The Anatomy of Smart Regs

-Written by Dan Estey

In early 2011 the City of Boulder passed a package of new ordinances related to rental housing dubbed “SmartRegs”. These ordinances updated the rental license program by adopting components of the International Property Maintenance Code (IPMC) and also put into place a requirement for energy efficiency performance in rental properties.

This policy was debated for close to 18 months with various working groups and public forums. The required energy retrofits were the most contentious of these discussions with many housing providers raising concerns about the potential costs of such a new requirement. As President of the Boulder Area Rental Housing Association (a landlord advocacy group representing over 8,500 units), a member of Boulder Area Board of Realtors, and an owner of a multifamily rental property myself,  I participated in this process from the beginning as an advocate for landlords and housing providers.

Regardless of how one feels about the philosophy, these requirements are now on the books and landlords will need to comply with them. There has been a great deal of misinformation and confusion on the energy retrofit requirements and how this will impact owners and the market.

While it is difficult to encapsulate all of the changes and background in one article, I have compiled a summary of the key components of the energy requirements.

Energy Retrofits Summary:

The impetus for required energy retrofits stems from the Climate Action plan approved by voters in 2006 with the  goal of reducing greenhouse emissions in accordance with the Kyoto Treaty Protocol (below 1990 emissions levels). While it is clear the city will not meet this goal, greenhouse gas emissions remain a focal point of concern of our local government. The rental housing sector was identified by the city as an area in need of an ordinance due to the fact it comprises over 50% of the housing stock and the concept of the split incentive as most tenants pay their utility bills landlords generally lack the incentive to make energy improvements and conversely tenants rarely stay in property long enough to cost justify making the improvements on their own.--

This set the stage for a lengthy debate on how to accomplish the energy efficiency goals of the city without creating an excessive burden on property owners. The end result was a requirement that all rental properties must be a minimum of 20% less efficient than the 2004 International Energy Conservation Code (IEEC) by January 02, 2019. In essence, this requires existing property to be brought up closer to current energy codes.. 

To be compliant with this requirement, owners must achieve a HERS (Home Energy Rating System) score of 120 or achieve a total of 100 points based on a prescriptive checklist devised by the city. Both compliance pathways are based on being 20% less efficient than the 2004 IEEC.

One of the key concessions the city made was allowing owners eight years to come into compliance with the ordinance. This is especially helpful to owners of larger buildings or portfolios as it enables to them plan their capital improvements and budgeting intelligently. However, the city still desires to have ample early adopters and has put together enticing rebates in tandem with Xcel and other government entities. There are some compelling reasons for owners to take advantage of these programs (while the funding lasts) and achieve early compliance. For example, a $1,000 insulation improvement may only cost an owner $450 out of pocket if they take advantage of the current rebates being offered.

There is also the debate of what impact this new requirement will have on the sales market and rental market. As this

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 is the first ordinance of its kind in the country to require retrofits on rental properties it remains to be seen. However, here are my thoughts:

-          Smart Regs compliance will be an item that is negotiated in a purchase transaction. There were several transactions that occurred before the ordinance was adopted where buyers made substantial requests on the inspection based more on fear than their actual understanding of the requirements. Energy efficiency and Smart Regs compliance are likely to be negotiated like an aging roof or mechanical system. A seller that is compliant will have one less hurdle in the negotiation.  At a minimum, I would recommend owners have an audit performed in the near future to see where they stand and then be able to create a compliance plan. Further an owner that becomes compliant now or in the near future may reduce the cost of compliance by up to 50% by taking advantage of the rebates and incentives currently available. An owner who waits to perform their audit and come into compliance will likely face higher costs when negotiating a sale.

-          In the public debate the issue of increasing rental rates was raised. Clearly this is a cost being absorbed by a landlord that will eventually be passed on at some point to tenants (this is after all a business).. Rental rates are of course based on supply and demand in a competitive market place, they are not based on what the owner’s mortgage is or how much they had to spend to upgrade their building. Housing providers who can effectively manage the ordinance requirements and communicate the benefits to their residents will emerge from this just fine. Those who choose to ignore it and don’t articulate the benefits to residents, will see downward pressure on their bottom line.

-          In simplistic terms the ordinance creates an unfunded mandate that will have varying degrees of expense per unit depending on how efficient or inefficient the building currently is. As part of the capitalization rate equation this would certainly appear to be a challenge to one’s net operating income, as it is an additional expense with no additional top line revenue to offset it. Again, effective planning and integration will minimize the blow to NOI and effective resident marketing may even offset most of the cost. I do not, however, buy the argument that these requirements will increase the value of one’s building, as some have suggested.  

Each property is different and therefore will feel- different impacts, but the key will be effective asset management and planning.

Please feel free to call or e-mail with any questions on this topic. I have a brief Smart Regs 101 presentation that I have shared with owners, property managers, and fellow realtors that has been well received. I am happy to share this with other folks and am available to provide a Smart Regs consultation to help owners navigate this new challenge in an effective manner.

Dan Estey has over a decade of Front Range estate experience, closing over 250 transactions totaling over $100 million in sales. In 2004, Dan was recognized nationally by Realtor Magazine as one of “30 under 30″ exceptional real estate brokers in the country and was consistently ranked in the top 2% of national Coldwell Banker agents prior to starting his own brokerage company – Estey Realty Group.

Don’t Discount Discounting

People centric real estate includes the use of equity marketing to assist both buyers and sellers in gaining the benefits they are seeking through the acquisition or disposition of all types of real estate. This article is one of a series that illustrates individual techniques that in the past have proven to be useful in accomplishing client’s goals.

P. Kardonis had been trying to sell his old bowling alley for a year and a half. As hard as it had been for Peter to accept it, the old building was simply not competitive as a bowling alley anymore.  Unfortunately, Peter didn’t have the capital to renovate it so that it would once again produce a solid income.

 

There was one prospective buyer, a fellow named Dickens, who for months had been interested in its acquisition.  He had a plan to convert the building so that it would be useable by charities as a bingo parlor and other such uses. He had even secured some substantial interest for its rental that was conditioned upon his gaining control of the property and renovating it.

The five main attractions to the building for Dickens were the property’s unusually large parking lot, its commercial zoning, its proximity to a large population base and its location near a freeway interchange.  Also, of course, the open expanse of the building was ideal for large benefits and assemblies.

The problem that kept the buyer and seller from being able to agree to a contract was that Dickens needed Kardonis to carry a loan for most of the equity because he was unable to obtain conventional financing based upon a business with no track record.  The prospect of having a sizable income from

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carrying a note against the property was enticing to the seller but as he wanted to retire across the country he thought it was just too risky to be that far away from his security.  Finally, after the listing expired with a residential brokerage firm, Kardonis contacted a commercial real estate broker/counselor, Mason, to see if he had any resolution to their stalemate.

After gathering information about Kardonis’ personal and financial situation and the benefits that he was seeking from a sale, Mason consulted with the seller regarding alternative ways that a transaction might be structured.  As a result of this conversation, the broker called a private lender, Blakemore, who had a reputation for being able to assemble investors for nontraditional investment opportunities.

Mason explained the situation to Blakemore and they agreed upon a plan which would allow both the seller and the buyer to reach their objectives.  When the smoke cleared and the deal was complete, this is what happened: Dickens and Kardonis agreed to a sales price of $1,000,000. Dickens arranged to make a down payment of $250,000 and Kardonis agreed to carry a first note secured by the building for $750,000 to be amortized over 25 years, with monthly payments of $5,788.62 including 8% interest, but with a maturity date of ten years at which time the balance of $605,725 would be due and payable. An alienation clause was inserted so that if Dickens sold the property, or otherwise removed himself from title, the loan would be immediately become due.  Also, the note contained a prepayment penalty of 5% for the first 3 years, 4% for the next two years and 3% for years 6 and 7 after which there was no prepayment penalty.

Blakemore agreed to purchase the note from Dickens, in escrow, for $595,000. This discount would produce a return to Blakemore and his investors of just over 11.75% if the loan were not paid off before its maturity.  Of course, the return would be higher upon the earlier retirement of the debt. For arranging the loan, Blakemore’s fee was five points ($37,500). The loan fees were $2,500.

Kardonis was very pleased with the transaction because he was able to get on with his life with over three quarters of a million dollars, before taxes, in his bank account.  Also, he knew in his heart that he would have quickly accepted a cash offer of $800,000, so a net sales price before real estate commissions of $855,000 ($250,000 down payment, plus $595,000 from the discounted loan, less $37,500 in loan points and $7,500 in loan, title and miscellaneous fees) made him ecstatic.

Dickens was also excited. First, he was able to acquire a building that allowed him to start a

business that promised to be very profitable with a loan at a reasonable interest rate that would not mature for ten years.  In the current lending climate this was next to impossible at any price. In addition, he was able to do so by only making a 25% down payment. As an extra benefit, since making the final arrangements with Kardonis, Dickens had secured firm contracts and others were discussing options for the rental of the building.

Of course, Blakemore was also pleased. He was able to secure a good market rate for his investors with strong increases if an early payoff materialized. In addition, he believed that the sizeable commercial lot was easily worth $1,000,000 as a redevelopment site and so he felt very secure with his investors’ position if worst came to worst and they had to foreclose. InSight Brokerage, Inc. combines their expertise in equity marketing with traditional sales and marketing techniques to provide a complete palette of choices for our clients. People centric transactions such as these often provide investors with real world solutions to problems they encounter.

Outperforming the Market

Which locations will outperform the market over the next three years? Five years?  Ten?

Is it possible to determine which locations, and more specifically which properties, will provide their owners with the increased potential for high returns and protection from a declining market place?

IBI thinks the answer is yes.  Decidedly yes.

How?  The answer lies in the going back to basics, back to principle.  All real estate investment is based upon people; where they want to be, where their jobs are, where they recreate, where they feel comfortable, where they enjoy, where they prosper, where they can afford, where they save time, where they feel safe, where they feel included.

Research demographics.  Study trends.  Contemplate people’s habits.  That’s where you will find the answers to where to invest in real estate.

Tax Shifting

It’s no secret that it is always a good idea to work with a CPA before getting involved in matters involving taxes, just as working with an attorney on legal matters is prudent.  The following idea is one which definitely must be approved by a CPA and/or tax attorney. 

Over his lifetime, Wesley T. assembled substantial equities in several real estate assets and set up his will so that his properties would be transferred to his son upon his death.  In the meantime, he would like to take advantage of the provisions of the tax law by gifting him $20,000 each year in cash. 

One of the properties Wesley owns is positioned for considerable appreciation in value because of its proximity to a recently announced, large federal project scheduled to be built in the next few years.  Wesley has decided to sell this property to his son and carry back a purchase money note at the lowest possible rate allowable without incurring imputed interest.  The major benefit to Wesley will be to transfer this property to his son now and in so doing to further benefit him by being able to forgive $20,000 of interest payments a year which will have the same result as giving him the maximum allowable, annual, cash gift. 

In addition however, if the property does appreciate as rapidly as Wells anticipates that it will, the value of the appreciation will not add to Wesley’s estate, but will accrue solely to his sons benefit.  The only addition to Wesley’s estate will be the annual forgiveness of the interest.  Additionally, Wesley will not have to deplete his cash position by making his son a cash gift annually.  Because the property will not be in Wesley’s estate when he dies, the increased appreciation that may occur will not further diminish the estate’s value by being taxable.

InSight Real Estate Investments, Inc. combines their expertise in equity marketing with traditional sales and marketing techniques in order to provide a complete palette of choices for our clients.  People centric transactions such as these frequently provide investors with real world solutions to the real world problems they encounter.

The Perfect Circle

Chris T. owned a 4,000 sq. ft. metal building and four cinderblock buildings ranging from 1,600 to 2,000 sq. ft. They were all located on a two acre parcel of land just outside the city limits of a suburban town of 100,000 people or so.  All the buildings had been vacant for more than two years.  Chris had been trying to sell the property ever since his last tenants left, but the run down condition and the lack of any income just didn’t attract anyone’s interest.  He had listed the property with three different brokers, but no one seemed enthusiastic about it and none of the brokers were able to stir up any interest.

Finally, Chris’s CPA suggested that he speak with Wes, a counselor/broker who had been successful with the real estate interests of some of the CPA’s other clients.  Not long after Chris listed his property, Wes presented him with an offer from a church.  Chris had told Wes that he would carry a loan on the property but he was a bit disconcerted when Wes’ offer was asking him to carry a loan for 100% of the equity.  On the other hand, the offered price was extremely good.  However, as he told Wes, “…the last thing I want to do is to have to foreclose on a church if they don’t pay!”  Chris was clear that he did not want to take the property back under any circumstances but he would bend over backward to help them just so long as he had no risk of later problems … like foreclosure.

Wes thoroughly understood and suggested that the solution might be for Chris to accept the offer from the church subject to the closing being delayed until he could find a suitable replacement property whose owner would be willing to take the note on the farm as full or partial payment.  Chris took Wes’s advice and on the first day of March, agreed to sell the property to the church subject to his purchase of a property as yet unknown.  The properties were to be transferred simultaneously.

About thirty days later, Wes found a nice little strip center on the other side of town whose owner was agreeable to the deal.  The way it worked out was that there were three parties involved in the closing: Chris, the church and the owner of the strip center.  Chris paid $600,000 for the strip center.  The purchase price was composed of a down payment of $50,000 cash, a bank loan for $150,000 and the balance was a $400,000 note and deed of trust on Chris’ land and buildings.  Obviously, Chris accomplished his goal of selling his land and acquiring another investment property.

The church agreed to take Chris’ land encumbered by a $400,000 note and deed of trust.  They accomplished their goal of having a piece of land upon which they could hold their services today, put their pledges into building equity rather than paying rent and eventually building a sanctuary.  

The owner of the strip center got his building sold, $50,000 in cash, $150,000 from the proceeds of the bank loan and a $400,000 note and deed of trust that had monthly payments.  His goal was to get out from under the daily work load at the strip center, get a solid down payment and have a monthly income from his new investment with very little involvement.

InSight Real Estate Investments, Inc. combines their expertise in equity marketing with traditional sales and marketing techniques in order to provide a complete palette of choices for our clients.  People centric transactions such as these frequently provide investors with real world solutions to the real world problems they encounter.

Corporately Speaking

Mason B., the CEO of a technology Company, TecknoTreks, wanted to purchase the industrial lot next door to his company’s assembly facility to provide for the future expansion possibilities of his plant.  However, he was stymied by the fact that he was fearful of depleting either TecknoTreks’ capital or their credit line. 

At a meeting of the local economic development council, Mason was introduced to Will, a real estate broker/counselor, so he posed his problem to him in case he might have a solution as to how he might purchase the lot without using any of his personal money or his company’s capital.  The following afternoon Mason and Will met at TecknoTreks.  The result of this conversation was an offer to the lot owner of a corporate note secured by corporate stock.

Even though the lot had been on the market for nearly two years, the owner, Paul K., felt that a note secured only by corporate stock was just not enough security.  The negotiations were faltering until Will suggested that perhaps Mason would consider also securing the note with the lot itself.  With this blanket security, an increase in the interest rate, a decrease of the term and the insertion of an acceleration clause a counterproposal was constructed.

Mason was delighted to get this opportunity to be able to secure the lot without any immediate capital expenditure.  Paul was pleased to get out from underneath the tax burden of holding a nonproductive asset.  A few months later, Will helped Paul use this note for the purchase of a cash flowing multifamily building … but that is another story.

SCENARIO 4
Mason	Paul
Gave	Gave
Corporate Note	Industrial Lot
Got	Got
Industrial Lot	Corporate Note

InSight Real Estate Investments, Inc. combines their expertise in equity marketing with traditional sales and marketing techniques in order to provide a complete palette of choices for our clients.  People centric transactions such as these often provide investors with real world solutions to the real world problems they encounter.

The Market: A Double Edged Sword

We know it’s true, t’was ever thus:

            For every up there is a down,
            For every good a bad.
            It’s been that way each day by day
            Since Adam was a lad.

I agree, the poetry is questionable but its truth is undeniable and, sure, the current real estate market is in a down cycle.  No question.  No argument.  However, the market blade cuts both ways and just because an investor would be prudent to be cautious in this market, that does not mean he would be wise to sit on the sidelines until the bulls return.

The definition of a perfect market is one in which for every buyer there is a seller.  After decades in this business, I’ve never personally witnessed a perfect market, however I admit the possibility that one may have passed by while I was on vacation for three days twenty years ago.  The fact is that the market is always tilted one way or another; sometimes in favor of buyers and sometimes in favor of sellers.

Now the market favors buyers, only fools or Harvard professors would argue otherwise.  So what might that indicate to an investor in today’s market?  Time to buy?  I think so.