Bruce Norris is joined again this week by John Bohannon. He is co-owner of a company called Build Zig, and they are in the builder control business among other things. They take projects from the very beginning all the way to the very end, and they even get involved once in a while with being an expert witness in court.
In the last segment they talked about the inspections by the city. When you have builders, a lot of times people get done with their portion of it and it is really prior to one of those major milestones. Because of this they want to get funds. Bruce asked how difficult it is for them to get paid. John said it is not hard at all. It is a process, but one that is easy to follow. California has a good law called the Mechanics Lien Law, and it is a process set up to protect not only lenders but the property owners as well as subcontractors performing work on the property. The basic goal of this is if you have performed work on a property, you have the right to be paid. If you are not paid, then you have a right to file what is called a mechanics lien that follows like title to a property.
Typically with a property the first on title is the lender, then you can have a second, third, fourth, or fifth. What happens on the mechanics lien law is that it is a vehicle that allows contractors to collect on money if they have not been paid. They can file it to go on title, and if the property owner has not paid somebody and they have recorded it, then they would have to clear the title if they want to refinance the house. They would either have to settle with the contractor or pay them off depending on the case. He is not saying the only time the mechanics lien law is recorded is for good and just cause since this is not always the case. At the core, the law is there to help people get recovery if they have proved the property. The filing of this is unusual, but the filing of a preliminary notice is not.
The process is you have to let everyone know that you are about ready to perform work on the job. This is called a 20-day preliminary notice. You have to record this in order to establish your right to one day potentially file that mechanics lien. You also have to give a warning that you are about ready to file one. However, the idea is that if you are a property owner and have contracted with a general contractor, you may no idea who someone is going to hire to build the house. What they do is they tell them they know who their general contractor is and have a direct contract with that person. However, they may not know who is being hired and therefore will have to file a notice you are about ready to perform work and the estimated value of the work is a specific amount. This is on the record, so now the contractor can go to the homeowner and say that you need to pay him, for example, $30,000 since they are done with framing. The property owner can look and say they have a preliminary notice from the lumber company, so how can they know they have or will pay them with the notice. This is where they had the lien releases.
There are four types of lien releases, two on which John went into detail. There is a conditional and unconditional. A conditional means there is a condition left on it that he will sign it, and once he receives money, whether a check or some other form of payment, then and only then have you released all your lien rights and can no longer lien your property. The other type is an unconditional, and that means all conditions have been met. The person has been paid and is acknowledging they have been paid and cannot lien the property anymore. A lot of times we say we will advance the general contractor a lump sum of $50,000. With that, they need to make sure they will pay the framing of the lumber supplier and framing contractor. They ask them to go ahead and give them those conditionals, meaning they still need to get paid. Once they are paid, they will not have those lien rights anymore. They advance the $50k to the general and have to presume he is going to pay the right people. What they do is they will not advance the next ones after that until they do have that proof that they were in fact paid.
When they say they presume the person will pay, but the person does not, then Bruce asked what would happen next. John said the account would then be frozen until he brings proof that he has paid. This is one method, although John said as a funds control company they do not strongly endorse this method. For a lot of the bigger contractors, however, this is how they want it done. Usually they have the reputation and where with all to stand behind it. John said as a funds control company, they strongly endorse direct payments as often as possible. They would tell people to give them a list of everybody on the draw request who has done work and needs to be paid. They do not care if this is the excavator who dug the trenches for the foundation and cement supplier as well as framer and lumber supplier. They could all be on one draw request depending on what you have done in that period of time. They will pay them all direct, and that way they will know they have been paid, which makes them and all the investors happy.
Bruce asked when joint checks come into play. John said they come into play if you have a foundations sub-contractor. You sign an agreement with the foundations sub-contractor to put in the foundation, and you have a direct agreement. He is going to go out and buy gravel, lumber for forms, and maybe an excavator if he does not have one. Now you have all these vendors for one task. If one of them files a preliminary notice and says they will do some work on your property or supply it with materials, now you know who they are. Instead of writing a check directly to the foundation subcontractor, you write a check to him and the rebar supplier.
You could also do direct payments, although John said it is better to do joint checks than not. However, he has seen too many games played with joint checks where vendors said they would not pay the whole amount because they did not like the delivery time of the drop-off. They would tell them they need to sign it, but they are only paying them a little bit. They may do it because they feel coerced into doing it, but then later they get mad and file a lien anyway. He is a big fan and proponent of direct payments, as are most good funds companies. In this case, there would still be liability to the owner, although the money would be released and everything he thought would be fine. Ultimately the owner would prevail because they did everything they thought was right. However, it does not avoid a long problem with which you have to deal.
Bruce and John went on to discuss inheriting a broken project. He has personally handled three of them, and every one of them was very different. He could imagine after 2008 through 2010 there were tons of them in all different phases. You could have three models, 50 finished lots, and 250 blacktop lots with a mile of dirt behind it. He assumed people probably did not get paid. Bruce asked how long they have lien rights and what the path is back to finally saying they will somehow move forward and make something out of it. John said for lien rights, liens do have to be perfected. In order to perfect a loan, you have to bring forward a lawsuit.
A lot of times contractors do not have the where with all to do such a thing or follow the process all the way. A lot of these fade out over time. The other thing is if there is a foreclosure by the lender, then in most cases the foreclosure wipes out all of those mechanics liens. This is what they were seeing a lot of, and it is unfortunate that a lot of these lenders who suddenly had property that was not worth what they had made a loan for. They have all these mechanics liens on top of it and really felt like there was no way out but to foreclose. This wiped out a lot of people who worked very hard and should have been paid. Nonetheless, this is what happened. Because of real estate cycles, what they saw the most of with the broken projects was condo projects. There were a lot of condo projects being dumped at the end of this last downturn since it was a popular product.
John had mentioned that this was at the end of the cycle, so Bruce wondered if he was always aware of more condos coming in. John said he was and this is a trigger point where they always start to say they need to stop working on the projects. Even within the condo space, it is the condo conversions that are really the last signal that they are at the end of this one. When all those apartments and those that should barely be classified as apartments are being converted into condos and selling, this is a good sign you are at the end of that real estate cycle. Bruce said when a lot of hard money lenders were in this boat, if they lent on land since it was the only source for that type of loan, they ended up with a lot of projects.
Bruce asked how long the approvals are likely to be okay and stay in place for the lender/owner. John said typically it is one year, but during this last downturn the governor signed a special law that extended the vesting or permit rights on a lot of these entitled projects at the strong urging of the developers. Normally that would have been the right thing to do, and it would have been enough. We all know Bruce predicted perfectly the last one, but even those who did predict it predicted how long and deep it would go. They called it, but did they know it would be this bad? John said he thinks by extending any vesting rights for an additional year over the automatic one year, normally it would have been enough. However, in this case it just wasn’t enough.
There is a lot of land where the lenders did not know any better to extend the entitlements since this is not their business. A lot of them had to take back dirt and ended up losing their entitlements for not knowing any better. For some, they did the extension but ran out due to the downturn going on too long. Bruce asked about when entitlements run out if you are starting from scratch or can you go back and re-up it after three years. John said it is really at the discretion of that particular city and its building department. As we were slowly coming out of this thing, there was a lot of cooperation by government agencies who wanted to see a project and get it put back together.
Now as things are getting busier, they have not replaced the staff that they downsized. They are becoming overwhelmed and not being exactly as cooperative as they were but still trying to get things done. There were also a lot of projects that were never really popular or highly desired by either the officials of that city or the neighboring community. They voiced their concern over a particular, and this one lost its entitlement. There is not a lot of political will to allow that to get re-entitled or be put back on the books. You can see that politics does make a play in here, and they do not want to exhaust themselves over an unpopular project. If it ran out, then it just ran out.
Bruce asked if the highest and best use of a property offer could conflict with someone else’s opinion of highest and best use. John said it could, and Bruce asked if we should just leave it pristine forever. John said yes, and Bruce then asked about the discovery of something held sacred. This could mean a big piece of land on which you are going to do a project, and they found some lizard about which they are concerned. There are a lot of special zone areas, but Bruce wondered if people get surprised by something being found on the project midstream. A lot of times with large projects the environmental concerns are already pre-identified and mitigation plans have already been discussed and put in place. Sometimes there is just a swap of one person disturbing land that may have an endangered frog and they need to create a preserve habitat to offset it. These are ones you can identify up front and can manage. He is not saying it is pleasant or inexpensive, but it is manageable.
One of the scariest things is when you are excavating and in construction, then you suddenly find Native American bones. This will shut down your project for a very long time. They may want to go through and do some discovering. In Riverside County in the areas around Temecula and Murrieta, almost every project has that clause as part of the approval or conditions of approval. They have to be on the lookout for any native remains, and if found the construction must stop and you must bring out somebody certified to deal with it and examine the area. This is one you cannot manage and just happens to you. It is uncomfortable when you have millions of dollars at stake where you can be thrown something from left field. Bruce said he can see why lenders would probably not want to get involved until the dust has settled. This is why you typically see the bigger or larger homebuilders take on that market risk. They are doing it fully aware that this could happen since it has happened before and they know how to manage it.
Another thing to consider is how we always talk about these poor builders, but production builders’ profit margins are not that high. They would make a high-tech company shrill in fear since they are typically looking for single-digit returns. They take on a part of building that the average person and money does not want to do. For this we have to thank them. Bruce asked if the city’s response somewhat related to who is across the counter from them, whether it is someone in whom they are confident or already know. Bruce wondered if the response to them is very different from a brand new person wanting to do something. John said it is, and in fact one of the things cities have nightmares about is projects starting, stopping, and sitting there forever. This is not what they want, especially on the larger scale projects. This is why cities often will require a completion bond.
The average person cannot qualify for a completion bond since it is underwritten by insurance companies and you have to have qualified financials and experience. There are a lot of barriers to entry on sale and sub-division that the builder cannot do. This is the result of a city seeing a project that started and never got finished. You may call it an overreaction, but these things were set in place so these things would not happen again. The larger homebuilders or any homebuilder with experience and success within any city will always gain favor because they know they can count on them to get it done.
Bruce asked if, since the downturn, cities have backed off from their fees to make building possible. John said you would like to think so, but the answer is no. It is possible that very early on you saw certain fees that were not applied and it was not an acknowledgement of lowering the fees. Rather, they said the fees would not be charged for a particular job. Some cities desperately wanted this, but it never really went away nor did we see a reduction in the fees. They are all back now. There are some cities in California that cost more in fees than it does to build in Texas. A lot of homebuilders get negative press for not being able to build more affordable homes here in California. There are some real examples where $100,000 worth of fees went into a project before they even started construction. You have to somehow build in enough margin to overcome those fees and the cost of construction. There is no doubt it is expensive in California, and this is why you had the phrase “McMansion.” It was feasible for them to build a 3-4,000 square foot house where it wasn’t a 1500 square foot house. This has to be as true today as it was then.
When Bruce and John first spoke, they talked about the builders who made the custom homes. He could imagine this was a unique market where somebody is going to have a pretty healthy amount of money already. As far as the builder that is going to build a track, Bruce asked John if he sees them building a different track than they did in 2004-2006. Or is it the same since it has to do with math? John said there were some math and projects that were started and are just now being completed. We do see statistically that newer projects that have not started due to improvements being done but there being no vertical construction on the homes are being reduced in size. Statistically we can show the national average home size is going down where from 1980 until the downturn it was going steadily up.
This is also a market reaction to what the customer wants. Baby boomers do not want two stories, but rather a smaller house that is easier to maintain. This is a pure response to the buyers. On the national average on the square footage going down, it is pretty telling and could be a reaction to the general sentiment that we have to find a way to have more affordable prices. There has also been a shift in who the buyer is as we now have a very high percentage of people buying who are single. Bruce asked when fund control is necessary for doing a rehab. John said he used to have a strong opinion, but he got out of it since he did not like the arguments. He relies on SB 978 that says if the rehab is over $100,000, you have to fully fund the loan up front and use an independent third party to hold funds for a qualified inspection. This is the new rule he uses. You definitely want it and by law have to have fund control if it is over $100,000. Bruce asked if there are plans and permits when he gets involved. John said no, not on fix-and flips but there are for ground-up. This is not even the case for a $100 grand rehab.
Thank you so much for listening to our radio show. If you would like more information on Build Zig and John Bohannon, go to www.buildzig.com.
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