Subdivide and Conquer [Debt]

A longtime client recently reached out to get my opinion on how to either improve their cash flow or free up some equity from their home, which has an attached legal Accessory Unit that they were having issues with tenants running up their electrical bill. 

After assessing their high utility costs, we determined the first order of business is to get an electrician to split the utility service between their home and the ADU so they can either install a submeter or a new meter for the ADU. A call to PG&E confirmed that allocations are available in their neighborhood at a reasonable cost delivered within just a few months, so they got that ball rolling right away.

We then went over options for how they might divide ownership to be able to sell the second unit to pay off their remaining long-range financial obligations including their mortgage on the property. 

A basic method used for splitting off an ADU or apartment unit for sale is to form a Tenancy In Common, complete with an Operating Agreement and Rules defining the rights and responsibilities of each member. A main shortfall of this method is that ownership of the collective remains under a single entity. This creates shared liability during ownership, as well as logistical challenges when a member seeks to sell their share after a change in value. Unless the TIC was set up with fractional financing, the new LTV will generally require either a full refinance, a carryback by the selling member, or an adjusted down payment for a new member buying in.

Due to the size of their parcel and available parking, their property appeared eligible to divide into independent condos. And while this provides clear advantages in terms of liability and access to conventional financing, it is a time consuming and expensive process with a high number of regulatory standards that includes setting up an HOA with Rules, Bylaws and a Budget. And with Condo values declining in recent months the sale of an ADU converted to a Condo may not command as high a price as they had originally hoped. 

Under the guidance of local architect John McKelvey, who I tapped for counsel on their options, the client ultimately ended up deciding on pursuing an SB9 split to create fee simple ownership for each unit, with minimal parking requirements, and no need for a governing organization or rules to abide by. SB9 can also be used for a simple lot split, with approval handled as a ministerial process in much the same manner as a regular building permit, in order to meet the State’s mandate for increasing density, and there are strict timelines under which SB9 applications are required to be reviewed within 3 weeks and approved within a few months.

The catch is that the Seller has to continue to occupy a portion of the property for 3 years after the transfer—but then, that happens to be exactly what my client was seeking to be able to afford to do as they settle into retirement, by selling off their ADU in the first place.