Due Diligence: Local Government Regulations, Policies and Procedures

Recently, I witnessed the adverse impact of a commonly overlooked and hidden cost in real estate investing — complying with local government regulations.¬† These costs can be as expensive as they are surprising to the inexperienced investor, and can make the difference between a profitable venture and a disaster.¬† In my article, “The Five “P”s of Prudent Investing,” I discussed some of the issues investors should consider that relate to local government regulations.¬† In these times of ever-tightening public budgets, where local governments need every dime from every fee, the need to pay attention has never been greater.

There are over 480 cities in the State of California, each with its own Municipal Code, Zoning Regulations, planning staff, elected officials, and policies and procedures that govern everything from historic preservation to rent control to how many parking spaces are required to open a new restaurant.¬† In addition, there are 58 separate Counties, each with their own land use regulations that may or may not be compatible with the different municipal regulations within the same county.¬† Within each County, there may be several special Districts that govern everything from transportation to sewer to water treatment facilities, and of course, multiple School Districts, each with their own governing Boards, boundaries, and policies.¬† You need only compare housing values as they relate to certain school districts versus others to see the dramatic impact that the quality of public schools has on housing prices.¬† This is not unique to California.¬†¬† With some variations, this same pattern is repeated in each of the Nation’s 50 states.

The typical real estate investor considers purchase price and rental rates, and in some cases potential appreciation, in calculating a return on investment.¬† Whether you are purchasing for a “buy and hold” or a “fix and flip” strategy, the formula is fairly similar.¬† However, very few investors seriously consider the impact that local government regulation may have on their plans.¬† The impact is usually felt most dramatically with commercial property investments, but some of these regulations, such as historic preservation, could affect residential property investments as well.¬† Nothing takes the “P” out of Profit faster than learning that the REO property you got at auction for a “steal” turns out not to be a 3:2 with in-law quarters, but a 2:1 with an illegally converted garage that must be returned to garage use before you can post the “For Rent” ad on Craigslist.¬† Or that the dilapidated “tear down” on an urban acre of raw land turns out to be eligible for listing on the National Historic Register and cannot be moved or removed, and must be restored as a condition of acquiring any entitlements to subdivide and develop the remaining property.¬† Or the hillside ranch home that would have a fabulous view, were it not for the fact that over time, the line of trees that originally marked the property boundary to the west had grown to a size that not only blocked any view of the sunset, but now qualified under the local municipal ordinance as a “protected tree” that could not be cut down without risking a severe civil penalty of several thousands of dollars.

One of the first questions I ask a client who is considering the purchase of property is whether local regulations allow them to use the property for their intended purpose.¬† In some cases, for example, the buyers based their pricing offer on a two-lease income projection for what they thought was a duplex, only to find out that the property is zoned R-1 and the second unit was never properly permitted.¬† Or they want to convert the long-vacant commercial building into a restaurant, only to find out that such a use will require a zoning amendment — a process that could take anywhere from six months to 2 years.

Even if the zoning regulations permit the desired use of the investment property, there are many other obstacles to overcome, not the least of which are compliance with current building, fire, electrical and plumbing codes, not to mention regulations and policies governing energy efficiency, access for persons with disabilities, sign ordinance restrictions, and public works requirements such as undergrounding of overhead utilities, installation of sewer lines, and assessment fees for previously installed facilities.¬† In one recent case, the developer not only had to widen the road and construct a new railroad crossing, but also raise the level of a public street by two feet for a distanced of approximately 3/4 of a mile as a condition of building¬† a group of commercial buildings.¬† I imagine his investors weren’t too pleased to hear they not only had to foot the bill for that project, but also deal with the complex nature of negotiating with the railroad company.

The best solution to these obstacles is to learn as much as you can before you commit your funds to a project.¬† If you are an investor, be sure ask the right questions.¬† Consult with a knowledgeable land use attorney, a planner, and a qualified architect with local knowledge of local government practices, procedures and policies.¬† The money you spend up front for professional advice may end up saving you substantial sums in the long run — and may provide the greatest return on your investment overall!