What is Funds Control? with BuildZig #576

John Bohannon

This week Bruce Norris is joined by John Bohannon of BuildZig which does funds control for real estate investors building new houses or rehabbing large fix and flip projects. John took his first interest in shop class for the construction industry at large in elementary school and has turned it into a career. He is the director of business development at BuildZig, a funds control firm that has been in the industry since 1936. John is a licensed general contractor, certified construction inspector, registered home inspector, and a certified review appraiser.

Episode Highlights

  • What is Joint Control Escrow Licensing, and how is it related to escrow companies?
  • What is funds control?
  • Where does he see a lot of activity, and what areas are the hottest?
  • Is John currently working with co-living and micro apartments?
  • What is this new business incubator, and how will it benefit both the living and work environments?
  • Did other states like California utilize heavy regulations after the downturn?
  • What are the biggest mistakes that funds control catches?
  • What projects are popular these days?
  • How will the fires in California affect construction?

Episode Notes

During the last interview, they talked a lot about the basics of funds control: what it is, how the industry got started, and the basic process of the players in the mix, how to go about setting it up, and why it’s required here if you are regulated under the bureau of real estate. It protects a lot of the players, including the general contractor, the borrower, and the lender. It makes a lot of sense and was one of the best things that came out of the overlay from California on everything with the CFPB from Dodd-Frank. Aaron recently ran into John at the California Mortgage Association. This is a private industry association for private money lenders. One of the only reasons Aaron goes is he gets bored to death by all the attorneys that show up to describe all the different regulations we are under in California.

Aaron asked John about when he selects a funds control company and if it is the Department of Business Oversight involved (DBO). John said it is called the Joint Control Escrow Licensing. Interestingly enough, it has nothing to do with the traditional escrow company. Technically speaking, a regular escrow company doing a buy/sell of the property cannot actually engage in the practice of funds control. You would need a special license called the joint control escrow license, and it is regulated quite differently. John said they are subject to minimum threshold requirements for assets and have to have regular audits. They are required to do an annual audit. There could also be random audits from the DBO in between.

The license he spoke of before is not a common license, and there are only a few in this state. If John were to do funds control in Nevada, it is not as robust of a license. However, it is a different license. There are a few other states on the East Coast that have similar provisions. Western states are pretty wide open. Usually when told it is regulated by the DBO of California, that is satisfactory enough. It is really concentrated with the West Coast and East Coast as far as regulation.

Aaron asked John where he currently sees a lot of activity. His company is nationwide as well as does their own projects in California. Bruce asked what areas are really hot. John said the East has been exploding for the last few years. This is the spillover effect of the overly expensive San Francisco market where people are sharing an overly expensive Victorian apartment with three other people. It all comes down to the spillover effect. East Bay apartments and condos have really been the top in the country.

As far as new development, rehabbing, and apartment conversion, and condos it is definitely an explosive market. He assumed this will last as long as the San Francisco economy is in its own bubble or is able to sustain itself. There are a lot of jobs coming out of there, so that is the appeal. There is also a mass transit connecting the East Bay to San Francisco, and this makes it very viable. It has been developing over time, and the East Bay is a very good hot spot right now for tunnels.

Aaron asked John if he has worked on any projects involving co-living or micro apartments. Aaron said he saw a few of these projects popping up in San Francisco, so Aaron wondered if he had any experience. John said it is a real trend right now nationwide, usually in densely populated areas like San Francisco. They are also seeing it in the East Bay. John had even heard of one co-living project being sponsored that was around an incubator. It will pretty much be one of the first of its kind. This allows for this micro-living/co-living. This is when you can have your own private room and the common area with a space that has almost a commercial-sized kitchen. You also have a place you can play pool or hang out, almost like a business center or hotel. This way you can be around like-minded people, usually younger. The idea of combining the co-living with the business incubator, specifically around a theme.

In the same building is both housing and office space. They would live upstairs, then just take the elevator or stairs down to work. If you go to countries like China, a lot of the people they import from China’s interior to work some of the labor jobs have huge dormitories in the background. Aaron worked on a cruise in his 20s, and what made him laugh was how some of the property managers on the cruise had the sole job of planning things for people to do. It is similar to the concept of co-living. In one co-living space, you can have a group of 45 and older single individuals living and sharing the same space. You can also be in a building where you almost need a coordinator to match up millennials.

John said it is not for everyone; but if you are a young professional going from a college dormitory to co-living, it is probably an ideal situation for you, especially in an expensive place to live. The most recent project Aaron saw in San Francisco had a room that was $2,600 a month. Each of the co-living spaces had 3 bedrooms, a bathroom, and an interior space that looked straight out of HD TV. Everything about it was beautiful, and $2,600 sounds like a steal in the San Francisco market for something new.

John said a lot of the projects he has done go back to the adaptive re-use project. In the last show, they talked about how they took a church that sat abandoned on a corner in San Francisco. No one did anything with it, and no church wanted it because of the cost of repairs and upgrades. One guy came in and noticed the high ceilings in the middle of the building that would make a perfect common area. It had wood beams and big lead glass windows and a huge common area in the middle. Along the sides were 250 square foot bedrooms.

Aaron said some people refer to this as micro-living. There is a particular projects in Rhode Island that involves the oldest mall in America that is still standing. It’s three stories, and the top two floors are micro apartments, 250 square feet. This is a tiny living area connected to a little micro kitchen, bathroom, desk, and a little bedroom. You are not sharing a huge living space, so you are really only missing the large family room and commercial kitchen.

One of the other interesting things about the co-living is that it’s typically surrounded by services such as a maid service. You also get internet included as well as utilities that makes it really easy. They are taking out the friction of being a renter, which is interesting. There are some larger companies that do this, one being Open Door. Its full title is opendoor.io. They also manage things like co-living spaces across the nation. There are a lot more options for this type of space right now rather than just managing it right after you finish it.

Aaron asked John if he saw other states like California utilize heavy regulations after the downturn. John said there was for condos in Florida since there were so many. It got around the pre-sales since they did not quite have the restrictions that they do in California. Here, we have a system with colored slips, such as pink and yellow. Florida is careful about utilizing these slips too soon and first makes sure the project actually gets dealt before taking people’s money.

What surprises John altogether is how unaffected Texas was throughout this whole thing. They kept building the apartments, and when they do this in Texas it is like a 1500 unit. Prices didn’t really escalate in the up cycle, nor did they really drop in the down cycle. They just kept going. A lot of people went and said they wanted this. It is not heavily regulated at all, nor does it have the same market swing. In California, the swings are based on the equity of property that are either cashed out or pulled out to invest in something else.

Texas was actually one of the states the Norris Group 1031 exchanged in during 2005 and 2006 before the downturn. They shared all this in their market timing report since usually Texas is countercyclical to what California does and a steady reign. Aaron next asked John about when it comes to funds control and what the biggest mistakes it caught because of the process. John said the biggest thing was in California, for example, where you do not want to use funds control or asset control where there is potential for the state to freeze those assets when the person may be operating illegally and not have a proper escrow license. You want to make sure you are working with properly licensed escrow company.

The second biggest thing was really listening to the funds control company. There is usually tension because you have a borrow you like who may have had a couple projects with you. You will want to keep him as a borrower, and they will want their money right away. You would have to call up the funds control company to ask what is going on, and you may decide to just have it released anyway and do a follow-up. This is the breakdown. Maybe there is a case for this, but usually if the backup is not there then you really have to measure the risk of releasing funds.

This is a common problem especially for the smaller builders who need their cash right away. They don’t really have cash flow, it’s just one job to the next for them. They will say they need a certain amount of money at the close of escrow. They may really need this to buy the materials to get started. But, technically, you are not supposed to do this. You are not supposed to give money away ahead of work. John said the biggest downfall was measuring the risk and managing it appropriately for those who don’t follow the rules correctly.

This lead to their next topic: inflation. In California, the builders are just starting to put a fire under it, and there will be a lot of pressure from private lenders if they are still in the lending space with lending on construction. There is a sense that everything works, so why would you not pre-fund things? Aaron had a conversation about this, and the sense was that the person was wondering why they would not be given 100% of the purchase price. If they planned on tearing the building down to one wall and a foundation, then you would have to explain this to a private money lender who will put aside $500,000 of after-tax dollars for you to build this project. The other party is trying to ask if you will fund the entire $500,000 and take it down to one wall and a foundation. Well, what if they walk away from the project? You say you will put $300,000 down, but at that moment in time you would somehow have to explain to the lender how it is a fantastic risk for them.

John himself had been in uncomfortable situations where they had borrowers who were definitely under pressure, and BuildZig was a fantastic third party. They took the heat and provided intel. It is a really important relationship in the mix to have that visibility and control. Aaron thanked John for this.

John said inflation is huge and could become a bigger problem as the next couple years progress. This is largely due in part to the fires we had. Almost 7,000 houses were burned down. We are looking at a building boom, which John said he experienced something very similar to with the Oakland Hills fire several years ago. They were doing funds control back then and had their headquarters in Oakland. They noticed that the average homeowner was over 60. They took their insurance money, sold their lot, and moved either out of state or to a retirement community. There are a lot of Bay Area folks fleeing to Nevada because of the sustained income tax and lower cost of living. This creates opportunity for builders to buy lots.

Aaron asked, at least for the Oakland fire, what percentage rate is being cashed out by the insurance providers as well as the potential builder or real estate investor coming in to make that consumer whole so they can come in and get full market price. If you are in the mindset that you just got a big check from the insurance company, probably more than they thought, and could make another $200,000, then there is very little pressure and maybe even downward pressure to hurry and sell the lot.

From a builder perspective, there was a lot of people running around and saying they would give cash for the lot. It was not represented well nor a lot of listings by brokers trying to get the maximum price. However, there was not any of this going on. They just wanted to cash out, take the money, and leave. For those who stayed and wanted to rebuild, the other problem was there were not sufficient funds to rebuild. That was exacerbated by the fact that there was so much going on with contractors. This was because insurance companies wanted to hurry up and do their payoffs. You own a property, have a mortgage on the property, and the insurance company writes a check. It goes to you and the mortgage company, they’re done, and then they’re out of there.

Now, you have to decide if you will pay off your mortgage and go find new money to build. Or, does the mortgage company work with you? The environment right now is largely due to leaders trying to create an environment of expedited permits and mortgage companies working with homeowners who want to rebuild. They don’t want to take a full payoff, but rather do some new construction financing where they can start rebuilding and deferring payments to the back end. It is a healthier environment than you had in previous disasters. We have to hope this will continue.

The opportunity for lenders and investors is two-fold. There are lots people want to sell off, while others want to build on it. This is known as ground-up construction. What will happen is there will not be sufficient insurance funds to rebuild the property, and a lot of private money seconds were coming in to finish the project. Those were the opportunities BuildZig noticed in the Oakland Hills fire.

Besides the politics, when you are dealing with a disaster of that size, you are also dealing with labor shortages. Aaron did a rehab, and he had a difficult time for specialty things like laying tile. He had to call in favors, and the guy was cutting tile and 8:00 in the morning. Aaron asked John if he expects people to relocate from out of state and migrate to the area to build those 7,000 homes. John simply said inflation will be off the charts. There is just not enough skilled labor or material supplies that satisfies the demand coming our way. It’s going to be bad.

Even before this, they were noting that larger projects had a brand new line item on the construction budget, and it was right after contingency. People argue over the amount it should be, but a general rule of thumb is 10% and 3-5% for larger projects. Then, inflation made the line item. They were seeing 3% here. Essentially, if you are looking at a two-year build-out for a school or correctional facility, the price today will not be the price tomorrow. They were accounting for that right there in the budget.

John is opening another field office in the Santa Rosa area. It will not just be a funds control company, but a development. This is for somebody who is already an emotional wreck who comes in and wants to know the process. The process will be to get a plan together, get it signed, submit it to the city, get the approval and permits, then help you bid it out and find a qualified contractor. There will be a lot of hand-holding through a difficult process. This is another thing BuildZig does. They plan, review, and help people understand the scope of a project and what they need. This will be needed in that area for several years.

For more information, you can visit their website at www.buildzig.com. You can also call them at 1-800-380-0180.

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