I recently helped a client with an evaluation of her property, a well-located two-unit building with approximately 3,000 square feet of living space. She purchased in the Richmond area because of the district’s large units and appealing location – between the Clement Street shopping district andGolden GatePark. She bought the building in the late 90s, and after marrying and starting a family, concluded that the family needed more space. She defied the odds and kept the family in the city, but moved to a single-family home closer to the school that her children would eventually attend. She was able to afford the move by renting out the two units and expanding the building to increase its livable rental space with an unwarranted in-law unit.
Today, each of the flats generates roughly $2,700 per month, and the “illegal” in-law unit rents for $1,750. In all, the building currently generates about $7,150 per month, or close to $86,000 per year, in rent.
At first glance, this sounds like a good story of risk versus return. It has indeed been good for cash flow, but much less so for purposes of refinancing the building or selling it as an investment. The problem is that the building underwrites for only two-thirds of its actual income. Banks will not lend on the unwarranted unit’s rental income. So while the building’s monthly income is $7,150, banks will only consider $5,400 of that amount in underwriting the building for a loan. Furthermore, for purposes of refinancing or sale, the building is worth only $1.3 million in today’s market.
Living in Fear of Discovery, Loss of Income
For many years, the owner lived in fear that the illegal unit would be discovered, and that she would have to remove it and lose the much-needed income it provided. So she did what many owners with illegal units in the under five-unit market in San Francisco do: even when she had the opportunity to do so, she did not increase the rents to market level for the two big legal units or the unwarranted unit, not even by the meager yearly allowable amount. The irony is, had she not built the unwarranted unit and instead increased the rents on just the two legal units to market – rents for comparable units in the area are about $4,500 per month – she would now have about the same income from them that she has today from all three units.
With this in mind, you’d think that the owner would jump at Supervisor Chiu’s recently introduced legislation that would allow her to legalize the in-law, “come out of the shadows,” and ensure that lenders recognize the property’s full income should she wish to sell or refinance. Unfortunately, there’s a big catch.
Owner Faces a Dilemma
As two units, as it’s now zoned, the building is exempt from the condo lottery. If two owners occupy it for 12 consecutive months, they can proceed directly to condo
conversion. In many parts of the city, condos are approaching $1,000 per square foot, and a condo still generates a premium over TIC ownership. The owner thus finds herself in a dilemma: If the legislation passes, and she legalizes the in-law unit, the building will be considered three units, never again exempt from the condo lottery. And with the current 10-year moratorium on the lottery, legalization would make condo conversion effectively impossible.
So while legalization would yield a legal unit and more rental income, the building itself would have less value to buyers seeking to convert the two units to fractional ownership, and ultimately, to condos.
Relocation Costs and Property Value
There’s another key issue that the owner must consider in planning for the future: the value of her building with its current under-market rents. As a two-unit, 3,000-square-foot vacant building, it would sell for close to $2 million if the vacancies came about with no Ellis Act or OMI evictions. Compare that with its value as an occupied two-unit building with an illegal unit and low rents – $1.3 million – and the benefits of legalizing the unwarranted unit no longer look very appealing.
Prior to the new law that dramatically increases relocation fees for Ellis Act evictions, the cost to get her building vacant would have been under $100,000. But now that relocation fees have been increased to an amount equal to two years’ rent differential, the cost to
vacate her building could be closer to $200,000. The net result is that the evicted tenants will have lived for many years paying rent heavily subsidized by the owner (worth tens of thousands of dollars), and emerged with a bonus of many more tens of thousands of dollars in relocation fees to boot.
Owner Decides Against Legalizing
Fortunately, the owner is not planning to sell or refinance in the near future. Instead, she will leave the unwarranted unit as is, continue to collect rent on it, and leave vacant any units that become vacant in the future. If she’s lucky and can afford the resulting loss of rental income, she may be able to get to a 100% vacant building when she plans to sell in about five years.
The Law of Unintended Consequences
One wonders if our supervisors are aware that their efforts to severely restrict condo conversions and allow legalization of in-law units to protect their large rent-controlled voter constituency are having unintended consequences.
Most of the city’s owners of two-unit buildings with an illegal unit – and there are a great many – will conclude that the most logical and profitable thing to do in this market and political climate is to avoid legalizing their unwarranted in-law, allow the units to vacate
by attrition, then sell to a developer or two owners who will do the condo conversion for two future buyers.
Over time, the net result will not be additional rent controlled units, but rather an acceleration of their conversion to condos. In other words, the supervisors are speeding the removal of more “progressive” voters from the city’s renter base (their base) and the demographic conversion of registered voters to more conservative condo-owning, taxpaying voters. Ironically, they’re adding more homeowners to the city’s voter
base and diminishing their political power. Given this fact, all I can say to these supervisors is, “Thank you very much, supervisors. In order to gain the votes of rent-controlled voters in the November election by selling more tenant protections today, without regard to the long term effects of your actions, you are ensuring that there will be fewer voters beholden to your agenda tomorrow.”
Terrence Jones is a Senior Broker Associate with TRI Commercial. He can be contacted at (415) 786-2216 or firstname.lastname@example.org. Reprinted with permission of the Small Property Owners of San Francisco Institute (SPOSFI) News. For more information on becoming a member of SPOSFI or to send a tax-deductible donation, please visit their website at www.smallprop.org or call (415) 647-2419.