Clueless at City Hall: Foreclosures and Tenants

You may have noticed the cascade of articles about foreclosure-related evictions that have streamed through mainstream media and the blogosphere with the common theme that tenants are drowning and need a legislative life vest. But you may not know that the Los Angeles City Council, in an ill-advised and shortsighted move, voted to give them more than that vest; it handed them an ocean liner, sinking everyone around them.

I am talking about the ordinance 180441 or Article 14.1 of Chapter IV of the Los Angeles Municipal Code, known as the “Eviction of Tenants from Foreclosed Residential Rental Properties.” It essentially bars evictions from foreclosed properties and places foreclosed single-family residences under the rent stabilization ordinance (RSO). Listed as an emergency measure, the ordinance barreled scrutiny-free through city hall in 12 days, leaving the public and neighborhood councils little time to respond.

This ordinance states a tenant cannot be evicted from a foreclosed house, condominium or post-1978 apartment building—all which would normally be exempt from the RSO--unless one of two conditions are met: 1) the tenant fails to pay the rent or breaches the lease in a significant way (residing in the country illegally or getting roommates in violation of the contract do not qualify as eviction-worthy offenses), or 2) the landlord plans to occupy the property or demolish the premises, which triggers payment of pricey relocation fees. In other words, a renter must be allowed to live in a foreclosed home until the new buyer takes possession, gives proper notice for him to move, and pays him thousands.

The ordinance was established to safeguard tenants from getting a mere 60-day notice, as state law provided, when they had fully complied with their lease. Although some tenant protections are sensible, this ordinance goes radically overboard, proving disastrous for buyers, financially strapped homeowners, property maintenance crews, real estate agents, banks, neighbors and the community as a whole.

The ordinance encourages fraud. According to local Realtors, it is common these days for a property owner, who is losing his home in foreclosure, to sign a bogus lease agreement with a friend or relative (pretending to be a “tenant”) at a below-market value. The owner can then continue to live in the property for pennies on the dollar, and can, upon eviction, collect $7300 - $18,300 in relocation fees. Real estate agents say they frequently find utility bills listed in the name of the property owner rather than the “tenant,” indicating a scam rather than a valid lease. Sometimes two property owners facing foreclosure will switch houses and sign bogus lease agreements for each other. A new cottage industry has emerged: owners facing foreclosure are contacted and told that for a fee they can stay in their homes. The above scheme is explained.

When foreclosing on houses, banks do not have rental schedules in their files like they do with large apartment buildings; this makes it easy to pretend a low lease amount is fair market value. High-end properties—which may have a view, a large lot or elaborate upgrades--are ideal for this purpose. A “tenant” can convincingly argue that $2000 per month is all that can be collected for a house that would really bring in $5000 due to amenities.

The new ordinance also hurts buyers, especially those who have slender bank accounts and lack experience in the real estate market. Let’s assume a first-time buyer wants to purchase a tenant-occupied foreclosure. First, he must get a loan on the property. The bank may charge him a higher interest rate and the insurance company may charge him an excessive premium due to the fact that the property cannot be owner-occupied at the close of escrow.

Even though the buyer plans to reside in the home, he cannot ask the tenant to leave until 60-days after the close of escrow, at which time the buyer will be responsible for thousands of dollars in relocation fees. If the renter refuses to vacate, the buyer will have to hire an attorney and go through costly and time-consuming eviction process. In the meantime, the tenant could stop paying rent, destroy the house and steal appliances. Unless the insurance company chips in, repairs and replacements will come out of the buyer’s pocket as will the unsubsidized mortgage payments.

Why would anyone purchase a tenant-occupied foreclosure? Apart from a naïve buyer who is unaware of the ramifications, these properties sell to savvy investors who require deep price discounts in order to accept the tenant-related risks. Realtors tell me that they must regularly mark down these properties by 20-40% in order to get them sold, thereby devastating neighborhood values. Nearby homeowners may not be able to refinance or sell their homes for their true worth. When property values tumble, tax revenues decrease, and the overall economy suffers.

The ordinance means an increase in foreclosures as tenants learn it is in their interest to undermine short sales. A short sale occurs when a homeowner, who wants to avoid foreclosure and has a property worth less than the mortgage, asks the bank to take a reduction on the note so he can sell. The bank agrees.

However, when a tenant learns about the ordinance, he is usually unwilling to cooperate with a short sale. He knows that if he refuses to leave, he can force the property into foreclosure, and can probably avoid paying rent for a number of months, stay in the home until 60 days after it is sold and receive thousands in relocation fees. It is a windfall for the tenant, but quite painful for the property owner, who was hoping to maintain a semblance of creditworthiness and sell for the highest price so as not to be damaged by exorbitant taxes. Neighbors prefer short sales because they sell for more than foreclosures and usually mean a smoother transfer of ownership. Short sales are also better for a bank’s bottom line, thus making wiser use of taxpayer “bailout” funds.

LA Council President Eric Garcetti says the new ordinance saves communities from “the nuisances that can accompany empty, boarded-up homes.” It is true that some vacant foreclosures are an eye-sore, but hanging onto a tenant is not the answer. Tenant-occupied properties tend to look worse than vacant foreclosures, especially on the interior, and they are a much tougher sell. It would be preferable to mandate banks to keep the exterior of foreclosure properties tidy, watered and free from vagrants.

Real estate agents usually recommend evicting tenants prior to putting a home on the market. Tenants who do not want to leave often intentionally sabotage sales; they may whisper to potential buyers that the house is falling apart or that the neighborhood is undesirable. They rarely allow a lockbox for easy access and even though they agree to appointments (as required by law), they may repeatedly “stand up” buyers, agents, repairmen and maintenance crews, wasting everyone’s time. They may refuse to let the pool man and gardener into the backyard; these low paid workers are rarely compensated for lost hours. A tenant-occupied property, on average, sells for less than a vacant home, again impairing neighborhood values.

LA’s ordinance is wholly unnecessary now that President Obama and Congress have passed a measure called “Protecting Tenants at Foreclosure Act of 2009,” which provides a 90-day eviction notice for month-to-month renters and gives those with a bona fide lease the ability to remain in a property until the end of the agreed-upon term. “Bona fide” means the contract is the result of an arm’s length transaction and the rent is not substantially under fair market value. This law is unlikely to fall prey to scams and does not provide for outrageous tenant paydays.

Although the federal law puts banks in the landlord business, it provides the necessary protections for renters and communities. It is a vast improvement over the local ordinance, which currently trumps federal law.

When society has floated too far to the east, there is a tendency for politicians to make a wide and radical swing to the west rather than guide the sail to a sane middle-ground. This is what the LA City Council has done. Tell them to revoke the local ordinance so the waters can be calm again.

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Note: The Greater Valley Glen Council recently passed a motion, which was forwarded to the LA City Council, suggesting the new ordinance be revoked entirely, or revised to apply only to (five units or greater) apartment buildings, since these properties tend to be sold with renters intact.