08 March 2011

True Anecdotes of the Mortgage Crisis Part I: Negotiating from a Position of Power

So, I was thinking that maybe I ought to write a bit about something that I actually have a good deal of first-hand knowledge about: real estate and the mortgage crisis.

I'm an attorney, and for the better part of the last ten years I've been practicing real estate law in a variety of capacities.  I've represented real estate developers, and I've been a title closer.  I've worked in-house with developers in a strong market, and worked in-house with real estate vultures in a weak market, and now I'm investigating title claims on loan policies (which I love, BTW).  I was there in the early 2000s when interest rates were dropping and housing prices were climbing, and I was there when people were investing millions of dollars in huge tracts of desert in Arizona.  I was also there when it all came crashing down and the ganefs scrounged to pick up foreclosed homes from banks by the dozens at forty cents on the dollar.  I've seen the tricks that the lenders and brokers used to get us into this mess, and I've seen the tricks they're using to try to get out it (for themselves, not for you).  I even lost my entire investment in the real estate market myself.

I've spoken to many people about the mortgage crisis, and read a lot of people's opinions about who is to blame and what should be done.  Everyone seems to be interested in it at some level, especially if they are homeowners, and when they find out what I do for a living it's often a topic of conversation.  There's a lot of misunderstanding out there, as well as a good deal of flat out misinformation.  I certainly don't have all of the answers, but I am a smart guy who pays attention, spots bullshit pretty well, and has been up close and personal with many people on all sides of the real estate business throughout the last decade.  I think I've mostly got the right idea, and I've got some stories.

I'll start at the beginning, because although my first gig in real estate law was pretty short, it did yield one great story that has amazed friends and business associates alike for the past 10 years.  In 2001, I was living in Chicago, and I was working legal temp gigs (they call it "contract work", but it has nothing to do with contracts) after losing a job with a dotcom.  One job I got was with a small firm in The Loop that was representing the developer of a new high-rise condo project on the near South Side.  The construction was just about finished, and they were in the midst of closing all of the sales of the 300 or so units.  In this heady real estate market, all of the units had been sold about 18 months earlier, when the project had barely broken ground, and I'm sure the competition was hot to get in.  My job was to draw up the closing documents and then spend all day at the main office of Chicago Title walking around from closing to closing delivering the seller's docs, signing the closing statements and then returning to the office with the checks.

So here's where the story gets good.  Because there was so much competition for these units in this building, I don't think the buyers had ever read their purchase and sale agreements very carefully before they signed them, and the ones that had their lawyers look at them apparently didn't do much better.  Out of all of the closings I attended over those couple of months, only 4 buyers, 3 of whom were represented by the same attorney, caught the little nugget that the developers had dropped in the contracts to make themselves a little extra cash.

When you buy a property, one of the charges on your settlement statement is for the proration of the real estate taxes.  This is usually a pretty simple calculation where you figure the taxes for the current year (or other tax period), divide it up between the buyer and seller based on how many days each party owned the property, and then one party gives the other a credit to pay for the taxes they owe.  95% of the time, it's the seller that gives the buyer the credit, because the tax bill will come out later in the year and the buyer will have to pay the whole thing.  Occasionally, the seller has already paid the taxes for the year, so the buyer has to give the seller the credit, but that generally only happens within the month when the tax bills are released and closers try to avoid that situation if they can by having the taxes actually paid on the closing statement.

With a new development however, there is an additional twist.  Undeveloped land is worth much less than developed land, and is often taxed at a different rate, so the taxes are much lower.  If you buy a newly constructed home, it is very likely that the taxes will go up quite a bit in the first year from the assessment the previous year.  The slimebag developers that I was representing saw this as an opportunity.

The language of the purchase and sale agreements in this deal addressed the proration of taxes by making it the responsibility of the seller to pre-pay the taxes for the year, and for the buyers to give the seller a credit of the prorated portion of 2% of the sale price of the unit (which was an estimate of the property taxes based on the City of Chicago's "mill rate" at the time).  This would be a relatively fair way to estimate an unknown tax bill, except that the tax amount was known by the developers, and they had paid the taxes based on the undeveloped value of the vacant lot that the high-rise was built upon.  The developers paid approximately $90,000 in real estate taxes for the year the closings took place.  But the 300-some-odd units, selling at an average of about $350,000 each, yielded well over a MILLION dollars in tax proration overpayments to the developers!  If you ever need to define the term "windfall", just remember this story.

The kicker was that the contracts specifically stated that there would be no re-prorations of the taxes after the closing (a remedy that is sometimes used when estimating taxes that are very difficult to ascertain).  Like I said earlier, only those 2 attorneys representing 4 buyers caught this trick, and even they were only able to negotiate the tax proration down to 1.5% because the properties were so in demand.

That gig ended after about two months, but I learned something very important for my future career path.  I learned that I would rather be the closer working for the title company than represent the interests of a party that I found distasteful in a real estate deal.  It would certainly not be the last time that I would advocate for a position or client that I found unseemly, but I decided to pursue the path of the poorly paid referee in the real estate world rather than the highly paid player.

In the next chapter, "Who is the customer here, anyway?"

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