided by court. 97

98 Termination of an Offer Death or Insanity If offeror dies before offer is accepted, offer is terminated and no contract is formed. If a court determines offeror is mentally incompetent, offer is terminated. Termination of an Offer Rejection by Offeree Rejection terminates offer. After rejecting offer, offeree can t simply change mind and accept it. Termination of an Offer Counteroffer Counteroffer: When offeree agrees to some terms of original offer, but changes one or more other terms. Although sometimes called a qualified acceptance, a counteroffer has the legal effect of a rejection. Counteroffer terminates original offer and replaces it with new offer. Offer and Acceptance Communication of Acceptance To create binding contract, offeree must communicate acceptance to offeror before offer terminates. Offer may specify how acceptance must be communicated. If no time or manner of acceptance is stated in offer, a reasonable time and manner is implied. 98

99 Negative Forces Affecting Consent Acceptance must be freely given. Contract voidable by victimized party if he or she can show consent resulted from: fraud mistake undue influence duress Negative Forces Affecting Consent - Fraud Fraud: Misrepresenting a material fact to someone who relies on the misinformation. Fraud is either actual or constructive. Negative Forces Affecting Consent - Fraud Actual fraud: Person making misrepresentation knows or should know that it s false. Intentional deceit. Constructive fraud: Person in a position of trust or with superior knowledge unintentionally misleads other person. Also called innocent misrepresentation. Negative Forces Affecting Consent - Mistake Mistake: When parties are mistaken as to a material fact or the contract terms. If parties are mistaken, the contract may be void for lack of mutual agreement. 99

100 Negative Forces Affecting Consent Undue Influence Undue influence: Using one s influence to pressure a person into making a contract. Or taking advantage of someone s distress or weakness of mind to induce him into entering into a contract. Negative Forces Affecting Consent Duress Duress: When one party uses force, constraint, or the threat of force or constraint to force other party to enter a contract. Negative Forces Affecting Consent Lawful Objective Lawful objective: A contract must have a lawful objective to be valid. Sometimes the unlawful portion of a contract can be severed from the lawful (enforceable) portion. Negative Forces Affecting Consent Consideration Consideration: Something of value exchanged by contracting parties. Money, property, services, or a promise to provide something of value in the future. Consideration in typical real estate sale: seller s promise to convey title buyer s promise to pay agreed price 100

101 Negative Forces Affecting Consent Statute of Fraud The statute of frauds is a state law that requires some types of contracts to be: in writing, and signed. Statute of Fraud Which Contracts Must be in Writing Most statutes of frauds apply to any agreement: 1. that is not to be performed within one year 2. for sale or exchange of real estate (e.g., purchase and sale agreement) 3. for leasing real estate, if it will expire more than one year after it is entered into (e.g., 13-month lease) Statute of Fraud Which Contracts Must be in Writing 4. authorizing agent to purchase or sell real estate (power of attorney) 5. authorizing agent to find buyer or seller for real estate, if agent will receive compensation (listing agreement) 6. for assumption of a mortgage or deed of trust Statute of Fraud A contract subject to the statute of frauds is unenforceable if it: isn t in writing, or isn t signed by the party to be bound (the one who s being sued). 101

102 Statute of Fraud The Writing Requirement The writing required by the statute of frauds does not need to be in a particular format or contained entirely in one document. It simply must: identify the contract s subject matter indicate an agreement and its essential terms be signed by the parties Statute of Fraud The Writing Requirement May be printed, handwritten, or a combination. If conflict between printed and handwritten parts, handwritten part takes precedence. Statute of Fraud Parol Evidence Rule When a written agreement is considered complete and unambiguous, the parties cannot introduce parol evidence to prove the contents of the contract. Parol evidence: oral statements or other extraneous evidence Legal Status of Contracts Terms indicating to what extent a contract is legally binding: void voidable unenforceable valid 102

103 Legal Status of Contracts Void Void contract: no legal effect whatsoever. Contract can be disregarded. Neither party needs to withdraw, because there s nothing to withdraw from. Legal Status of Contracts Void A contract that doesn t fulfill one of the basic requirements may be void. Examples: no consideration exchanged party is mentally incompetent minor is party to real estate contract objective is unlawful party s signature is forged Legal Status of Contracts Voidable A voidable contract has some defect allowing one or both of the parties to withdraw from the agreement. For example, a contract entered into as a result of fraud is voidable by the defrauded party. Legal Status of Contracts Voidable Voidable contract is binding unless party asks court to rescind contract. Withdrawing party must take legal action within reasonable time. Otherwise, court may rule that contract has been ratified. 103

104 Legal Status of Contracts Unenforceable Contract is classified as unenforceable if its contents can t be proved in court. Often a problem with unwritten contracts. Or if written contract is too vaguely worded and parties can t prove what they intended, court will refuse to enforce it. Legal Status of Contracts Unenforceable Contract is unenforceable if beyond limitations period. Statute of limitations sets time limit for filing a lawsuit. Party who misses applicable deadline loses right to sue. Each state has its own statute of limitations. Legal Status of Contracts Unenforceable Court may also bar legal claim under doctrine of laches. Legal principle that allows court to decide there s been an undue delay in asserting the claim. Different from statute of limitations, which sets specific deadline for filing claim. Legal Status of Contracts Valid Contract is valid if: it meets all requirements for forming a contract, its contents can be proved in court, and statute of limitations hasn t run. If one party fails to perform as promised, other can sue to have contract enforced. 104

105 Discharging a Contract A contract may be discharged by: full performance, agreement between the parties, or termination of the contract. Discharging a Contract Full Performance Most contracts are discharged by full performance: Each party performs as promised. Contractual relationship ends. Discharging a Contract Agreement Between Parties Parties can agree to discharge contract through: rescission, cancellation, assignment, novation, or partial performance. Discharging a Contract Rescission Rescission: Parties agree to terminate contract and undo any steps already taken to perform. If either party has paid the other party money or given any property, it s returned. Parties put themselves back in positions they were in before contract was formed, as if contract never happened. 105

106 Discharging a Contract Cancellation Cancellation: Parties agree to terminate contract without undoing whatever steps they ve already taken. If money has changed hands, party who received it is allowed to keep it. Discharging a Contract Assignment Assignment: One party withdraws and has someone else take his place. Original party (assignor) assigns his interest in contract to new party (assignee). Assignor remains secondarily liable. Contract not really discharged. If assignee defaults, other party can still sue assignor. Discharging a Contract Assignment General rule: one party can assign her interest without other party s permission, unless contract has clause expressly forbidding assignment. Exception: Personal services contract typically can t be assigned without consent from other party. Discharging a Contract Novation Novation: Original party withdraws and is replaced by new party, and also is released from further liability. Always requires consent of the other original party. Differs from assignment in that withdrawing party is released from liability. Novation can also refer to substitution of new agreement for old agreement, between same parties. 106

107 Discharging a Contract Partial Performance Partial performance: Parties may agree to discharge contract after one party has performed partially. Requires a written agreement stating that work performed is sufficient to discharge contract. Discharging a Contract Termination A court may terminate a contract on the basis of: substantial performance, impossibility of performance, or operation of law. Discharging a Contract Substantial Performance Doctrine of substantial performance: If one party performs without precisely following contract s terms, a court may still find performance sufficient to discharge contract. Example: Contractor builds home as planned, but installs kitchen cabinets that are a shade darker than owner wanted. Discharging a Contract Impossibility Impossibility: Contract may be terminated when unforeseen event makes performance legally impossible. Example: When house burns down, the contract to paint the house is terminated due to impossibility of performance. 107

108 Discharging a Contract Operation of Law Operation of law: A court may terminate a contract for legal reasons, such as fraud, duress, mistake, incompetent party, etc. Remedies for Breach of Contract Breach of contract: When one party doesn t perform as agreed, without discharging contract and without legal excuse. Other party has the right to sue if breach is material: the promise that hasn t been fulfilled is an important part of the contract. Remedies for Breach of Contract If contract contains a time is of the essence clause, timely performance is crucial failure to meet a contract deadline would be a material breach. Four legal remedies for breach of contract: rescission damages liquidated damages specific performance Remedies for Breach of Contract Rescission As explained earlier, in rescission the contract ends and any steps taken to carry it out are undone. Parties are put back in their pre-contract positions. Rescission may be: result of agreement between parties, or court-ordered remedy for breach of contract. 108

109 Remedies for Breach of Contract Liquidated Damages Liquidated damages: Remedy that parties may agree to in advance, by including provision in contract. If one party breaches, other party is entitled to specified sum of money (the liquidated damages). The liquidated damages are the other party s only remedy; can t sue for more. Remedies for Breach of Contract Liquidated Damages In a real estate transaction, the buyer s good faith deposit is often treated as liquidated damages. Remedies for Breach of Contract Damages Damages: An amount of money a court orders breaching party to pay other party. Compensates non-breaching party for losses resulting from breach. Most common remedy for breach of contract. Remedies for Breach of Contract Specific Performance Specific performance: Court orders breaching party to carry out contract. Sometimes damages aren t enough to compensate for breach of contract. Non-breaching party wants to make other party fulfill promise. Specific performance not always granted. Court may decide damages award is adequate compensation. 109

110 Breach of Contract Tender To be entitled to sue for breach of contract, non-breaching party must be ready to carry out his side of the bargain. Before filing lawsuit, non-breaching party is usually required to make a tender: unconditional offer to perform as agreed. Tender Offer Anticipatory Repudiation Anticipatory repudiation: One party repudiates contract by making definite statement that she is not going to perform as agreed. If anticipatory repudiation occurs, other party can sue without making a tender. 110

111 8. Types of Real Estate Contracts Types of Real Estate Contracts Types of Real Estate Contracts Five types of contracts real estate agents commonly encounter: listing agreements purchase agreements land contracts leases option agreements Listing Agreement Listing agreement: Written employment contract between property seller and a real estate broker. Sets forth parties rights and responsibilities. Parties are seller and broker (not salesperson). Earning a Commission In a listing, seller agrees to compensate broker for services, usually by commission (also called brokerage fee). Commission amount is usually a percentage of property s sale price. If broker s commission is 6% and house sells for $200,000, he gets 6% of $200,000, or $12,

112 Earning a Commission Three Requirements Broker is legally entitled to collect a commission only if 1. parties had written employment agreement (listing agreement), 2. broker was licensed at time she performed brokerage services for seller, and 3. broker met employment agreement terms. Earning a Commission Three Requirements Most states require listing agreements to be in writing. A few states recognize oral listing agreements for a period of less than 1 year. Earning a Commission Ready, Willing, and Able Buyer Terms of most listing agreements met if ready, willing, and able buyer for property is found during listing period. Ready, willing, and able buyer: Any party who offers to buy property at price and on terms stated in listing agreement, and who has financial ability to complete the purchase. Earning a Commission Ready, Willing, and Able Buyer What if an offer meets all of seller s terms, but seller doesn t accept it? In most states, seller still must pay broker s commission. Broker is generally entitled to commission if a buyer makes an offer on terms stated in listing agreement (or on any other terms seller decides to accept). 112

113 Earning a Commission Ready, Willing, and Able Buyer Able : capacity to contract and enough financial resources to complete purchase. Adequate financial resources: sufficient cash available to pay agreed price, or eligibility for loan. Ready, Willing, and Able Buyer Sale Fails to Close General rule: once ready, willing, and able buyer is found, broker has earned commission even if sale never closes. Seller obliged to pay commission even if: seller does not have good title to property circumstances prevent seller from delivering possession of property to buyer both buyer and seller agree to walk away from transaction Types of Listing Agreements Payment of broker s commission also affected by type of listing agreement used: open listing exclusive agency listing exclusive right to sell listing Types of Listing Agreements Open Listing Listing given to as many brokers as owner chooses (also called non-exclusive listing). Broker earns commission only if she is procuring cause: primarily responsible for bringing about sale. Competing brokers working under open listings for same property may end up in dispute over who was procuring cause. 113

114 Types of Listing Agreements Open Listing Broker working on open listing may lose commission if another broker finds acceptable buyer first. If seller finds buyer on her own, no commission owed to any broker. Open listings generally used only if seller insists. Virtually no advantage for broker. Types of Listing Agreements Exclusive Agency Listing Seller signs listing agreement with only one broker. If seller finds buyer, no commission owed to broker. If broker or anyone other than seller finds buyer, broker is entitled to commission. Types of Listing Agreements Exclusive Right to Sell Listing Seller lists property with only one broker, who is entitled to commission if property sells during listing period no matter who finds buyer. Even if seller finds buyer without any help, listing broker still gets commission. Types of Listing Agreements Exclusive Right to Sell Listing Exclusive right to sell listing is the type of listing most frequently used. Brokers prefer it because it gives them the greatest degree of protection. 114

115 Types of Listing Agreements Exclusive vs. Open Listings Many states require listing agreements to include a specific termination date. In states where it isn t required, seller may be permitted to terminate at any time, or agreement may expire after reasonable time. Open listing usually unilateral contract: seller agrees to pay commission if broker finds buyer, but broker doesn t promise to try to find a buyer. Exclusive vs. Open Listings Due Diligence Exclusive listing usually bilateral contract: in exchange for seller s promise to pay a commission, broker promises due diligence and good faith effort to sell property. Elements of a Listing Agreement A listing agreement should: identify the property set terms of sale grant broker authority determine broker s compensation Elements of a Listing Agreement Property Description A listing agreement must identify the seller s property. Attach legal description of property to listing agreement as exhibit. Attached pages should be dated and initialed by the parties. 115

116 Elements of a Listing Agreement Property Description To avoid typos/errors, photocopy a complicated description from seller s deed. Most listing forms provide space for property s street address but remember that street address alone is not adequate property description. Elements of a Listing Agreement Terms of Sale Include terms of sale acceptable to seller, including listing price and any other terms on which seller is willing to sell. Seller need not accept offer on these terms, but will likely be liable for commission if offer is turned down. Elements of a Listing Agreement Terms of Sale If seller is willing to pay discount points or other costs to help buyer obtain loan, listing agreement should state maximum amount seller will pay. Most listing agreements provide that seller will pay for title insurance and certain other closing costs. Elements of a Listing Agreement Broker s Authority Broker generally authorized only to find a buyer for property not to accept offers or transfer title to seller s property. To grant broker these other powers, seller must execute and record a power of attorney. 116

117 Elements of a Listing Agreement Broker s Authority Listing agreement usually authorizes broker to accept good faith deposits from buyers. Broker is acting for seller (not buyer) when accepting deposit. So if broker misappropriates funds, the seller (not the buyer) suffers the loss. Elements of a Listing Agreement Commission Provisions Forms have space to write in broker s commission rate/amount. Commission amount can t be pre-printed because commissions must be negotiable between seller and broker. Pre-printed rate = Violation of antitrust laws Elements of a Listing Agreement Commission Provisions Some states require listing agreement to contain statement that commission rate is not fixed by law and is negotiable. Net listing: Agreement that specifies net amount seller will accept from sale. Any proceeds over that amount no matter how much will belong to broker. Can be abused by dishonest brokers. Illegal in most states. Commission Provisions Payment Usually by check, but sometimes with new promissory note, assignment of existing note, or assignment of funds from buyer to seller. Broker can t charge seller for expenses of selling property (unless seller specifically agrees in listing agreement). 117

118 Commission Provisions Safety Clause Safety clause: Provides that broker is entitled to commission if seller sells property during certain safety period (for example, six months) after listing expires. Included in most exclusive listing agreements. Also called protection clause or protection period clause. Commission Provisions Safety Clause Using safety clause helps prevent seller from avoiding liability for commission by waiting until after listing expires to accept buyer s offer. Commission Provisions Safety Clause Terms of safety clause will specify when seller is liable for commission. For example: only if property is sold to party that broker (or broker s agent) negotiated with during the listing period only if property is sold to party that first learned about property in a way connected with broker or a cooperating agent (for sale signs, newspaper ads, etc.) Commission Provisions Safety Clause Some safety clauses require broker to give seller a list of prospective buyers that broker and his agents had contact with during listing period. 118

119 Elements of a Listing Agreement Termination Date Date when broker s authority to act on seller s behalf ends. Many states require listing agreements to specify a termination date Purchase Agreement Sales contract between buyer and seller: also called deposit receipt, earnest money agreement, or contract of purchase formed though offer and acceptance Buyer (offeror) makes offer to purchase. Seller (offeree) has power to accept and form a legally binding contract. Forming the Contract Written Offer Writing requirement: In most transactions, buyer presents a written, signed offer to seller. Statute of frauds requires an agreement to buy and sell real property to be in writing. Forming the Contract Good Faith Deposit Good faith deposit (also called earnest money deposit) is submitted with written offer to show intent to complete purchase. Form buyer used to make offer serves as buyer s receipt. 119

120 Forming the Contract Seller s Acceptance Seller accepts offer by signing it. Agent gives each party a copy, and a binding contract has been formed. Underlying consideration = promises parties have made to one another (buyer s promise to pay agreed price and seller s promise to transfer title). Forming the Contract Functions of Form Contract form serves three functions: 1. buyer s offer to seller 2. buyer s receipt for deposit 3. when signed by seller and returned to buyer, it becomes binding contract Elements of Purchase Agreement Parties and Signatures Under statute of frauds, agreement unenforceable unless signed by all parties. Many transactions involve more than one buyer and more than one seller: real estate agent is responsible for having all parties sign. Parties and Signatures Married Parties If party is married, state marital property laws may require party s spouse to sign purchase agreement for it to be enforceable. 120

121 Parties and Signatures Capacity Contract may be void if: either party is a minor (under 18) either party is mentally incompetent Elements of Purchase Agreement Property Description Must identify property being sold with certainty: if description is ambiguous, contract may not be enforceable. Complete legal description is always recommended. Elements of Purchase Agreement Property Description If description won t fit easily in space provided, put it in attachment, and write See attached legal description on form. Buyer and seller should initial attachments to show that attachments are part of signed agreement. Elements of Purchase Agreement Terms of Sale Total purchase price Downpayment Buyer s financing arrangements: loan amount and type interest rate discount points loan term amortization monthly payment 121

122 Elements of Purchase Agreement Terms of Sale Agreement should also specify what is included/excluded from sale: personal property to be sold with real estate fixtures seller will be removing from property Elements of Purchase Agreement Conditions of Sale Purchase agreement usually includes one or more contingency clauses: provisions making sale depend on fulfillment of specified conditions. If conditions are not fulfilled, agreement will terminate without liability. Elements of Purchase Agreement Conditions of Sale Most residential purchase agreements contain financing contingency making contract contingent on buyer s ability to obtain financing. Also common: 1. making agreement contingent upon receiving satisfactory results from a specified type of inspection 2. making agreement contingent upon sale of the buyer s current home Elements of Purchase Agreement Conditions of Sale Contingency clause must cover: What must occur to fulfill condition? What is time limit for fulfillment of condition? How should one party notify other when condition is fulfilled? Does either party have right to waive condition? What are parties rights if condition isn t fulfilled or waived? 122

123 Elements of Purchase Agreement Conditions of Sale Parties required to make good faith effort to fulfill contingencies. One party can t get out of contract by failing to take steps to ensure contingencies are met on time. Closing date may be expressly tied to fulfillment of a contingency. Elements of Purchase Agreement Condition of Property Seller may make warranties or representations about property condition. Contract may provide property is sold as is (seller still must to disclose any known defects not visible to buyer). Most agreements have provision for buyer s right to inspect property. Elements of Purchase Agreement Conveyance and Title Agreement should specify type of deed seller will use to convey title. Contract also typically states: there are no liens or other undisclosed encumbrances against the property seller will pay for a title insurance policy protecting buyer Elements of Purchase Agreement Closing Provisions Agreement should set closing date on which transaction is completed: deed and other documents are recorded and sale proceeds disbursed to seller. Date should allow sufficient time to fulfill all requirements of agreement, including obtaining financing. 123

124 Elements of Purchase Agreement Closing Provisions Specified closing date = purchase agreement s termination date. If it looks like agreement won t be fulfilled by closing, buyer and seller should execute amendment to agreement. Elements of Purchase Agreement Closing Provisions Most purchase agreement forms allow parties to appoint closing agent, who: handles tasks such as ordering title insurance and paying off liens tries to ensure contract terms met by closing Parties must agree to closing agent one party can t choose agent without other s consent. Elements of Purchase Agreement Transfer of Possession Typically occurs on closing date. Sometimes buyer moves in before closing, or seller stays on after closing. If transfer takes place before or after closing, arrangements should be included in agreement. Parties should also execute separate rental agreement. Elements of Purchase Agreement Transfer of Possession Uniform Vendor and Purchaser Risk Act: A law adopted in many states providing that seller bears risk of loss until possession is transferred to buyer. Example: If house is destroyed by fire the day before buyer takes possession, seller bears loss. But once possession transfers to buyer, risk of loss is buyer s. Seller and buyer can include risk clause in contract, assigning risk differently. 124

125 Elements of Purchase Agreement Time is of the Essence States that deadlines are important part of contract and will be strictly enforced. Failure to perform by agreed date is material breach of contract: other party need not fulfill agreement, and can sue for breach of contract. Elements of Purchase Agreement Good Faith Deposit Offer form usually contains deposit receipt provision. Amount of deposit varies according to local custom, but deposit is not required for valid contract. Elements of Purchase Agreement Good Faith Deposit Receipt Receipt provision is signed by agent accepting deposit on behalf of seller. Should state deposit s form cash, check, or promissory note. Form of deposit should be disclosed to seller before she accepts the offer. Elements of Purchase Agreement Good Faith Deposit Agreement should state when/how deposit will be refunded to buyer or forfeited to seller. Some states allow deposit to be treated as liquidated damages. Often impose specific requirements that must be met. Agreement should specify how deposit is split between seller and broker if buyer defaults. Broker typically receives half of amount kept by seller. 125

126 Elements of Purchase Agreement Brokerage Fee Provision When seller signs form to accept offer, she usually also agrees in writing to pay broker s commission. If no written listing agreement exists, this provision in purchase agreement fulfills statute of frauds requirement for written commission agreement. Purchase Agreement Binder In some parts of U.S., broker does not prepare purchase agreement. Instead, a binder is used as basis for offer and acceptance. Binder: document stating essential terms of the agreement such as the purchase price and amount of downpayment. Functions as contract between parties for only short time. Full purchase agreement drafted by attorney after binder is signed. Purchase Agreement Amendment of Agreement Once parties have both signed agreement, contract can be modified only by written amendment (also called rider). Amendment must be signed by all parties who signed original agreement. Purchase Agreement Escrow Agreements Escrow agreement: contract with an escrow agent (third party) to carry out the terms of the purchase agreement at closing. May involve separate contracts with buyer and seller, or a single contract. 126

127 Types of Real Estate Contracts Land Contracts Financing agreement in which buyer agrees to pay seller purchase price in installments over time, rather than paying full price all at once. Also called called real estate contract, real property sales contract, conditional sales contract, installment sales contract, or contract for deed. Types of Real Estate Contracts Land Contracts Seller = Vendor Buyer = Vendee Vendee agrees to make regular payments of principal and interest to vendor over a set period. Vendee takes immediate possession of property. Land Contracts Equitable Title and Legal Title Vendee gets possession immediately but holds only equitable title to property during contract term. Vendor keeps legal title until contract price is fully paid. When fully paid off, vendor delivers deed to vendee, transferring fee simple estate. Land Contracts Vendee s Rights and Duties Recording: Vendee generally has right to record contract Many states don t allow contract to prohibit recording Some states require contract to be recorded Taxes and insurance: Vendee generally responsible for keeping property insured and paying property taxes 127

128 Land Contracts Vendee s Rights and Duties Encumbrances: Vendee may encumber property Few lenders are willing to accept vendee s equitable interest as security Sale of property: Vendee may sell interest by assigning right to receive deed when contract price paid off Vendee may also devise his interest in a will Land Contracts Vendee s Rights and Duties Can t assign responsibility to make payments, unless vendor consents to assignment. Specific performance: If vendee pays contract price in full but vendor fails to transfer legal title, vendee can sue for specific performance of contract. Land Contracts Vendee s Rights and Duties Receipt of payments: Vendor has right to receive payments. If vendee defaults, vendor can terminate contract. Conveyance of title: Vendor must convey marketable title to vendee when contract price is paid off. Liens: Any liens vendor creates against property must be removed before delivering deed to vendee. Land Contracts Termination on Default If vendee defaults, vendor can terminate land contract by giving notice of termination. Most states restrict the use of forfeiture as a remedy. Vendor may be required to reimburse vendee the amount paid so far. But vendor can deduct for any damage and for property s fair market rental value during vendee s period of possession. 128

129 Land Contracts Termination on Default Some states do not allow immediate forfeiture upon default. Vendor required to give notice of default to vendee. Vendee given period of time to cure default and reinstate contract. Land Contracts Termination on Default Even if default not cured, if vendee has already paid a substantial portion of contract price, court may provide right of redemption. If vendee does not cure default or redeem property, vendor may retake possession. Recorded land contract leaves cloud on title. Types of Real Estate Contracts Leases A lease temporarily transfers right of possession from owner (landlord) to tenant, in exchange for rent. Also called rental agreement. Relationship between landlord and tenant governed partly by lease terms and partly by landlord/tenant law. Leases Basic Requirements Lease is contract: not valid without all essential contract elements. Some leases enforceable only if in writing and signed by landlord: lease is for longer than one year lease will not end within one year after parties enter into it 129

130 Leases Basic Requirements Written lease should state parties names and include adequate property description. Tenant may not need to sign written lease. If lease agreement should be in writing, but is not, periodic tenancy is created. Leases Renewal of Lease Tenant may be given option to renew lease at end of lease term. Tenant usually required to give notice of intent to exercise option. Parties often sign a renewal agreement. May also be renewed by implication. Leases Transferring Leased Property Leased property may be transferred in three ways: Assignment Sublease Novation Transferring Leased Property Assignment Assignment: Tenant transfers the entire unexpired term of lease to assignee. Assignee (new tenant) becomes liable for paying rent to landlord. Assignor (old tenant) is secondarily liable for the rent. 130

131 Transferring Leased Property Sublease Sublease: A sublease is a transfer of the leasehold estate for a period shorter than the unexpired term. Original tenant retains part of the leasehold estate. Subtenant is liable for rent to original tenant. Transferring Leased Property Novation Novation: Existing lease is replaced with new lease. New lease can be created between the same parties. New lease can be created between different parties. Leases Termination of a Lease Most leases terminate when the lease term expires and the lease is not renewed. Periodic tenancy terminates at end of one period upon notice from one party. Fixed-term tenancy ends automatically when term expires. Leases Termination of a Lease A lease may also be terminated before the end of its term in a variety of ways: 1. surrender 2. actual eviction 3. constructive eviction 4. illegal or unauthorized use 5. destruction of the premises 6. condemnation 131

132 Termination of a Lease Surrender Surrender occurs when landlord and tenant mutually agree to terminate lease before it s scheduled to end. Simplest form of termination. Termination of a Lease Actual Eviction Actual eviction occurs when landlord expels tenant from property. Landlord must file court action and give tenant notice of eviction proceeding. Landlord should never use self-help eviction (threatening tenant or cutting off utilities). Termination of a Lease Constructive Eviction Constructive eviction occurs when landlord causes/permits substantial interference with tenant s possession of the property. Tenant may be justified in abandoning property and terminating lease. Termination of a Lease Constructive Eviction Covenant of quiet enjoyment: Landlord s implied promise that tenant s exclusive possession of property will not be disturbed. Contained in every lease. Implied because part of lease agreement as a matter of law, even if not in writing. 132

133 Termination of a Lease Constructive Eviction Most states require landlord to maintain property in habitable condition and make necessary repairs. Failure to keep property habitable may constructively evict tenant. Termination of a Lease Illegal Use by Tenant Illegal or unauthorized use of property may give landlord right to terminate lease. Termination of a Lease Destruction of the Premises In most states, destruction of leased building will not terminate the lease, absent provision to contrary. Lease must be for use of entire building. Tenant not relieved of duty to pay rent If lease is only for part of building, destruction of building frustrates purpose of lease. Tenant released from duty to pay rent. Termination of a Lease Condemnation Lease can also be terminated when government takes private property to put it to a public use (such as a park). 133

134 Option Agreements Contract giving one party opportunity to do something, without obligating him or her to do it; a contract to keep contract offer open. In real estate, the most common type of option is option to purchase. Option Agreements Gives one party (optionee) opportunity to buy property belonging to other party (optionor) at certain price during specified period. Optionor agrees not to sell property to anyone other else during option period. If optionee decides to buy property, she must give written notice of acceptance. Option expires automatically at end of period. Option Agreements Requirements for Valid Option Writing requirement: Option agreement for real property must be in writing and state all terms of sale. Oral option agreement is unenforceable. Consideration: May be nominal amount such as $1, but optionee must actually pay that consideration to optionor. Option Agreements Option Rights Option gives optionee a contract right. Does NOT create interest in real property. Option is not a lien. Can t be used as security for mortgage or deed of trust. Optionee can assign rights in an option, absent provision to the contrary. Option binding on heirs and assignees of optionor. 134

135 Option Agreements Recording If option is recorded and then exercised, optionee s interest in property will relate back to recording date. Regardless of whether recorded, until option is exercised, it is only contract right and not an interest in property. If option not exercised, it will remain on record as cloud on optionor s title. Option Agreements Right of First Refusal Don t confuse right of first refusal with option. Right of first refusal: only gives someone first opportunity to purchase property if it becomes available. 135

136 9. Real Estate Agency Law Real Estate Agency Law Definitions Agency relationship: Established when one person authorizes another to represent her in dealings with other people (third parties). Person authorizing another to represent her: principal. Person authorized to act as principal s representative: agent. Agency Relationship Seller or buyer hires a broker to act as representative (agent) in a real estate transaction. Real estate salesperson not licensed to represent seller or buyer directly, without a broker. Agency Relationship Many real estate transactions involve more than one agency relationship: each party may have own agent real estate salespersons are agents for their brokers 136

137 Agency Law Agency relationship has important legal consequences for both parties: Dealing with agent may be legal equivalent of dealing with principal directly. Agent owes certain legal duties to his principal. Real estate agency law is two-part: 1. General agency law 2. Real estate agency statutes General Agency Law General agency law governs agency relationships and establishes agent s powers and duties. Applies to agency relationships between: lawyer and client trustee and beneficiary real estate agent and seller or buyer Real Estate Agency Statutes Many states have passed statutes that specifically define and regulate real estate agency relationships. Statutes may replace or supplement general agency law. Creating an Agency Creating an agency relationship simply requires consent of both parties. Under general agency law, agency relationships are created by: express agreement ratification estoppel implication 137

138 Creating an Agency Express Agreement Principal appoints someone to act as his agent, and agent accepts appointment. Most agencies created by express agreement. Examples: listing agreement buyer agency agreement power of attorney Creating an Agency Express Agreement Consideration NOT required. Agency relationship can exist even if principal isn t compensating agent. Creating an Agency Express Agreement In some states, valid agency can be created with oral agreement (but written agreement always best). Agency relationship begins as soon as parties agree to it. Without written agreement, broker can t sue client for compensation. Creating an Agency Ratification Principal gives approval after the fact to acts performed by: a person without authority to act for the principal, or an agent whose actions exceeded the authority granted by the principal. 138

139 Creating an Agency Ratification Principal may ratify agency by: expressly approving unauthorized acts, or accepting benefits of unauthorized acts. Creating an Agency Estoppel Doctrine of estoppel: A person cannot take a position contradicting previous conduct, if someone else relied on the previous conduct. Agency is created by estoppel when it would be unfair to deny agent s authority, because principal allowed third party to believe agency relationship existed. Creating an Agency Implication One person s behavior implies that he s acting as another person s agent. If a person believes that someone is acting as her agent, and that someone fails to correct that impression, he may be held to owe agency duties to the first person. Creating an Agency Implication Agency by implication is similar to agency by estoppel, except: in agency by estoppel, principal must acknowledge agency for protection of third party in agency by implication, agent must acknowledge agency for protection of principal 139

140 Legal Effects of Agency Dealing with agent can be the legal equivalent of dealing with principal: agent s actions may be binding on principal principal may be held liable for agent s mistakes/misconduct principal may be held to know information known by agent Legal Effects of Agency Agent s Actions Bind Principal General rule: authorized acts performed by agent are legally binding on principal, as if principal had performed acts himself. Principal typically bound only by agent s acts that are within the scope of authority granted by principal. Legal Effects of Agency Agent s Actions Bind Principal Three types of agents: Universal agents General agents Special agents Agent s Authority Universal Agent Universal agent: Agent authorized to do anything that can be lawfully delegated to a representative. Greatest degree of authority. Much less common than other types of agents. 140

141 Agent s Authority General Agent General agent: Agent who is authorized to act in one or more specified areas of principal s affairs. Within those areas, general agent has broad authority. Often handles all matters for particular business or property owned by principal (example: property managers). Agent s Authority Special Agent Special agent: Agent is authorized to do only a specific thing or conduct a specific transaction. Broker typically authorized to represent seller/buyer only in single transaction. Broker s authority usually quite limited in that single transaction. Agent s Authority Actual vs. Apparent Authority Two types of agency authority: actual apparent Actual Authority Actual authority: Written or oral authority granted to agent by principal. Express actual authority: when principal specifically directs agent to do something. Implied actual authority: additional authority to do whatever necessary to carry out acts expressly authorized by principal. 141

142 Actual Authority Principal is bound by agent s actions if within scope of agent s actual authority. Principal may also be bound by actions within scope of agent s apparent authority. Apparent Authority Apparent authority: Authority agent appears to have, although principal didn t actually grant it. Principal negligently or deliberately allowed it to appear that person (apparent agent or ostensible agent) was authorized to act on behalf of principal. Apparent Authority Principal not bound by unauthorized actions unless she s aware of them and her conduct indicates approval. If principal fails to deny that apparent agent s actions are authorized, and third party relies on agent s apparent authority, principal may be bound by agent s actions. Third party has duty to make reasonable effort to discover scope of agent s authority. Legal Effects of Agency Vicarious Liability Tort: mistake, accident, or misconduct resulting in injury/financial harm to another. Party committing tort may be held liable and required to compensate injured party. If agent commits tort, principal may be held liable under theory of vicarious liability. 142

143 Legal Effects of Agency Vicarious Liability Principal can be vicariously liable for acts of broker. Broker can be vicariously liable for acts of salesperson. Some state real estate agency statutes have modified or eliminated vicarious liability. Legal Effects of Agency Imputed Knowledge Rule Under general agency law, principal is held to have notice of information in agent s possession. Agent s knowledge is imputed to principal. True even if agent never actually tells principal. Legal Effects of Agency Imputed Knowledge Rule If agent knows something that third party should be told, principal held to know that information as well. Principal may be held responsible for failing to disclose that information to third party, even if agent never actually told principal. In some states, real estate agency statute has eliminated the imputed knowledge rule. Duties in Agency Relationship General agency law imposes legal duties (standards of conduct) on agent. Two broad categories: duties agent owes to principal duties agent owes to third parties 143

144 Duties to the Principal Agency is fiduciary relationship: agent is fiduciary in relation to principal. Fiduciary: someone who acts for benefit of another in relationship founded on trust and confidence. Duties to the Principal Agent owes fiduciary duties to principal : reasonable care and skill obedience and utmost good faith accounting loyalty disclosure of material facts Duties are owed to principal from time agency relationship begins until it ends (in a real estate transaction, until closing). Duties to the Principal Reasonable Care and Skill When representing principal, agent must use same degree of care and skill ordinarily used by others competently engaged in same business. Agent liable to principal for any harm caused by carelessness or incompetence. Duties to the Principal Obedience and Good Faith Agent must obey principal s instructions in good faith. If principal suffers loss because agent didn t follow instructions, agent can be held liable. This doesn t mean agent must follow instructions to act illegally or unethically. 144

145 Duties to the Principal Accounting Agent must avoid commingling, or mixing any trust funds with his or her own funds. Agent must regularly report to principal on status of trust funds. Most states require real estate broker to deposit trust funds in special trust account. Duties to the Principal Loyalty Agent must put principal s interests above those of third party, and above agent s own interests. Agent may not take any action detrimental to principal s interests in transaction. Duties to the Principal Loyalty If principal tells agent something in confidence, agent must not disclose it to third parties or use it for his own benefit. Part of duty of loyalty Agent can t have an interest in the transaction without principal s consent. Agent can t collect any secret profit: a financial benefit agent receives without principal s consent. Duties to the Principal Disclosure of Material Facts Agent must disclose any facts that could influence principal s judgment in transaction. Examples: offers to purchase property s true value any relationship between agent and buyer dual agency 145

146 Duties to the Principal Disclosure of Material Facts Seller s agent must present all offers to purchase: even if offer seems unacceptable even if not accompanied by good faith deposit Seller s agent must disclose any relationship with prospective buyer. Potential for conflict of interest. Seller s agent must also disclose if he s buying interest in the property himself. Duties to the Principal Disclosure of Material Facts In most states, broker may act as dual agent only if both principals consent to arrangement. Broker must always exercise caution when acting as a dual agent, because it s difficult to represent two parties who have conflicting interests. Duties to Third Parties Agent also owes duties to third parties: reasonable care and skill - Agent owes duty of reasonable care and skill to third parties as well as to principal. good faith and fair dealing - Both principal and agent owe third parties duty of good faith and fair dealing. Seller and seller s agent must treat prospective buyers fairly. Good Faith and Fair Dealing Avoiding Misrepresentation Duty of good faith and fair dealing requires agent to avoid making inaccurate or misleading statements. Unintentional as well as intentional misrepresentations may amount to fraud, giving third party the right to rescind purchase agreement or sue for damages. 146

147 Good Faith and Fair Dealing Avoiding Misrepresentation But a party generally can t sue agent based on agent s opinions, predictions, or puffing. Puffing: nonfactual or exaggerated statements, which a party should recognize as unreliable. Be aware that sales talk might be interpreted as statement of fact leading to charge of misrepresentation. Good Faith and Fair Dealing Latent Defects Duty of good faith and fair dealing requires agent to disclose any known latent defects in the property to prospective buyers. Latent defect: problem with property not discoverable through casual inspection. Certain latent defects are red flags of more serious underlying problems. Example: Cracks in garage floor may signal that foundation is shifting. Good Faith and Fair Dealing Latent Defects Property may be advertised as is (the seller is not claiming the property is in good condition). This doesn t relieve seller or seller s agent of duty to disclose latent defects. Duties to Third Parties Duty to Inspect Some states impose duty of inspection on seller s agent. Must conduct a reasonably competent and diligent visual inspection of the property and disclose any material information to prospective buyers. 147

148 Duties to Third Parties Stigmatized Properties Stigmatized property: When property was site of crime, suicide, gang-related activity, or political or religious activity. Can make property seem undesirable even though property s physical condition and title are unaffected. Duties to Third Parties Stigmatized Properties Many states have laws stating that stigmatizing events are not material facts and do not need to be disclosed (unless buyer specifically asks). When dealing with potentially stigmatized property, agent should check disclosure requirements. Duties to Third Parties Stigmatized Properties Under fair housing laws, agent/seller are not permitted to disclose whether the house was occupied by person with HIV or AIDS. Duties to Third Parties Megan s Law Since 1996, federal law has required all states to have sex offender registry. Generally, if buyer asks agent about presence of registered sex offenders in the area, agent should refer buyer to law enforcement agency. If agent knows of offender in area, agent may need to disclose this to buyer. 148

149 Duties to Third Parties Seller Disclosure Statement Many states require seller to give buyer a written statement disclosing any known defects in the property. Disclosures are typically made on a standardized form. Duties to Third Parties Lead-based Paint Disclosure In transaction involving house built before 1978, federal law requires seller/landlord to: disclose location of any lead-based paint he or she is aware of, provide copy of any report concerning lead-based paint in the home, and give buyers/tenants copy of EPA pamphlet. Duties to Third Parties Lead-based Paint Disclosure Buyers must be given at least a 10-day period to have home tested for lead-based paint. Warnings must be attached to the purchase and sale agreement or lease, along with signed statements from parties that legal requirements have been met. Signed statements must be kept for at least 3 years. Duties to Third Parties Other Disclosures Depending on state law, seller may need to provide buyer with other disclosures, such as: flood zone, earthquake zone, or other hazards. 149

150 Breach of Duty If agent breaches duties to principal and/or third parties, what are the consequences? Tort liability Disciplinary action Breach of Duty Tort Liability Breach of duty may result in tort lawsuit against agent (injured party can sue agent). Injured party might be either agent s principal or third party. Remedies for injured party: compensatory damages rescission Breach of Duty Tort Liability Vicarious Liabilty If salesperson commits tort against buyer, buyer can sue salesperson and also salesperson s broker and broker s principal (seller). Defendants may all be held liable for any damages awarded. If seller did nothing wrong but had to pay damages, seller can sue broker for amount paid. Breach of Duty License Suspension or Revocation Agent s breach of duty is usually a violation of state real estate license law. May result in license suspension, revocation, or other disciplinary measures. 150

151 Terminating an Agency Termination of agency: agent no longer authorized to represent principal. Most agency duties and liabilities end. Agency terminated in two ways: 1. by actions of parties 2. by operation of law Terminating an Agency Action of the Parties Agency is based on mutual consent, so relationship can be terminated by: mutual agreement revocation by the principal renunciation by the agent Termination by the Parties Mutual Agreement Principal and agent can terminate agency by mutual agreement at any time. Get termination in writing, especially if agency based on written contract. Termination by the Parties Principal Revokes Principal can fire agent for any reason or no reason at all. However, revocation before agreed termination date might breach the contract in that case, agent could sue principal for damages. 151

152 Termination by the Parties Principal Revokes Exception to revocation rule: agency coupled with interest can t be revoked. Agency coupled with interest: agent has financial stake or other interest in agency subject matter. Termination by the Parties Agent Renounces Agent may terminate agency at any time without principal s consent. However, renunciation before agreed termination date might breach the contract in that case, principal could sue agent for damages. Termination by Operation of Law Terminating Events Agency will terminate automatically if: agency term expires agency s purpose is fulfilled either party dies/becomes incompetent subject matter becomes extinct Termination by Operation of Law Expiration of Agency Term Agent s authority ends automatically on termination date of agency agreement. If no termination date specified in contract, agency will expire after reasonable time. Reasonable time may have to be determined by a court. 152

153 Termination by Operation of Law Purpose Fulfilled Agency terminates when its purpose has been fulfilled. Example: Seller hires broker to find buyer for his property. When buyer is found and transaction closes, purpose of agency has been met and agency ends. Termination by Operation of Law Death or Incompetence Agency terminated automatically if either party dies, or (in most states) if either party becomes legally incompetent. Even before agent is informed of terminating event, agent s actions are no longer authorized. Termination by Operation of Law Extinct Subject Matter Agency ends when property that is subject matter of agency becomes extinct (destroyed or title is transferred). Example: Rob manages office building. When owner sells the building, the subject of Rob s agency is extinguished. The agency is terminated by operation of law. Real Estate Agency Relationships Typical Residential Transaction Sale of home usually involves more than one real estate agent: listing broker listing salesperson selling broker selling salesperson other cooperating agents who showed home to other prospective buyers 153

154 Real Estate Agency Relationships Terminology Real estate agent Broker Salesperson Client Customer Selling agent Cooperating agent In-house sale Cooperative sale Listing agent Real Estate Agency Relationships Historical Background Previously, there was considerable confusion as to who the agent represented in a real estate transaction. A Unilateral offer of subagency provision in listing agreements provided that any cooperating MLS agent who found the buyer represented the seller. Real Estate Agency Relationships Historical Background However, many buyers thought the agent they were working with was representing them, not the seller. Some agents were also confused about which party they represented. Real Estate Agency Relationships Historical Background Agent might act as if she represented buyer, even though legally she represented seller, which created an inadvertent dual agency. Inadvertent (or accidental) dual agency: agent accidentally ended up representing both buyer and seller, without parties knowledge or consent. 154

155 Real Estate Agency Relationships Historical Background In the 1990s, the unilateral offer of subagency was replaced with a cooperation and compensation provision: other MLS members act as cooperating agents, not seller s subagents. Cooperating agents can choose to represent either seller or buyer. Real Estate Agency Relationships Historical Background Many states have passed disclosure laws requiring agents to disclose to both buyer and seller which party they represent in a transaction. Types of Agency Relationships Three types of agency relationships in real estate transactions are: seller agency buyer agency dual agency In some states, licensees may act as nonagents. Types of Agency Relationships Seller Agency Traditionally, real estate agents almost always represented sellers. Buyer agency now common, but seller agency still most common agency relationship. 155

156 Seller Agency Establishing Seller Agency Typically created with written listing agreement (employment contract): 1. Seller hires broker to find buyer for property. 2. In exchange for broker s efforts, seller agrees to pay broker a commission under certain conditions. Seller Agency Establishing Seller Agency Seller agency can be established by oral agreement even actions of seller and agent may be enough to create agency relationship. But without written agreement, broker may not be entitled to sue seller for commission. Seller Agency Role of Seller s Agent Promoting seller s interests: marketing property to best advantage, finding buyer, and negotiating sale on most favorable terms possible. Must be done according to seller s instructions and rules of agency law. Seller Agency Working with Buyers May perform some services for buyers: filling out offer, helping buyer apply for financing. Helps sell property: no violation of agent s duty of loyalty to seller. Must be sure buyer knows agent represents seller only never give buyer advice. 156

157 Types of Agency Relationships Buyer Agency Advantages of buyer agency: buyer gets the agent s loyalty and confidentiality buyer gets the agent s objective evaluation of the property and advice on how much to offer buyer gets help with negotiating the transaction buyer gets access to more properties Buyer Agency Establishing Buyer Agency Written buyer agency agreements typically contain these provisions: term of the agency property characteristics buyer is looking for price range of the property conditions under which the fee will be earned who will pay the fee agent s contractual duties Buyer Agency Types of Buyer Agencies Buyer and broker may enter into: Exclusive buyer agency: Buyer s agent is entitled to compensation as long as buyer purchases the type of home described in the agreement. or Nonexclusive buyer agency: Buyer s agent is entitled to compensation only if agent locates home that buyer purchases. Buyer Agency Compensation Three typical methods of compensating a buyer s agent: retainer seller-paid fee buyer-paid fee 157

158 Buyer Agent s Compensation Retainer Retainer: a fee paid up front, before agent starts working for buyer. Typically nonrefundable, but if buyer s agent becomes entitled to other compensation (such as seller-paid fee), retainer will be credited against that amount. Buyer Agent s Compensation Seller-Paid Fee Seller-paid fee: when buyer s broker receives share of listing broker s commission (also called a commission split). Most common compensation arrangement. Agreement may be written or oral. Agency representation not determined by which party is paying agent s fee. Buyer Agent s Compensation Buyer-Paid Fee Buyer-paid fee protects agent if buyer purchases FSBO (seller not represented by agent and not paying any commission). Buyer-paid fee may be: hourly rate, commission, or flat fee. Types of Agency Relationships Dual Agency Dual agency: when real estate agent represents both seller and buyer in same transaction. Generally allowed with written consent of both parties. Dual agent owes fiduciary duties to both clients. 158

159 Dual Agency Conflict of Interest Inherent conflict of interest: seller wants highest possible sales price, while buyer wants lowest price. Difficult for dual agent to promote interests of both parties at same time. However, in some situations, parties willing to accept dual agency. Dual Agency Conflict of Interest If dual agent works within certain limitations, she can avoid violating agency duties owed to either party. Each party should be warned that he or she will not receive full representation. Dual Agency Confidential Information Dual agent must not reveal confidential information from one party to other, or manipulate either party based on confidential information. Must explain to each party at outset that he must withhold certain information. Each party should understand agent will keep other party s negotiating position confidential. Dual Agency Designated Agency Some states permit in-house transactions called designated agencies: listing agent represents seller only, selling agent represents buyer only, and broker acts as dual agent representing both parties. 159

160 Dual Agency Inadvertent Dual Agency Seller s agent working closely with buyer may unintentionally develop agency relationship with buyer, creating an inadvertent dual agency. Agent should comply with any disclosure requirements and act in accordance. Agent should avoid conduct giving other party wrong impression. Non-Agency A few states permit an agent to act as a nonagent (also called transactional broker, intermediary, or facilitator). Non-agent doesn t represent either party simply assists with paperwork and closing. No fiduciary duties are owed to either party, just the duties of reasonable care and skill and good faith and fair dealing. Agency Disclosure Requirements Many states have laws regarding agency disclosures to clients and customers in real estate transactions. Some states require agents to give out pamphlets describing the different types of agency relationships. Some states require agent to disclose to each party whom he or she is representing. 160

161 10. Regulation of the Real Estate Profession Regulation of the Real Estate Profession Real Estate Licensing Each state has real estate license laws that set forth: licensing requirements legal responsibilities of agents administration of laws enforcement and penalties for violations Real Estate Licensing Purpose of Licensing Government uses educational requirements and testing to regulate real estate industry. Requiring licensing protects public from incompetent and unethical agents. Real Estate Licensing Administration Each state legislature enacts license law. Real estate license law authorizes state agency to issue licenses and implement law. Agency may be called Department of Real Estate, Real Estate Commission, Real Estate Division of Department of Licensing, or something similar. Agency headed by official, usually appointed by state governor. 161

162 Real Estate Licensing Administration Director of state agency given broad power to implement/enforce license law, including: adopting regulations, investigating non-licensees, screening license applicants, investigating complaints, and holding formal hearings. Real Estate Licensing Administration Generally, a commission advises the director on policies and functions of the agency. Most states require the commission to hold a number of public meetings. Real Estate Licensing When a License is Required A real estate license is generally required when engaging in certain activities: 1. on behalf of another person, 2. for compensation or in expectation of compensation. Real Estate Licensing When a License is Required The activities requiring a license vary from state to state, but generally include: selling, buying, or exchanging real estate; negotiating sale, purchase, or exchange of real estate; and listing or advertising real estate for sale or exchange. 162

163 Real Estate Licensing When a License is Required Some states also require license for: negotiation, sale, or purchase of loans secured by real estate; sale or purchase of real estate securities; property management activities; and/or sale of business opportunities. Real Estate Licensing When a License is NOT Required License law typically includes specific exemptions, such as: attorney engaged in practice of law; partner/corporate officer acting on behalf of business organization; acting under recorded power of attorney; acting under court order; or performing clerical functions. Real Estate Licensing When a License is NOT Required Real estate assistant: Unlicensed assistant hired by real estate agents to perform clerical work. Resident property manager: Property manager residing on site is not usually required to have real estate license. Real Estate Licensing Types of Licenses Typically two types of real estate licenses: broker s license salesperson s license Some states also offer an associate broker s license. 163

164 Types of Licenses Broker s License Broker s license may be issued to individual or corporation. For corporate license, it may be necessary for at least one corporate officer to be appointed as the designated broker. Associate broker: licensed broker who works for another broker, instead of operating his own brokerage. Types of Licenses Salesperson s License Salesperson s license: Authorizes person to engage in regulated activities under the supervision of a licensed broker. Salesperson can t act directly for principal (buyer/seller) in transaction. Broker is agent for principal and salesperson is subagent for broker. Salesperson may only receive compensation from broker. Types of Licenses Salesperson s License Affiliated licensees: all licensees that work for a particular broker. Includes licensees with broker s or salesperson s license. Types of Licenses Special Licenses or Permits State may require special license or permit in addition to real estate license for certain activities. Example: Licensed broker might require special permit to broker sale of oil or mineral rights separate from land. 164

165 Real Estate Licensing Qualifications for a License Generally, salesperson applicant must: be at least 18 or 19 years old; have completed one or more basic real estate courses; and have passed a written examination. Some states also require a high school diploma or the equivalent. Real Estate Licensing Qualifications for a License Broker s applicant generally must: have taken additional courses; and passed a written exam. Often required to have specific number of years of experience as a salesperson (other work experience may be substituted in some circumstances). Real Estate Licensing Qualifications for a License Most states also have additional requirements regarding honesty and may require: character references background check fingerprinting Real Estate Licensing Out-of-state Licensees Out-of-state licensees may not have to fulfill usual licensing requirements in another state. Some states have reciprocity agreements with other states. 165

166 Real Estate Licensing License Renewal License renewal may be required every year, or every two, three, or four years. Must pay a renewal fee. Submit proof of continuing education. Late renewal: states usually require payment of additional fee. If not renewed within specified period, license may expire. Real Estate Licensing License Renewal Licensee may apply for inactive license status if taking a break from real estate activities. State law determines length of inactive status period and requirements. Majority of states require licensees to complete continuing education courses to renew license. Real Estate Licensing Disciplinary Action Director of a state s real estate licensing agency is empowered to enforce license law through disciplinary procedures. Disciplinary Action Procedures Director has power to investigate licensee with or without formal complaint. Statement of charges given to licensee if violation of law appears to have occurred. Formal administrative hearing scheduled. Licensee must be given certain amount of advance notice of charges. 166

167 Disciplinary Action Procedures Administrative law judge hears testimony of witnesses at hearing. Licensee may appear with/without attorney. Disciplinary Action Procedures If sufficient evidence presented at hearing, Director may suspend or revoke the license. May impose fines. May ask court to issue cease and desist order. Licensee may also be subject to criminal prosecution and civil suits. Disciplinary Action Grounds for Disciplinary Action License law includes a list of grounds for disciplinary action that set minimum standards for licensee conduct. Disciplinary Action Grounds for Disciplinary Action Grounds for disciplinary action may include: making misrepresentations; fraud or dishonest dealing; acquiring license by fraud or misrepresentation; being convicted of a felony or misdemeanor involving moral turpitude; commingling property; 167

168 Disciplinary Action Grounds for Disciplinary Action negligence or incompetence; failing to exercise reasonable supervision as a broker; employing unlicensed person for act requiring a license; acting as an undisclosed dual agent; making a secret profit; Disciplinary Action Grounds for Disciplinary Action failing to disclose any conflicts of interest; failing to present written offer to a seller as a seller s agent; violating any state or federal fair housing or civil rights law; and willfully disregarding/violating any provision of real estate license law. Disciplinary Action Real Estate Recovery Funds Injured party has right to sue a licensee in a civil court. However, if licensee has no money or assets, a civil judgment is worthless. Disciplinary Action Real Estate Recovery Funds Some states maintain a fund for reimbursing members of the public injured by a licensee s actions or omissions in a real estate transaction. Usually funded by portion of license application and renewal fees. 168

169 Broker/Salesperson Relationship Salesperson must be affiliated with a broker in order to engage in real estate activities. May be required to have a written employment agreement with the broker. Brokers generally must keep license certificates of affiliated licensees in their custody. Broker/Salesperson Relationship Supervisory Responsibilities Brokers responsible for supervising affiliated licensees. Failure to do so is grounds for disciplinary action. In some states, broker may also be subject to disciplinary action when affiliated licensee is disciplined. Broker may also face civil liability for losses caused by misconduct of affiliated licensee. May be sued by client or customer. Broker/Salesperson Relationship Termination of Affiliation Broker/salesperson relationship can be terminated at any time, by either party. Broker must notify state licensing agency of termination. May also be required to report circumstances of termination and return license to state agency. Regulation of Business Practices Most states have provisions regulating business practices of broker and affiliated licensees in areas such as: brokerage offices handling transactions recordkeeping trust funds advertising 169

170 Regulation of Business Practices Brokerage Offices Broker generally required to maintain office in licensing state. Some states require office to be open to public. Regulation of Business Practices Brokerage Offices Broker generally permitted to have home office if it complies with zoning laws. Must have conspicuously placed sign identifying it as real estate brokerage office. States also impose rules on the naming of businesses. Broker may be allowed to obtain a license under a fictitious business name. Real estate regulatory body has power to reject name that is misleading or confusing. Regulation of Business Practices Brokerage Offices Specific procedures exist for establishing and managing branch offices. No limit to number of branches in most states. Each office must have a branch manager. License law may regulate the types of businesses that can be run out of the same office as a brokerage business. Certain office procedures may be required (separate records, etc.) Regulation of Business Practices Brokerage Offices Dual-state brokers may be exempt from certain brokerage office rules. Example: If broker has office open to public in State A, then State B may not require broker to have office in State B as well. 170

171 Regulation of Business Practices Handling Transactions Real estate license law typically regulates how licensees serve clients and customers in a transaction. During negotiations, a licensee must present all written communications from one party to the other. Generally, a licensee must give parties to transaction a copy of every document they sign. Regulation of Business Practices Handling Transactions Licensees generally obligated to perform transaction tasks expeditiously. Intentional/negligent delay may be grounds for disciplinary action. License law may specify when agent can serve as a closing agent. Some states prohibit an agent from charging an additional fee for closing services. Regulation of Business Practices Recordkeeping Broker generally required to keep copies of all documents from real estate transactions, such as: listing agreement purchase agreement escrow instructions settlement statements agency disclosure statement property management agreement/lease Regulation of Business Practices Recordkeeping Documents must be kept for statutory period, such as three years from closing date. Generally must be available for inspection. State agency may audit the records. 171

172 Regulation of Business Practices Trust Funds Most common reason for disciplinary action is the mishandling of trust funds. Trust funds: money temporarily entrusted to a broker by clients or customers. Regulation of Business Practices Trust Funds Commingling: mixing trust funds together with the broker s own money. Rules prohibit broker from commingling. Broker generally required to maintain a trust account for funds held on behalf of clients and customers. Trust funds must always be deposited into trust account. Broker s money may not be deposited into trust account. Also called escrow account. Regulation of Business Practices Trust Funds Brokers are required to follow requirements for trust accounts, which may include: account held in broker s name account specifically designated as trust account accrued interest (if interest-bearing account permitted) belongs to client service charges paid by broker Regulation of Business Practices Trust Funds Mishandling trust funds often comes from agents not understanding what trust funds are. Trust funds include: earnest money (good faith deposit) tenant security deposits rents collected by property manager advance fees paid by client 172

173 Regulation of Business Practices Trust Funds Generally, a broker is required to do one of three things with trust funds upon receipt: 1. deliver them directly to a principal, 2. turn them over to an attorney or escrow agent to hold in trust, or 3. deposit them in broker s trust account. State license laws establish specific deadlines for depositing funds after receipt. Funds given to affiliated licensee must be turned over to broker as soon as possible. Regulation of Business Practices Trust Funds Buyer s deposits some states have special rules for handling these funds. Broker may be allowed to hold deposit check without depositing it until seller accepts/rejects offer. Trust funds must remain in trust account until withdrawn and disbursed in accordance with instructions from owner of funds. Regulation of Business Practices Trust Funds Ownership of funds may change as real estate transaction progresses. Example: Ownership of buyer s deposit changes depending on whether offer is accepted or rejected. Prior to acceptance deposit belongs to buyer. After acceptance deposit can t be returned to buyer without seller s express written permission. Regulation of Business Practices Trust Funds If transaction falls through and there is dispute over ownership of deposit, broker may file interpleader action with the court. Court decides who is rightful owner. Personal property entrusted to a broker by a client/customer must be treated in accordance with trust fund rules. 173

174 Regulation of Business Practices Trust Funds - Records Broker must keep proper trust fund records of all trust funds, including: trust fund checks funds sent directly to escrow funds released to owner Regulation of Business Practices Trust Funds - Conversion Conversion: broker using trust funds for his own benefit. Owner of funds can sue broker. Basis for criminal charges against broker. Serious violation of license law, fiduciary duties, and professional ethics. Regulation of Business Practices Advertising License law in most states include provisions regulating real estate advertising. False advertising usually a violation of license law. Grounds for disciplinary action May fall within prohibition against fraud or misrepresentation Regulation of Business Practices Advertising Blind ad: advertisement that fails to include name of broker and licensee, or fails to indicate ad was placed by licensee. Prohibited in many states. May not apply when licensee advertises her own property for sale. 174

175 Regulation of Business Practices Advertising Internet advertising some states have specific regulations regarding internet advertising. Regulation of Business Practices Advertising Inducements a salesperson offering an incentive (prize, gift, discount) to induce recipients to attend a presentation. Some states require disclosure in ad if attendance is required to receive incentive. If inducement was given to a party in a transaction, this may be considered a material fact that must be disclosed. Regulation of Business Practices Advertising Do Not Call Registry Federal Trade Commission telemarketing rule prohibits cold calling numbers listed on the registry. Antitrust Laws Federal antitrust laws impose restrictions on real estate agent s behavior towards clients, customers, and other agents. Some states also have antitrust laws. 175

176 Antitrust Laws Sherman Act: federal antitrust law prohibiting any agreement that has the effect of restraining trade, including conspiracies. Conspiracy: when two or more business entities participate in a common scheme that has effect of restraining trade. Antitrust Laws Foundation of antitrust laws is that competition is good for the economy and society. U.S. v. National Association of Real Estate Boards Supreme Court held that mandatory fee schedules, established and enforced by real estate board, violated Sherman Act. Antitrust Laws Individual licensee guilty of violating Sherman act may be: fined up to one million dollars and/or sentenced up to 10 years in prison. Corporation guilty of violating the Sherman Act may be: fined up to one hundred million dollars Antitrust Laws Three categories of activities prohibited by antitrust laws: price fixing group boycotts tie-in arrangements 176

177 Antitrust Laws Price Fixing Price fixing = cooperative setting of price or price ranges by competing firms. Agents should NEVER discuss their commission rates. Casual announcement of broker changing rates might be an antitrust violation. Publications appearing to fix prices are prohibited. MLS should not publish recommended or going rates for commissions. Antitrust Laws Group Boycotts Group boycott = agreement between two or more people engaged in business to exclude another from fair participation. Encouraging other brokers not to do business with another broker could be considered a group boycott. Antitrust Laws Tie-in Arrangement Tie-in arrangement = an agreement to sell one product, only on the condition that the buyer also purchases a different product. Antitrust Laws Avoiding Violations To avoid antitrust violations, brokers should: establish fees and listing policies independently; never use forms with preprinted commission rates or imply that commission is non-negotiable; never discuss business plans with competitors; never participate in group boycotts or tie-in arrangements. 177

178 11. Real Estate Financing Real Estate Financing Economics of Real Estate Finance For a lender, a loan is an investment. The interest paid on the loan is the lender s return. A riskier loan requires a higher return (a higher interest rate). Economics of Real Estate Finance Real Estate Cycles Real estate cycles follow the law of supply and demand. Housing prices go up when demand is high and supply is low. Prices go down when supply is high and demand is low. Economics of Real Estate Finance Federal Economic Policies Federal economic policies that influence interest rates include: fiscal policy monetary policy 178

179 Economics of Real Estate Finance Fiscal Policy Fiscal policy includes: spending taxation debt management Set by Congress and the President, through tax legislation and the federal budget. Economics of Real Estate Finance Fiscal Policy Government overspending creates a federal deficit. To cover deficit, U.S. Treasury sells interest-bearing securities to investors. In effect, government is borrowing money to cover overspending. Economics of Real Estate Finance Fiscal Policy Increased federal borrowing means less money is available for investment in the private sector. Therefore, an increase in the federal deficit usually makes interest rates rise. Economics of Real Estate Finance Monetary Policy Monetary policy: Federal government s control of the money supply and interest rates. Monetary policy is determined by the Federal Reserve ( the Fed ). 179

180 Economics of Real Estate Finance Monetary Policy Federal Reserve chairman sets monetary policy using these tools: key interest rates reserve requirements open market operations Economics of Real Estate Finance Monetary Policy The Fed controls two interest rates: the federal funds rate the discount rate These are the rates charged when a bank borrows money from another bank or from a Federal Reserve Bank. Economics of Real Estate Finance Monetary Policy If the Fed raises interest rates, banks also raise the rates they charge their borrowers. If the Fed lowers interest rates, banks also lower their interest rates. Lower interest rates can stimulate the economy. Economics of Real Estate Finance Monetary Policy Reserve requirements: The amount of money banks are required to keep on deposit in order to meet requests for withdrawals. Fed raises reserve requirements: less money is available for lending interest rates go up Fed lowers reserve requirements: more money is available for lending interest rates go down 180

181 Economics of Real Estate Finance Monetary Policy Open market operations: When the Fed buys and sells government securities (such as Treasury notes). This is the Fed s primary method of managing money supply. Buying government securities from investors puts more money into circulation, so that: money supply increases, and interest rates go down Interest Rates and Federal Policy Other Federal Influences on Finance Federal Home Loan Bank System (FHLB) Federal Deposit Insurance Corporation (FDIC) Department of Housing and Urban Development (HUD) Rural Housing Service (RHS) Farm Credit System Community Reinvestment Act (CRA) Finance Markets There are two mortgage markets: the primary market the secondary market Finance Markets Primary Market Primary market: The local lending institutions in a community, which lend money to local borrowers. Primary market lenders are easily hurt by local economic conditions. 181

182 Finance Markets Primary Market When local economy is booming: less money is saved lenders can t keep up with demand for loans When local economy is slow: more money is saved lenders have ample funds but little demand for loans Finance Markets Primary Market Disintermediation: when depositors withdraw funds from savings accounts and put them into competing investments that offer higher returns Finance Markets Secondary Market Secondary market: Private investors and government agencies that buy and sell mortgages nationwide. Allows local lenders to sell loans to obtain more funds. Moderates local real estate cycles because it s a national market. Finance Markets Secondary Market Secondary market investors buy loans at a discount (for less than their face value). Discounted loans can be foreclosed for the full face amount if borrower defaults. When secondary market agency buys mortgage loans, it issues mortgage-backed securities as collateral. Agency sells securities to private investors. 182

183 Finance Markets Secondary Market Government-sponsored agencies Fannie Mae Freddie Mac Ginnie Mae Farmer Mac Government-sponsored Agencies Fannie Mae Federal National Mortgage Association (FNMA) Created in 1938 to establish a secondary market for FHA loans. Now it s a government-chartered corporation (rather than a federal agency) supervised by HUD. Buys conventional, FHA, and VA loans. Government-sponsored Agencies Freddie Mac Federal Home Loan Mortgage Corporation Created in 1970 to provide a secondary market for savings and loans. Like Fannie Mae, it s a private corporation supervised by HUD. Government-sponsored Agencies Ginnie Mae Government National Mortgage Association A government agency within HUD. Buys FHA and VA loans. 183

184 Government-sponsored Agencies Farmer Mac Federal Agricultural Mortgage Corporation Buys agricultural real estate loans and rural housing mortgage loans. Government-sponsored Agencies Financial Oversight Office of Federal Housing Enterprise Oversight: monitors Fannie Mae and Freddie Mac to make sure they remain financially sound. Fannie Mae and Freddie Mac set uniform underwriting standards that lenders follow so that their loans will be easy to sell on the secondary market. Finance Documents Most home buyers are required to sign two finance documents: promissory note security instrument (either a mortgage or a deed of trust) Finance Documents Promissory Notes Promissory note: A document in which a borrower agrees to repay the amount borrowed, plus a specified amount of interest. Borrower = Maker Lender = Payee 184

185 Finance Documents Promissory Notes Four basic elements of a promissory note: amount borrowed (principal amount) interest rate (and whether it s fixed or variable) payment amount when and how payments are made In many states, interest rates are subject to usury laws that limit rate. Finance Documents Promissory Notes There are two types of promissory notes Straight note Installment note Finance Documents Promissory Notes Straight note: A promissory note used for a term loan or interest-only loan. Payments made during the loan term cover only interest (no principal). At end of loan term, borrower must pay back the entire principal amount with one balloon payment. Finance Documents Promissory Notes Installment note: A promissory note used for an amortized loan. Part of each payment is interest, while the rest of each payment is principal. Each payment gradually reduces the principal balance. 185

186 Finance Documents Promissory Notes Interest paid on a real estate loan is always simple interest (not compound interest). Computed annually on remaining principal balance. Finance Documents Promissory Notes Most promissory notes used in real estate are negotiable instruments. Can be assigned to someone else by endorsement (like a check). Finance Documents Promissory Notes Holder in due course: A third party who purchases a negotiable instrument. Entitled to payment even if there were problems with the original transaction between payee and maker. Finance Documents Security Instruments Security instrument: A contract that makes a borrower s property collateral for a loan. If borrower doesn t repay the loan, lender can foreclose. Forced sale of property. Lender collects debt from sale proceeds. 186

187 Finance Documents Security Instruments Secured creditor: A creditor who has a security interest in the debtor s property. A secured creditor is in a much better position to collect a debt than an unsecured creditor. Finance Documents Security Instruments Title Theory vs. Lien Theory Hypothecation: Borrower transferred title to lender until loan was repaid. Borrower remained in possession of security property. Lender held legal title (title without possessory rights). Possessory rights retained by the borrower are called equitable title. Finance Documents Security Instruments Title theory states: Lender holds legal title throughout loan term. Lien theory states: Borrower retains full title while paying the loan off. Lender has only a lien against the property. Most states are lien theory states. Finance Documents Security Instruments There are two types of security instruments: mortgages deeds of trust The main difference between the two is that foreclosure is an easier process with a deed of trust. 187

188 Finance Documents Security Instruments There are two parties to a mortgage: mortgagor (borrower) mortgagee (lender) There are three parties to a deed of trust: trustor or grantor (borrower) beneficiary (lender) trustee (neutral third party who handles foreclosure if necessary) Finance Documents Security Instruments Lender should record the security instrument as soon as the loan is made. Recording: gives public notice of the lender s lien against the property protects the lender from subsequent claims Finance Documents Security Instruments A mortgage, deed of trust, or promissory note is considered personal property. When a secured loan is sold to an investor, lender executes an assignment of mortgage/assignment of deed of trust. Investor may obtain offset statement (from borrower) and beneficiary s statement (from lender) regarding status of loan. Finance Documents Security Instruments When personal property is used as collateral, borrower signs a security agreement, which is equivalent to a mortgage or deed of trust. 188

189 Security Instrument Provisions Mortgaging or Granting Clause A security instrument must state that the property is pledged as security for the loan. Mortgaging clause in a mortgage. Granting clause in a deed of trust. Security Instrument Provisions Property Description Security instrument must contain complete and unambiguous description of the collateral property. Security Instrument Provisions Acceleration Clause Acceleration clause: Gives lender the right to demand immediate payment of the entire amount owed if borrower defaults. If borrower doesn t meet the demand, lender can foreclose. Security Instrument Provisions Covenants Covenant to pay taxes: borrower promises to pay real estate taxes and special assessments when due. Covenant of insurance: borrower promises to keep property insured against damage or destruction. 189

190 Security Instrument Provisions Covenants Covenant against removal: borrower promises not to remove or demolish improvements. Covenant of good repair: borrower promises to keep property in good condition. Security Instrument Provisions Alienation Clause Alienation clause: Permits lender to accelerate the loan if borrower sells the property or transfers it to someone else. Also called a due-on-sale clause. Alienation clause does not prohibit sale of the property. But borrower must be able to pay off the loan if property is sold without lender approval. Security Instrument Provisions No Alienation Clause If there is no alienation clause in the security instrument, a new buyer may either: assume the seller s mortgage or deed of trust, or take title subject to the mortgage or deed of trust. Security Instrument Provisions No Alienation Clause In an assumption: new buyer assumes responsibility for repaying lender original borrower remains secondarily liable unless released from liability by lender 190

191 Security Instrument Provisions No Alienation Clause If new buyer takes title subject to an existing mortgage, without assuming it: original borrower remains primarily liable for repaying the loan new buyer is not personally liable for the loan However, lender can still foreclose if original borrower defaults. Security Instrument Provisions Late Payment Penalty Late payment charges are allowed only if provided for in the finance documents. Most states place some limits on late payment penalties. Security Instrument Provisions Lock-in Clause Lock-in clause: Prohibits borrower from paying the loan off early. Security Instrument Provisions Prepayment Penalty Prepayment penalty: Borrower pays a penalty if more than a specified amount of the principal is paid back before it is due. Some states restrict prepayment penalties on certain types of loans. Example: Prohibiting prepayment penalty during first 5 years of residential mortgage loan. Prepayment penalty not allowed if loan is insured or guaranteed by federal government (VA and FHA loans, etc.). 191

192 Security Instrument Provisions Subordination Clause Subordination clause: Makes the lien created by instrument with subordination clause have a lower priority than a mortgage or deed of trust that will be recorded in the future. Often found in the security instrument for a loan used to buy vacant land. Buyer intends to obtain a construction loan later. Later lender will require first lien position for construction loan (high risk). Security Instrument Provisions Condemnation Clause Condemnation clause: If property is taken in eminent domain action, clause gives lender the right to use all or part of the condemnation award to satisfy the loan. Security Instrument Provisions Assignment of Rents Clause Assignment of rents clause: If borrower defaults, rental income from the property is assigned to lender. Security Instrument Provisions Assignment of Rents Clause Defeasance clause: Lender agrees to cancel the security instrument when the debt has been paid off. Buyer receives and records: deed of reconveyance, or certificate of discharge (satisfaction of mortgage) 192

193 Foreclosure Foreclosure is a real estate lender s remedy when a borrower defaults. Foreclosure forms and procedures vary from state to state. Typically, mortgages are foreclosed judicially and deeds of trust are foreclosed nonjudicially. Mortgage Foreclosure Judicial Foreclosure Process 1. Mortgagee files a foreclosure action. 2. Lender records a lis pendens. 3. Judge issues a decree of foreclosure. 4. Property is sold at public auction (sheriff s sale). Mortgage Foreclosure Reinstatement In some states, a reinstatement period exists, during which the borrower can cure the default by paying all past due amounts. Reinstatement period lasts until foreclosure decree is issued. Mortgage Foreclosure Equitable Redemption In some states, borrower has equitable right of redemption: can stop foreclosure and redeem property by paying off entire loan balance, plus all interest, costs, and fees. Instead of reinstatement period. 193

194 Mortgage Foreclosure Statutory Redemption In some states, borrower has statutory right of redemption: after sheriff s sale, borrower may redeem property by paying off entire loan balance, interest, costs, and fees. Length of statutory redemption period depends on state law. If property is sold at sheriff s sale subject to right of redemption, the buyer receives a certificate of sale. At the end of redemption period, buyer receives sheriff s deed to property. Mortgage Foreclosure Credit Bidding Long statutory redemption period can make property unattractive to investors; often the lender simply acquires the property by bidding what the borrower owes. Mortgage Foreclosure Surplus or Deficiency After liens paid off, borrower receives any surplus from the foreclosure sale. If proceeds don t cover loan amount, some states permit lender to sue borrower for deficiency judgment. Mortgage Foreclosure Redemption & Deficiency Judgments No redemption period allowed if lender: waives its right to a deficiency judgment or is prohibited from obtaining a deficiency judgment. 194

195 Deed of Trust Foreclosure Nonjudicial Foreclosure Process Power of sale clause: Provision in deed of trust that authorizes trustee to sell the property (without going to court) if borrower defaults. 1. Trustee records notice of default and sends copies to borrower and junior lienholders. Deed of Trust Foreclosure Nonjudicial Foreclosure Process 2. Notice of sale must be published in newspaper of general circulation (may also need to be posted at property and mailed to borrower and junior lienholders). 3. Trustee holds an auction (trustee s sale). 4. Successful bidder receives a trustee s deed. 5. Foreclosed owner receives any surplus after liens are paid off. Deed of Trust Foreclosure Reinstatement and Redemption Usually, borrower may reinstate the loan: by paying the past due amount plus costs up until shortly before trustee s sale. Borrower may redeem the property: by paying off loan balance plus costs at any time until trustee s sale After trustee s sale, redemption generally not allowed. Deed of Trust Foreclosure Deficiency Judgments In most states, deficiency judgments are not permitted in nonjudicial foreclosures. If deficiency judgment is permitted, lender typically must obtain court order to collect judgment. 195

196 Judicial vs. Nonjudicial Foreclosure Lenders usually prefer nonjudicial foreclosure since it s faster and has no statutory redemption period. But no right to deficiency judgment so lender may choose judicial foreclosure if sale proceeds won t cover debt. Junior Lienholders Junior lienholders are generally entitled to notice of foreclosure sale. Sale proceeds often aren t enough to cover junior liens. Junior lienholder can protect interest by curing default and then foreclosing on own lien. Strict Foreclosure Strict foreclosure: When borrower defaults, lender files lawsuit and court establishes deadline for redemption. If borrower misses deadline, lender is awarded title to property (without public sale). Only allowed in a few states. Deed in Lieu A defaulting borrower who cannot cure default can give the lender a deed in lieu of foreclosure, which transfers title to lender and stops foreclosure. Lender takes title subject to any other liens on property. 196

197 Foreclosure vs. Bankruptcy Bankruptcy is a federal court procedure that enables a debtor to reduce, modify, or eliminate unmanageable debts. If mortgage/deed of trust borrower files for bankruptcy, any foreclosure proceedings are put on hold. Foreclosure vs. Bankruptcy Chapter 13: Debtor repays debts over 5 years; allowed to keep property. Chapter 7: Most debts are discharged; debtor required to surrender certain types of property. If debtor s equity in home is more than homestead exemption, home will be sold. Seller Financing Seller financing: Seller extends credit to buyer, accepting a downpayment and arranging to be paid over time. If seller asks buyer to execute mortgage or deed of trust, it s called a purchase money loan. Alternatively, seller can use land contract (also called real estate contract, installment sales contract, or contract for deed). Seller Financing Land contract: Vendee (buyer) agrees to pay vendor (seller) the purchase price, plus interest, in installments over a specified number of years. Vendee takes possession of property immediately, but title doesn t transfer until full purchase price is paid. 197

198 Types of Mortgage Loans First Mortgage First mortgage: A loan with first lien priority. Loans with lower priority are known as second mortgages, third mortgages, and so on. Types of Mortgage Loans Senior or Junior Mortgage A first mortgage is senior to a second mortgage. A second mortgage is junior to a first mortgage, but senior to a third mortgage. Types of Mortgage Loans Purchase Money Mortgage Purchase money mortgage: In general, any mortgage loan used to buy the property that serves as security for the loan. May also refer specifically to a mortgage given by a buyer to a seller in a sellerfinanced transaction. Types of Mortgage Loans Purchase Money Mortgage Hard money mortgage: When a borrower gives a lender a mortgage and receives cash in exchange. Soft money mortgage: When a borrower gives a lender a mortgage and receives credit in exchange. 198

199 Types of Mortgage Loans Budget Mortgage Budget mortgage: When a prorated share of the property taxes and insurance is added to the monthly principal and interest payment. Helps insure that property taxes and insurance are paid on time. Types of Mortgage Loans Swing Loan Swing loan: Secured by property that is for sale; paid off when sale closes. Used when buyers need funds for new home before sale of current home has closed. Types of Mortgage Loans Package Mortgage Package mortgage: A mortgage used to pay for both real property and personal property. For example: when office or farm equipment is included in the sale of the real property. Types of Mortgage Loans Construction Mortgage Construction mortgage: A temporary loan used to finance the construction of improvements on land. Fixed disbursement plan: Loan funds disbursed to borrower as construction proceeds (known as obligatory advances). 199

200 Types of Mortgage Loans Construction Mortgage Take-out loan: Borrower obtains permanent financing of the construction debt after construction completed. Standby loan commitment: Lender s promise to make take-out loan later, when borrower needs it. Types of Mortgage Loans Blanket Mortgage Blanket mortgage: When several pieces of property are used to secure one loan. When a certain portion of the loan has been repaid, some parcels will be released from the lien, under a partial release clause. Types of Mortgage Loans Participation Mortgage Participation mortgage: Lender is entitled to a portion of the mortgaged property s earnings, in addition to interest payments. Types of Mortgage Loans Shared Appreciation Mortgage Shared appreciation mortgage: Lender is entitled to a portion of the mortgaged property s appreciation in value. In other words, part of the equity will belong to the lender rather than the borrower. 200

201 Types of Mortgage Loans Graduated Payment Mortgage Graduated payment mortgage (GPM): Borrower makes lower payments in the early years of the loan and later steps up to a fully amortized payment. Types of Mortgage Loans Growing Equity Mortgage Growing equity mortgage (GEM): Interest rate remains fixed, but payment size increases over loan term. Types of Mortgage Loans Adjustable-rate Mortgage Adjustable-rate mortgage (ARM): Interest rate may be increased or decreased periodically to reflect changes in market interest rates. Types of Mortgage Loans Wraparound Mortgage Wraparound mortgage: A new mortgage that incorporates an existing first mortgage. (If a deed of trust is used, it may be called an all-inclusive trust deed.) With a wraparound mortgage: the buyer makes loan payments to the seller the seller uses a portion of each payment received to make the payment on his underlying mortgage 201

202 Types of Mortgage Loans Open-end Mortgage Open-end mortgage: A mortgage that allows a borrower who has paid off part of the loan to re-borrow the funds up to a certain limit. Types of Mortgage Loans Home Equity Mortgage Home equity mortgage: Loan obtained using equity in borrower s home as collateral. Equity: difference between property s market value and the liens against it Home equity line of credit (HELOC): Revolving credit account that borrowers can draw on as the need arises. Types of Mortgage Loans Reverse Equity Mortgage Reverse equity mortgage: Allows elderly person who owns home free and clear to bring in additional income by converting home equity into cash. Owner receives a monthly payment in return for mortgaging the home. In most cases, mortgage is paid off when home is sold after owner s death. Types of Mortgage Loans Refinance Mortgage Refinance mortgage: Using funds from a new mortgage loan to pay off an existing mortgage loan. Typically used when interest rates drop, or when payoff date approaches and large balloon payment is due. 202

203 12. Applying for a Mortgage Loan Applying for a Mortgage Loan Applying for a Residential Loan This lesson will cover four topics: choosing a lender the loan application process basic loan features residential financing programs Choosing a Lender Types of Lenders Buyers may choose the type of lender they want, although most distinctions between mortgage lenders no longer exist. Types of lenders include: savings and loans commercial banks savings banks credit unions mortgage companies Choosing a Lender Types of Lenders Savings and loans: emphasize home purchase loans get most of their loan funds from the savings of individuals 203

204 Choosing a Lender Types of Lenders Commercial banks: traditionally made short-term business loans now accept more long-term deposits and offer more long-term loans Choosing a Lender Types of Lenders Savings banks: are owned by small depositors rather than stockholders are relatively rare today Choosing a Lender Types of Lenders Credit unions: serve only members of a particular group specialize in small personal loans Choosing a Lender Types of Lenders Mortgage companies: are not depository institutions act as loan correspondents (an intermediary between an investor with money to lend and a home buyer looking for financing) act on behalf of large investors make the most mortgage loans 204

205 Choosing a Lender Types of Lenders Mortgage companies: sell their loans to investors on the secondary market often service the loan for a fee Mortgage company Mortgage broker A mortgage broker simply arranges loans, bringing borrowers and lenders together for a commission. Choosing a Lender Other Financing Sources Seller financing: When the seller extends credit to the buyer. (Most important source of private financing.) Seller financing is important when: buyer s income is inadequate interest rates are high buyer has poor credit history Choosing a Lender Other Financing Sources Real estate investment trusts: often finance large residential developments and commercial ventures. Don t offer loans to individual home buyers Choosing a Lender Loan Costs Buyers also want to compare loan costs when choosing a lender. Loan costs include: interest charges origination fees discount points lock-in fees 205

206 Choosing a Lender Loan Costs Origination fee: An administrative charge for processing the loan. The fee is paid at closing. Also known as a loan fee, service fee, or administrative charge. Choosing a Lender Loan Costs Discount points: A fee paid to the lender at closing to increase the lender s yield (or profit) on the loan. One point is equal to 1% of the loan amount. Two points are equal to 2% of the loan amount. Choosing a Lender Loan Costs The more discount points a borrower pays, the lower the interest rate will be. The seller may choose to pay the buyer s discount points to lower the buyer s interest and make the loan more affordable. This is known as a buydown. Choosing a Lender Loan Costs Lock-in fee: A fee paid to the lender by the buyer to ensure that the interest rate will be guaranteed for a certain period. Without a lock-in, the lender may change the loan s interest rate at any point before closing. 206

207 Choosing a Lender Loan Costs - TILA The Truth in Lending Act (TILA) is a federal consumer protection law that requires lenders to disclose the total cost of obtaining a loan. TILA is implemented through Regulation Z, a Federal Reserve regulation. Choosing a Lender Loan Costs - TILA TILA applies to consumer loans: used for personal, family, or household purposes paid off in more than four installments or involving finance charges for $25,000 or less or secured by real property Choosing a Lender Loan Costs - TILA TILA does NOT apply to: loans made to corporations or organizations loans made for business, commercial, or agricultural purposes seller-financed transactions Choosing a Lender Loan Costs - TILA If a loan is covered by TILA, the lender must disclose the loan s: total finance charge annual percentage rate (APR) 207

208 Choosing a Lender Loan Costs - TILA Total finance charge: The sum of all fees the borrower will have to pay, including interest, origination fees, discount points, service fees, and mortgage insurance premiums. The finance charge does NOT include seller-paid points, appraiser fees, or credit report fees. Choosing a Lender Loan Costs - TILA Annual percentage rate (APR): The cost of the loan expressed as an annual percentage of the loan amount. The APR (also called the effective interest rate) is a more accurate way to compare loan costs than by comparing nominal rates (the interest rates stated on the promissory notes). Choosing a Lender Loan Costs - TILA TILA advertising rules: an advertisement can list the cash price or APR without triggering full disclosure requirements if an ad goes beyond those terms, it must also disclose: the required downpayment the points terms of repayment (i.e., loan balance and total number of payments) Choosing a Lender Loan Costs - TILA TILA also: requires a good faith estimate of closing costs to be given to the borrower within three days of the loan application date gives home equity borrowers a right of rescission The borrower has three days to change her mind after signing the loan agreement. 208

209 Loan Application Process Once a lender is chosen, the buyer fills out the loan application. This may be done: after a property has been chosen before the buyer begins looking for a home (called prequalification) Loan Application Process Required Information The buyer will need to give the lender the following: personal information (such as age) current monthly housing expenses employment information current income assets and liabilities type of loan sought Loan Application Process Underwriting The lender will evaluate the completed application according to the lender s qualifying standards (called underwriting the loan). The loan underwriter will assess the degree of risk the loan would create and decide whether the loan should be approved. Loan Application Process Underwriting Underwriters focus on three main considerations about the borrower: income net worth credit history 209

210 Loan Application Process Underwriting - Income The underwriter checks to see if the applicant has enough stable monthly income to make the loan payments. She will consider the: quality quantity and durability of the applicant s income Loan Application Process Underwriting - Income Quality and durability of income: income from a permanent job, or regular benefits such as Social Security, will be considered stable income earnings from a temporary job are not stable income Loan Application Process Underwriting - Income Quantity of income: The underwriter uses income ratios to determine whether the applicant s income is enough. There are two ratios: a housing expense to income ratio a debt service to income ratio Loan Application Process Underwriting Net Worth The borrower s net worth is determined by subtracting her total liabilities from total assets. An applicant must have enough funds to pay for the down payment and closing costs while retaining at least several months reserves. 210

211 Loan Application Process Underwriting Credit History The underwriter will also consider the applicant s credit history, including factors such as: late payments on debts bankruptcies foreclosures Loan Application Process Underwriting Credit History Underwriters typically use credit scores to evaluate the borrower s likelihood of defaulting on a loan. Credit scores are issued by credit reporting agencies. The underwriter also evaluates the property, to make sure it provides adequate security for the loan amount. The underwriter does this with an appraisal report. Loan Application Process Automated Underwriting Automated underwriting: computer program performs preliminary analysis of loan application and makes recommendation for or against approval. Use has become widespread. Streamlines underwriting process. Lenders still use traditional (manual) underwriting. Loan Application Process Automated Underwriting AU system gives each application three different classifications: risk classification documentation classification appraisal classification 211

212 Loan Application Process Automated Underwriting Risk classification determines level of underwriting scrutiny application will receive. Approve/Accept = meets all qualifying standards. Refer/Caution = does not meet qualifying standards. Loan Application Process Automated Underwriting AU report also issues a documentation classification for each application: standard streamlined (low-doc) minimal (no-doc) Loan Application Process Automated Underwriting Standard documentation: full verification process used in traditional underwriting. Required for Refer/Caution loans Approve/Accept loans generally qualify for streamlined or minimal documentation. The stronger the application, the lower the documentation requirement. Loan Application Process Automated Underwriting Appraisal classification: refers to the type of appraisal and/or inspection required. Full or drive-by appraisal may be required. Based on strength of application and information provided about property. 212

213 Loan Application Process Subprime Lending Subprime lending involves lenders making riskier loans than prime (standard) lenders. Deal with buyers who don t meet standard underwriting requirements. Loan Application Process Subprime Lending Subprime financing necessary for buyers who: can t meet income/asset documentation requirements of prime lenders; have good credit but carry more debt than prime lenders permit; are purchasing nonstandard properties; or need super jumbo loans to buy expensive properties. Loan Application Process Subprime Lending Characteristics of subprime loans include: more flexible underwriting standards higher interest rates and fees prepayment penalties balloon payments negative amortization Basic Loan Features Basic loan features include: the loan term amortization loan-to-value ratios secondary financing fixed or adjustable interest rates 213

214 Basic Loan Features Loan Term Loan term: How long a borrower has to repay a loan (also called repayment period). The loan term affects the amount of the monthly payment and the amount of interest paid over the life of the loan. Basic Loan Features Loan Term Common loan terms: 30-year: Main advantage is smaller monthly payment. (Most loans have a 30- year term.) 15-year: Bigger monthly payment, but borrowers get a lower interest rate, pay off the loan in half the time, and pay much less interest overall. Basic Loan Features Amortization Amortized loan: A loan that requires regular installment payments of both principal and interest. Fully amortized loan: The monthly payments will pay off the entire debt at the end of the loan term. Partially amortized loan: The monthly payments won t be enough to pay off the entire debt; the borrower will owe a balloon payment at the end of the term. Basic Loan Features Loan-to-Value Ratios Loan-to-value ratio (LTV): The relationship between the loan amount and the value of the security property, expressed as a percentage. An $80,000 loan on a property worth $100,000 would have an 80% LTV. The lower the LTV, the greater the buyer s equity in the property. Equity is the difference between the property s value and any liens against it. 214

215 Basic Loan Features Loan-to-Value Ratios Lenders prefer a lower loan-to-value ratio because: the borrower makes a larger investment and will try harder to avoid foreclosure in there is a foreclosure sale, the lender is likelier to be able to recover the entire debt Basic Loan Features Secondary Financing Buyer may take out a second mortgage loan to pay for part of the down payment and closing costs. The source of secondary financing can be: an institutional lender the property seller a private investor Basic Loan Features Interest Rates The interest rate for a loan can be either fixed or adjustable. Fixed-rate: the interest rate remains the same throughout the loan term. Adjustable-rate: the interest rate is adjusted periodically throughout the loan term to reflect current market interest rates. Basic Loan Features Adjustable Rate Mortgages (ARM) With ARMs, the borrower rather than the lender bears the risk of market rate fluctuations. Because of this risk, ARMs have lower initial interest rates than fixed-rate loans. 215

216 Basic Loan Features Adjustable Rate Mortgages (ARM) Elements of an ARM include the: index margin adjustment periods caps possibility of negative amortization Basic Loan Features Adjustable Rate Mortgages (ARM) Index: A published statistical report that indicates changes in the cost of money. An ARM s interest rate is initially set according to market rates at the time the loan begins. The rate is then adjusted periodically according to the selected index. Basic Loan Features Adjustable Rate Mortgages (ARM) Margin: The difference between the index rate and the interest rate charged to the borrower. The lender adds a margin (i.e., 2 percentage points) to the index rate to cover the lender s expenses and profit. The margin stays the same throughout the loan term. Basic Loan Features Adjustable Rate Mortgages (ARM) ARMs have two adjustment periods. Rate adjustment period: This determines how often the interest rate of an ARM can change. Payment adjustment period: This determines how often the monthly payment may change. 216

217 Basic Loan Features Adjustable Rate Mortgages (ARM) Lenders use caps to avoid large payment increases that might force a borrower into default. Interest rate cap: Limits the amount the interest rate may go up over a year, or over the loan term. Payment cap: Limits the amount the lender can raise the monthly payment amount. Basic Loan Features Adjustable Rate Mortgages (ARM) Some ARMs (not many) permit negative amortization: causes a loan s principal balance to go up rather than down, as unpaid interest is added to the balance occurs if increases in the monthly payment amount don t keep up with increases in the loan s interest rate Residential Financing Programs The major types of residential financing include: conventional loans FHA-insured loans VA-guaranteed loans Rural Housing Service loans Residential Financing Programs Conventional Loans Conventional loan: Any institutional mortgage not backed by a government program. Lenders can make conventional loans according to their own rules, but most follow Fannie Mae and Freddie Mac standards so the loans can be sold on the secondary market. 217

218 Residential Financing Programs Conventional Loans Nonconforming loan: A loan that doesn t meet Fannie Mae or Freddie Mac standards. A lender can make a nonconforming loan, but will have to keep it in its own portfolio. Residential Financing Programs Conventional Loans Loan-to-value ratios - Conventional loans are divided into 80%, 90%, and 95% loans. If a loan falls between these percentages, round up to determine which kind it is. A loan with an 81% LTV, for instance, is a 90% loan. The standard LTV is 80% for conventional loans. Loans with 90% or 95% LTVs represent added risk for the lender, and will require the borrower to pay private mortgage insurance. Residential Financing Programs Conventional Loans Private mortgage insurance covers only a portion of the loan, typically 20% to 25% of the loan amount. If a borrower defaults on a loan with PMI, the lender can: sell the property, or relinquish the property to the insurer and file a claim for any losses suffered, up to the policy amount Residential Financing Programs Conventional Loans Owner occupancy - A conventional lender usually requires the borrower to live in the house rather than renting it to others. Exception: when the down payment is 25% or more. 218

219 Residential Financing Programs Conventional Loans Fannie Mae and Freddie Mac set underwriting standards for conventional loans. Their standards include both a maximum housing expense to income ratio and a maximum total debt service ratio. The applicant must meet standards under both these tests. Residential Financing Programs Conventional Loans Assumption - most conventional loans contain an alienation clause. This prevents the borrower from selling the loan and having the buyer assume the loan without lender s permission. Residential Financing Programs FHA-insured Loans The Federal Housing Administration (FHA) was created in 1934 to promote home sales and financing for low- and middle-income homebuyers. The FHA s main activity is insuring mortgage loans through the Mutual Mortgage Insurance Plan. Residential Financing Programs FHA-insured Loans The FHA does not accept loan applications directly from borrowers. Borrowers should apply to a lender that has been approved to make FHA-insured loans. 219

220 Residential Financing Programs FHA-insured Loans Key characteristics of FHA loans: Typically 30-year loans, although they may be shorter. Property must be owner-occupied, with 1-4 units. Lender will charge a 1% origination fee. Qualifying standards are less stringent than conventional loans. FHA loan may have a lower interest rate than a conventional loan. Residential Financing Programs FHA-insured Loans Key characteristics of FHA loans (con t): FHA loans require a low down payment, often less than 3% of the loan amount. Mortgage insurance is required for every FHA loan for the duration of the loan term. Maximum FHA loan amount varies from area to area. Loan limits in areas with expensive housing are higher than those in areas of inexpensive housing. Residential Financing Programs FHA-insured Loans FHA has a number of different programs to meet different needs. 203(b) standard program to insure purchase/refinance loans on residences with up to 4 units. Other programs a variation of the basic program. Residential Financing Programs FHA-insured Loans Qualifying standards - The maximum income ratios are higher for FHA borrowers than conventional borrowers. An FHA borrower s mortgage payments can be a higher percentage of his income than a conventional borrower. The FHA program doesn t have maximum income limits. A buyer at any income level could qualify for an FHA loan so long as the loan amount didn t exceed the maximum allowed for the area. 220

221 Residential Financing Programs FHA-insured Loans FHA loans require both: a one-time mortgage insurance premium (paid at closing), and annual mortgage insurance premiums (usually paid each month). Residential Financing Programs FHA-insured Loans Assumption - FHA loans that closed before 1990 may be freely assumed. Newer loans may be assumed only if the buyer: meets FHA underwriting standards intends to occupy the home as a primary residence Residential Financing Programs VA-guaranteed Loans VA loans: Loans guaranteed by the government, meaning that if the borrower defaults, the Department of Veterans Affairs will reimburse the lender for all or part of its loss. Residential Financing Programs VA-guaranteed Loans To be eligible for a VA loan, a borrower must have served a period of active duty in the U.S. armed forces. Spouses of deceased or missing veterans and long-term national guard or reserves members are also eligible. 221

222 Residential Financing Programs VA-guaranteed Loans An eligible veteran will be issued a Certificate of Eligibility by the VA. The veteran will apply to a lender, not the VA. The property must be appraised according to VA guidelines. The appraised value will be set forth on a Certificate of Reasonable Value. Residential Financing Programs VA-guaranteed Loans Key characteristics of VA loans: VA loans don t require a down payment or have a maximum loan amount. VA qualifying standards are even less strict than FHA standards. VA loans do not require mortgage insurance. Residential Financing Programs VA-guaranteed Loans A VA loan applicant must intend to occupy the property being purchased. VA loans are usually fixed-rate 30-year loans. VA borrowers may opt to pay discount points on a loan. Residential Financing Programs VA-guaranteed Loans Although there is no maximum VA loan amount, the VA sets a maximum guaranty amount. For a large loan, the lender may require a down payment if the purchase price exceeds the maximum guaranty amount. 222

223 Residential Financing Programs VA-guaranteed Loans Restoration of entitlement - if a veteran pays off a VA loan: his or her full guaranty entitlement is restored he or she can obtain another VA loan with the maximum guaranty If a VA loan is assumed, in order for the seller s entitlement to be restored, the buyer who assumes the loan must be an eligible veteran willing to substitute his entitlement. Residential Financing Programs VA-guaranteed Loans A VA loan underwriter will apply only one ratio, a total debt to income ratio. The underwriter must also consider minimum residual income requirements. The borrower must have a certain amount of income left after meeting all monthly debt obligations. Residential Financing Programs Rural Housing Service Loan Rural Housing Service (RHS) is a federal agency within U.S. Department of Agriculture that makes/guarantees loans to purchase, build, or rehabilitate homes in rural areas. Rural area = open country or town with rural character and population of 10,000 or less. Population of up to 20,000 under special circumstances may be considered rural. Residential Financing Programs Rural Housing Service Loan To qualify, borrower must: not currently have adequate housing, have reasonable credit history, and be able to afford mortgage payments. Home must also be modest in size and design. 223

224 Residential Financing Programs Rural Housing Service Loan 100% RHS financing available to low-income borrowers. Income must be less than 80% of area median income. Loan term may be as long as 38 years. Interest rate set by RHS. Residential Financing Programs Rural Housing Service Loan RHS also guarantees loans made by approved lenders. Borrower must have income less than 115% of area median income. May be 100% of purchase price. Loan term is 30 years. Predatory Lending The practices used by lenders and brokers to take advantage of unsophisticated borrowers are called predatory lending. More common in subprime market, refinancing, and home equity lending. Predatory Lending Predatory lenders and brokers target prospective buyers who can t understand the transaction or are uninformed. This includes the elderly, borrowers with limited income and education, or those who speak limited English. 224

225 Predatory Lending Home Ownership and Equity Protection Act (HOEPA) of 1994 provides limited protection against predatory lending. Loans covered by HOEPA require lender to make certain disclosures. Specific practices and loan provisions are prohibited. Predatory Lending HOEPA only applies to high-cost home equity loans. Many states have state predatory lending laws, and other states are in the process of adopting such laws. Predatory Lending Predatory Practices Predatory steering - steering buyer toward more expensive loan when buyer could qualify for less expensive one. Fee packing - charging interest rates, points, or fees that are excessive and not justified by cost of services provided. Loan flipping - encouraging home owner to refinance repeatedly in short period, with no real benefit. Predatory Lending Predatory Practices Equity stripping - stripping away home owner s equity by charging high fees on repeated refinancing. Property flipping - purchasing property at discount and rapidly reselling to unsophisticated buyer at inflated price. Disregarding buyer s ability to pay - making loan based on property s value, without considering borrower s ability to make payments. 225

226 Predatory Lending Predatory Practices Unaffordable payments - making loan without using proper qualifying standards, so that borrower can t afford payments. Loan in excess of value - loaning more than appraised value of the property. Balloon payment abuses - making partially amortized or interest-only loan without disclosing to borrower that large balloon payment will be required. Predatory Lending Predatory Practices Fraud - misrepresenting or concealing unfavorable loan terms or excessive fees, falsifying documents, or other fraudulent means to induce buyer to enter loan agreement. Excessive or unfair prepayment penalties - imposing unusually large penalty, failing to limit penalty period to first few years of term, and/or charging penalty even if loan is prepaid because property is being sold. 226

227 13. Real Estate Appraisal Real Estate Appraisal Appraisal Basics Appraisal: An estimate of a property s value, made by a professional appraiser and set forth in a written appraisal report. An opinion, not a scientific conclusion. Competent appraisers may disagree about the value of a property. Appraisal Basics Purpose Vs. Function Purpose of an appraisal: to estimate value, usually the property s market value. Function of an appraisal: the reason the appraisal is being done, or how the appraisal will be used. Appraisal Basics Functions of Appraisals Seller sometimes requests an appraisal before listing a property, to help set price. Buyer sometimes requests an appraisal to find out how much to offer. Most common function: To help buyer s lender determine whether the property offers adequate security for a loan. 227

228 Appraisal Basics Functions of Appraisals Other functions of real estate appraisals: land development (highest and best use) property tax assessments establishing rental rates property exchanges Appraisal Basics Functions of Appraisals Other functions (cont.): determining needed insurance coverage estimating remodeling costs/contribution to value condemnation proceedings probate of estates corporate mergers, acquisitions, and bankruptcies Appraisal Basics Appraiser/Client Relationship Many appraisers are employed by: banks or savings and loans, mortgage companies, private corporations involved in real estate government agencies such as the FHA or VA Fee appraiser: A self-employed appraiser, hired by a client to appraise a specific property for a fee. Appraisal Basics Appraiser/Client Relationship Appraiser must disclose if he has any financial interest in the property being appraised. Appraiser s fee must be tied to the difficulty of the appraisal and how long it will take. Fee can t be a percentage of the property s value. 228

229 Appraisal Basics Licensing and Certification Appraisers are licensed and certified under state law. Appraisals used for federally related loans must be prepared by state-licensed or statecertified appraisers. Exemption: loans of $250,000 or less Appraisal Basics Licensing and Certification Appraisals used in federally-related loan transactions also must conform to the Uniform Standards of Professional Appraisal Practice (USPAP). Failure to abide by the USPAP in order to defraud a federally insured lender is a felony. The Concept of Value Value: The present worth of the future benefits of property ownership. Value is almost always measured in terms of money. The Concept of Value Elements of Value To have value, an item must have four characteristics known as the elements of value: utility scarcity demand transferability 229

230 Types of Value Market value: How much a property is worth to the average person who might buy it. Also called objective value or value in exchange. Types of Value Market Value Definition of market value from Uniform Standards of Professional Appraisal Practice: The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Types of Value Market Value Market price: Price that someone paid for the property in an actual transaction. Commonly called the sales price. Market value: Price that someone should pay for the property under ideal conditions. Most probable price property should bring A matter of likelihood, not certainty. Market value Market price Types of Value Market Value Arm s length transaction: Sale of property made under ideal conditions. Competitive and open market Prudent and informed parties No undue stimulus (no unusual pressure to sell or buy immediately) If a sale occurs under less than ideal conditions, price paid may be more or less than market value. 230

231 Types of Value Value in use: How much a property is worth to a particular person. Also called subjective value or utility value. Investment value: The value of a property to a particular investor with specific investment criteria. Types of Value Liquidation value: Similar to market value, except that liquidation value assumes the property must be sold in a limited period of time (without reasonable exposure to the market). Assessed value: Set by state taxing authorities for purpose of assessing general real estate taxes. Types of Value Insurable value: Value of property for purposes of reimbursement under an insurance policy. Defined by insurance policy terms. Loan value: Value assigned to property for purpose of determining the loan amount. Types of Value Going concern value: Total value of a proven, ongoing business operation. Usually inapplicable to residential real estate. 231

232 Principles of Value Value is created and changed by these major forces: social ideals and standards economic trends government regulations physical and environmental factors Forces That Affect Value Social Social ideals and standards: demographics (population size, growth, density) family size and living arrangements attitudes about education Forces That Affect Value Economic Economic trends: local economic conditions national economic trends employment trends and wage levels cost and availability of financing Forces That Affect Value Governmental Government regulations: zoning ordinances building codes environmental regulations fire regulations taxation policies 232

233 Forces That Affect Value Physical Physical and environmental factors: climate topography soil characteristics flood control Principles of Value Principles of value: help appraisers determine how major forces affect a property s value apply no matter which appraisal method appraiser is using Principles of Value Highest and best use Change Anticipation Supply and demand Substitution Conformity Competition Balance Contribution Increasing/Decreasing Returns Principles of Value Highest and Best Use Highest and best use: The use of the property that would bring the owner the greatest net return. Important in appraisal of incomeproducing property. 233

234 Principles of Value Change Principle of change: A property s value will increase or decrease over time. Changes in value occur: in response to external forces, and as the property improves or deteriorates. Principles of Value Change Property s four-phase life cycle: integration equilibrium disintegration rejuvenation A property s value depends on where it is in its life cycle. Principles of Value Change A property has: a physical life cycle, and an economic life cycle. The economic life usually ends before the physical life. The improvements become obsolete before they actually fall apart. Principles of Value Anticipation Principle of anticipation: The anticipated future benefits of owning a property add to its value. If a property s value is expected to increase in the future, that anticipation increases its current value. If a property s value is expected to decrease, that anticipation decreases its current value. 234

235 Principles of Value Supply and Demand Principle of supply and demand: If demand for a product exceeds available supply, its value will increase. If the supply of a product exceeds demand, its value will decrease. Principles of Value Supply and Demand In real estate, if the demand for housing in a location increases, prices will rise. Developers will respond to the increased demand by building more houses. As supply increases, demand will be met and prices will fall. Principles of Value Substitution Principle of substitution: The value of a product is limited by the cost of obtaining an equally desirable substitute, if the substitute can be obtained without undue delay. Principles of Value Substitution If two equally desirable properties are available, the one that costs less will be purchased first. Example: A house is listed for $250,000, but comparable properties are available nearby for $210,000 to $220,000. An informed buyer would choose one of the lower-priced houses. 235

236 Principles of Value Substitution The principle of substitution is the theoretical basis for all three methods of appraisal (discussed later). Principles of Value Conformity Principle of conformity: In a residential neighborhood, some conformity among properties has a positive effect on values. If there s great disparity within a neighborhood (in terms of quality and condition of homes), that may decrease values. Principles of Value Progression/Regression The value of a property is affected by the value of surrounding properties. Principle of progression: An inexpensive home is more valuable surrounded by expensive homes than in a neighborhood of similar homes. Principle of regression: An expensive home is less valuable surrounded by smaller or rundown homes than in a neighborhood of similar homes. Principles of Value Competition Principle of competition: The value of property, especially income-producing property, is affected by competing properties. Example: The income from (and therefore the value of) a gas station will be reduced if a second gas station is built across the street. 236

237 Principles of Value Balance Principle of balance: The value of a property is maximized when the agents of production are in balance with each other. The four agents of production: labor coordination capital land Principles of Value Contribution Principle of contribution: An improvement may contribute more or less to the property s value than the improvement cost to make. Principles of Value Increasing & Decreasing Returns Principle of increasing and decreasing returns: If one agent of production remains fixed and money is invested in the other agent(s), the overall rate of return first increases and then decreases. The Appraisal Process 7 Steps 1. Define problem. 2. Determine data needed and where to find it. 3. Gather and verify general data. 4. Gather and verify specific data. 5. Select and apply appraisal methods. 6. Reconcile value indicators for final value estimate. 7. Issue appraisal report. 237

238 The Appraisal Process Step 1: Define the Problem To define the problem, appraiser must: identify the subject property determine the function of the appraisal The Appraisal Process Step 2: Determine Data Needed General data: Information pertinent to the subject property s value that does not concern the property itself. Specific data: Data concerning the subject property itself. The Appraisal Process Step 3: Gather & Verify General Data Includes information about: economic situation in the community condition of the neighborhood The Appraisal Process Step 4: Gather & Verify Specific Data To collect specific data, appraiser performs: site analysis building analysis 238

239 The Appraisal Process Step 5: Apply Appraisal Methods Appraiser must choose appropriate appraisal method(s), given the type of property being appraised. May choose only one method, use two methods, or use all three. The Appraisal Process Step 6: Reconciliation After an appraiser applies an appraisal method, the resulting estimate of what the property is worth is called a value indicator. Each method applied results in a different value indicator. Value indicators must be reconciled to arrive at a final value estimate. The Appraisal Process Step 7: Issue Appraisal Report The final step in the process is to prepare an appraisal report and present it to the client. Gathering General Data Appraiser first gathers general data: examination of economic conditions (especially local conditions) neighborhood analysis 239

240 Gathering General Data Economic forces include: Population growth shifts Employment and wage levels Price levels Building cycles Personal tax and property tax rates Building costs Interest rates Gathering General Data In neighborhood analysis, appraiser considers: Land use patterns Utilities and public services Proximity to schools, employment, shopping, and traffic arterials Area s general reputation Percentage of home ownership Gathering General Data Indicators of stable property values: high percentages of home ownership high occupancy rates many families with children presence of public services restrictive zoning and private restrictions Gathering Specific Data After gathering general data, appraiser gathers specific data (about the property itself): site analysis building analysis 240

241 Gathering Specific Data Objective of site analysis: to determine the property s highest and best use. Appraiser examines the site s physical characteristics, such as: lot size lot shape topography Gathering Specific Data Site Analysis Frontage: The length of the lot boundary that abuts a street, a body of water, or some other amenity. Important consideration for: retail property residential property beside a lake or other desirable feature Gathering Specific Data Site Analysis Plottage: An increase in value that occurs when two properties are combined into one. May occur in industrial or commercial development, where large lots are necessary. Single large lot often worth more than the sum of the values of the smaller lots that were joined together. Gathering Specific Data Building Analysis In examining the subject property s improvements, appraiser considers: construction quality current condition of structures size of structures (square footage) interior layout number and size of rooms orientation (placement of structures on site in relation to views and privacy) 241

242 Methods of Appraisal There are three methods of appraisal: sales comparison approach cost approach income approach Each is a method of determining the subject property s market value. Methods of Appraisal For certain types of property, only one or two of the methods is appropriate. If more than one method is applied, appraiser gives more weight to the most relevant method in the reconciliation process. Sales Comparison Approach Sales comparison approach: Appraisal method that uses recent transactions in the local market as the basis for estimating the subject property s value. Also called the market data approach. Best method for appraising: single-family homes vacant land Sales Comparison Approach Comparable Sales Appraiser using sales comparison method must locate at least 3 comparable properties. Comparable property: A property similar to the subject property that has recently sold. Also called a comp. Appraiser adjusts sales price of each comparable to reflect the differences between it and the subject property. 242

243 Sales Comparison Approach Choosing Comparables Appraiser decides whether a property would be a good comparable using the primary elements of comparison: date of sale location of the property physical characteristics of the property terms of sale whether sale was an arm s length transaction Sales Comparison Approach Elements of Comparison Date of sale: The date the buyer and seller agreed on a price. Important because property values are constantly changing. Appraiser should use most recent sales available. Preferably within the last six months. If market has been inactive, may use older sales and adjust for inflation and other trends. Sales Comparison Approach Elements of Comparison Appraiser should never use sales that are: more than a year old, or from a period with particularly volatile prices. Sales Comparison Approach Elements of Comparison Location is the factor that has the greatest effect on a property s value. Appraiser looks for comparables in same neighborhood as subject property. 243

244 Sales Comparison Approach Elements of Comparison Comparables should be similar to subject property in: architectural style construction quality overall condition Sales Comparison Approach Elements of Comparison A sale that involved seller financing or other special terms often isn t a good comparable. Buyer may have been willing to pay more because of special terms. Difficult to judge their effect on sales price. Appraiser generally looks for comparables sold on terms that are cash equivalent. Sales Comparison Approach Elements of Comparison Each comparable must be an arm s length transaction: Property was offered in a competitive and open market for a reasonable time. Buyer and seller both acted prudently and knowledgeably. No unusual pressure on either party. Sales Comparison Approach Making Adjustments To take into account physical differences between a comparable and the subject property, appraiser adjusts the sales price of the comparable. It s always the comparable s price, not the subject s, that is adjusted. 244

245 Sales Comparison Approach Making Adjustments If subject property has a feature the comparable lacks, appraiser adds value of feature to comparable s sales price. If subject property lacks a feature the comparable has, appraiser subtracts value of feature from comparable s sales price. Sales Comparison Approach Estimating Subject Property s Value Appraiser estimates subject property s value based on the adjusted prices of at least three comparables. Never simply averages the adjusted prices. More weight given to the comparables to which fewer adjustments were made. Sales Comparison Approach Using Listings If few comparable sales are available, listings may be used as comparables. However, remember that listing prices tend to represent the ceiling of the market value range. Cost Approach to Value Cost approach: An appraisal method that bases an estimate of the subject property s value on how much it would cost to build a replacement of the improvements. 245

246 Cost Approach to Value Sets Ceiling on Value Cost approach provides the ceiling for the subject property s value. Buyers won t pay more for a used property than for a new property of equal desirability. This is the principle of substitution. Cost Approach to Value 3 Steps Steps in the cost approach: 1. Estimate the cost of replacing the improvements. 2. Subtract any depreciation. 3. Add the value of the lot. Cost Approach to Value Step 1: Estimating Replacement Cost Replacement cost: How much it would cost to build improvements with the same utility, using modern materials and construction methods. Reproduction cost: How much it would cost to build an exact replica of the improvements, using identical materials and methods. Replacement cost is a much better indicator of a property s market value. Cost Approach to Value Step 1: Estimating Replacement Cost 1. Square-foot method Easiest and most widely used. Square footage Construction cost per square foot 2. Unit-in-place method Estimate cost of replacing building components (roof, floors, plumbing, etc.). 3. Quantity survey method Detailed, time-consuming estimate of materials and labor. 246

247 Cost Approach to Value Step 2: Subtract Depreciation Depreciation: A loss in value due to any cause. Three categories of depreciation: deferred maintenance functional obsolescence external obsolescence Cost Approach to Value Depreciation Deferred maintenance: A loss in value resulting from a need for repairs. Also called physical deterioration. May be caused by: damage construction defects wear and tear Easiest kind of depreciation to identify and measure. Cost Approach to Value Depreciation Functional obsolescence: A loss in value because of poor design or lack of utility. May be caused by: design defects outdated fixtures an inadequate floor plan If a problem is inside the property lines and it s not deferred maintenance, then it s functional obsolescence. Cost Approach to Value Depreciation External obsolescence: A loss in value caused by factors outside of the property lines, external to the property itself. Also called economic obsolescence. Examples: adverse zoning changes undesirable neighborhood traffic congestion proximity to a nuisance 247

248 Cost Approach to Value Depreciation Depreciation is curable if the cost of correcting the item can be recovered in the sales price. Depreciation is incurable if: Problem can t be corrected, or cost of correcting it would be too high. Cost Approach to Value Depreciation Deferred maintenance: Usually curable, unless particularly severe. Functional obsolescence: May be curable, depending on the cost of modifications. External obsolescence: Never curable, because it s out of the property owner s control. Cost Approach to Value Depreciation Methods of estimating depreciation fall into two categories: indirect and direct. Cost Approach to Value Depreciation Indirect methods of estimating depreciation: capitalization method market data method Indirect methods are considered more accurate than direct methods, since they re based on market data. 248

249 Cost Approach to Value Depreciation Direct methods of estimating depreciation: straight-line method engineering method Straight-line method is concerned with the property s effective age, rather than its actual chronological age. Effective age: Reflects how much longer the structure is likely to remain effective in its current use. Cost Approach to Value Step 3: Adding Land Value Last step in replacement cost approach is to add the value of the land to the depreciated value of the improvements. Land value is usually estimated using sales comparison approach. Income Approach to Value Income approach: Method used to appraise income-producing property such as an office building or apartment building. Also called the capitalization method. Appraiser uses the income generated by the property to estimate its value to an investor. Income Approach to Value 5 Steps 1. Calculate the property s potential gross income. 2. Deduct the bad debt and vacancy factor to estimate effective gross income. 3. Subtract operating expenses to determine net income. 4. Select an appropriate capitalization rate. 5. Capitalize the property s net income to estimate its value. 249

250 Income Approach to Value 1. Calculating Potential Gross Income Potential gross income: How much the property would rent for if it were available in the current rental market. Also called gross scheduled income. Also called economic rent, in contrast to contract rent. Contract rent: How much the property currently rents for under an existing lease. Income Approach to Value 2. Calculating Effective Gross Income Effective gross income: Potential gross income (economic rent) minus a bad debt and vacancy factor. Bad debt and vacancy factor: Percentage of potential gross income deducted to allow for unpaid rents and vacancies. Property won t be rented 100% of the time and tenants may not always pay the rent. Income Approach to Value 3. Calculating Net Income Net income: Effective gross income minus operating expenses. Three types of operating expenses: fixed expenses maintenance expenses reserves for replacement Income Approach to Value 3. Calculating Net Income Fixed expenses: real estate taxes hazard insurance Maintenance expenses: tenant services utilities supplies cleaning repairs administrative costs 250

251 Income Approach to Value 3. Calculating Net Income Reserves for replacement: Funds set aside for eventual replacement of structures and equipment that will wear out. Certain other expenses connected with real property ownership are NOT considered operating expenses: mortgage payments (debt service) income tax paid on the property s earnings Income Approach to Value 4. Selecting Capitalization Rate Capitalization: The process of converting future net income into an estimate of the property s present value. Expressed as a mathematical formula: Income Rate = Value Income Approach to Value 4. Selecting Capitalization Rate Rates reflect investor s risk If a property is a risky investment, an investor: requires a greater return on the investment chooses a higher capitalization rate A higher capitalization rate translates into a lower value for the property. Income Approach to Value 4. Selecting Capitalization Rate To select an appropriate capitalization rate, appraiser must account for both: return OF the investment (ability to recapture the original sum invested), and return ON the investment (the investor s profit). 251

252 Income Approach to Value 4. Selecting Capitalization Rate Appraisers use three methods for selecting an appropriate capitalization rate: direct comparison method band of investment method summation method Income Approach to Value 5. Capitalizing Net Income The final step is to capitalize the property s annual net income to arrive at an estimate of value. Three methods used to capitalize income: building residual technique (used to determine value of the building) land residual technique (used to determine value of the land) property residual technique (used to determine value of the property as one unit) Income Approach to Value Gross Multiplier Method Gross multiplier method: A simplified version of the income approach used to appraise a single-family home that is used as an incomeproducing rental. Income Approach to Value Gross Multiplier Method Appraiser locates comparables: rental homes similar to the subject property that sold recently. For each comparable, appraiser calculates a gross multiplier. Multiplier indicates relationship between comparable s sales price and rental rate. 252

253 Income Approach to Value Gross Multiplier Method To calculate gross multiplier, appraiser divides comparable s sales price by its rent. Appraiser may calculate: gross rent multiplier (uses monthly rental income), or gross income multiplier (uses annual rental income) Income Approach to Value Gross Multiplier Method Next, appraiser uses gross multipliers of comparables to choose multiplier for subject property. Finally, appraiser multiplies gross multiplier by the subject property s monthly rent or annual income to find its value. Income Approach to Value Gross Multiplier Method Example: The subject property rents for $900 per month. Across the street is a rental property that rents for $1,000 per month and sold recently for $234,000. What is the subject property s value? Comparable s gross rent multiplier: $234,000 $1,000 = 234 Subject property s value: 234 $900 = $210,600 Income Approach to Value Gross Multiplier Method Gross multiplier method provides only a rough estimate of value. It s based on gross income. Doesn t take into account operating expenses or vacancies. 253

254 Site Valuation An appraiser uses site valuation techniques to: appraise vacant land, or value land separately from its improvements (as in a property tax assessment). Site Valuation Methods Four methods of site valuation: sales comparison method land residual method distribution method development method Site Valuation Methods Sales comparison method is the most widely used. It uses recent sales of comparable sites to estimate the value of the subject site. Land residual technique (discussed earlier) is used for improved property. Site Valuation Methods Distribution method: analyzing recent property sales to determine what percentage of prices was due to land costs, and applying that percentage to subject property. Not as reliable as sales comparison approach. 254

255 Site Valuation Methods Development method is used to value vacant land when highest and best use is for subdivision and development. Appraiser estimates future value of developed lots and subtracts costs of development to get value of land. Reconciliation and Final Estimate of Value The final step of the appraisal process is reconciliation. By interpreting the value indicators resulting from each method of appraisal, appraiser arrives at final value estimate for subject property. Reconciliation and Final Estimate of Value Remember, appraiser does not simply average the three value indicators. Instead, she gives more weight to the most relevant method. Appraisal Report Appraiser presents his conclusions to the client in an appraisal report. Three formats for written appraisal reports: Narrative reports Form reports Letter reports 255

256 Appraisal Report Narrative report: A thorough, detailed presentation of appraiser s data and reasoning. Form report: A brief, standard form used by lending institutions (FHA and VA) presenting only key data and the appraiser s conclusions. Uniform Residential Appraisal Report form used for most residential appraisals. Appraisal Report Letter report: An appraisal communicated in the form of a single-page letter. Does not conform to USPAP requirements and is therefore no longer considered appropriate for most appraisals. Competitive Market Analysis Competitive market analysis (CMA): Estimate of value prepared by a real estate agent for purposes of helping seller set a listing price. Involves modified form of sales comparison appraisal method. Competitive Market Analysis Preparing a CMA Steps in preparing a CMA: 1. Collect and analyze information about seller s property. 2. Choose comparables. 3. Compare seller s property to comps and adjust comps values. 4. Estimate realistic listing price for seller s property. 256

257 Competitive Market Analysis Preparing a CMA Agent gathers information about the seller s property s neighborhood, site, and improvements. Unlike a formal appraisal, CMA may include current and expired listings as comps. Adjustments to comps prices are made on basis of differences in location, physical characteristics, date of sale, and terms of sale. Competitive Market Analysis Preparing a CMA Agent evaluates reliability of each adjusted comparable value those comparables most like subject property are most reliable. When presenting CMA results to seller, agent should use standardized form that lists information in logical sequence. 257

258 14. Closing Real Estate Transactions Closing Real Estate Transactions Closing Closing: The final stage in a real estate transaction. Also called settlement. Buyer pays seller. Seller transfer title to buyer. Closing and Escrow In some states, all of the parties involved in the transaction meet in person to close transaction. In other states, the closing process is usually handled through escrow. Closing and Escrow Face-to-face Closing Face-to-face closing: seller and buyer meet in person to sign papers, exchange deed, and transfer funds. Real estate agents, attorneys, and lender/title representatives may attend as well. Also called roundtable closing, passing papers, or settlement and transfer. 258

259 Closing and Escrow Face-to-face Closing Each party is responsible for bringing certain items/documents. Role of real estate agent depends on local customs. Closing and Escrow Escrow: An arrangement in which a neutral third party holds money and documents for the parties until the transaction is ready to close. Closing and Escrow Appointment of Escrow Agent Neutral third party is called escrow agent or closing agent. Chosen by agreement between buyer and seller. Acts as a dual agent. Closing and Escrow Escrow Instructions When escrow is opened, buyer and seller sign escrow instructions. The instructions: direct escrow agent to take necessary steps to close the transaction specify conditions that must be met before escrow agent releases funds or documents reflect the contingencies and other requirements in the purchase agreement 259

260 Closing and Escrow Escrow Instructions If there is any conflict between the escrow instructions and the purchase agreement, the later contract (the escrow instructions) prevails. Closing and Escrow Escrow Purpose and Benefits Escrow ensures that: seller receives purchase price buyer receives clear title lender s security interest is perfected Escrow has two main benefits: neither party is required to attend the closing in person protects each party against a change of heart by the other party Closing and Escrow Escrow Agent s Services Escrow agent may provide many services, such as: ordering title report and inspections preparing documents paying off seller s loan and other liens prorating and allocating expenses depositing and disbursing funds preparing Uniform Settlement Statements delivering and recording documents Closing and Escrow Termination of Escrow Escrow terminates in any of these circumstances: Transaction closes. Terms of escrow instructions not fulfilled by scheduled closing date or within a reasonable time, if no closing date was specified. Buyer and seller mutually agree to termination. 260

261 Closing and Escrow Termination of Escrow Escrow can t be terminated unilaterally (by only one party). Death or incapacity of one party does not terminate an escrow. Closing and Escrow Interpleader After termination, if a dispute arises over funds in escrow: Escrow agent files an interpleader action and deposits the funds with the court. Court decides which party is entitled to the funds. Escrow agent should not try to decide the dispute. Escrow Agents Most states require escrow agents to be licensed. Escrow agents may be: Independent escrow company Attorney Title company Escrow department of institutional lender Escrow Agents Real estate brokers may sometimes offer escrow services, but state regulations limit when they can charge fees. 261

262 Closing Costs Closing costs: Fees, charges, and expenses related to a real estate transaction that are typically paid at closing. A particular cost may be paid by the buyer or by the seller, or shared by both parties. Either party may have to pay: the other party, or a third party. Settlement Statements Settlement statement: Document that sets forth the financial details of a transaction. Also called a closing statement. Shows how much cash: buyer needs for closing seller will receive at closing Provides an accounting for buyer and seller. Settlement Statements Escrow agent prepares a settlement statement for each party when the sale is ready to close. For most home sales, escrow agent uses Uniform Settlement Statement form. We ll use a simplified format, to make the settlement statement easy to understand. Settlement Statements Four Column Format Simplified settlement statement has four columns: buyer s debits, buyer s credits, seller s debits, or seller s credits. 262

263 Settlement Statements Debits and Credits Debit: An amount to be paid by one of the parties. Credit: An amount to be paid to one of the parties. Settlement Statements Debits and Credits Closing costs paid by one party to the other are a debit for one and a credit for the other. These are listed in two columns. Example: purchase price is debit for buyer, credit for seller Debits and credits one party pays to or receives from a third party are listed in only one column. Example: loan fee is only a debit for buyer Settlement Statements Preparing Statement Escrow agent may need to contact third parties for information about specific debits or credits. Example: escrow agent contacts seller s lender to learn exact loan payoff amount Lender sends agent payoff statement Settlement Statements In four-column format, each party s total credits should equal his or her total debits. Settlement statement is like check register for bank account. After all deposits (credits) and withdrawals (debits) have been made, each party s balance should be zero. 263

264 Settlement Statements Allocation of Credits and Debits Allocation of expenses depends on purchase agreement terms, escrow instructions, and local custom. Purchase price Buyer s debit, seller s credit Good faith deposit Buyer s credit Sales commission Seller s debit Settlement Statements Allocation of Credits and Debits Buyer s new loan Buyer s credit Assumed loan Buyer s credit, seller s debit Seller financing Buyer s credit, seller s debit Settlement Statements Allocation of Credits and Debits Seller s loan payoff Seller s debit Prepayment penalty Seller s debit Seller s reserve Seller s credit account refund Settlement Statements Allocation of Credits and Debits Appraisal fee Buyer s debit Loan costs Buyer s debit Survey fee Buyer s debit Title insurance Depends on local premiums custom 264

265 Settlement Statements Allocation of Credits and Debits Personal property Buyer s debit, seller s credit Inspection fee Debit for party ordering inspection Transfer tax Seller s debit Settlement Statements Allocation of Credits and Debits Attorney s fees Debit for both parties Recording fee Debit for both parties Closing fee Debit for both parties Prorations An expense must be prorated if one of the parties is responsible for only part of it. Escrow agent calculates share that must be paid by or refunded to that party. Items that may need to be prorated: property taxes mortgage interest insurance premiums rent Prorations Example: If seller has paid property taxes in advance, she is entitled to a prorated refund of the taxes paid. If taxes are in arrears, seller required to pay a prorated share of the owed taxes at closing. 265

266 Prorations Three steps to prorating an expense: 1. Calculate the daily rate of the expense (the per diem rate). 2. Determine the number of days the party is responsible for the expense. 3. Multiply the number of days by the per diem rate to determine that party s share of the expense. Prorations Step 1: Per Diem Rate To find the per diem rate: Annual expense: divide by 365 days (366 days in a leap year) Monthly expense: divide by number of days in the month when closing occurs (28, 29, 30, or 31) Alternative to simplify calculations: 360-day year all months have 30 days Prorations Step 2: Number of Days Count the number of days between closing date and beginning or end of the month in which closing will occur. Prorations Step 3: Rate x Days The final step is to multiply the per diem rate by the number of days. This gives you the party s prorated share. 266

267 Prorations Prorating Property Taxes Property taxes are: seller s responsibility up to closing date buyer s responsibility from closing date forward Prorations Prorating Property Taxes Taxes paid in advance: buyer debited for days following the closing date that the advance payment covers seller credited for same amount Taxes in arrears (not yet paid): seller debited for days before the closing date that the tax payment will cover buyer credited for same amount Prorations Prorating Property Taxes Property tax payments may be divided into installments. Property tax year is not necessarily the same as the calendar year. Prorations Prorating Hazard Insurance Hazard insurance is paid for in advance. At closing, seller entitled to prorated refund of the premium. Refund is credit for seller. Buyer not debited for prorated share unless buyer is assuming policy. 267

268 Prorations Prorating Hazard Insurance The sale is closing on November 22. The annual hazard insurance premium ($310.25) was paid in advance, on March 1 of this year, for coverage through February 28 of next year. Using a 365-day year, how much will be refunded to the seller? $ = $0.85 per diem Count days: 9 (Nov.) + 31 (Dec.) + 31 (Jan.) + 28 (Feb.) = 99 days $0.85 per diem 99 days = $84.15 Prorations Mortgage Interest Two types of mortgage interest usually must be prorated at closing: final interest payment on seller s loan (debit for seller) prepaid interest for buyer s loan (debit for buyer) Prorations Prorating Interest Mortgage interest is paid in arrears. Example: Payment made on April 1 includes interest that accrued in March. As a result, seller s last mortgage payment did not include interest for the month in which closing will take place. Seller must pay this interest at closing. Prorations Prorating Interest Buyer s first mortgage payment isn t due on first day of the month after closing, but on first day of the month after that. Example: Closing date is August 15. First loan payment due October 1. First mortgage payment doesn t cover interest accruing from closing date until end of the month in which closing occurs. Buyer is required to pay that interest, which is called prepaid interest, at closing. 268

269 Prorating Rate When income property is sold, it may be necessary to prorate rent. Rent is prorated income, rather than a prorated expense. Rent is usually paid in advance. Seller must give buyer a prorated share of the collected rent at closing. Security deposits are not prorated. Cash at Closing Balance Due From Buyer To calculate the balance due from the buyer (the amount the buyer needs to bring to the closing): add up all of the buyer s credits add up all of the buyer s debits subtract buyer s credits from buyer s debits The balance due from the buyer is entered in the buyer s credit column. Cash at Closing Balance Due to Seller To determine the balance due to the seller (the amount the seller will take away from closing): add up all of the seller s credits add up all of the seller s debits subtract seller s debits from seller s credits Cash at Closing Balance Due to Seller The balance due to the seller is listed as a debit for the seller on the settlement statement. That way, the total in the seller s debit column equals the total in the seller s credit column. 269

270 Cash at Closing Don t forget that the buyer s column totals don t have to match the seller s column totals; in fact, they virtually never will. It s as if each party has his or her own checkbook, and each checkbook must be balanced separately. Income Tax Aspects of Closing Escrow agents must be sure these tax-related laws are complied with: 1099 reporting rule FIRPTA Income Tax Aspects of Closing 1099 Reporting Escrow agent has primary responsibility for reporting every sale of real property to the Internal Revenue Service. Escrow agent will report the sale using Form 1099-S, which includes: seller s name seller s social security number sale proceeds Income Tax Aspects of Closing FIRPTA Foreign Investment in Real Property Tax Act (FIRPTA): Escrow agent must determine whether seller is a U.S. citizen or a foreign person. If foreign, 10% of sale proceeds must be withheld and sent to the IRS within ten days after closing. Many residential sales are exempt. 270

271 Income Tax Aspects of Closing FIRPTA FIRPTA is intended to prevent foreign investors from evading U.S. tax liability for sale of property located in the U.S. Many residential sales are exempt from FIRPTA. RESPA The Real Estate Settlement Procedures Act affects how closing is handled in residential transactions. It s intended to: provide homebuyers with information about closing costs to help them shop around for settlement services eliminate kickbacks that increase costs for buyers and sellers Transactions Subject to RESPA Federally Related Loans RESPA applies to any federally related loan transaction that is not exempt. Loan is federally related if it meets two requirements. Transactions Subject to RESPA Federally Related Loans 1. The loan is secured by a mortgage or deed of trust against: property on which there is (or on which loan proceeds will be used to build) a dwelling with four units or less, condominium unit or co-op apartment, or mobile home, AND 271

272 Transactions Subject to RESPA Federally Related Loans 2. The lender: is federally regulated, has federally insured accounts, is assisted by the federal government, makes loans in connection with a federal program, sells loans to Fannie Mae, Ginnie Mae, or Freddie Mac, or makes real estate loans totaling more than $1,000,000 per year. Transactions Subject to RESPA Federally Related Loans Almost all institutional home loans are therefore covered by RESPA. RESPA doesn t apply to seller-financed transactions, however. RESPA Exemptions A loan is exempt from RESPA if it s used: to purchase 25 acres or more primarily for a business, commercial, or agricultural purpose to purchase vacant land (unless a 1- to 4-unit dwelling or a mobile home will be put on it) as temporary financing (e.g., a construction loan) Also exempt: assumption if lender s approval is neither required nor obtained. RESPA Requirements and Prohibitions 1. Within 3 business days of loan application, lender must give loan applicant: HUD booklet that explains RESPA, closing costs, and settlement statements good faith estimate of closing costs mortgage servicing disclosure statement 272

273 RESPA Requirements and Prohibitions 2. Closing agent must itemize the loan closing costs on a Uniform Settlement Statement. Statement must be given to buyer, seller, and lender on or before the closing date. Buyer (borrower) must be allowed to inspect the statement at least one business day before closing. RESPA Requirements and Prohibitions 3. Lender may not require excessive deposits into the reserve or impound account. RESPA Requirements and Prohibitions 4. Lenders or providers of settlement services can t: pay referral fees or kickbacks for referring customers to them accept unearned fees (for services not actually provided) charge a fee for preparation of: Uniform Settlement Statement escrow account statement Truth in Lending Act disclosure form RESPA Requirements and Prohibitions 5. Seller may not require buyer to use a particular title company. 273

274 15. Income Taxation and Real Estate Income Taxation And Real Estate Basic Taxation Concepts Progressive Tax Progressive tax: Someone with a higher income is taxed at a higher rate. He pays not only more money in taxes, but also a higher percentage of his income in taxes. Federal income tax is a progressive tax. Compare: Proportional tax: All income levels taxed at same rate. Regressive tax: Higher income levels taxed at lower rate than lower income levels. Basic Taxation Concepts Tax Brackets Tax rates increase in uneven steps called tax brackets. An additional dollar earned may be taxed at a higher rate than the dollars earned before it, but that won t increase the tax paid on dollars previously earned. Basic Taxation Concepts Income For taxation purposes, income includes more than just salary or wages. Income is any economic benefit realized by a taxpayer. 274

275 Basic Taxation Concepts Deductions vs. Tax Credits Deductions: Certain expenses may be subtracted from income before it is taxed. Example: mortgage interest deduction Tax credits: Credits are subtracted directly from the amount of tax owed. A tax credit represents a greater savings than a tax deduction of the same dollar amount. Basic Taxation Concepts Gains and Losses A gain results when someone sells an asset for more than she invested in it. Any gain is taxable income, unless the tax code makes a specific exception for that type of gain. Basic Taxation Concepts Gains and Losses If property is sold for a loss, the loss is usually not deductible. The only losses an individual may deduct are those connected with: the taxpayer s trade or business a transaction entered into for profit theft or casualty loss of the taxpayer s property. Basic Taxation Concepts Capital Gains and Losses Capital gain or loss: A gain or loss that results from the sale of a capital asset. Capital asset is property held for: personal use, or investment purposes Capital gains are taxed at a lower rate than ordinary income. Capital losses also receive special tax treatment. 275

276 Basic Taxation Concepts Capital Gains and Losses Even though a loss on a home or other property held for personal use is a capital loss, it isn t deductible. Capital losses on property held for investment purposes are deductible. Basic Taxation Concepts Capital Gains and Losses Deductible capital losses are subtracted from capital gains, resulting in a net gain or loss. Net loss may be deducted. But no more than $3,000 in net capital losses may be deducted in a single year. Net losses in excess of limit may be carried forward and deducted in future years. Basic Taxation Concepts Basis Basis: A property owner s investment in the property. Initial basis: Original cost of acquisition. How much the owner paid to acquire the property. Also called cost basis or unadjusted basis. Basic Taxation Concepts Basis IRS will use adjusted basis to calculate capital gain or loss when the property is sold. To calculate adjusted basis: start with initial basis add capital expenditures subtract allowable depreciation deductions 276

277 Basic Taxation Concepts Basis Capital expenditures: Expenditures that add to a property s value or extend its life. Examples: remodeling; new roof Maintenance expenses are not capital expenditures. Examples: painting; fixing leaky plumbing Basic Taxation Concepts Realization Income isn t taxed until it is realized. A gain is realized when the owner sells or exchanges the property. Amount realized is all benefits received by the seller, including: cash property the seller received in exchange debt the buyer is assuming from the seller Selling expenses are subtracted from sales price in calculating the amount realized. Example: broker s commission Basic Taxation Concepts Recognition Taxes must be paid on a gain in the year in which it is recognized. Usually, a gain is recognized in the same year it is realized. Nonrecognition provisions in tax code permit exceptions in certain transactions. Taxpayer may be allowed to defer recognition of the gain until a later year. Example: installment sale Classifications of Real Property Tax code has 6 classifications of real property: principal residence property personal use property unimproved investment property property held for the production of income property used in a trade or business dealer property 277

278 Classifications of Real Property Principal residence property: The home owned by a taxpayer that he or she lives in most of the time. A person can have only one principal residence at a time. Personal use property: Real estate owned for personal use other than a principal residence. Example: vacation home Classifications of Real Property Unimproved investment property: Vacant land that is held for appreciation and produces no income. Property held for production of income: Any type of property (residential, commercial, or industrial) from which the owner collects rent. Classifications of Real Property Property used in a trade or business: Any commercial or industrial property associated with a business owned by a taxpayer. Dealer property: Property a taxpayer is holding for later sale to customers. Example: subdivided land available for sale Nonrecognition Transactions Taxpayer is generally required to pay tax on gain in the year it is realized. But tax code allows recognition of gain to be deferred to a later year in: installment sales involuntary conversions sales of low-income housing tax-free exchanges 278

279 Nonrecognition Transactions Installment Sales Installment sale: A sale where the seller receives less than 100% of the price in the year the sale was made. Only the part of the gain that the seller receives in a particular tax year is taxed that year. Nonrecognition Transactions Installment Sales Amount of gain seller must report per year is based on the gross profit ratio. Gross profit ratio: Relationship between the seller s gross profit and the contract price. Nonrecognition Transactions Installment Sales To calculate gross profit: start with the contract price (sales price) subtract seller s basis at time of sale subtract selling expenses To calculate gross profit ratio: divide gross profit by contract price Nonrecognition Transactions Installment Sales Seller s adjusted basis: $248,500 Property sold on installment basis Contract price: $300,000 Broker s commission: $18,000 Other selling expenses: $3,500 What s the gross profit? The gross profit ratio? $300,000 - $248,500 - $18,000 - $3,500 = $30,000 gross profit $30,000 gross profit $300,000 contract price =.1, or 10% gross profit ratio 279

280 Nonrecognition Transactions Installment Sales Calculating the year s gain Principal payments received Gross profit ratio Gain to be taxed that year Important: Gross profit ratio is not applied to interest. Interest is always taxed in the year it s collected. Nonrecognition Transactions Installment Sales Gross profit ratio: 10% In year of sale, seller received: $27,500 downpayment $2,067 in principal payments $19,725 in interest payments Nonrecognition Transactions Installment Sales What s the taxable income from the sale for this year? $27,500 downpayment + $2,067 principal = $29,567 $29, = $2, recognized gain $2,957 gain + $19,725 interest = $22,682 taxable income for year of sale Installment sales are permitted for all classes of property except dealer property. Nonrecognition Transactions Involuntary Conversion Involuntary conversion: When property is converted into cash without an owner s voluntary action. May occur through: condemnation, destruction, theft, or other loss of property. 280

281 Nonrecognition Transactions Involuntary Conversion Involuntary conversion usually involves a gain for the owner. Government or insurer compensates owner based on property s current market value. Nonrecognition Transactions Involuntary Conversion IRS allows deferral of gain if taxpayer replaces the property within the allowed replacement period. Replacement period: 2 or 3 years, depending on property type Any gain not applied toward replacement property will be taxed as income. Nonrecognition Transactions Sale of Low-Income Housing Taxpayer who sells qualified low-income housing and reinvests proceeds in similar housing may defer recognition of the gain. Any gain not reinvested in similar property is subject to taxation in the year of the sale. Nonrecognition Transactions Tax-free Exchange Tax-free exchange: When real property is exchanged for other real property and owner is allowed to defer recognition of gain. Also known as a 1031 exchange. Exchange isn t truly tax-free: recognition of gain is only deferred, not avoided altogether. 281

282 Nonrecognition Transactions Tax-free Exchange Eligible for tax-free exchange: investment property income producing property property used in trade or business Not eligible: principal residence personal use property dealer property Nonrecognition Transactions Tax-free Exchange To qualify, properties exchanged must be like-kind properties. Real property must be exchanged for other real property located in the U.S. Like-kind property isn t necessarily the same type of real property. Example: apartment building can be exchanged for unimproved land Nonrecognition Transactions Tax-free Exchange Boot: Anything received in an exchange other than like-kind property. cash stock personal property debt relief (difference in mortgage balances) Boot is recognized in the year of the exchange. Nonrecognition Transactions Tax-free Exchange Example: Taxpayer who owns an apartment building trades it for an office building. Apartment building: $970,000 mortgage Office building: $880,000 mortgage How much boot is the taxpayer receiving? $970,000 - $880,000 = $90,000 boot (debt relief) 282

283 Nonrecognition Transactions Tax-free Exchange Boot (debt relief): $90,000 Taxpayer s adjusted basis in apartment building: $1,120,000 Value of office building: $1,270,000 How much gain is the taxpayer realizing? $1,270,000 property + $90,000 boot = $1,360,000 total received $1,360,000 - $1,120,000 adjusted basis = $240,000 realized gain Nonrecognition Transactions Tax-free Exchange How much of the realized gain ($240,000) will be taxed in the year of the exchange? Only the $90,000 boot will be recognized and taxed in the year of the exchange. Taxation of the remaining $150,000 gain will be deferred. Nonrecognition Transactions Tax-free Exchange If boot received exceeds realized gain, only the amount of the gain is taxed, not the full amount of the boot. As a general rule, taxpayer s basis in the property received is the same as her basis in the property that she traded. But if the exchange involved boot, then adjustments to the basis will be necessary. Nonrecognition Transactions Tax-free Exchange Exchange of real property may be tax-free for one party but not the other. Example: Taxpayer A trades principal residence for Taxpayer B s rental home. A and B will each use their new property as a rental. Exchange tax-deferred for B but not for A, because principal residence is not eligible. 283

284 Nonrecognition Transactions Tax-free Exchange A real estate agent who arranges a tax-free exchange may be paid a commission by both parties to the transaction. Special Provisions for Home Buyers and Sellers Federal government s policy is to promote home ownership. Tax code includes provisions to benefit homeowners: Exclusion of gain from the sale of a principal residence IRA withdrawals Sale of Principal Residence Gain on the sale of a principal residence: may be permanently excluded from taxation not just deferred (as in an exchange or an installment sale) Sale of Principal Residence Individual home seller may exclude up to $250,000. Married couple filing a joint return may exclude up to $500,000. Any amount in excess of $250,000 or $500,000 will be taxed as a capital gain in the year of the sale. 284

285 Sale of Principal Residence Qualifying for the Exclusion Within the last five years, property owner must have: owned the home for at least two years, and lived in the home as a principal residence for at least two years. A taxpayer may not use this exclusion more than once every two years. IRA Withdrawals Generally, early withdrawal from individual retirement account (IRA) is taxable income and subject to additional 10% tax penalty. But homebuyer can withdraw funds from IRA without penalty. IRA Withdrawals Traditional IRA Person buying, building, or rebuilding first home can withdraw up to $10,000 in IRA funds without penalty (married couple can withdraw up to $20,000). First-time buyer: cannot have owned principal residence during previous two years IRA Withdrawals Roth IRA Same exception as for traditional IRAs, but buyer must have held account for at least 5 years. 285

286 Deductions for Property Owners Deductions: Subtracted from income before taxes are calculated. Available deductions for property owners: cost recovery (depreciation) uninsured losses repairs property taxes mortgage interest points and other loan costs Deductions for Property Owners Cost Recovery Deductions Taxpayer can recover the cost of an asset used: for production of income, or in a trade or business Cost recovery deductions are also called depreciation deductions. Deductions for Property Owners Cost Recovery Deductions Cost recovery deductions are not available for: principal residences personal use property unimproved investment property dealer property Deductions for Property Owners Cost Recovery Deductions Assets are depreciable only if they will eventually wear out and need to be replaced. Includes structures as well as equipment for a farm or business. Does not include the land, which does not wear out. Deductions must be taken over a period of years (usually between 15 and 31½ years). 286

287 Deductions for Property Owners Cost Recovery Deductions Allowable depreciation or cost recovery deductions are subtracted from initial basis to arrive at the adjusted basis. Reduction in adjusted basis occurs whether or not taxpayer actually takes deduction. Deductions for Property Owners Uninsured Losses Property owner may deduct an uninsured loss from taxable income. Property damaged, destroyed, or stolen. Loss was not fully covered by insurance. Deductions for Property Owners Uninsured Losses In most situations, to determine the amount of the deductible loss, subtract the market value of the property after the loss from the market value of the property before the loss. Value before loss Value after loss Reduction in value Insurance (if any) Deductible loss Deductions for Property Owners Uninsured Losses Special rule for personal property (including a principal residence): subtract $100 from deductible loss then subtract 10% of taxpayer s adjusted gross income (AGI) 287

288 Deductions for Property Owners Repair Deductions Repair deductions: Property owner may deduct expenditures made to keep the property functional. Not available for principal residence or personal use property. Capital expenditures are not deductible. Capital expenditures add to property s value and may prolong its life. Deductions for Property Owners Property Tax Deductions General real estate taxes may be deducted from property owner s taxable income. Special assessments: deductible if for maintenance or repairs not deductible if for improvements Deductions for Property Owners Mortgage Interest Deductions Interest paid on a mortgage loan is deductible for all types of property, but there are limits on the deduction for personal residences. Taxpayer can deduct interest paid on: Loan of up to $1,000,000 used to buy, build, or improve principal residence or second home. Home equity loan of up to $100,000, no matter what the loan was used for. Interest paid on amount over the limit is not deductible. Deductions for Property Owners Points and Other Loan Costs Points paid in connection with a new loan: are considered prepaid interest can be deducted from taxable income Includes: discount points origination fee 288

289 Deductions for Property Owners Points and Other Loan Costs Points paid by the seller on the borrower s behalf are deductible. But borrower s basis must be reduced by the amount of the seller-paid points. Fees charged by a lender for specific services are not deductible. Examples: appraisal fee, mortgage insurance premiums Deductions for Property Owners Points and Other Loan Costs Prepayment penalty: considered to be punitive interest therefore may be deducted Deductions for Property Owners Vacation Homes If home is a personal residence (rented out < 15 days/year and used by owners > 14 days/year), rental income need not be declared as income. Rental expenses aren t deductible. Mortgage interest and taxes are deductible. Deductions for Property Owners Vacation Homes If home is a vacation home (rented at least 15 days/year and used by owner > than 14 days/year or 10% of rented days), owner must report rental income. Some rental expenses are deductible. Mortgage interest and taxes are deductible. 289

290 Deductions for Property Owners Vacation Homes If home is a rental property (rented at least 15 days/year and used by owner < than the greater of 14 days/year or 10% of rented days), rental income must be declared. Rental and operating expenses, mortgage interest, and taxes are all deductible. Owner may be able to claim loss if rental expenses exceed rental income. Deductions for Property Owners Vacation Homes If home is a timeshare, mortgage interest and taxes are usually deductible. But for rental income to be tax-free, owner must use timeshare > 14 days per year and the combined rental days for all owners must < 15 days. Deductions for Property Owners Home Office To claim home office deduction: 1. Office space must be used regularly and exclusively for business, and 2. Office space must be individual s principal place of business. Deductions for Property Owners Home Office If home office is used as place to meet clients, it will qualify for deduction even if most other work is done elsewhere. Home office may be located in separate building (such as studio or garage). 290

291 Deductions for Property Owners Home Office Home office deduction includes: percentage of real estate taxes and mortgage interest, business expenses (business insurance, additional utilities, repairs, etc.). Home office may be depreciated over 39 years. Deductions for Property Owners Rental Payments Rental payment deductions are available to tenants only if the rented property is used in a trade or business. Rent paid for residential property is never deductible. State Income Tax Most states and many cities levy additional income taxes. State and local income tax laws tend to mirror federal tax code. 291

292 16. Civil Rights and Fair Housing Civil Rights and Fair Housing Introduction Federal and state laws prohibit discrimination: based on race, religion, sex, or other characteristics apply to almost all real estate transactions Particular laws vary in terms of: what groups they protect, and what types of activities and transactions they apply to Federal Antidiscrimination Laws Civil Rights Act of 1866 Civil Rights Act of 1866: prohibits discrimination only on the basis of race or ancestry applies to any type of real estate transaction: residential or commercial improved or unimproved Federal Antidiscrimination Laws Civil Rights Act of 1866 The act was passed right after the Civil War. Not widely used until after 1968 Supreme Court decision Jones v. Mayer : Court held that the act prohibits all racial discrimination, private or public, in the sale and rental of property. 292

293 Federal Antidiscrimination Laws Civil Rights Act of 1866 Remedies available to a plaintiff who wins a lawsuit under the 1866 act include: injunction (an order to stop violation) actual damages (to compensate plaintiff) punitive damages (an additional amount as a penalty) Federal Antidiscrimination Laws Civil Rights Act of 1964 Civil Rights Act of 1964 prohibits discrimination: based on race, color, religion, or national origin in programs and activities that receive financial assistance from the federal government Exclusions for the FHA and VA loan programs limited the impact of this law on real estate. Federal Antidiscrimination Laws Civil Rights Act of 1968 Title VIII of the Civil Rights Act of 1968 is better known as the Fair Housing Act. Applies to sale or lease of: residential property vacant land to be used for residential construction Federal Fair Housing Act Scope of Law In residential transactions, Fair Housing Act also prohibits discrimination in: advertising lending brokerage other services 293

294 Federal Fair Housing Act Scope of Law Fair Housing Act prohibits discrimination based on: Race Color Religion Sex National Origin Disability Familial Status Federal Fair Housing Act Exemptions 1. For Sale by Owner - Doesn t apply to a single-family home rented or sold by a private individual if: she owns no more than 3 such homes no discriminatory advertising used no real estate broker employed If owner isn t the most recent occupant, she may use this exemption only once every 24 months. Federal Fair Housing Act Exemptions 2. Owner-occupied Rental - Doesn t apply to rental of a room or unit in a dwelling with up to four units if: owner resides in one of the units no discriminatory advertising used no real estate broker employed Federal Fair Housing Act Exemptions 3. Religious organizations may limit occupancy to members when dealing with their own property. 4. Lodgings belonging to private clubs may give preference to their own members, if the lodgings are not open to the general public. 294

295 Federal Fair Housing Act Exemptions Fair Housing Act always applies to any transaction involving a real estate agent. Exemptions aren t permitted when an agent is involved. An agent may never discriminate. Federal Fair Housing Act Discriminatory Actions Refusal to rent or sell residential property after receiving a good faith offer. Refusal to negotiate for the sale or rent of residential property. Any other action that would make residential property unavailable. Federal Fair Housing Act Discriminatory Actions Discriminating in terms or conditions of sale or rental of residential property. Discriminatory advertising that indicates a preference or limitation. Representing that property is not available for inspection, rent, or sale when it is in fact available. Federal Fair Housing Act Discriminatory Actions Fair Housing Act also prohibits: steering blockbusting redlining 295

296 Federal Fair Housing Act Discriminatory Actions Steering: Channeling prospective buyers or tenants to or away from particular neighborhoods based on their race, ethnicity, or another protected characteristic. Federal Fair Housing Act Discriminatory Actions Blockbusting: When someone tries to induce homeowners to sell by predicting that: members of minority groups will be moving into the neighborhood property values and quality of life will suffer as a result Federal Fair Housing Act Discriminatory Actions Redlining: When a lender refuses to make mortgage loans in a particular neighborhood because of its racial or ethnic composition. Federal Fair Housing Act Handicap 1988 amendments to Fair Housing Act added handicap and familial status as protected categories. Handicap refers to: physical and mental disabilities that substantially limit one or more major life activities 296

297 Federal Fair Housing Act Handicap Landlord must: make reasonable exceptions to rules for disabled tenants, and allow disabled tenants to make reasonable modifications at their own expense. Landlord isn t required to modify property for tenant. Tenant can be required to restore property to original condition when tenancy ends. Federal Fair Housing Act Handicap Fair Housing Act s wheelchair access rules apply to new construction of residential buildings with four or more units. New construction: built since Entryways, hallways, kitchens, and bathrooms must be designed to accommodate wheelchairs. If building has an elevator, units above ground floor must accommodate wheelchairs. Federal Fair Housing Act Familial Status Familial status refers to parents or guardians who have children under 18 living with them. It s generally illegal to refuse to rent or sell to someone because: she is pregnant he or she has children he or she is about to adopt or gain custody of children Federal Fair Housing Act Familial Status Housing for older persons is exempt from the prohibition against discrimination against families with children. Determining whether a property is intended for older persons involves consideration of: design, facilities, and advertising. 297

298 Federal Fair Housing Act Familial Status To qualify as housing for older persons, a property must fit one of three categories: 1. Developed under a government program to assist the elderly. 2. Intended for and solely occupied by people age 62 and older. 3. Intended for people age 55 and older: designed to meet their physical or social needs, and at least 80% of the units are occupied by at least one person 55 years or older. Federal Fair Housing Act Enforcement A person who feels she has been discriminated against in violation of the Federal Fair Housing Act may: file a complaint with the Office of Fair Housing and Equal Opportunity, or file a lawsuit in state or federal court. Federal Fair Housing Act Enforcement The Office of Fair Housing and Equal Opportunity is part of the Department of Housing and Urban Development (HUD). HUD sometimes uses testers: persons who pretend to be trying to obtain housing, to evaluate compliance with fair housing laws. Federal Fair Housing Act Enforcement A person who feels she has been discriminated against in violation of the Federal Fair Housing Act may: file a complaint with the Office of Fair Housing and Equal Opportunity, or file a lawsuit in state or federal court. Complaint must be filed within one year of the discrimination. Lawsuit must be filed within two years. 298

299 Federal Fair Housing Act Enforcement If complaint filed with HUD, agency investigates and tries to resolve issue between parties. If that doesn t work, administrative hearing is held. HUD attorneys represent complainant, and administrative law judge hears case. Federal Fair Housing Act Enforcement Possible penalties: an injunction against discriminatory activity, affirmative steps to correct a violation, compensatory and/or punitive damages, and/or a civil penalty paid to the federal government. Other Federal Laws Equal Credit Opportunity Act (ECOA) Home Mortgage Disclosure Act Americans with Disabilities Act Other Federal Laws Equal Credit Opportunity Act ECOA applies to all consumer credit: credit used for personal, family, or household purposes Prohibits lenders from discriminating against credit applicants on the basis of: race sex color marital status religion age national origin receipt of public assistance 299

300 Other Federal Laws Home Mortgage Disclosure Act HMDA is aimed at detecting redlining. Requires larger residential lenders to disclose: number and type of loans made loan amounts location of the properties Government will investigate lenders who have made no loans or few loans in certain neighborhoods. Other Federal Laws Americans with Disabilities Act ADA (1992) is intended to ensure disabled people equal access to all public accommodations. Disability: any physical or mental impairment that substantially limits one or more major life activities. Public accommodation: a private entity with facilities open to the public. Examples: real estate offices, banks, stores Other Federal Laws Americans with Disabilities Act If readily achievable in a public accommodation: architectural and communications barriers must be removed auxiliary aids and services must be provided New commercial construction must be accessible to the disabled, unless structurally impractical. State Antidiscrimination Laws Many states have antidiscrimination laws that may have more limited exemptions or cover additional protected classes (such as age or sexual orientation). Many laws cover employment, credit transactions, and other areas in addition to housing. 300

301 Complying with Fair Housing Laws Violating laws doesn t require intent to discriminate; even good intentions can lead to problems. Complying with Fair Housing Laws Working with Clients Real estate agents should never say or imply that the presence of persons of a protected class in a neighborhood will: lower property values, change the neighborhood s composition, create a more dangerous neighborhood, or cause a decline in the quality of schools. Complying with Fair Housing Laws Working with Clients Watch for signs of discriminatory attitudes to avoid helping others violate antidiscrimination laws. If sellers aren t willing to follow the law, decline the listing. Complying with Fair Housing Laws Advertising Properties Certain statements/practices may be construed as discriminatory: Advertising property only in neighborhoods where residents are of same background as seller. Sending property flyer to all neighboring properties except those owned by people of particular race or background. 301

302 Complying with Fair Housing Laws Advertising Properties Certain statements/practices may be construed as discriminatory: Wording an ad so that it suggests that recipient can control who buys property ( uphold standards of the community ). Choosing non-diverse models in display advertising. Complying with Fair Housing Laws Actions that don t Violate Laws Asking questions or making statements as necessary to accommodate needs of disabled person. Positive measures to reach out to members of protected class. Truthfully answering questions about racial composition of neighborhood. Discriminatory Restrictive Covenants Covenants prohibiting sale or lease of a property to non-whites or non-christians were once common U.S. Supreme Court decision Shelley v. Kraemer : Unconstitutional for state or federal courts to enforce racially restrictive covenants. Discriminatory Restrictive Covenants This type of covenant still appears in the chain of title of some older properties. Such a covenant does not invalidate the deed, although the covenant itself is unenforceable. 302

303 17. Property Management Property Management Property Management Property management: Where non-owner supervises operation of income property in exchange for fee. Most brokerages engage in some property management, so real estate agents should be familiar with its basics. Licensing Organizations State law generally requires a property manager to be licensed either as real estate agent or property manager. Property managers often obtain certifications from professional organizations: Certified Property Manager (CPM), Accredited Residential Manager (ARM), etc. Investing in Real Estate Real property is an investment for its owner. A property manager is employed to help a property owner with her investment goals. An investment is expected to generate a return (or profit) for its owner. The return may take the form of: interest, dividends, or appreciation in value. 303

304 Investing in Real Estate An investment may appreciate because of: inflation, or growing demand for that asset. Investments can be divided into two categories: ownership investments (such as real estate and stocks), and debt investments (such as government bonds). Investors often diversify. Mix of investments is portfolio. Characteristics of Investments Investments have three characteristics: liquidity (the ability to convert an asset to cash quickly), safety (the likelihood the investor will lose the asset), and yield (the total return on the investment). Characteristics of Investments Liquid assets are generally the safest, but do not offer high returns. Savings accounts and certificates of deposits are liquid and safe, but offer low yields. Real estate can generate higher returns, but at greater risk and not much liquidity. Advantages of Real Estate Advantages of investing in real estate include: appreciation, leverage, and cash flow. 304

305 Appreciation Appreciation: An increase in the value of property due to outside factors. Real estate values tend to increase at a rate equal to or faster than the rate of inflation. As a result, real estate is considered a good hedge against inflation. Appreciation Appreciation increases the owner s equity. Equity: The difference between the value of a property, and the liens against it. Leverage Leverage: Using borrowed money to invest in an asset. Appreciation allows an investor to earn a return on the borrowed money as well as her own invested funds. Cash Flow Investment property will generate positive cash flow, which is the money left after expenses are paid. Cash on cash: The cash received in a year divided by the amount of the initial investment. 305

306 Cash Flow Cash flow can be generated through a saleleaseback arrangement: a commercial property owner sells building to an investor for a large cash sum and then leases it back. This will often include a buy-back agreement. Disadvantages of Real Estate Real estate investment requires expert advice, time, and effort (as opposed to savings). Property requires management. Real estate is not liquid. Income may not be enough to cover operating expenses. Types of Managed Property Principal types of income-producing properties: residential properties, office buildings, retail property, and industrial property. Types of Managed Property Residential properties may include both single-family residences and apartment buildings. Both types are subject to high turnover. Residential property manager will be concerned with finding tenants for vacant units. 306

307 Types of Managed Property Office buildings require more maintenance than other types of buildings. Lease arrangements are different for offices. The leases: tend to be longer-term, and are measured by the square foot. Types of Managed Property In managing retail space, tenant selection is important. In a mall or shopping center, the right mix of stores is necessary to draw shoppers. Industrial properties are very specialized and expensive to operate. Industrial leases are usually long-term, with little turnover. Property Management Agreement The property management agreement guides the daily activities of a property manager. The agreement: establishes the terms of the manager s employment, creates an agency relationship between owner and manager, and sets forth the property manager s authority. Scope of Authority The agreement should define the scope of the manager s authority. The manager might or might not be able to: undertake major repairs, hire and fire employees, and execute leases on the owner s behalf. 307

308 Basic Provisions Management agreement must be in writing and signed by both parties. At a minimum, management agreement should include: the term of the agreement, the manager s compensation, the type of property, Basic Provisions the legal description of the property, the number of units or square footage, whether manager has authority to hold and disburse funds and security deposits, and provisions concerning manager s reports to owner. Basic Provisions Agreement might also include: description of other responsibilities, statement of owner s goals, extent of manager s authority, and allocation of costs. Basic Provisions The manager may be compensated through: a percentage of the property s gross income, a commission on new rentals, a fixed fee, or a combination of these. 308

309 Management Plan The management plan lays out the basic framework for the manager s activities. The plan: states the manager s strategies for achieving the property owner s goals, and addresses financial management and physical maintenance issues. Management Plan The owner s goals will dictate management strategies. An owner who is hoping to maximize monthly income may require a different strategy than an owner whose goal is to increase the property s value for resale. The owner s goals may also change with time. If so, the management plan will need to be updated. Preliminary Study To create a management plan, the manager will need to study the property and its context. This involves four levels of analysis: regional analysis, neighborhood analysis, property analysis, and market analysis. Regional Analysis The regional analysis concerns characteristics of the property s metropolitan area. This includes: occupancy rates, market rental rates, employment rates, and family size and lifestyles. 309

310 Regional Analysis Supply and demand guide the relationship between occupancy and rental rates. If demand for rentals is up, rental rates also go up. If the supply of rentals is up, rental rates will fall. Regional Analysis Technical oversupply: more units than potential tenants Economic oversupply: more units than tenants who can afford the current rent Technical or economic shortage: more tenants than units Neighborhood Analysis A property s neighborhood will affect property s value and use. Factors in a neighborhood analysis include: economic status of the residents, occupancy rate, whether the population is increasing or decreasing, and how well surrounding properties are maintained. Property Analysis Factors a manager will consider when analyzing the property include: number and size of living units, appearance of property and its rental spaces, physical condition of the building exterior, physical condition of the rental spaces, 310

311 Property Analysis facilities and amenities provided, services provided (such as janitorial or security services), relationship between the building and its site, current occupancy rate and tenant composition, and size and effectiveness of current staff. Market Analysis Property manager must also analyze property in terms of the properties it competes with. This will be the last step, since it relies on information from the other analyses. Market Analysis The manager will decide which market the property competes in, and then evaluate these aspects of that market: number of units available in the area, average age and character of buildings where the units are located, quality of the average unit in the market, number of potential tenants in the area, current rental rate for the average unit, and occupancy rate for the average unit. Management Proposal Manager will create a management proposal after completing preliminary analysis. The proposal includes: a proposed rental schedule, income and expense projections, a plan for day-to-day operations, and proposed physical changes to the building. 311

312 Management Proposal Rental schedule lists rental rate assigned to each unit or space in the managed property. Manager will set the highest rents that can be charged while maintaining high occupancy. Rental schedule will be periodically reevaluated, so it s in line with current market rates. Management Proposal Proposal will also include a budget. This should include: total income, operating expenses (both fixed and variable), and the monthly cash flow. Proposal will also include plans for day-to-day operations. Management Proposal The proposal is then submitted to the property owner. When approved, the proposal becomes the management plan. Management Functions The functions of a property manager can be divided into three categories: leasing and tenant relations, recordkeeping and manager-owner relations, and property maintenance. 312

313 Leasing and Tenant Relations Leasing and tenant relations include: marketing the property, negotiating leases, addressing tenant complaints, and collecting rents. Marketing The manager s strategy is to advertise to the greatest number of potential tenants at the lowest possible cost. Different marketing methods a manager might use include: signs, newspapers (classified and display ads), radio and TV, and direct mail. Leasing Techniques If the manager locates a suitable tenant, the next step is to enter into a lease. The lease is a contract between landlord and tenant, allowing occupancy in exchange for rent. Many leases contain restrictions on the tenant s use of the property. Otherwise, the tenant would be able to engage in any legal use of the property. Leasing Techniques Many leases contain automatic renewal clauses, which renew the lease at term s end unless one party gives the other notice of termination. Managers almost always prefer to renew leases rather than finding a new tenant. 313

314 Tenant Complaints Manager is responsible for responding promptly and professionally to requests and complaints. One one-site manager can usually handle units. Rent Collection The first step to reliable rent collection is to select financially sound, responsible tenants. How, when, and where rent is to be paid should be clearly stated in the lease, along with penalties for late payment. If rent collection efforts fail, the manager should be prepared to take legal action to evict the tenant. The legal procedure is known as an unlawful detainer action. Manager/Owner Relations A property manager must account for all money received and disbursed in connection with management of the property. Beyond that, what the manager reports to the owner is a matter of the owner s preference. Statement of Operations The manager s report to the owner is usually made through a monthly statement of operations. The statement contains: summary of operations, rent roll, statement of disbursements, and narrative report of operations. 314

315 Statement of Operations The summary of operations is a brief description of the property s income and expenses. The rent roll is a report on collections that: lists all occupied and vacant units, and shows current rent, total received, and balance due for each unit. Statement of Operations The statement of disbursements lists all expenses paid during the period. Disbursements are grouped by type (administrative, maintenance, etc.). Many statements contain a narrative report of operations, which is a letter explaining the information. This may be needed in unusual months, such as ones involving poor cash flow or unanticipated expenses. Property Maintenance Maintenance activities include: preventive maintenance (preserving the physical condition of improvements), corrective maintenance (repairs to keep the property in working order), housekeeping (routine cleaning), and new construction (remodeling and redecoration to improve the property). Property Maintenance When a manager starts out, he should: inventory the physical elements and equipment of the building, create a schedule for inspections and repairs, and keep records on when elements of the property were inspected, repaired, or replaced. 315

316 Property Maintenance Most maintenance activities are handled by specific employees or outside contractors, but manager must be able to recognize maintenance needs and oversee repairs and services. When managing commercial property, manager may need to alter building interior to meet needs of a new tenant. Risk Management Unexpected event can cause huge financial losses due to property damage, lost rents, or lawsuit damages. Property manager must evaluate precautionary measures: insurance, etc. Landlord-Tenant Relationship The landlord-tenant relationship is governed by: the terms of the contract forming the relationship (the lease), and landlord-tenant law (state law that establishes landlord and tenant rights and responsibilities). The Lease A lease is a contract that allows a tenant to possess a property for a period of time in exchange for rent. A lease must contain all essential elements of a contract. 316

317 Lease Provisions Landlord/tenant issues addressed by lease provisions include: possession, payment of rent, lease term, use of the premises, security deposits, entry and inspection, and maintenance. Possession Tenant is entitled to exclusive possession and quiet enjoyment of the leased property. In most states, landlord is required to take all necessary measures to remove a holdover tenant or adverse claimant. Payment of Rent Rent is the consideration that makes a lease a valid contract. Most leases require the rent to be paid at the beginning of the rental period. Unless specified, the rent is due at the end of the rental period. Lease Term Lease should contain statement of lease term (with beginning and ending dates). Lease with indefinite term may be invalid (and in some states a lease term of 100 years or more is invalid). If an option to renew is included, lease should specify how and when option may be exercised. 317

318 Use of Leased Property Use of rented property must comply with zoning and private restrictions. The use may also be limited by the lease terms. A lease of retail space might limit the tenant to operating a particular kind of store. Security Deposit Most leases require a security deposit as protection against the tenant: moving out without paying all rent that s due, or leaving the property in poor condition. Many states have restrictions on security deposits, such as: Limits on size of deposit. Deposits must be held in trust account. Security deposit may not be used for both property damage and non-payment of rent. Entry and Inspection Typically, lease allows landlord to enter leased unit to: inspect the unit, perform repairs or other agreed-upon services, or show it to prospective buyers or tenants. Landlord must provide tenant advance notice of entry. Maintenance In most states, residential leases contain landlord s implied guarantee that premises meet building and safety code requirements. If not, tenant must notify landlord, who must correct situation within certain amount of time. The tenant s duty is usually to leave the premises in the same condition as before, less any reasonable wear and tear. If damage caused by tenant exceeds value of security deposit, landlord may sue tenant. 318

319 Rent Control Rent control ordinances are laws that set maximum limits on the amount of rent that a landlord may charge. Goal is to make property available at reasonable rates. But many economists believe rent control laws to be ineffective. Types of Leases Among the most common types of leases are: fixed leases, graduated leases, index leases, net leases, percentage leases, and ground leases. Fixed Lease A fixed (or flat or gross) lease requires the tenant to pay the same amount of money each month. The landlord will pay for all operating expenses, such as maintenance, taxes, and insurance. This is used for most apartment rentals. Graduated Lease In a graduated lease, the tenant s rent is subject to an escalation clause. Periodic increases are made. 319

320 Index Lease Under an index lease, rent is tied to the Consumer Price index or some other measure of inflation. When index increases, so does rent. Used with long-term tenancies. Net Lease A net lease requires the tenant to pay: a fixed rent, plus some or all of the property s operating expenses (such as utilities and insurance). Triple-net lease (net-net-net lease) requires tenant to pay all operating expenses (such as property taxes, insurance, utilities, and maintenance) in addition to rent. Percentage Lease A percentage lease requires a tenant (usually a retail business) to pay: a minimum rent, plus a percentage of the gross or net income generated by the tenant s business. Ground Lease In ground leases, tenants lease vacant land and construct their own buildings on the land. These are typically long-term leases to commercial tenants. 320

321 18. Home Ownership and Construction Home Ownership and Construction The Decision to Rent or Buy Real estate agents need to understand the advantages and disadvantages of both buying and renting, in order to: discuss the issue with hesitant first-time buyers know how someone s reasons for buying may affect choice of home The Decision to Rent or Buy Advantages of renting: less financial commitment less risk easier mobility fewer responsibilities access to amenities The Decision to Rent or Buy Advantages of buying: security and stability privacy and freedom from restrictions lower monthly payments (eventually) investment appreciation tax advantages such as mortgage interest deductions 321

322 The Decision to Rent or Buy Comparison Worksheet Agent talking to potential buyer may want to use comparison worksheet to demonstrate the true net costs of buying versus renting. Worksheet shows the benefits of buying by accounting for: tax deductions, and increasing equity. The Decision to Rent or Buy Comparison Worksheet To calculate the true cost of buying: Start with the monthly payment (including taxes and insurance). Subtract average monthly principal amortization. Subtract tax savings from mortgage interest and property tax deductions. Subtract average monthly appreciation. The Decision to Rent or Buy Comparison Worksheet To calculate the true cost of renting: Start with the monthly rent on a comparable property. Subtract the monthly yield on an investment equivalent to the down payment. Choosing a Home Important considerations in choosing a home: Type of housing Neighborhood Home (site and improvements) Different types of housing include: Single-family dwellings Multi-family dwellings Other arrangements (PUDs, etc.) 322

323 Choosing a Home Single Family Dwelling A single-family home is usually one house on a single lot. Also: Modular homes Mobile (manufactured) homes Townhouses Choosing a Home Multi-Family Dwelling Multi-family dwellings include: Apartment complexes Duplexes, triplexes, etc. Condominiums Cooperatives Choosing a Home Other Housing Arrangements Certain subdivision arrangements are designed to appeal to specific segments of society, such as: Planned unit developments (PUDs) Mixed-use developments (MUDs) Converted-use properties Choosing a Home Neighborhood Considerations Buyers should evaluate a home in the context of its neighborhood. Neighborhood considerations include: percentage of home ownership conformity among properties presence of changing uses condition of streets and sidewalks availability of utilities and public services presence of schools availability of social services 323

324 Choosing a Home Evaluating the Home To evaluate the home itself, buyer should consider: site and view architectural style exterior appearance plumbing and electrical systems HVAC attic and/or basement garage or carport energy-efficient features interior floor plan design deficiencies Choosing a Home Evaluating the Home Agent should investigate prospective home for environmental hazards such as: asbestos insulation urea formaldehyde radon lead-based paint underground storage tanks water contamination illegal drug manufacturing mold geologic hazards Property Insurance Almost all residential lenders require borrowers to provide adequate insurance for property securing a loan. Property Insurance What is Covered Home owner (insured) pays insurance premium in exchange for promise by insurance company (insurer) to pay for specific types of loss (perils). Insurable interest = insured s financial interest in the property covered by policy. 324

325 Property Insurance What is Covered Replacement cost = cost of replacing old, damaged structure, with a new structure. Most policies cover replacement cost. Actual cash value = cover the amount of the new replacement, less accumulated depreciation on the structure. Owner makes up the difference. Property Insurance What is Covered Personal property covered to a limited degree. Additional structures (garages and tool sheds) generally covered. Cars, pets, jewelry not covered. Most homeowner s insurance also covers: bodily injury property damage to others Property Insurance Types of Insurance Most homeowners buy standard package policy called a homeowner s policy. Endorsement: additional coverage that may be purchased for perils not covered by standard policy. Property Insurance Types of Insurance Eight standard homeowner s policy forms: Basic form (HO-1) Broad form (HO-2) Special form (HO-3) Tenant s form (HO-4) Comprehensive form (HO-5) Condominium unit owner s form (HO-6) Mobile homes (HO-7) Older homes (HO-8) 325

326 Property Insurance Types of Insurance Basic form (HO-1) covers losses resulting from: fire or lightning, windstorm or hail, explosion, smoke, aircraft, vehicles, Property Insurance Types of Insurance Basic form (cont.) theft, riot or civil commotion, vandalism or malicious mischief, glass breakage, and removal of property from endangered premises. Property Insurance Types of Insurance Broad form (HO-2) cover all perils under basic form, plus seven additional perils: falling objects, weight of ice, snow, or sleet, collapse of building, freezing of plumbing, heating, and airconditioning systems and appliances, cracking, burning, bursting, or bulging of steam/hot water heating system, Property Insurance Types of Insurance Broad form (cont.) accidental discharge, leakage, or overflow of water or steam from plumbing, heating, or air conditioning system or domestic appliances, and sudden and accidental injury from artificially generated currents to electrical appliances, devices, fixtures, and wiring. 326

327 Property Insurance Flood Insurance National Flood Insurance Act of 1968 helps provide affordable flood insurance to owners in flood-prone areas. Most homeowner s insurance policies exclude damage caused by flood. Property Insurance Flood Insurance National Flood Insurance Program (NFIP) issues federally subsidized flood insurance. Property financed with federal or federally related loan must be covered by flood insurance if in flood zone. Additional requirements may be imposed if buildings are remodeled or expanded. Property Insurance Changes in Policy Homeowner s insurance policy may be suspended by certain acts of insured: insured building left unoccupied for more than 60 days substantial change to building adding increased risk of loss Policy effective when condition causing suspension is corrected. Property Insurance Changes in Policy Policy may be canceled at any time by insured or insurer. Insurer required to provide written notice of cancellation to insured before cancellation. Insurer may choose not to renew a policy rather than cancel it. Buyer may be able to assume insurance policy of seller. 327

328 Property Insurance Home Warranty Home warranties are often provided by builders. Cover structural and mechanical defects. Not the same as homeowner s insurance. May be possible to purchase home warranty for used home, although coverage is not as comprehensive. Construction Some states impose duty on agents to visually inspect homes they sell. Agents must be able to evaluate basic soundness of home s construction. Real estate agents should be familiar with: local codes and regulations role of the architect plans and specifications construction methods and terminology Construction Legal Codes and Regulations Building codes prescribe: types of materials used acceptable methods of construction placement of items (windows, outlets) size and placement of building on its lot Primary purpose is to keep communities safe by setting standards for upkeep and care of housing. Construction Legal Codes and Regulations Building and housing codes issued and enforced by municipal government. State government regulates licensing of residential contractors. 328

329 Construction Role of Architect Architect hired to design a home: creates a design to meet the owner s needs and preferences helps owner obtain government permits and bids from contractors visits work site to inspect the work and interpret the plans Architect who designed a house can be the best source of information about the house. Construction Plans and Specifications Plans: Drawings that show vertical and horizontal cross-sections of a building. Specifications: The text that accompanies plans, specifying construction materials and methods to be used. Construction Plans and Specifications Four types of plans used in the construction process: site plans foundation plans floor plans elevations Construction Elements of Construction Basic elements of house construction: foundation framing exterior sheathing siding interior sheathing roofing plumbing electrical system HVAC 329

330 Construction Elements of Construction Foundations are almost always made of reinforced concrete. Footing: The wide bottom base of the foundation wall. Sill plate: A board on which the wood frame rests that is bolted to the top of the foundation wall. Construction Elements of Construction The frame of a house is typically constructed of dimensional lumber. Framing elements include: Beams: Horizontal members that support the load of the house. Joists: Horizontal members that hold up the floor and ceiling. Subflooring: Plywood boards that form the floor. Construction Elements of Construction Sole plate: Horizontal board that rests on top of the floor joists. Studs: Vertical members attached to the sole plate. Top plate: Horizontal board on top of the studs. Rafters: Diagonal roof members. Ridge board: Highest member at the peak of the roof. Construction Elements of Construction Interior walls are either load-bearing or non-load-bearing. Load-bearing walls: support the upper structure are sturdier are not easily moved in remodeling 330

331 Construction Elements of Construction Exterior sheathing: Plywood panels applied to the outside of the frame. Siding is placed over the exterior sheathing. It may be: wooden boards aluminum or vinyl siding shingles Construction Elements of Construction Interior sheathing is applied to the interior of the frame, to form wall and ceiling surfaces. Today, drywall is the most commonly used material. Construction Elements of Construction To install a roof, roofers: attach plywood to the rafters cover the surface with roofing felt and shingles Flashing: Sheet metal installed around chimneys and other openings to prevent water leakage. Construction Elements of Construction Roof types: flat shed gable hip mansard gambrel 331

332 Construction Elements of Construction Plumbing consists of: fixtures supply pipes (galvanized steel, copper, or plastic) drain pipes (cast iron, concrete, or plastic) Soil pipe: A heavy clay drain pipe for sewage outflow. Construction Elements of Construction Electrical wiring consists of cable, an insulated cord containing strands of copper wire. Cable is run through conduit, metal or plastic piping that provides added protection. Construction Elements of Construction HVAC: The heating, ventilation, and air conditioning systems in a house or other building. Provides warm, cool, or fresh air to the various rooms. Insulation is important for keeping heating and air conditioning costs down. R-value: An effectiveness rating for insulation that measures resistance to heat transfer. House Construction Issues Termite Problems Wood frame construction is vulnerable to termite infestation. Termite inspection: good investment for buyer often required by buyer s lender or (in some termite-prone areas) the FHA or VA 332

333 House Construction Issues Termite Problems Termite problems can be minimized by: chemically treating the soil under and around the house inserting metal shields between the foundation and the wood frame House Construction Issues Termite Problems A pest inspection is usually ordered by the seller upon first listing a property. Inspection report should be: given to property owner and anyone else who requests a copy (such as a buyer) in some states, the report must be filed with the state and kept for a set number of years House Construction Issues Soil Problems Another important consideration is the quality of the soil on which the house is built. 333

334 19. Real Estate Math Real Estate Math Solving Math Problems Four steps 1. Read the question. 2. Write down the formula. 3. Substitute the numbers in the problem into the formula. 4. Calculate the answer. Solving Math Problems Using Formulas Each of these choices expresses the same formula, but in a way that lets you solve it for A, B, or C: A = B C B = A C C = A B Solving Math Problems Using Formulas Isolate the unknown. The unknown is the element that you re trying to determine. The unknown should always sit alone on one side of the equals sign. All the information that you already know should be on the other side. 334

335 Solving Math Problems Using Formulas Example: What is the length of a property that is 9,000 square feet and 100 feet wide? The formula for area is A = L W. L is the unknown, so switch the formula to L = A W. L = 9, = 9, Decimal Numbers Converting Fraction to Decimal Calculators use only decimals, not fractions. If a problem contains a fraction, convert it to a decimal: Divide the top number (the numerator) by the bottom number (the denominator). 1/4 = 1 4 = /3 = 1 3 = /8 = 5 8 = Decimal Numbers Converting Decimal to Percentage To convert a decimal to a percentage, move the decimal point two numbers to the right and add a percent sign = 2% 0.80 = 80% 1.23 = 123% Decimal Numbers Converting Percentage to Decimal To convert a percentage to a decimal, reverse the process: Move the decimal point two numbers to the left and remove the percent sign. 2% = % = % =

336 Area Problems Rectangles To determine the area of a rectangular or square space, use this formula: A = L W Width Area Length Area Problems You might also be asked to factor other elements into an area problem, such as: cost per square foot, rental rate, or the amount of the broker s commission. Area Problems Example: An office is 27 feet wide by 40 feet long. It rents for $2 per square foot per month. How much is the monthly rent? Part 1: Calculate area A = 27 feet 40 feet A = 1,080 square feet Part 2: Calculate rent Rent = 1,080 $2 Rent = $2,160 Area Problems Square Yards Some problems express area in square yards rather than square feet. Remember: 1 square yard = 9 square feet 1 yard is 3 feet 1 square yard measures 3 feet on each side 3 feet 3 feet = 9 square feet 336

337 Area Problems Triangles To determine the area of a right triangle, use this formula: A = ½ B H Right triangle - a triangle with a 90º angle Area Problems Triangles Visualize a rectangle, then cut it in half diagonally. What s left is a right triangle. If you re finding the area of a right triangle, it doesn t matter at what point in the formula you cut the rectangle in half. In other words, any of these variations will reach the same result: A = ½ B H A = B ½ H A = (B H) 2 Area Problems Triangles A triangular lot is 140 feet long and 50 feet wide at its base. What is the area? Do the calculation in any of the following ways to get the correct answer. Area Problems Triangles Variation 1: A = (½ 50) 140 A = A = 3,500 sq. feet Variation 2: A = 50 (½ 140) A = A = 3,500 sq. feet Variation 3: A = (50 140) 2 A = 7,000 2 A = 3,500 sq. feet 337

338 Area Problems Odd Shapes To find the area of an irregular shape: 1. Divide the figure up into squares, rectangles, and right triangles. 2. Find the area of each of the shapes that make up the figure. 3. Add the areas together. Area Problems Odd Shapes The lot s western side is 60 feet long. Its northern side is 100 feet long, but its southern side is 120 feet long. To find the area of this lot, break it into a rectangle and a triangle. A = 60 x 100 A = 6,000 sq. feet Area Problems Odd Shapes To find the length of the triangle s base, subtract length of northern boundary from length of southern boundary = 20 feet Area of triangle: A = (½ 20) 60 A = 600 sq. feet Total area: 6, = 6,600 sq. ft. Area Problems Odd Shapes A common mistake when working with odd shapes is to calculate the area of part of the figure twice. This can happen with a figure like this one. 338

339 Area Problems Odd Shapes Here s the wrong way to calculate the area of this lot = 1, = 800 1, = 2,050 By doing it this way, you measure the middle of the shape twice. Area Problems Odd Shapes Find height of smaller rectangle by subtracting height of top rectangle (25 feet) from height of the whole shape (40 feet) = 15 feet Now calculate the area of each rectangle and add them together: = 1,250 sq. ft = 300 sq. ft. 1, = 1,550 sq. ft. Area Problems Odd Shapes To find width of the rectangle on the right, subtract width of left rectangle from width of whole shape: = 30 feet Now calculate the area of each rectangle and add them together: = 800 sq. ft = 750 sq. ft = 1,550 sq. ft. Area Problems Odd Shapes Some area problems are expressed only in narrative form, without a visual. In that case, draw the shape yourself and then break the shape down into rectangles and triangles. 339

340 Area Problems Odd Shapes A lot s boundary begins at a certain point and runs due south for 319 feet, then east for 426 feet, then north for 47 feet, and then back to the point of beginning. To solve this problem, first draw the shape. Area Problems Odd Shapes Break it down into a rectangle and a triangle as shown. Subtract 47 from 319 to find the height of the triangular portion = 272 feet Calculate the area of the rectangle = 20,022 sq. ft. Area Problems Odd Shapes Calculate the area of the triangle. (½ 426) 272 = 57,936 sq.ft. Add together the area of the rectangle and the triangle to find the lot s total square footage. 20, ,936 = 77,958 sq. feet Volume Problems Area: A measurement of a two-dimensional space. Volume: A measurement of a threedimensional space. Width, length, and height Cubic feet instead of square feet To calculate volume, use this formula: V = L W H Volume = Length Width Height 340