Investing in multi-family property is a great way to build wealth. Multi-families are also great first investments for new investors looking to make a smaller purchase to get their feet wet before buying something bigger. However, when buying a multi-family property there are a number of legal issues that every real estate investor should be aware of that do not arise when purchasing a condominium or single-family home. I have outlined three important issues to consider when purchasing a multi-family property.
ZONING: IS THE PROPERTY A LEGAL MULTI-FAMILY PROPERTY?
One of the first things I advise clients buying multi-families is that they need to understand whether the property is a legal multi-family. This comes in two forms: it must be either a permitted use under the current zoning regulations or a “legally non-conforming” property. If it is neither, then the purchaser may be in for serious problems down the road. That is why every investor should understand the zoning issues that can arise when purchasing multi-family property and how to navigate through them.
If the multi-family property is a permitted use under the zoning regulations, then you can rest comfortably that the use of the property does not violate the zoning regulations. However, what if the multi-family is in a zone where multi-family property is not a permitted use? Is it an illegal use and therefore a buyer should shy away from the purchase? Not necessarily.
The multi-family property may be a legally non-conforming use. In the world of land use law, a property may not be a permitted use under the current zoning regulations but multi-family may have been a permitted use in the past. A property is considered legally non-conforming if the use complied with the zoning prior to the date that the town changed the zone to remove such use from the zone. For example, if a multi-family was a permitted use in the R2 Zone in 1999 and the town thereafter removed multi-family from the R2 zone, as long as the property was in use as a multi-family prior to the change of zoning it can continue as a multi-family property after the change of zoning as a “legally nonconforming” property.
However, it is possible that an owner illegally converted a property to a multi-family property in a zone that does not permit it. This would mean the property is an illegal multi-family that you do not want to purchase. This is why it is important to explore the zoning and the history of the property to make sure you do not purchase an illegal property. As long as the property is in a zone that permits multi-family or the property is legally – nonconforming, you can safely purchase the property.
I have experience helping clients purchase multi-family homes and can help you with your zoning due diligence to make sure you do not purchase an illegal property.
PROTECT YOURSELF: CREATE A LIMITED LIABILITY COMPANY (LLC) TO LIMIT YOUR LIABILTIY
Buying a multi-family, or any property with tenants, is a transaction that comes with risks and potential exposure to liability that are not inherent in purchasing a residence for you and your family. For example, what if a tenant slips and falls and files a lawsuit against you arguing that her injuries are a result of you failing to comply with your obligations under the lease? What if a tenant accidentally starts a fire that spreads and causes damage to other homes in the surrounding neighborhood? These are examples of the inherent risks in buying multi-family properties. This is why it is imperative to do everything you can to minimize your liability if something goes wrong. One important thing you can do to limit your liability is to create a Limited Liability Company (LLC) and take title in the name of the LLC.
Taking title in the LLC instead of individually will insulate you from personal liability and limit your exposure to the assets of the company – the real estate (there are several narrow exceptions not discussed in this post). In other words, any Plaintiff that obtains a judgment will only be able to look to the company’s assets to satisfy the judgment, which is the real estate. If the property was owned by you individually, a plaintiff could look to the real estate and other personal assets (such as personal bank accounts, other real estate, etc.) to satisfy the judgment. This is why setting up the LLC minimizes liability.
It is of course prudent to also carry an insurance policy on the property. However, an insurance company could deny the claim or its policy limit may be inadequate to cover the claim. Therefore, you should not rely on insurance and setting up the LLC will provide you another layer of protection.
Setting up the LLC may seem like a simple process but there are various things to consider. For example, if you are creating the LLC with more than one member, you should think about creating an operating agreement. This document will essentially detail how the members will manage the company and how they will make decisions. A carefully drafted operating agreement will include provisions that explain the authority of each member; whether the company will be managed by a designated manager or by its members; the process that decisions will be made; the process to be used in taking on new members; how the company will decide a tie vote of its members; along with other important provisions relevant to the operation of the company. Drafting a detailed operating agreement will prevent problems between members in the future.
I have experience setting up limited liability companies for investors and drafting operating agreements for the companies. I can help you set up your real estate holding company and create a detailed operating agreement so you and your partners are protected and avoid problems down the road.
TENANTS AND LEASES: DO YOUR DUE DILIGENCE
When buying any property with tenants, it is essential to do your due diligence with respect to the tenants and the leases. As an investor, you want to make sure that the tenants are current on the rent. You do not want to purchase the property only to learn that the tenants are six months behind on the rent and are vigorously fighting an eviction lawsuit. Therefore, it is prudent to request that the seller and tenant(s) sign a document called an estoppel certificate. This document will require the seller and tenant(s) to make a representation that the leases are in full force and effect and that the tenant is not in default. This will provide you some assurance that the tenants are not behind on the rent.
It is also prudent to thoroughly review each lease. You should be aware of the termination date of each lease and whether the tenant has the option to renew. If the leases are set to terminate a month after closing, you should be prepared for the possibility of vacancies. Moreover, if the tenants have an option to renew, this may interfere with plans to lease to other tenants. Similarly, some leases have options to purchase or “lease to own” arrangements. This type of provision is problematic for any investor as the tenant would have the option to purchase the property after you closed. You would likely not want to move forward with the investment if there was such a provision in any of the leases.
In summary, multi-family properties are great investments to build long-term wealth. However, such investments come with certain risks. Careful planning and proper due diligence will mitigate risk and help prevent future problems.