This is an example of effective pre-underwriting from a mortgage brokerage company who did a thorough job assisting a borrower in contemplation of purchasing an income producing property.
A borrower approached a mortgage broker about making an offer to purchase the property. The borrower had received a mail solicitation offering for what appeared to be an outstanding opportunity to purchase and develop a wonderful ongoing cash flow. The borrower needed advice from his knowledgeable and experienced commercial lender before making an offer to purchase mortgages.
The prospective lender has the task of figuring out what were and were not valid representations made by the property seller, and the seller’s commercial real estate sales broker. A public records search by the mortgage broker quickly revealed certain factual misrepresentations by the seller and the seller’s listing broker.
The mortgage broker/lender called the city enforcement officer to discuss the inconsistencies. The sellers and the seller’s broker appeared to have made multiple misrepresentations or outright lies.
In a public records search and in discussions with the city about zoning, building permitting and business licensing, several issues relating to the property’s advertised usage were discovered to in incorrect.
The first inquiry was made to check the city’s public website for possible notices of violation letters addressed to the owner. The mortgage broker/lender noticed that the owner had made an application to install an exterior linen closet and gotten a permit to build it out. The city had approved the renovation plans and had made adequate inspections during the construction period. After the last inspection, the linen closet somehow became the operation office for the business enterprise, referred to as a “boutique hotel”.
Did the owner provide incorrect information to the listing broker? Did the listing broker make any inquiry himself, or just take the information without question? Did the listing broker create an advertising solicitation to be distributed to the public which was knowingly false?
Here is a list of issues that the mortgage broker/lender discovered while researching about the property’s many inconsistencies.
- Representing the property as an ocean front property was false as clearly the satellite view showed there were buildings between the property and the beach.
- The postcard and offering boasted “Ample Parking” when in fact the site was under parked for the current zoning and under the conditional Administrative Use Permit (AUP). One of the advertisements showed 12 parking spaces. The parking was not delineated but included garages that were used as storage and supplies for the operation of the business. Conditional use permits do not run with the land. They are temporary permits to run a certain business and can be cancelled by the city for multiple reasons.
- There may have been an overstatement of the building square footage by almost 1300 square feet from that which the city acknowledged. This is significant given the price per square foot sales price that the owner was asking. Public records suggested the square footage was 4,395 rather than the advertised 5,700 square feet.
- The fact the property was converted from 4 units apartment building into 8 units was never mentioned, nor was that there were only 4 electric meters.
- The advertising stated that there were 8 one-bedroom units, but one of the units was a studio apartment. There was no dividing wall for the bedroom.
- The property was nonconforming to the existing zoning. If more than 50% were to be destroyed the owner could not rebuild the 8 units. This fact was not disclosed.
- The city requires a prospective new owner to get a public report, which they compiled.
- The property was represented as “Licensed Weekly Rentals”, but there was no such “licensing” available. The owner obtained a conditional Administrative Use Permit (AUP) from the City to run as weekly rentals. The AUP was in jeopardy of being revoked unless certain conditions were corrected.
- There was no mention as to whether contaminants were present, such as asbestos or lead based paint because the buildings were originally built-in 1960.
- An AUP was conditional upon several factors including the maintenance of 8 parking spaces, when there were only five spaces, six if you count the garage which had been illegally converted to the hotel office and storage that was also in violation of the conditional permit. Not sure how this was considered “Ample Parking”?
The postcard solicitation stated that this was a “Boutique Hotel Opportunity,” but omitted was the requirement to apply for and obtain business license in to run a retail business (note that a retail service business was allowed in the residential zoning). In reviewing the violation notice and the city records it was clear that no such business license was issued nor was one available to a prospective buyer. At the time, the website for the property was portraying the investment as a featured “JustLuxe partner in the JustLuxe Collection of Best Luxury Hotels”. The property was also advertised as a “Bed and Breakfast” lodging establishment, implying that they served breakfast.
Because of the continued advertising of “Romantic Getaway Packages” on the website that include in-room champagne, flowers & chocolates for an extra charge’ along with an offer for in room private dining, a county health permit and liquor license was to be required but none existed. The county issued a cease and desist letter to the owner to discontinue all commercial events, except residential lodging.
At the time that the prospective borrower received the advertising solicitation, cash flow generation included income from the property being used in conjunction with a separate business enterprise referred to as a “wellness program” being operated by the owners of the property. It was known and advertised as “The Experience”. Guests stayed there for a “healthy living seminar”, participated in physical fitness sessions such as on deck yoga classes, enjoyed meals and snacks on site. The business website referred to providing champagne, food services and concierge services. None of this intermingled business operation income information from the separate ongoing business concerns, that directly or indirectly contributed to the property cash flow was included in the advertised property offering memorandum.
Upon questioning the listing broker about the suspected illegal usage, the business website that advertised the wellness program was removed. Presumably the owner was placed on notice by the city to end all hosted retail events, and commercial activities. However, rental listing agent kept the old advertising through the internet.
Regarding the property’s rental income stream, the seller’s advertising solicitations failed to include a few important facts:
- The income stream floating between the ongoing “hotel” business concern, the operating wellness business, and residential tenancy of month to month or week to week were not segregated. The rental listing for rental rates by the owner’s rental agent offered the month-to-month tenancies as regular apartments for as low as $2,250 per month, which is dramatically less as compared to the week-to-week rental as stated in the offering memorandum. The value of any income producing property is based upon verifiable cash flow of a legally operated usage and not a projection based upon an illegal use.
- The cashflow in the listing broker’s offering was a projection supplied by the property owner, of a future rather than actual and historical rents. Also, rents are reduced during the winter months. The actual winter income (far below the projections) coupled the fact that an onsite manager and concierge” occupied one unit to manage the weekly rental business was not disclosed. There was no rental income for that unit.
- Rent comparisons are a result of hospitality related amenities from a hotel business with concierge/massages/food & beverage services, etc. Rather than an apartment building.
- There was no historical support for income, vacancy, and expenses to calculate the net operating income that is reflected in a capitalization approach.
- Asking price based on capitalized income from an illegal and unlicensed ongoing concern business/health spa and related personal property rather than the permitted month-to-month or week to-week tenancy is a false representation.
- There was no mention of a possible separate value conclusion of the ongoing concern business enterprise or goodwill assets and their effect on the property value.
- Reliance on the income stream from the illegal sale of alcohol with without a permit from Alcohol & Beverage Control is false.
- Income from illegal food services without a permit from the county health department is false.
- Income from unlicensed business-related activities characterized as hospitality amenities is false.
The listing broker was notified in a letter from the mortgage broker about the misrepresentations relating to this property. The real estate broker was apparently embarrassed and cancelled his listing.
The mortgage broker/ lender who had to dig into the real story about the potential loan request, helped the prospective purchaser of the property not to make a costly and bad decision.
Business and Private Money Finance Consultant
Bus. 949 521 7115
Cell 949 533 8315
This article is intended for educational purposes only and is not a solicitation.