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Table of Contents
Chapter 1: Part I: California The Golden State
Geography...8
Early History...8
Mission Period.9
Advent of the United States.9
The Housing Bubble10
Today12

Chapter 1: Part II: Real Property Vs. Personal Property

Real Property and Personal Property.13
Bundle of Rights...14
Water Rights..14
Airspace15
Mineral Rights15
Improvements...16
Land Description..17
Chapter Quiz..21

Chapter 2: Types of Estate and Ways of Holding Title

Types of Estates...23
Types of Leasehold Estates...25
Ways of Holding Title to Real Estate..26
Business Ownership of Real Estate29
Condominiums and Cooperatives..31
Chapter Quiz..34

Chapter 3: Transfer of Real Estate

Title and Alienation.36
Requirements for a Valid Deed37
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Types of Deeds..39
Involuntary Alienation43
Adverse Possession..45
Recording47
Title Insurance..49
Chapter Quiz.53

Chapter 4: Encumbrances
Liens.56
Homestead Protection.60
Nonfinancial Encumbrances61
Easements..61
Profits65
Licenses65
Encroachments.65
Nuisances...66
Private Restrictions..66
Chapter Quiz..69

Chapter 5: Public Restrictions on Real Estate

Land Use Controls72
Comprehensive Planning73
Zoning Ordinances..73
Building Codes..76
Subdivision Regulations.77
Environmental Laws81
Eminent Domain..82
Taxation of Real Property..83
Chapter Quiz..90

Chapter 6: Contract Law

Contracts.93
Legal Classification of Contracts.93
Elements of a Valid Contract...94
Legal Status of Contracts100
Discharging a Contract102
Breach of Contract.104
Tender105
Chapter Quiz107

Chapter 7: Real Estate Contracts

Listing Agreements110
Commission.111
Listing Agreement Types.112
Elements of a Listing Agreement..114
Buyer Representation Agreements..117
Brokers Commission.. 119
Purchase Agreements..120
Amendments124
Land Contracts124
Option Agreements127
Right of First Refusal128
Leases128
Rights and Duties of Landlord and Tenant..129
Transfer of a Lease132
Termination of a Lease.133
Types of Leases...136
Chapter Quiz138

Chapter 8: Real Estate Agency Law

What is an Agency?....................................................................141
Agency Relationships in Real Estate142
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The Legal Effects of Agency144

Duties of the Agent in an Agency Relationship145
Duties of the Agent Toward Third Parties.....147
Breach of Duty152
Termination of an Agency Relationship.153
Real Estate Agency Relationships155
Types of Agency Relationships..158
Agency Disclosure Requirements.161
Agent-Salesperson Relationship162
Contracts Between Broker and Salesperson....164
Chapter Quiz...166

Chapter 9: Financing in Real Estate

Real Estate Finance The Economics169
Real Estate Cycles.169
Interest Rates and Federal Policies.171
Real Estate Finance Markets.175
Real Estate Finance Documents..179
Security Instruments182
Foreclosure..190
Substitutes to Foreclosure.194
Types of Mortgage Loans.198
Land Contracts204
Chapter Quiz206

Chapter 10: Residential Loan Application

Types of Mortgages...209
Loan Costs...214
Truth in Lending Act.216
California Finance Disclosure Requirements218
Loan Application Process....222
Subprime Lending.228
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Basic Loan Features.229

Residential Financing Programs235
Predatory Lending..248
Mortgage Fraud..250
Chapter Quiz251

Chapter 11: Real Estate Appraisal

Appraisal: Purpose and Functions.256
Appraisers Licensing and Certification258
Value260
The Appraisal Process.267
Methods of Appraisal..275
Site Valuation290
Reconciliation and Final Estimate of Value292
Chapter Quiz.294

Chapter 12: Settlement of Real Estate Transaction

Closing..298
Escrow. 298
Closing Costs and Settlement Statements...301
Proration..307
Income Tax Aspects of Closing.310
Chapter Quiz..316

Chapter 13: Real Estate Taxation

Progressive Tax.320
Income.321
Real Property Classification..325
Installment Sales..326
Tax-Free Exchanges.328
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Excluding Gains From the Sale of Principal Residence329

Deductions Used by Property Owners330
California Income Tax..335
Chapter Quiz337

Chapter 14: Civil Rights and Fair Housing

Federal Anti-Discrimination Legislation341
California Anti-Discrimination Legislation349
Discriminatory Restrictive Covenants.352
Chapter Quiz...355

Chapter 15: Real Estate Construction, Ownership and

Investment
Construction...359
Architectural Styles..360
Plans and Specifications.362
Wood Frame Construction.362
Renting and Buying.366
The Home.371
Investing in Real Estate..374
Chapter Quiz.....383

Chapter 16: Real Estate License Law in California

Administration of the Real Estate Law..387
Real Estate Licenses.388
Non-Requirement of a License..391
License Qualifications..393
License Application and Term395
Miscellaneous License Provisions.398
Special Activities.400
Business Opportunities401
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Disciplinary Actions..403
Examples of Unlawful Conduct.409
The Real Estate Fund...415
Trust Funds.416
Advance Fees..423
Documentation Requirements..424
Advertising Regulations..425
Antitrust Laws and Real Estate Licensees427
Chapter Quiz...432

Chapter 17: Real Estate: Math

Solving Math Problems437
Decimal Problems..440
Area Problems.443
Volume Problems448
Percentage Problems.448
Commission Problems..450
Loan Problems.452
Profit or Loss Problems454
Capitalization Problems...456
Tax Assessment Problems..460
Sellers Net Problems462
Proration Problems464
Chapter Quiz471

Chapter Quiz Answer Key473

Index.476
Glossary..486

CHAPTER 1

PART - I

CALIFORNIA THE GOLDEN STATE

CHAPTER OVERVIEW
This chapter provides a brief look at Californias history, geography
and economy, and the importance of real estate on the states
economy.
California is the 3rd largest state at 158,706 square miles. With over
38 million people, California is the most populous state in the
U.S.A, but culturally the most diverse, too. Sacramento is its
capital. The Gold Rush of 1849 gave California the title of The
Golden State.
GEOGRAPHY
Some basic facts about the states geography: California's climate is
similar to that of southern Europe, with warm to hot, dry summers
and mild to cool, wet winters. Of course, different locations in the
state will not follow this model exactly, based on their elevation or
proximity to the ocean; for instance, northern CA receives more
annual rainfall than the south.
Major rivers in California include the Sacramento, San Joaquin and
Colorado Rivers. Some major lakes are Lake Tahoe, Owens Lakes,
Searles Lake, and the Salton Sea.
The highest point in California is Mt. Whitney at 14,494 feet. The
lowest point is Death Valley; at 282 feet below sea level, it is the
lowest point in the United States. Again, illustrating the states
contrasting areas being in such close proximity, the highest point
above sea level and the lowest -- Mt. Whitney and Death Valley -- lie
only 85 miles from each other.

EARLY HISTORY
It is thought that people from Asia first arrived in North America
over 16,000 years ago during the Ice Age, walking over the Bering
land bridge which connected what is now called Alaska and western
Russia. The mountain ranges of the Pacific Coast separated these
early settlers from the tribes that came together in Mexico to the
south and the plains to the east, so that the two regional groups
shared nothing of their language and ways.
More than 20 tribes or groups reside in what is now California.
When Europeans first reached these shores, Native American tribes
included the Modoc, Mohave and Chumash. Each tribe had a
chieftain sometimes they were women -- who settled community
disputes, assisted by a crier or assistant and a Shaman (doctors).
Native American settlements had three classes: the elite, a middle
class and finally a less successful lower class.
Tribal ways depended on the climate and conditions of the regions
where they were situated. Coastal communities made stone tools
out of mussels. The southeastern deserts spawned a people who
survived by developing many uses for the scrubby plants and trees
that were hardy enough to grow there while husbanding precious
water from oases and water courses. Then as now, the Central
Valley was home to agriculture. The mountainous ranges of the
north had plentiful fish and game, where hunting parties foraged.
It is estimated that 300,000 natives lived in what would later
become California. The first European explorers sailed from Spain
and England in the early 1500s. Balboa claimed all lands touching
the Pacific Ocean for the Spanish crown in 1513, but the many
miles of ocean that separated California from Europe kept any
permanent European settlements at bay.
MISSION PERIOD
Beginning in the latter part of the 18th century, the Spanish
missions refer to a group of military and religious settlements
established by the Franciscan religious order to spread Christianity
among the native population. Those natives were taught European
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farming methods and craft-making. To become Spanish citizens and

productive inhabitants, the Native Americans had to learn to speak
Spanish along with their religious instruction.
The Missions movement was the first major effort by Europeans to
colonize the Pacific Coast region, and provided Spain with a
foothold in the frontier land. But abusive work demands and
horribly unsanitary living conditions engendered rampant disease,
decimating the native population. About 100,000 or nearly a third
of the aboriginal population of California died as a direct
consequence of the missions here. The Mexican government
abolished the missions in the 1830s.
PRESIDIOS AND PUEBLOS
Along with the cross came the gun. The missions were meant to
provide supplies for the presidios, which were military outposts.
The civil side was manifested in the pueblos, or farming
communities. It was hoped these would be able to independently
support the missions and presidios with grain and crops so as to
reduce the amounts coming from Mexico.
Four pueblos sprung up at San Jose, Los Angeles, Branciforte, and
Sonoma. The four communities acquired four square leagues of
land to be partitioned into house lots, farm lots, and land to be
rented for revenue, commons, and pasture lands.
ADVENT OF THE UNITED STATES
In 1844, the California Trail began to be used by emigrants to the
region, a 2,000-mile route across the western half of the North
American continent from Missouri River towns, penetrating
California's isolation from the east.
The MexicanAmerican War began to the south in May 1846. A
relatively small number of marines and sailors wrested control of
California by January 1847; the war with Mexico was over a year
later. The Treaty of Guadalupe Hidalgo made California a part of the
United States.
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The California Gold Rush began with the discovery of the precious
yellow mineral at Sutter's Mill near Sacramento in January 1848.
California had a population explosion of "49ers," with San Francisco
alone growing from 500 to 150,000 in between 1847 and 1870. In
1850, California became a state.
The linkage between the Central Pacific railroad with the Union
Pacific Railroad cut travel time from Chicago to San Francisco from
six months to six days. This advent of transcontinental rail lines in
1869 securely joined California to the rest of the nation and the
transportation systems that grew out of them in the century that
followed contributed to the state's social, political and economic
development.
California, befitting its status as the United States in microcosm,
was the recipient of waves of immigration from the rest of the world,
and the rest of the country, too. Los Angeles iconic film industry
had star power, but it was the defense industry that drew close to a
million new worker during World War II; after the war, they stayed,
many of them shifting to the incipient aerospace, aviation, and
shipping industries.
The state was also in the forefront of the high school movement
leading naturally to mass college education. The development of a
highly efficient public education system in the University of
California and California State University systems helped produce
an educated workforce, which in turn was a magnet for investment,
especially in areas related to high technology. By 1980, California
had become the eighth-largest economy in the world.
THE HOUSING BUBBLE
Housing prices in bigger California cities continued their rise so
that homes with modest values in the 1960s and 70s soared by the
2000s. More people preferred commuting longer hours so as to
afford a home in more rural areas and earning larger salaries in the
urban ones. People purchased houses they never intended to live in,
but expected to make a huge profit in a short period of time then
rolling over the profit money by buying more properties. Mortgage
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companies were accommodating, as everyone thought that the

prices would keep moving upwards. The boom years ended with the
bubble bursting in 2007-8 as housing prices began to crash.
TODAY
According to U.S. Census Bureaus Quick Facts, Californias
estimated 2011 population of 37.7 million is a 10 percent increase
over 2000, and makes up about 12% of the entire nation.
The home ownership rate between years 2006-2010 was 13.7
million, about 10% of the entire country. And the median home
value in California in that same five-year period was $458,000,
compared to $188,400 of the nation as a whole.

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Chapter 1

PART-II

REAL PROPERTY vs. PERSONAL PROPERTY

CHAPTER OVERVIEW
Real property includes the land and improvements and also
incorporates the rights that go with the ownership of land. This part
of the chapter will explain those rights which are known as
appurtenances. We shall also learn about natural attachments and
fixtures, sold as part of the land and also the difference between
fixtures and personal property (this is generally not transferred with
the land). The final part of the chapter will deal with methods of
legal description; the various ways in which a parcel of land may be
identified in legal documents to avoid misperceptions regarding its
boundaries or ownership.

REAL PROPERTY AND PERSONAL PROPERTY

The two types of property are real property and personal property.
Real property or real estate can be land, anything attached or
affixed to that land, and anything incidental or appurtenant to the
land - immovable is the key concept here. When real estate is
transferred from one owner to another, anything that is attached
belongs to the new owner.
Personal property is movable. It can include items like furniture,
clothes, jewelry, art, household wares. There may be situations in
which there are formal title documents that reflect the ownership
and transfer rights of the particular property after the death of a
person; for example, cars, sporting equipments, etc. In other cases,
tangible personal property shall not be "titled" in the name of the
owner, and is believed to be whatever property someone had in their
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possession at the time of their death.

Personal property that cannot physically be moved, touched or felt,
but rather represents something that has value such as negotiable
instruments, securities, services and intangible assets including
chose in action, are called as intangible personal property or
"intangibles."

BUNDLE OF RIGHTS
The purchase of real estate conveys the ownership of what is
termed the bundle of rights, legal rights that include:
1. The right of possession, meaning the right to live on the property
and exclude others from living there;
2. The right to use a property for any lawful purpose;
3. The right to encumber property, using it as security to borrow
funds;
4. The right to enjoy a property, without interference from others;
5. The right to transfer property, by sale or gift.
The term land refers to the earths surface, the material that
extends downward to the Earths center. Land also includes water
rights, mineral rights, airspace and surface rights.
WATER RIGHTS
The right to use water can be an appurtenant right, tied to land
ownership. Water is located on both the earths surface and below
it. If on the surface, flowing in a stream or if underground, water is
deemed percolating: real property. Surface water may be confined
to a channel or basin or it may be unconfined, like flooding or runoff.
With confined surface water, two systems apply to water rights:
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riparian and appropriative rights.

Under the riparian doctrine, a landowner has the right to divert the
water flowing through or next to his property for use upon his land.
But a landowner cannot utilize the water so as to impede other
owners use by decreasing the waters flow in speed, quantity or
quality. The correlative-rights doctrine holds that an owner may
take only a reasonable share of underground waters, usually based
on the amount of land owned on the surface above.
Riparian water refers to flowing water: a river, a creek. Littoral
water that is not flowing applies to a lake, or the ocean. According
to the riparian doctrine, a littoral landowner - land next to a pond,
for example - also can use the water for domestic purposes.
Appropriative rights, the other type of water rights, are not
dependent on land ownership. They are based on the right to use
water for a beneficial cause by diverting surface water. To set up an
appropriate right, someone who wants to use water from a lake or
river for a particular lawful purpose -- such as farming, watering
domestic animals, or generating electricity -- applies to the state
government for a permit. Once granted, if the right is not exercised
in an appropriate time period, that particular water right is likely to
be revoked.
Of course, the state may exercise its right of appropriation in order
to divert water for the public good.
AIRSPACE
Air rights endow a landowner with the right to use the airspace over
his land. However, the federal authorities still exercise complete
power over airspace used by planes and satellites; land owners have
the right to use the lower areas of airspace. Such landowners
airspace is considered real property, and can be sold as such.

MINERAL RIGHTS
These apply to the right to take substances from the land, both
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surface and subsurface (but usually the latter). Minerals include

solid materials, like precious metals, coal, iron and the like.
When certain mineral rights are sold separately from a parcel of
property, the buyer obtains an easement, or the rights to enter the
property in order to mine the minerals from it.
Minerals are considered real property unless they not stationary:
fluid, such as oil or natural gas. Then they are termed fugitive
substances. The right to extract these substances is considered
real property, but once these substances are removed from the
ground and contained they become personal property.
IMPROVEMENTS
Also belonging to an owner are things resting on the land and
permanently attached to the property, such as homes or additions
to homes (such as garages).
Natural attachments are affixed to the ground such as growing
plants, crops and trees. They are sold and transferred along with
the real property to which they are attached. The Doctrine of
Emblements states, however, that a farmer whose tenancy on the
land is terminated through no fault of theirs can re-enter the land
to harvest the first crop after the tenancys termination.
If something is affixed to a building by people, it is considered a
fixture. Fixtures are personal property which become real property
when attached to the land.
When an item of personal property is added to real property, and
becomes a fixture, it is called annexation. Taking a fixture away
from a real property so that it reverts to personal property is termed
severance.
There are five tests to help decide whether an article of property is a
fixture, with the acronym of MARIA.
- Method of attachment: The stronger its attachment, the greater
probability that it is a fixture. A set of lights that are welded into
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sconces on an outdoor patio is probably a fixture; a hammock tied

to two palm trees is probably not.
- Adaptability of the item for the lands ordinary purposes: The
greater the degree of adaptation, the greater likelihood that it is a
fixture. Has a putting green been installed to fit the contours of the
backyard? Is there a custom-made countertop that has been
fashioned for the dimensions of the family kitchen?
- Relationship of the parties: For instance, a tenant who attaches
something to the property has a better chance of claiming it was
personal property. In conflicts over fixtures, a deciding authority
will give greater credence to tenants over landlords and buyers over
sellers.
- Intent: This is a key factor. If a tenant decides to install an alarm
system, and declares to the landlord his intent to take the system
with him upon his departure, then it will likely be considered as his
personal property.
- Agreement of the parties: Noting whether an expensive item is a
personal property or a fixture in a lease signed by tenant and
landlord is a perfect way to forestall disputes over its status.
Note that not all five tests have to be met for something to be judged
a fixture. The last test, agreement of the parties, will have the most
dispositive effect.
LAND DESCRIPTION
When real property changes hands, the documents describing this
change in ownership must describe with some degree of precision
the land involved in the transaction.
Street addresses are inadequate to specify rural areas, and street
names may change. The best practice is to use a legal description.
In California, as in the rest of the country, there are three types of
legal description:

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1)

Metes and bounds;

2)

Rectangular survey system;

and,

3)

Lot and block.

METES AND BOUNDS

Metes and bounds relies on boundary markers and measures the
distance between landmarks to set a propertys perimeter.
Landmarks such as trees or big rocks are called monuments. This
type of description utilizes direction and distance. Metes are ways
to measure length: inches, feet, yards or rods. Bounds are
boundaries, either natural, like rivers or artificial, like roads.
A metes and bound description will begin at a certain point called
the point of beginning, a well-delineated point on one of the parcels
boundaries. It measures the distance between it and other
boundaries, in a certain direction and at an angle from the last
point; these are called courses and distances, i.e., north 20 degrees
west, 100.5 is a course and distance. The description always
returns the surveyor to the point of beginning, so that the
dimensions of land parcel can be obtained.
However, monuments may erode or be knocked down. Rivers
change their course. A particular tree may be uprooted in a storm.
Metes and bounds can thus vary over time, and the fact that a
trained surveyor is necessary to interpret their description also
limits its usefulness as a land description method.
RECTANGULAR SURVEY SYSTEM
This is also called the section and township system or U.S.
Government Section and Township Survey, established in the 19th
Century by the U.S. Surveyor General to survey public lands. It
uses imaginary lines to set land descriptions on the distance: base
lines that go east-west and meridians running north-south. There
are three major starting points in the state -- the Humboldt
Baseline and Meridian on Mt. Pierre in northwest California; the Mt.
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Diablo Baseline and Meridian in Contra Costa County in

Northeastern-Central California; and the San Bernardino Baseline
and Meridian in Southern California.
Grid lines are parallel to the principal meridian and the base line at
distances of six miles. The north-south lines are called range lines
and they demarcate the land into columns called ranges. The eastwest lines are called township lines, and they intersect with
meridians that runs north-south from a reference point. These
imaginary lines divide land into rows or tiers termed township tiers.
A grid of squares called townships are measured and numbered in
each direction from the point of intersection of the baseline and
meridian. Each township is six miles by six miles: 36 square miles.
LOT AND BLOCK SYSTEM
Alternative names for this method of legal description are the lot,
block and tract system or subdivision system. This method of
description is based on the California legal requirement that
developers who parcel land into lots must prepare and file a
subdivision or plat map with the County Recorder showing the
location and dimensions of all the lots in the subdivision. Every lot
is identified by tract, the largest area; then into blocks; and, then
blocks into lots.

Chapter Summary
- California has a remarkably wide range of climates, and a history
of different groups and nations rising and waning in ascendancy -Native Americans, the Spanish, Mexico, and finally the U.S.
- The Gold Rush of 1849 attracted an influx of Americans leading to
the admission of California as a state.
- Californias rapid expansion and prosperity, fueled by the
railroads and immigration, followed into the next century. The
defense industry led to continued growth, the legions of defense
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workers needing homes starting a housing boom.

- The states latest and perhaps greatest housing bubble burst in
the latter part of the 00s. Yet Californias median home price is still
about 40% higher than the rest of the country.
- The two types of property are real property and personal property.
- Real property cannot be moved while personal property can be.
Real property is land, anything that is attached to the land, and
appurtenant to it (used with the land for its owners benefit such as
a walkway to the beach). The land also includes water rights,
surface rights, airspace, and mineral rights.
- Personal property can become classifiable real property when it
becomes affixed to the land. Since fixtures are permanently
attached to land, they are considered real property.
- MARIA is the acronym for the five tests to be considered whether
something is a fixture or not when land is being sold or transferred:
method of attachment, adaptability, and relationship to the parties,
intent of the parties when the item was attached, and agreement of
the parties.
- The transfer of real property from owner to owner must be
accompanied by a legally sufficient description of the property. The
three most commonly used methods of legal description are metes
and bounds, rectangular survey and lot and block.

Chapter Quiz (Part I & II)

1. The highest point in California is:
a. The top of the U.S. Bank Tower in Los Angeles.
b. The top of Mt. Whitney
c. The top of Mt. McKinley
d. The Golden Gate Bridge
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2. The Spanish Mission system was designed to:

a. Convert Native Americans to Christianity
b. Teach Native American European farming methods
c. Teach Native Americans how to speak Spanish
d. All of the above
3. The Gold Rush began at:
a. Sacramento- in 1848
b. San Francisco in 1849
c. Sutters Mill in 1849
d. Los Angeles in 1865
4. The California economy, though battered by recession, is still:
a. The largest producer of tomatoes in the world
b. The seventh-largest economy in the world
c. Home of the nations highest per capita energy use
d. None of the above
5. Real property is the equivalent of:
a. Fixtures
b. Land
c. The bundle of rights
d. Riparian rights
6. Personal property is:
a. movable
b. Must be something that could be felt or seen
c. Must be titled under someones name
d. None of the above
7. Which of these is NOT part of the bundle of rights?
a. The right to use a property for a lawful purpose
b. The right to encumber property, as security for a loan
c. The right to build a commercial building on a property
d. The right to transfer a property, by sale or as a gift
8. The most important test among the group of tests under the
acronym MARIA for determining whether an item is a fixture is:
a. The method of attachment
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b. The adaptability of the item for the lands ordinary purpose

c. The relationship of the parties
d. Agreement among the parties
9. The riparian doctrine holds that a landowner can utilize water
even if it impedes other owners use by decreasing the flow of water.
a. True
b. False
10. The doctrine of emblements provides that a farmer whose
tenancy has been terminated through no fault of his:
a. Has no right of re-entry to harvest his crop
b. Must agree to share half his harvested crop with the leaseholder
c. Can re-enter the property to harvest his first crops after the
termination of his tenancy
d. None of the above
11. Which of these is NOT a method of land description?
a. Lot and block
b. Rectangular survey system
c. Metes and bounds
d. Longitude and latitude analysis
12. The rectangular survey system:
a. Is also called the section and township system
b. Uses imaginary lines to set land descriptions called
meridians and baselines
c. Both A & B
d. None of the above

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CHAPTER 2
Types of Estates and Ways of Holding Title
CHAPTER OVERVIEW
Ownership is a critical component of real estate, it is considered to
be one of the basic rights in our society. Real estate ownership
tends to take various forms. Normally, an owner is understood to
have full title and possession of the property, but often this is not
the case. An owner may have limited interest in the property and
not have exclusive title to it, or she may allow a tenant to take
possession while she keeps the title to herself. Also, the property
can be co-owned by more than one person at the same time, called
concurrent ownership.
In this chapter we shall learn the various types of ownership
interests, and the type of interests that tenants may have. Then we
shall learn the types of concurrent ownership and the different
ways in which the co-owners may hold title.
TYPES OF ESTATES
An estate is essentially the ownership interest or claim of an
individual in real property. The two distinguishing features of
different of estate are:
A)

How long the estate holder has the possession

rights.

B) When exactly will the estate holder get the possession rights
(immediately or sometime in the future?)

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It is noteworthy that while all estates are interests in land, not every
interest in land is an estate. Interests that are not estates are called
non-possessory interests.
Estates are of two types:
1) Freehold estates
2) Leasehold estates (less-than-freehold)
A freehold estate is an estate of indefinite duration which can be
sold or inherited. The holder of a freehold estate is generally
referred to as an owner. A less-than-freehold estate or the
leasehold estate has a limited duration. The one who owns such
an estate is referred to as a tenant. The tenant has temporary and
limited right of use in a real property.
Each type of estate can co-exist in the same piece of property at the
same time. Also, the mutual relationship of two or more parties
having interests in the same property is known as privity.
Freehold Estates: As stated before, freehold estates are real
property estates of ownership. Also known as an estate of
inheritance, this type of estate continues for an indefinite period of
time. Freehold estates can be further sub-divided into fee simple
estates and life estates.
1) Fee simple estates can be sub-divided:
a) Fee simple absolute is the highest form of interest in land.
This estate is held by the owner without any qualifications or
limitations, like private deed restrictions. However, all
government ordinances and limitations do apply.
b) Fee simple qualified (defeasible), which is owned with a few
limitations or private deed restrictions limiting the propertys
use. A fee simple estate may be qualified at the time of transfer
from one owner to another.
c) Life estate is created by will or deed for as long as one
specified individual is alive. As a life estate is a type of
freehold, the holder has all the rights that come with fee
24

ownership, but not to dispose of the estate by will. Life estate

holders have to pay the taxes and maintain the property. They
also collect the rent and retain all the profits for the durations
of the life estate. If the person wishing to grant the life estate
nominates someone else to the title of the estate upon his
death, the person so nominated will have an estate in
remainder.
However, if the property needs to be returned by the heir back
to the life estate owner, then the estate owner will have an
estate in reversion. Estate in remainder and estate in reversion
are known as future interests.
Reserving a life estate is when the owner sells the property to a
developer, but reserves the right to live on the property until
their death. The developer gets possession of the estate only
after the death of the property owner.
A life tenant must not engage in acts that might permanently
damage the property, thereby harming the interests of the
reversionary or remainder estate.
Example of a life estate owner: Mr. Collins, a widower, expires,
leaving a life estate to his sister Barbara and the remainder to his
only son, Ben. Barbara was pleased to move out of her rented
apartment to live on the Collins estate. However, Ben was upset
with what his father had done and insisted on being allowed to live
in the house. In this scenario, Barbara, the life tenant, has the sole
right of use/possession of the estate as long as she lives.
Leasehold Estate: Those who rent or lease property from a landlord
are called tenants. These non-freehold estates that a tenant owns
are termed as leaseholds or estates of tenancy (sometimes also
referred to as chattels real).
The leasehold is created with a lease, which governs the
relationship of landlord (the lessor) and tenant (lessee). The tenant
has exclusive possession and use of the real property for a fixed
period.
25

TYPES OF LEASEHOLD ESTATES

Term Tenancy or estate for years is a tenancy for a fixed
term. When a property lease mentions an end date, it is
termed as an estate for years. It will automatically terminate
when the agreed term expires. However, the term tenancy can
be terminated before its expiration date with the consent of the
other party. Such a termination is called surrender.

Periodic Tenancy is the most common type of lease/rental
agreement. This lasts for a specific period, such as month to
month or year to year. Here a notice from either party is
required to end the periodic tenancy, otherwise it
automatically renews.
Unless otherwise prohibited in the terms of the lease
agreement, a periodic tenancy can be assigned to another
person.

Tenancy at Will: There is no written agreement between the
landlord and the tenant and it can be terminated by the
unilateral decision of either party. However, in California, a
30-day notice period is required to terminate the tenancy at
will.
A tenancy at will is not assignable in any circumstances.

Tenancy at Sufferance describes a situation where a tenant
has possessed the estate lawfully, but continues to occupy it
even after the end of the term without the landlords consent.
Such a tenant is also called a holdover tenant. To regain
possession of the property, the landlord has to follow proper
legal procedures.
WAYS OF HOLDING TITLE TO REAL ESTATE
Every property has an owner -- it could be the government, an
26

institution or an individual. The proof of lawful ownership is the

title. There are two ways to take title (own real estate): separate
ownership and concurrent ownership.
Separate Ownership
Separate ownership or ownership in severalty means ownership by
one person or entity. Real property may be owned by a real person
or an artificial person (example a corporation, a city, or a state).

Concurrent Ownership
When a property is owned by two or more persons at the same time
it is known as concurrent or co-ownership. There are four types of
concurrent ownership.
i. Tenancy in common is created when more than one person
takes title, they are not married to each other and there is
no other way of taking title. Tenants in common may take
title at different times, on separate deeds, have unequal
shares and/or have equal rights of possession. Tenants in
common do not need the consent of the co-owner to deed
their interest to someone else. None of the owners have the
right to exclude any co-owner from the property or to claim
any portion of the property for their exclusive use. Any
expenses incurred on the property including taxes, loan
payment, repairs or insurance have to be proportionately
shared.
If there are any disagreements between the co-owners
pertaining to the property, they may file a partition suit,
which will legally divide the interests in the property.
ii. Joint Tenancy: Ownership of property by two or more coowners with the right of survivorship is termed a joint
tenancy. By right of survivorship it is meant that in the
event of the death of any one of the co-owners, the joint
owner by default becomes the sole owner of the property.
Such a property cannot be willed.

27

To create a joint tenancy, these four unities have to exist:

Time, title, interest and possession. (Acronym: T-TIP) A
joint tenant is free to sell his interest in the property to
someone else. However, this will destroy the unities of time
and title. A joint tenancy may be terminated through a
partition suit.
iii. Real or personal property which is acquired by a spouse or a
registered domestic partner (as defined in Family Code
section 297) during marriage is considered community
property in California. (The community property rights for
spouses noted below apply to domestic partners)
Community property does not include property acquired by
gift or bequest by a spouse during the marriage or property
acquired by a spouse before marriage.
Income for either spouse -- including salary, from
investments, or rents -- is classified as community property,
except if it stems from separate property. Any property
purchased with community property funds is also
community property. Both spouses take an undivided halfinterest in community property.
When ownership of property claims are in dispute, the
maxim usually applies that property obtained during a
marriage falls under the category of community property.
This would mean that such property could not be sold,
leased for over a year, or encumbered by a mortgage
without both spouses consent.
A spouses separate property is not subject to the other
spouses control and can be freely transferred or
encumbered. In some states, the community property
system does not exist, so the married couples in these
states hold title to property as tenants by the entirety.
This is similar to a joint tenancy, but is limited to a married
couple.
28

iv. Tenancy in partnership is that property which is owned by two

or more persons for business purposes. All parties have
possession rights of partnership property for partnership
purposes. The partnership will dissolve in the event of the
death of any one of the partners, unless otherwise
mentioned in a prior written agreement. If a business
continues after the death of a partner, that partners right
to possession of the partnership property goes to the
surviving partners. The heirs of the deceased partner are
only entitled to the deceaseds share of profits and have no
right over the property. However, a different distribution
may be agreed upon in writing by the partners.
BUSINESS OWNERSHIP OF REAL ESTATE
Business entities can also hold, use and sell real property. The
following section will discuss the types of ownership in a business
unit.
Sole proprietorship
Corporation
General Partnership
Limited Partnership
Limited Liability Partnership
Trust
Sole proprietorships have a single owner who conducts a
particular business in his name or alternatively under a trade
name. A sole proprietor may or may not have employees working for
them.
Corporation: Individuals who purchase shares of stock in the
company as an investment are known as shareholders. These
shareholders own the corporation. Shares in a corporation are
termed securities.
According to law, a corporation is an artificial person, which can
own estates, enter into contracts or incur debts and liabilities.
A corporation that is formed for a nonprofit intention is owned by
29

members rather than shareholders. Such a corporation can own,

lease or transfer estates as well.
A corporation will continue to operate even if a shareholder dies. A
corporation owns its property in severalty and shareholders have no
ownership rights in this property.
Domestic corporations are those which are formed under
California law while foreign corporations are incorporated in other
states or countries. For foreign corporations to conduct business in
California, a certificate of qualification is required from the
Secretary of State.
It is noteworthy that a corporation cannot co-own property in joint
tenancy. The corporation may co-own property with another entity
or person as tenants in common.
General partnerships are formed by contract when two or more
persons form an association to conduct business as co-owners for
profit. Legally, the contract may not be required to be in writing, but
it is advisable to spell out all the terms in a written agreement. Any
partnership agreement which is not written is governed by the
Uniform Partnership Act.
Each general partner has an unlimited liability, which implies that
a partner can be held responsible for the debts of the partnership.
The authorized acts of one partner are binding on the partnership
since each partner is a principal for, as well as an agent of, the
general partnership for business purposes.
Property which is acquired for the partnerships business is
partnership property. A partner is not a co-owner of the partnership
property.
Limited Partnership: An investor takes part in a limited
partnership to avoid the unlimited liability of being a general
partner. The California Uniform Limited Partnership Act governs
such syndicates and these limited partnerships need to strictly
conform to the bodys statutory requirements.
30

The limited partners have limited liability and no authority in the

management of the business. However, if they exert such authority,
they will be considered as general partners and will lose their
limited liability.
Limited Liability Company: Such a company has the advantages
of a corporation as well as a partnership. In California, a LLC is
created by filing articles of organization with the Secretary of State.
Once created, a LLC is required to pay an annual fee and file
annual statements with the state.
A LLC has a flexible organizational structure and provides a singlelevel tax benefit of a partnership. Either certain appointed members
may manage the company or all members may manage the
company. However, unlike in a general partnership, a LLCs
managing members are not personally liable for the companys
debts or obligations.
A LLC in California incurs higher taxes and fees than either a
general or a limited partnership.
Trust: A property managed by one or more trustees on behalf of one
or more beneficiaries is termed a trust. The document that
establishes the trust generally defines the powers of the trustee.
How long a trust can last depends on the intent of the trustor.
Real estate investment trust (REIT) is an example of a business
ownership trust. In California, REITs are regulated by the
Commissioner of Corporations and it must comply with the federal
and state tax law. REITs must have at least 100 shareholders.
Shares in REIT are securities, subject to federal regulations.

CONDOMINIUMS AND CO-OPERATIVES

Condominiums (condos) and co-ops embody a combination of
aspects of individual ownership and concurrent ownership.

31

Condominium: The owner of a unit in a condo possesses the unit

itself in severalty but shares ownership of the common elements
with other unit owners as a tenant in common. For example, the
driveway, elevators, recreational area, lobby, etc. are all examples of
a common element (or common areas). However, some features may
be a part of limited common elements such as an assigned parking
space.
Although a condo generally is a multi-family CC&Rs residential
unit, commercial and industrial properties may also be developed
as a condo. A condo seller is supposed to give the (covenants,
conditions, and restrictions) of the condo project to the prospective
buyer.
When an owner of an apartment complex desires to change the
complex into a condominium, the process is known as conversion.
Conversions are regulated to protect displaced renters.
Co-operatives: The residents of a co-operative building dont own
the property itself but instead hold shares in the corporation. They
are tenants with long-term proprietary lease on their units.
As in a condo, the co-operatives are generally regulated as
subdivisions. In a co-op, the corporation takes out one blanket loan
for the entire project, while in a condo, each unit owner get
individual financing to buy the unit.

Chapter Summary
As society grew to become political states, important
ownership traditions took the form of laws.
To safeguard the ownership land of its people, Americans
came up with a policy of recording evidence of title or interest.

32

 There are two ways of giving a public notice. A constructive

notice may be given by recording a document in the public
records at the office of the county recorder. Another way of
giving a public notice is by occupying or using the property in
a way that it notifies anyone interested that the party in
possession is the lawful owner.
Property owned by one individual or entity is known as
ownership in severalty or sole and separate ownership.
When two or more people or entities own a property at the
same time it is known as concurrent ownership or coownership.
An interest in real property that is held by someone who is not
the owner of the property is called an encumbrance.
An easement is the right to use the property of someone else
for a specified purpose.
A homestead exemption limits the amount of liability for some
of the debts against which a home can be used to satisfy a
judgment.
The title insurance companies started issuing policies of title
insurance. A major advantage of this was that the title
insurance rendered protection against matters of record and a
lot of non-recorded types of risks, according to the types policy
purchased.

Chapter Quiz
1. Technically speaking, property refers to:
a. A freehold estate
b. Personal property only
c. Rights or interest in the things owned
d. Land and building only
33

2. A possessory interest that has a limited duration is:

a. Freehold estate
b. Less-than-freehold (leasehold) estate
c. Fee simple absolute
d. Fee simple defeasible
3. Which of the following is described as the highest and the
most complete form of ownership with infinite duration:
a. Fee simple absolute
b. Life estate
c. Freehold estate
d. Fee simple defeasible
4. A title which is conveyed with a condition that the land will not
be used for selling alcohol establishes a:
a. Life estate
b. Estate at will
c. Fee simple defeasible
d. Less-than-freehold estate
5. _______________ is also known as an estate of inheritance.
a. Freehold estate
b. Less-than-freehold estate
c. Life estate
d. Fee simple absolute
6. An agreement is signed between two parties for the use and
possession of real property for a period of 120 days, creating a:
a. Tenancy at will
b. Periodic tenancy
c. Tenancy at sufferance
d. Term tenancy
7. Ownership in severalty would most probably mean:
a. Sole ownership
b. Ownership with other party
c. Tenancy in common
d. A fee simple defeasible estate
34

8. A ______________ may arise after a periodic tenancy or a term

tenancy terminates a:
a. Joint tenancy
b. Tenancy in common
c. Tenancy at will
d. Periodic tenancy
9. Two people own one real property together. One owner has
one-third interest and the other one has two-thirds interest, in
this case how will they hold title?
a. Tenancy at will
b. Tenancy in common
c. Joint tenancy
d. Ownership in severalty
10. Joint tenants have unity of:
a. Time, title, interest and possession
b. Only title and possession
c. Interest without possession
d. Title without interest
11. The meaning of community property is:
a. All property registered by a spouse/domestic partner
b. All property acquired by a spouse/domestic partner that is
not separate property
c. The only form of ownership during marriage
d. All property acquired by the husband during marriage
12. An agreement made by only one spouse for the sale of a
community property will be considered:
a. Valid
b. Illegal
c. Unenforceable
d. Enforceable
13. Absolute control and absolute liability are the characteristics
of a:
a. Limited partner
35

b. Trustee
c. Sole proprietor
d. Corporate shareholder
14. A unit in a cooperative is owned:
a. By the corporation that is the owner of the building, in
which the shares are owned by the residents
b. In partnership among all residents of the building
c. In severalty by its residents
d. In tenancy in common among all residents of the building
15. A _____________ is owned by its shareholders, who purchase
shares of stock in the company as an investment.
a. Trust
b. Joint venture
c. Corporation
d. Limited liability company
e.

CHAPTER 3
TRANSFER OF REAL ESTATE
CHAPTER OVERVIEW
This chapter will examine the necessary requirements to transfer
title to land, which in California must include the proper recording
of a written document. The most often-used method of transfer is
through a deed, and we will discuss the different types of deed, the
valid elements of each, and how they are recorded. Safeguarding
ones interest in a marketable title through title insurance is looked
at, as are the different types of wills, the legal requirements for each
36

and how the process of probate determines their validity.

TITLE AND ALIENATION
Title refers to the ownership a person has over a property. Title
defects or clouds on title means that there are problems in a
property owners title. Marketable title refers to a title without any
serious defects.
The process of transferring title (ownership) to real estate from one
party to another is called alienation. When a title is deliberately
transferred by the owner to someone else, it is termed a voluntary
alienation. When a transfer of property takes place as a result of the
operation of law (without any action by the owner), it is called
involuntary alienation.
Voluntary Alienation
The transfer of title of real property under voluntary alienation can
be executed by the following three methods:
a) Patent,
b) Deed, or
c) Will
a) Patents: A patent is a document through which the
government transfers title to a private party. For all land
under private ownership, the patent is the ultimate source.
b) Deeds: A deed is the most common of the three voluntary
alienation method of title transfer. The process of transferring
real property by deed is termed a conveyance. The title is
conveyed by grant (transfer) from the grantor (real property
owner) to the grantee (another person).
REQUIREMENTS FOR A VALID DEED
For transfer of a title, it is necessary that a deed meets the legal
37

requirements for validity, as mentioned below:

i) The deed must be in writing: There is a state law in place
which requires contracts and other such legal transactions
to be in writing. The term used for this law is the Statute of
Frauds.
ii) ii) Identity of the parties: Noting full names and marital
status is a must. The grantor and the grantee must be
identified in the deed; however, the name of the grantee is
not required (just an adequate description is enough); for
instance, Steve Johnsons only niece. It is also possible for
the grantee to take title under a fictitious name. Also, the
name of each spouse in full is required.

iii)

The grantor has to be a competent signatory: The deed is

only considered to be executed once it is signed by the
grantor. The deed is deemed void if the grantors signature
is forged.
The grantors attorney in fact may sign the deed on his
behalf. An attorney in fact is a person who is appointed by
the grantor to act on his behalf in a document called power
of attorney. Under law, the attorney in fact cannot deed the
property of his principal to himself.
Corporate deeds are often signed by the authorized
representative of the corporation, accompanied by the seal
of the corporate organization.
In the event of there being more than one grantor, all of
them have to sign the deed.
To convey community property, both spouses signatures
are required. For this reason, it is recommended to mention
the marital status of the grantor in the deed and obtain the
signature of the spouse, even if the property is not
38

community property.
The grantor must be a legally competent adult of at least 18
years with a sound mind, otherwise the deed is invalid.
iv)Proper description of the property being conveyed: A full
legal description of land is recommended although the deed
can be valid without it, if it has an identifiable description of
the property.
v) A living grantee: It is necessary for the grantee to be alive and
identifiable when the deed is executed for the deed to be
valid. However, the grantee does not have to be legally
competent for a valid deed.
vi)A granting clause: This is necessary, in which words of
conveyance are used such as grant or convey. Additional
technical language is unnecessary, since it does not affect
the validity of the deed.
vii) Acknowledgement, delivery and acceptance of deed by
the grantee: Acknowledgement is when the grantor
confirms before a legal witness that his signature is genuine
and voluntary. Note that an unacknowledged deed may be
valid but it cannot be recorded.
A valid deed becomes effective for title transfer only when it
is delivered to the grantee. The key element of delivery is
not just the physical transfer of the document but also the
intention of the grantor to transfer the title to the grantee
immediately. The conveyance is said to be completed when
the grantee accepts the delivery of the deed.
Since the delivery of a deed is a delicate legal issue, it is
advisable to consult a real estate lawyer on this point.
Important terms
Some terms that are not legally required in a deed but should be
included nonetheless include a habendum clause (also referred to as
39

a to have and to hold clause). This states the nature of the interest
the grantor wants to convey. If it is not specified, the grantors
entire interest passes to the grantee by default. In case there is
more than one grantee, the deed should specify how they intend to
hold title.
Some deeds have an exclusions and reservations clause, which is a
list of any encumbrances. Having mentioned that, valid
encumbrances usually remain in force even if not listed in the deed.
A deed also often includes a recital of consideration. This is to
confirm that the transfer is a purchase and not a gift. The recital of
consideration in a deed normally does not state the actual purchase
price paid.

TYPES OF DEEDS
Grant deed: This is the most frequently used instrument to transfer
title in California. The grant deed contains the word grant(s) in its
conveyance and the grantor warrants the following:
i)
ii)

The title has not been conveyed prior to this to anyone else,
and,
There are no hidden encumbrances on the property other
than those already disclosed.

The grantor also conveys to the grantee any rights he might acquire
to the property after conveying it to the grantee. This is termed as
after-acquired title. For instance, if the grantors title was not perfect
at the time of transfer, but later on he acquires a perfect title, the
additional interest will pass on to the grantee by default under the
original deed. The grant deed is the only form of deed conveying
after-acquired title.
Gift deed: The property given as a gift to the grantee by a relative or
close friend is executed through a gift deed. The consideration in a
gift deed is called love and affection.
Quitclaim deed: This type of deed contains no warranties and
40

conveys any interest the grantor may have in the property at the
time the deed is signed. A quitclaim deed is generally used to
correct a technical flaw in an earlier deed and it is often referred to
as a reformation deed. A quitclaim deed is sometimes also used to
clear a cloud on the title and to discard any future claim by the
grantor of this deed. It is advisable, however, to use a grant deed
rather than a quitclaim deed.
This type of deed is also used when the grantor is unsure of the
validity of his title and does not want to give any warranties. A
transfer of real property between family members is often done
using a quitclaim deed.
A grantor of the quitclaim deed is liable for any loans taken using
the property as security.
Trust deed: Also called a deed of trust, it is used when a property
serves as security for a debt.
When money is borrowed to finance the purchase of the property,
the borrower (new owner) is the trustor (the grantor) of the trust
deed. The party who holds the title until the debt is paid is the
trustee (the grantee). The party on whose behalf the title is held is
termed as the beneficiary (the lender). In the event of the debt not
being paid, the trustee has the power to sell the property at a
foreclosure sale and pay the beneficiary the remaining amount of
the loan from the proceeds. The balance, if any, goes to the trustor.
The buyer of the property would receive what is called a trustees
deed, from the trustee.
Reconveyance deed: The beneficiary notifies the trustee about the
clearance of the debt (by the trustor) by sending the trustee a
document called a request for reconveyance. The trustee then
returns title to the trustor by way of a reconveyance deed.
Sheriffs deed: A court-ordered sale of property is executed through
a sheriffs deed. Such a deed carries no warranties of title. Transfer
of property to the highest bidder at a court-ordered foreclosure sale
is an example of a sheriffs deed.
41

Tax deed: When a property is sold due to nonpayment of taxes, a

tax deed is issued by the county tax collector.
Warranty deed: In California, such a deed is used less frequently. A
warranty deed clearly warrants that the grantor has good title.
Thus, the warranty deed gives utmost protection to the real
property purchaser. A grantors warranty makes him liable for a
flaw in the title, even if a flaw without his knowledge is discovered
much later. This safeguards the buyers interests. This is also one
of the primary reasons why lenders require title insurance for most
transactions in California.
c)
Will: This is the third method of transfer by voluntary
alienation. It is the easiest way to acquire title to real estate. In a
will, the title is transferred by a person through a legal document
which specifies how his property is to be distributed in the event of
his death. If the decedent (the person who died) does not leave a
will, a court of law determines the new owners of the property.
The person who makes a will is known as the testator, and when he
dies, he is said to have died testate. Someone who dies before
making a valid will is said to have died intestate.
Beneficiaries are those who receive property through a will. Personal
property given as gift is called a bequest or legacy; a testator is said
to have bequeathed his personal property to legatees. A gift of real
property in a will is called a devise. The testator devises his real
property to devisees. During his life a testator has the right to
change a will or make a new will. Codicil is the term used when an
amendment is made in a will.
According to law, a
requirements. The will:

will

must

fulfill

the

following

legal

i)

Must be in writing

ii)

Should be signed by the testator

iii)

Must be attested to by at least two competent witnesses.

42

California law also accepts a type of unwitnessed will which is

known as a holographic will. A holographic will has all the
material provisions and the signature handwritten by the testator
himself. This type of a will is valid even though it is not signed in
the presence of witnesses. Printed or typewritten parts of a
holographic will are not acceptable by law.
Probate is the legal procedure through which the validity of a will is
determined and the directions of the testator are carried out. Note
that a will is activated only when the testator dies and the will is
probated.
In California, superior courts handle the probate proceedings. A will
names an executor who acts as the testators representative to carry
out the terms of the will. If no executor is named in the will by the
testator, the court then appoints an administrator to perform those
duties. This executor or administrator is referred to as the testators
personal representative.
Following are the duties of the executor:
Publish a notice to creditors of the death of the testator
Obtain an appraisal and conduct an inventory of the property
of the deceased testator
Prepare a report of the estate assets and liabilities for the
probate court
Distribute the proceeds of the estate as directed by the court
INVOLUNTARY ALIENATION
Transfer of real property which happens due to the rule of law,
adverse possession, or accession may be termed involuntary
alienation. Dedication, intestate succession, escheat, condemnation,
and court decisions regarding real property are all ways of
alienation by rule of law.
Dedication:

A private owners donation of real property to the

43

public is termed a dedication, which may be voluntary.

A dedication in which compliance with relevant
procedures is required is called statutory dedication.

statutory

A common law dedication occurs when a property owner devotes

land for public use for an unknown period of time. As mentioned in
the Subdivision Map Act, certain areas of the property will be set
aside for public use, such as a park, road, school play ground, etc.
This dedication may either be treated as a transfer of ownership or
it may establish just a public easement (discussed in the next
chapter), as circumstances demand.
Intestate Succession and Escheat: The process of legal
determination of property ownership which occurs in the event of
the owner not making a valid will is known as intestate
succession. There is no set order of succession but normally the
property is passed on first to the surviving spouse, then to any
surviving offspring and then to other relatives. As per California
law, the surviving spouse is entitled to all of the community
property.
Individuals who take property by intestate succession are known as
heirs and they are said to have received property by descent. The
probate court supervises the intestate succession through an
appointed administrator.
The legal procedure in which private property reverts to the state
government because the owner did not leave behind a will and the
probate court fails to locate any legal heirs is known as escheat.
The state government must wait for five years before making a claim
on the property. The state may also take, through escheat, the
ownership of abandoned property.
Condemnation: The federal and state governments have the
constitutional right to acquire title to private property by
compensating the owner by way of fair market value. (Fair market
value is the price the property should bring in the open market)
This is known as the power of eminent domain. The use of this
44

power is called a taking. The legal process of acquiring property by

eminent domain is known as condemnation.
Two compulsory requirements to be fulfilled for the power of
eminent domain to be exercised are:

The acquired property is to be used for the benefit of the
public

The owner must receive just compensation, i.e. the fair
market value of the property
The power of eminent domain may be exercised by any government
entity as well as by any semi-public entity, like utility companies.
At times when a property is damaged by a public entity, the
property owner claims monetary damages through a legal procedure
known as condemnation.
Court Decisions: There are various situations in which a court of
law establishes legal title to property regardless of the opposition
from the owner of record. Some of the common forms of actions
taken by court that affects title to property are:

Quiet title

Partition

Foreclosure, and

Bankruptcy
Quiet title action: This court action is usually taken to clear a
cloud on the title of the real property. Example of this type of court
action is to clear tax titles, as well as titles based on adverse
possession (discussed in detail in the next portion of this chapter).
Partition: When there is a difference of opinion between the coowners regarding the distribution of the property, a legal proceeding
called a partition action sorts out this dispute. In this way the co45

ownership ends and the property is either physically divided or the

money derived from its sale is divided.
Foreclosure: When a property owner fails to make timely payments
on their mortgage, the lender seizes the property of the owner
through a legal procedure known as foreclosure.
Bankruptcy: A persons or a companys financial insolvency is
relieved through a legal process known as bankruptcy. The debtors
real property may be sold to pay off the claims of the creditors or
mortgage lenders.
ADVERSE POSSESSION
In this form of involuntary alienation, the possession and use of
property can convert into title. It implies that the actual use of the
property by an individual may eventually result in a greater interest
in that property than the original owner who does not use the
property.
To acquire title to real estate by adverse possession, certain specific
requirements need to be fulfilled:

1. Occcupation of the property must be actual, open and notorious.

It implies that the use of property should be in accordance
with the standard uses for the type of property in question.
For example, residing on farmland is not required for
possession, just fencing the land and planting crops is
enough. On the other hand, residential or commercial use is a
requirement for the actual possession of urban property.
Open and notorious possession of the property is required for
the actual owner to know that his continued interest in the
property is in jeopardy. Actual possession of the property must
be apparent for the world to notice that the occupant is the
adverse possessor of the property.
2. Occupation of the property must be hostile to the actual owners
interest. It implies that the occupant is in possession of the
46

property without the permission of the actual owner. The

adverse possessors intention should be to claim the
ownership of the property and to defend the claim against all
parties.
3. Occupant must claim title to the real property under the Claim of
Right or Color of Title. Color of Title is the possession of a
document which mistakenly appears to convey title to the
occupant. In such a condition the adverse possessor may
acquire title to the entire property mentioned in the defective
document, even though he is occupying just a part of it.
4. Continuous and uninterrupted possession. In California the
adverse possessor must occupy the property for a continuous
and uninterrupted period of five years. To equal the
compulsory time period, the periods of possession by adverse
possessors may be added together; this is called tacking.
5. Payment of real property taxes. The adverse occupant is
required to pay all the real property taxes during his five years
(or more) of possession.
It is noteworthy that title to federal or state government property
cannot be acquired by adverse possession.
Accession
Accession refers to man-made or natural additions to real property.
An addition to ones own property may sometimes be a result of
involuntary alienation of another persons property. Accession may
happen due to the following natural processes:
Accretion
Reliction
Avulsion
Accretion: A process where soil gradually builds up over a period of
47

time, by natural causes on a property near a body of water like a

river, lake or ocean. This accumulation of soil is known as alluvium
and the process is termed accretion. A significant feature of
accretion is that the soil build-up has to be very gradual so that it
goes unnoticed.
Reliction: When the waters of a moving body of water recede
naturally and thereby uncovers new land, the process is known as
reliction. Reliction increases the adjacent land owners actual
property. This is a gradual process, like accretion.
Avulsion: The sudden and violent washing away of land by water
due to a natural cause is known as avulsion. This washed-away
land sometimes get deposited elsewhere. The original owner of the
land still holds title to it, provided he can find a way to reclaim it. If
the land remains unclaimed, it is considered to a part of the
property to which it becomes attached.
RECORDING
The method of safeguarding ones interest in real property, after it
has been transferred either voluntarily or involuntarily, is done by
recording the deed that conveys the property to the new owner. A
recorded document is placed in a public record, where it can be
examined by anyone interested.
Procedures of recording
Recording is done in the county where the property is located by
filing a copy of the deed at the county clerks (recorders) office. The
order of filing is chronological and each document is assigned a
recording number.
When a property is under consideration for purchase, a title search
is conducted to ascertain the validity of the sellers title and
whether the title is clear. One of the reasons for recording a deed is
also to protect the chain of title. This is the sequential record of the
transfer of property from one owner to another. Any document
pertaining to the title to land may be recorded. For example: a deed,
a mortgage, an abstract of judgment or a lis pendens (a notice
pending legal proceedings that may affect property). For the deed or
48

any other document of conveyance to be recorded, it has to be

acknowledged first.
Legal Consequences of Recording
The two most important consequences of recording a document
are: The owner is able to give a clear notice to the world about his
ownership of a particular property, and it sets the priority for that
property.
Notice: Certain information is made known to a person by way of
serving a notice on him. Having a notice implies that the person
knows or should have known a particular fact which may affect his
legal rights.
Actual notice and constructive notice are the two main types of
notice. When a fact is personally viewed, read about or heard about
it is said to be an actual notice. But, when in the eyes of the law a
person is assumed to have known about something whether or not
he actually did have such knowledge, this is known as constructive
notice.
Recording a document gives constructive notice to people in general
about the interest of property mentioned in the document. It is
assumed that anyone interested in buying a particular property is
aware of the recorded interest in that property, whether or not he
physically checked the public record.
A buyer who does not record his deed may lose title to the person
who buys the same property afterward in good faith without actual
or constructive notice of the earlier conveyance. In a conflict
between two buyers, the one who records his deed first has good
title to the property irrespective of the fact that the other buyers
deed was executed first.
Recording provides constructive notice as well as creating an
implication that the recorded document is valid and effective. That
being said, recording is not a means to validate deeds that are
otherwise invalid nor is it a protection against interests arising by
operation of law, as in adverse possession.
49

Wild Deeds: A deed that is outside of a chain of title is called a wild

deed. At times, such a deed may even be recorded but will not be
discovered in a standard title search.
Possession and Notice: Someone who has taken possession of land
other than the seller gives notice to the new buyer of his interest in
the land. The buyer is supposed to make further inquiry into the
matter. This is sometimes referred to as inquiry notice or implied
notice.
TITLE INSURANCE
The cost of real estate is very high and real estate laws very
complex. Thus, the prospective buyer should safeguard his interest
in any way possible. One of the methods of protecting an interest is
acquiring warranties of title from the seller. Warranties become
useless if the seller is financially unable to back them up.
The buyer can obtain the chain of title or an abstract of title (a brief
history of the interests in property) from the recording office. But
still the buyer has no protection against hidden or undisclosed
defects in the title. It is the title insurance policy that protects the
interest of the buyer.
A title insurance company agrees to reimburse the policy holder for
any losses caused by defective titles. However, title insurance will
not cover the losses caused by defects that are specifically excluded
from the policy.
Acquiring Title Insurance
First, the buyer asks the insurance company to conduct a title
search. The insurance company does a thorough search of the
countys public record as well as other records, such as the records
of the Federal Land Office.
After the completion of the title search by the title company, a title
report is prepared which describes the condition of the title in
question. The defects and encumbrances of record are listed and
then excluded from the policy coverage. On the basis of the report
50

both the buyer and the seller arrange to resolve the issues of the
title. Upon the complete satisfaction of the buyer, the transaction
comes to a close. The title company then issues a title insurance
policy in exchange for a certain premium. The entire life of the
policy is covered by one premium payment.
Different types of policies cover different levels of protection. Types
of title insurances are mentioned below:
In California, policy forms published by the California Land Title
Association (CLTA) and the American Land Title Association (ALTA)
are used by the insurance companies. There are two basic
categories of title insurance policies, as per what interest is being
insured and as per the extent of the coverage provided.
Interest insured: A title insurance policy is prepared so that it
insures the particular interest of the policy holder in the property.
The title of the buyer is insured through an owners policy whereas
the lenders security interest is insured through a lenders policy
or mortgagees policy. The buyer is supposed to pay for the
lenders policy as a condition of obtaining a loan. Another type of
policy that insures just the validity of a lease is known as a
leaseholders policy.
Extent of coverage: In California as well as some other states,
there are two main types of coverage offered by the insurers:
Standard coverage and extended coverage. A third type of coverage
recently made available is homeowners coverage.
A standard coverage policy, also known as a CLTA policy, insures
defects in titles, including forgery. It does not protect against an
adverse possessor or against title defect known by the owner but
not disclosed to the title insurer, nor will it protect against an
encroachment.
An extended coverage policy, also known as an ALTA policy, insures
against all matters covered by the standard policy in addition to
matters not of public record, like the rights of parties in possession
of the property, unrecorded mechanics liens, and encroachments.
51

A homeowners coverage policy is available for transactions in

residential property with up to four units. This policy covers all that
the standard policy does, as well as extended coverage and coverage
for violation of restrictive covenants.
The lender almost always opts for extended coverage while the
buyer traditionally chooses for the standard coverage. However, in
recent times in California, most residential purchase agreement
forms provide that a homeowners policy will be obtained for the
buyer.
Governmental Action: No matter what type of coverage is
acquired, the title insurance company cannot protect a policy
holder from the losses incurred in governmental actions like zoning
changes or condemnation.

Chapter Summary
The process of transferring the title (ownership) to real estate
from one party to another is called alienation.
The transfer of title of real property under voluntary alienation
can be executed by a patent, by a deed, or by a will.
he transfer of real property which occurs due to the rule of
law, adverse possession, or accession may be termed as
involuntary alienation.
The process of legal determination of property ownership
which occurs in the event of the owner not making a valid will
is known as intestate succession.
The federal and state governments have the constitutional
right to acquire title to private property by compensating the
owner by way of fair market value. This is known as the power
of eminent domain and the legal process of eminent domain is
52

known as condemnation.
Accession refers to man-made or natural additions to real
property.
The method of safeguarding ones interest in real property,
after it has been transferred either voluntarily or involuntarily,
is done by recording the deed that conveys the property to the
new owner.
It is the title insurance policy that protects the interest of the
buyer. A title insurance company agrees to reimburse the
policy holder for any losses caused by defective titles.
An interest in real property that is held by someone who is not
the owner of the property is called an encumbrance.
An easement is the right to use the property of someone else
for a specified purpose.

Chapter Quiz
1. Real property is transferred through a process called:
a. Acknowledgement
b. Dedication
c. Alienation
d. Will
2. A _____________ deed conveys to the grantee all after-acquired
title of the grantor.
a. Grant
b. Quitclaim
c. Trustees
d. Warranty

53

3. Margaret holds an inherited title which is being challenged in

a probate court. Since she is not sure if the title is valid, she
will use which type of deed to transfer the property?
a. Grant deed
b. Quitclaim deed
c. Trustees deed
d. Warranty deed
4. ____________ occurs when the grantor swears before a notary
public or other official witness that his signature is genuine
and voluntary.
a. Delivery
b. Acceptance
c. Recording
d. Acknowledgment
5. The person who makes a will is referred to as a:
a. Legatee
b. Devisee
c. Testator
d. Beneficiary
6. An amendment to a will is called:
a. Bequest
b. Testate
c. Devise
d. Codicil
7. What is a dedication?
a. When a person dies without leaving a valid will
b. When a person acquires title by using the property
continuously and openly
c. When a private owner voluntarily or involuntarily donates
real property to the public
d. When government takes private property for public use by
justly compensating the owner

54

8. A will which is hand written and not witnessed is called a:

a. Probative will
b. Nuncupative will
c. Holographic will
d. Formal will
9. The power of the state to take private property for public use
is called:
a. Eminent domain
b. Public grant
c. Abandonment
d. Escheat
10. Soil deposited over a period of time beside a body of water is
known as:
a. Accession
b. Reliction
c. Avulsion
d. Accretion
11. To claim a title as adverse possessor, one must occupy the
premises for _____.
a. One year
b. Three years
c. Five years
d. Ten years
12. The probate court appoints the :
a. Administrator
b. Executor
c. Heir
d. Testator
13. When a property owner fails to make timely payments on the
mortgage, the lender seizes the property of the owner through
a legal procedure known as:
a. Bankruptcy
b. Foreclosure
c. Condemnation
55

d. Dedication
14. A deed that is outside the chain of title is called the:
a. Trust deed
b. Tax deed
c. Wild deed
d. Reconveyance deed
15. A standard coverage insurance policy will insure against:
a. A forged deed
b. Encroachment
c. Adverse possession
d. Unrecorded

CHAPTER 4
Encumbrances
CHAPTER OVERVIEW
An interest in real property which is held by someone who is not an
owner of that property is known as an encumbrance. The nature of
56

the interest may be financial or non-financial. While a financial

encumbrance affects only the title, the non-financial encumbrance
affects the physical condition or use of the property as well.
LIENS
Financial encumbrances are known as liens. A lien uses real
property as security for the payment of a debt. A lien could be
voluntary or involuntary. When an owner chooses to use his
property as a security to obtain a loan he creates a voluntary lien.
On the other hand, when the owner fails to pay taxes or debts
owed, a lien is placed against his property without permission,
creating an involuntary lien.
A lien may also be termed specific or general. A lien placed against
a certain property is termed as a specific lien. Examples of specific
liens are the mechanics lien, trust deed, attachment, property tax
lien and lis pendens. On the other hand, a general lien is the kind
which affects all the property of the owner; for example, a judgment
lien or federal/state income tax lien. Judgment lien
Types of Liens
Mechanics Lien
Attachment Lien
Judgment lien
Property Tax Lien
Special Assessment Lien
Mortgages
Deeds of Trust
Mechanics Lien: Someone who supplies labor, materials, or
professional services for the improvement of real property may be
entitled to claim a mechanics lien. This lien is a specific,
involuntary lien. A mechanics lien is sometimes referred to as a
construction lien. A contractor, sub-contractor, a laborer on a
particular job, material providers like plumbing or roofing, or
service providers such as engineers, architects, interior designers,
electricians or equipment lessors are eligible to file a mechanics
57

lien.
It is necessary that a mechanics lien be verified and recorded. There
are some statutory procedures which need to be followed in order to
successfully create a mechanics lien. These procedures are:
1)
2)
3)
4)

Preliminary notice
Notice of completion
Notice of non-responsibility,
Foreclosure action
The preliminary notice: According to California law, a written
notice must be given to the owner within 20 days after the
claimant starts providing labor, services or materials in order
to file a mechanics lien.
The notice of completion: Once a project is completed, the
property owner must, within ten days, file a notice of
completion for recording. Or, the owner may file a notice of
cessation, if work on the project is stopped for a continuous
period of 30 days, whether or not the project is finished.
After the property owner has recorded a notice of
completion/notice of cessation, mechanics lien claimants
ideally must file a lien claim for recording within 30 days. But
an original contractor has 60 days after the recording of the
notice of completion/notice of cessation in which he can file a
lien claim.
In a situation where the property owner does not record a
notice of completion or a notice of cessation, all mechanics
liens may be filed for recording within 90 days after the
completion of the project.
Notice of non-responsibility: Sometimes a tenant hires
contractors, subcontractors and suppliers for work to be done
on the leased property, without the permission of the property
owner. If the tenant fails to pay for the work done, the
contractors, subcontractors and the suppliers could file
58

mechanics liens against the property and the owner could end
up being responsible for the cost of the jobs done.
To protect herself from these types of situations, the property
owner, within 10 days of becoming aware of the unapproved
construction, must give a notice that she will not be
responsible for the cost of the work done. This notice must be
placed somewhere on the property and be recorded as a
notice of non-responsibility.
4) Foreclosure: The claimant of the mechanics lien has to claim
foreclosure action within 90 days after the mechanics lien has
been recorded. Otherwise, the lien is deemed void and the
claimant loses the right of foreclosure.
Attachment Lien: Someone who files a lawsuit is called a plaintiff
and the party he sues is known as a defendant. Sometimes the
plaintiff fears that by the time a judgment happens, the defendant
may sell off or conceal assets which the court might award the
plaintiff at the time of the judgment. To prevent this from
happening, the plaintiff may ask the court to grant a writ of
attachment for a particular piece of real property owned by the
defendant. Thus, an involuntary, specific lien is created against the
property which is recorded in the country where the property is
located. The validity of the attachment lien measures three years
and is renewable.
Also, the plaintiff may record a document called a lis pendens (a
Latin phrase meaning action pending") at a time when a lawsuit
that may affect title to real property is pending. Lis pendens clouds
the title thereby preventing the sale or transfer of the property until
the lis pendens is removed, the action is dismissed or a final
judgment is made.
Judgment Lien: When the court of law determines the rights of the
parties it is called a judgment. The party who wins the judgment is
entitled to a judgment lien against the losing party's property. The
lien is created by recording a document termed an abstract of
judgment which can be recorded in any or all of the state's 58
59

counties.
A judgment lien is an involuntary and a general lien. After the
creation of the judgment lien by recording, it is effective against all
of the real property owned by the debtor in the county of filing. This
will also include any real property acquired by the debtor within the
lien term, which in California is 10 years.
The debtor has to pay the judgment to free the property from the
lien or else the judgment creditor can foreclose, and the property
will be sold by an official designated by the court. To execute the
sale the court issues a writ of execution on the request of the lien
holder.
Property Tax Lien: Government taxes like the income tax or
property tax which are not paid become a tax lien against the
property. Property tax liens are involuntary and specific liens.
Special Assessment Lien: Special assessments are levied against
property owners to pay for local improvements like road pavements,
sewer lines, street repairs or water projects. The share of the cost of
improvement is levied based on how much the property owner has
benefited from the improvement project. This assessment of cost of
improvement creates an involuntary and specific lien against each
of those properties.
Mortgage: A contract between the property owner (the mortgagor)
and the creditor (the mortgagee) is known as a mortgage. The
borrower or mortgagor attaches a lien as a security for repayment
against the loan which he is to receive from the lender or the
mortgagee. A mortgage is a specific and voluntary lien.
Deeds of Trust: A deed of trust (or trust deed) is similar to a
mortgage. One of the differences is that, with a trust deed, there are
three parties rather than two. Also with a trust deed, the borrower
is known as the trustor, the lender/creditor is known as the
beneficiary and the third party (which is normally a title insurance
company or an attorney) is known as the trustee.

60

Priority for Liens

A real property may have more than one lien recorded against it.
For example, a house may have a property tax lien and a mortgage
or a trust deed lien filed against it. In a situation when all the liens
against a property add up to an amount more than the actual sale
price of the property at a foreclosure sale, the liens are paid
according to their priority. A lien holder may receive a partial
payment or no payment at all. As per the rules, the lien priority is
established by the recording date of the lien.
Although the general rule states that the first recorded lien will be
paid first, there are some exceptions according to the rules in
California. Property tax liens and special assessment liens have a
higher priority over other liens. Another exception is a mechanics
lien. Its priority is based on the date on which the entire project
began, although the claim of lien was recorded afterward.
HOMESTEAD PROTECTION
For protecting families against creditors, California and many other
states have homestead laws. In California, the homestead law offers
protection only against judgment liens and attachment liens.
A property occupied by a family as their home is known as a
homestead. A recorded document known as the declaration of
homestead protects the owner from foreclosure by judgment lien.
The owner can also sell the property and reinvest the sale proceeds
in a new homestead within six months.
Requirements for a Valid Homestead:
The claimant must be occupying the property at the time of
filing
His status should be that of a head of a household
The claim must describe the property and its value
Only one homestead is valid at one point of time
61

Exemption in a homestead: The standard exemption amount now

is $75,000. The exemption for a member of a family is $100,000.
The exemption for a disabled family member or a debtor (or his
spouse) 65 years of age or older is $175,000. The exemption is
$175,000 if the debtor or the spouse is over 55 years of age with a
low income.
To foreclose on a homestead, the net value of the property should
be more than the exemption amount.
Termination of a homestead: An owner is required to file an
Abandonment of homestead form if he wishes to acquire a
homestead status on a new property. The homestead is terminated
in case the property is sold or if the owner files a declaration of
homestead on another property.
Homestead protection remains intact even if the owner dies; it
continues for the benefit of the spouse, children or any other family
member living on that property.
NONFINANCIAL ENCUMBRANCES
Just as the financial encumbrances affect only the title to property,
nonfinancial encumbrances affect the use of the property such as
an easement, profits, licenses, encroachments, nuisances or private
restrictions.
EASEMENTS
The right to enter or use someone's property for a specific purpose
is called an easement. An interest in an easement is nonpossessory. It implies that the easement holder does not have title
to or right of possession of the property. The right to enter a
property through an easement is called ingress, while egress is the
right to exit from a property through an easement.
There are two types of easements:
i) Appurtenant easement
62

ii)

Easement in gross

Appurtenant Easement: An appurtenance is anything which is

used for the betterment of the land. In an appurtenant easement
there is a servient and a dominant tenement. The owner who
provides the easement is the one whose land is being used and this
land is termed as a servient tenement. The land owner whose land
receives the benefit of the easement is termed as the dominant
tenement.
Unless otherwise specified in the deed, an easement appurtenant
""runs with the land,"" i.e., if either of the dominant or the servient
tenement is sold to a new owner, the benefit or the burden of the
easement is also transferred to the new owner.
A very common example of an appurtenant easement is the right of
way or an easement for ingress and egress, which means the right
of a land owner to cross the neighbor's land to reach his own land.
Easement in Gross: In an easement of gross there is a dominant
tenant but there is no dominant tenement. This means that the
benefit is that of a person (or a business corporation) and not of the
parcel of land. An easement in gross runs with the servient
tenement. An example of an easement in gross is the pipeline
easement, the power line easement, or a railroad's right of way.
Under California law, a personal easement in gross is assignable
and inheritable.
Creating an Easement
Both the appurtenant and the in gross easements can be created by
the following methods:
Express grant
Express reservation
Implication
63

 Prescription
Reference to a recorded plat
Dedication
Condemnation
Express Grant: The servient tenement grants the easement by deed
or express agreement. This grant must be written and must comply
with all the requirements for conveyance of an interest in land.
If a tenant grants an easement in a leased property, the easement
will apply only throughout the lease term.
A fee simple owner may grant an indefinite easement, or until the
length of the grantor's life or for a specific time period.
Express Reservation: At the time of conveying a portion of his
property, the owner reserves an easement in that land to benefit the
part of land that he has retained. This is created when the property
is sold, with a deed or an express agreement.
Implication: Even though it is not mentioned in the deed, the
existence of an easement can be obvious and necessary at the time
a property is being conveyed.
This type of easement normally will arise when the property is
divided into parts, and the grantor refuses to grant or reserve an
easement on one part of the land for the benefit of the other part.
The easement is then implied by law.
To create an easement by implication, there are two requirements:
i) It has to be necessary for the enjoyment of the property
ii) There should be an obvious prior use
Prescription: An easement by prescription is similar to acquiring
an ownership through adverse possession. An easement by
64

prescription is created by fulfilling the following requirements:

- Continuous and uninterrupted use of property by a single
occupant, for a five-year period
- The use must be open and notorious
- The use must be against the permission of the owner
- The occupant wishing to acquire the prescriptive easement
must have some reasonable claim to the property.
- If property taxes are assessed separately against the easement,
the easement claimant must pay those taxes for the five year
period.
Reference to a Recorded Plat: Once a property is subdivided by a
land owner and a plat map is recorded, the lot buyers then obtain
easements to use the alleys and roads as per the plat.
Dedication: A private property owner grants an easement on a part
of his property for public use. This dedication may be implied or it
may be expressly stated.
Condemnation: The government uses its power of eminent
domain to acquire a fee ownership land for a public utility. Even
private companies which serve the public such as railroads or
utility companies may exercise this power.
Easement Termination:
The easement may be terminated in the following ways:
1) Release: This may be achieved by written document which is
normally a quitclaim deed from the dominant tenement owner
(easement holder) to the servient tenement owner.
2) Merger: The easement is terminated when the servient
tenement owner obtains the right to use the easement by
65

buying the dominant tenement.

3) Failure of purpose: If the purpose for which as easement was
created no longer exists, then the easement terminates.
4) Abandonment: This requires the dominant tenant's acts
indicating his intention to abandon the easement. The
easement also terminates if a prescriptive easement is not
used for a period of five years.
5) Prescription: Easements can be created as well as terminated
by prescription. An easement terminates by prescription if the
servient tenant prevents the dominant tenant from using the
easement for the mandatory period of five years.
PROFITS
The right of taking something away from someone else's land is
known as a profit. Examples are the right to take timber, fruit or
gravel from a property. A profit may be created in writing or by
prescription.
LICENSES
Another way to transfer the right to use land is through a license.
The permission given to someone to use one's land is known as a
license. A license is different from an easement in many ways. While
an easement is a written document, a license is just a spoken
approval to use a landowner's land. Generally, easements are
permanent whereas licenses are temporary. An easement is
irrevocable but a license may be revoked at the will of the property
owner. A license being a personal right does not run with or pass
with the land nor can it be assigned. A license is not an
encumbrance nor does it convey an interest in the property.

ENCROACHMENTS
When a part of an improvement extends over the boundary line
between properties it is known as an encroachment. This
unauthorized intrusion on the neighboring land can reduce it in
size and value and also limit its use. A fence or a roof eave of a
building could be examples of an encroachment. Since an
66

encroachment is not a right or interest to the encroacher, it is not

an encumbrance.
If an encroachment violates the neighbor's rights of possession, it is
deemed a trespass. The removal of an encroachment is carried out
through a judicial court order known as an ejectment.
Once the property owner discovers an encroachment, he has three
years to sue the encroacher or else he will lose the right to sue for
damages and/or removal of the encroachment.
NUISANCES
A nuisance is described as a situation or activity on a neighboring
property which disturbs the owner's appropriate use or enjoyment
of his own property, examples being loud noises or bad odors. A
nuisance violates a property owner's possessory rights and
therefore is not an encumbrance.
PRIVATE RESTRICTIONS
A restriction is another type of encumbrance. It refers to a
limitation placed on the use of property. Private restrictions are
placed by a past or a present land owner which affects just a
specific property or development and are also called deed
restrictions or restrictive covenants.
Just as in easements, private restrictions can run with the land,
thereby binding all the following owners of the property.
Restrictions are also known as CC&Rs or covenants, conditions and
restrictions. CC&R's mainly control land use and are generally
found in the Declaration of Restrictions, which is filed by a developer
when a subdivision plan is recorded. CC&Rs normally contains
rules which limit all the lots to single-family residential use, prevent
activities disturbing to the neighbors and property maintenance.
Covenants and Conditions: A covenant is a promise to do or not
do something. Breach of a covenant may lead to the other property
owner to seek an injunction from a court or seek monetary
damages. Injunction is a court order to remove the cause of the
breach. Violation of a condition may lead to more serious
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consequences such as forfeiture of land.

The restriction reflected in a covenant or a condition depends on the
words mentioned in the deed. A court of law almost always
interprets a restriction as a covenant rather than a condition (even
though the term may include the word "condition") to avoid the
harsh treatment of forfeiture.
Termination of Restrictions
Restrictions (CC&Rs) may be terminated through the following:
- Voluntary cancellation
- Expiration of the terms of restriction
- Merger of ownership, when both the encumbered and the
benefited land is owned by a single owner
- Legal prohibition of certain restrictions on the basis of race or
religion
- A changed condition that motivates the court to terminate the
restriction

Chapter Summary
An interest in real property which is held by someone
who is not an owner of that property is known as an
encumbrance.
When an owner chooses to use his property as a security
to obtain a loan he creates a voluntary lien.
In California, the homestead law offers protection only
against judgment liens and attachment liens.

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 Financial encumbrances affect only the title to property,

nonfinancial encumbrances affect the use of the
property.
The right to enter a property through an easement is
called ingress, while egress is the right to exit from a
property through an easement.
In an easement of gross there is a dominant tenant but
there is no dominant tenement.
The right of taking something away from someone else's
land is known as profit.
When a part of an improvement extends over the
boundary line between properties it is known as an
encroachment.
Just as in easements, private restrictions can "run with
the land", thereby binding all the following owners of the
property.

Chapter Quiz
1. When an owner chooses to use his property as a security to
obtain a loan he creates a _________
a. Voluntary lien
b. Involuntary lien
c. Specific lien
d. General lien
2. All mechanics liens may be filed for recording within ___ days
after the completion of the project,
a. 30
b. 60
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c. 90
d. 120
3. When a project has been completed, the property owner has _____ days in which he can file a notice of completion for
recording.
a. 10
b. 20
c. 30
d. 60
4. Since a law suit is pending against a land owner, a court of
law orders a lien to be placed on the owners land, holding it
as a security in case of a negative judgment. This is known as:
a. An easement
b. A prescription
c. An attachment
d. Adverse possession
5. The right to use another's land for a particular purpose is:
a. An encumbrance
b. A general lien
c. A license
d. An easement
6. A judgment lien is a(n):
a. Involuntary, general lien
b. Voluntary, general lien
c. Voluntary, specific lien
d. Involuntary, specific lien
7. When a lawsuit that may affect title to real property is
pending, the plaintiff records a document called:
a. Notice of non-responsibility
b. Abstract of judgment
c. Lis pendens
d. Writ of attachment
8. The personal, irrevocable, unassignable permission to use
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another person's land without a possessory interest in it is

called:
a. An easement
b. An encroachment
c. An attachment
d. A license
9. The court orders a ______________ to sell property to satisfy a
judgment creditor.
a. writ of execution
b. writ of attachment
c. notice of cessation
d. release
10. Which of these is not a financial encumbrance:
a. A mortgage
b. A mechanics lien
c. An easement
d. An attachment lien
11. Easements cannot be terminated by:
a. release
b. merger
c. prescription
d. condemnation
12. A balcony or a roof extending over the established boundary
line of a plot of land is called:
a. An encroachment
b. An easement in gross
c. A license
d. An easement appurtenant
13. The maximum homestead exemption may be claimed by a
homeowner who is:
a. Single
b. Married
c. 65 years or above
d. A member of a family unit
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14. Which of the following is not considered to be a nuisance:

a. A house with regular drug dealing
b. Rotting of garbage in a neighbor's backyard
c. A fence extending over the boundary of an adjacent
land
d. Chemical waste from a plastic factory
15. It is up to the ___________ within the subdivision to enforce the
CC&Rs.
a. Court
b. Property owners
c. Builders
d. Contractors

CHAPTER 5
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Public Restrictions on Real Estate

CHAPTER OVERVIEW
In this chapter, we will see how government exercises its
constitutional power to oversee the use of private property, through
such public controls as zoning, building codes and environmental
rules. The different types of taxes on land use are also discussed.
LAND USE CONTROLS
The federal and state constitutions determine the powers of the
government in the United States. Constitutional issues arise due to
the efforts made by the federal, state or local government to control
the use of private property. Objection to the land use law by a
property owner raises a question: Does the government have the
constitutional power to interfere in citizens private property rights?
The state government uses the police power to adopt and enforce
land use control laws. Under the Constitution the federal
government does not hold power to regulate public health, safety,
morals and welfare.
There are constitutional limitations that the police power must
respect. A land use law or regulation has to meet certain criteria to
be considered constitutional. These are:
- It has to be related to a certain extent to public health, morals,
safety or general welfare;
- It has to be non-discriminatory, must apply to all land owners
who are located in similar locations;
- It must prevent harm to the public that could be caused by
the prohibited use of the property
- It does not reduce a propertys value to the extent that the
regulation amounts to a confiscation
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To protect the public from problems which are caused by the

unrestricted usage of private property, the government engages in
the following regulatory controls:
- Comprehensive planning
- Zoning ordinances
- Building codes
- Subdivision regulations, and
- Environmental laws
COMPREHENSIVE PLANNING
There can be adverse effects of unplanned and unrestricted
development. Dense development may cause traffic gridlocks or
pollution. A dairy farm situated next to a school may be
incompatible. To solve the problems caused by unplanned
developments, the state of California considered it necessary to
have planning agencies in the cities and counties. The planning
agencies are referred to as planning commissions.
The planning commission initiates a comprehensive, long-term plan
for all the development within the city/county. This plan is termed
a master plan or general plan. All the development and land use
regulations for the area has to conform to the general plan, once it
is adopted. The police power is used by the local government to
implement the plan.
ZONING ORDINANCES:
The division of land for a specific use such as residential,
commercial, agricultural or industrial is done through zoning
ordinances. This is done mainly to keep compatibility within the
zones. Also, areas that are zoned for incompatible use are often
separated by undeveloped areas which are known as buffers.
The above classified zones are further divided into subcategories.
Example: a residential locality may be divided into a single-family
74

zone (or R-1 zone) and multi-family zone (or R-3 zone). An industrial
zone could be divided into light industrial zone and heavy industrial
zone.
Zoning ordinances regulates the use of the building, along with its
size, shape and height. They also determine the minimum distance
between the buildings and the property boundaries including the
setback and side-yard requirements. The purpose of these
regulations is to control the density of population, to help maintain
enough open spaces and access to air and sunlight for ideal living
conditions.
A valid zoning ordinance:
- Cannot discriminate against any parcel of property
- Cannot be applied retroactively
- Cannot create any unfair situation
Exceptions and amendments in Zoning: Since complications are
bound to arise during the enforcement of zoning regulations, some
exceptions are provided to their rules. An individual property owner,
a developer, a city or county government may request a zoning
exception or change.
Exception or changes which can be made in a zoning regulation are:
Nonconforming uses
Variances
Conditional uses, and
Rezones
Nonconforming uses may arise due to an amended zoning
ordinance or when a new area is zoned. A lawfully-settled use may
not conform to the rules laid down in the new ordinance. It is not
required to apply for a permit to continue its establishment.
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The provision of a nonconforming use in a zoning ordinance is also

known as a grandfather clause. The ordinances generally make sure
that the nonconforming uses are phased out over a period of time.
Normally a deadline is set (for example, 15 years after the ordinance
is passed), or else the owner of such an establishment is prohibited
from extending the use and rebuilding damaged property.
Variances: Granting permission for building or maintaining a
structure or use which is actually prohibited by the zoning
ordinance is called a variance. There are cases where the zoning law
is established and because of that the property owners loss
becomes much more than the benefit of enforcing the zoning
regulation. In a situation like this the property owner may apply to
the local zoning authority for a variance.
The variance will only be granted to the property owner if he is able
to prove that without the variance he will be losing the privileges
which are available to other property owners in the same zone.
However, most variances permit only minor changes in the zoning
law. A variance is not supposed to reduce the value of the
neighboring property, change the prime character of the
neighborhood or become incompatible with the zones general plan.
Variances which authorize a land use that is actually not permitted
in a particular zone is called a use variance. A use variance is
usually not granted by local authorities in California. For example,
a variance which allows a single-family residential cluster in a
commercial zone will not be granted.
Conditional uses: There are certain uses that do not fit into the
ordinary zoning categories such as hospitals, schools or place of
worship. Although these uses may have an adverse effect on the
nearby properties, they are essential to the community in general.
The zoning authority allows a limited number of these uses to
operate in accordance with certain conditions by issuing conditional
use permits (or special exception permits) in most communities. For
instance, a private property owner may be permitted to construct a
hospital in a residential zone, as long as the hospital follows certain
76

regulations for security and parking and other such criteria.

Rezones: A property owner petitions a local zoning authority for a
rezone when he feels that his property is not zoned properly. This is
also referred to as zoning amendment. Before a decision is made on
a petition like this, a notice is served to the neighboring property
owners and a hearing is held.
An area which is rezoned to a restrictive use is called downzoning. A
change from a multi-family locality to a single-family locality is a
good example of downzoning.
BUILDING CODES
Building codes protect the public from unsafe construction and its
enactment is an exercise of the police power. There is a certain
standard for construction methods and materials used which is set
by the codes. These are divided into specialized codes like a fire
code, a plumbing code and an electrical code.
There is a building permit system through which the building codes
are generally enforced. Before constructing a new building, or
repairing, altering or refurbishing an existing structure a permit
has to be obtained by the property owner from the county or city
authority. Before providing the permit, the authority on its part is
required to inspect the building plans, and verify that building
codes and zoning ordinances reach satisfactory levels. The
completed structure has to undergo an inspection and meet
satisfactory standards and then a certificate of occupancy will be
issued.
In the state of California, the construction industry is regulated by
the state Contractors License Law. As stated in the Housing Law,
minimum construction and occupancy requirements have to be
fulfilled for a residential construction. Local building inspectors
enforce these requirements.
SUBDIVISION REGULATIONS
Regulating subdivisions is another tool of the state and local
government to control land use. Dividing one parcel of land into two
77

or more parcels is called subdivision.

Normally subdivisions are residential, but they may also be
commercial, recreational or industrial. There are three types of
subdivisions in California:
Standard subdivisions
Common interest subdivisions
Undivided interest subdivisions
Standard Subdivision: There is a separate individual owner for
each parcel of land in a standard subdivision. There is no common
right of ownership or use among the different owners of the
individual parcels which are created by the division.
There are normally five or more lots that have been improved with
utilities. In a standard subdivision, an individual buyer purchases a
lot on which he constructs his own house or alternatively a
developer purchases all the lots and constructs houses on each lot
and sells them to individual owners.
Common Interest Subdivision: A common interest subdivision is
also referred to as a common interest development or CID. In a CID,
an individual owner not only owns or leases a separate lot but also
has an undivided interest in the common areas of the project. An
example of a CID is a co-operative or a condominium project.
Planned Developments may also be a CID, since planned
developments consist of separately-owned lots as well as commonlyowned areas which are reserved for the use of some or all of the
individual lot owners. These common areas are generally managed
and maintained by an owners association, which charges a fee for
the management and maintenance of the common areas from the
lot owners.
Another type of CID is a timeshare. In a timeshare the buyer
purchases an exclusive right to a particular property but for a
specific time period each year. A common example of timeshare is a
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resort condominium.
Undivided Interest Subdivision: In this category, each owner is a
tenant in common with a non-exclusive right to occupy or use the
property. A campground with shared facilities is a good example of
an Undivided Interest Subdivision.
Laws Regulating Subdivisions: The state of California has made
the following laws to regulate subdivisions:
- Subdivision Map Act: This is a law that provides the
procedures which are to be followed to subdivide land.
- The Subdivided Lands Law: This law protects the consumer by
making it compulsory for the subdivider to disclose certain
information to the buyers of the lots.
- The Interstate Land Sales Full Disclosure Act: This is a federal
law for protecting consumers which applies to subdivision lots
in interstate dealings/sales.
Subdivision Map Act establishes a state-wide set of procedures to
be followed for filing of a subdivision plan when a property is
divided into two or more lots. These lots must be contiguous
(touching). The purpose of the Subdivision Map Act is to give direct
control of the physical aspects of a subdivision to the local
government; some examples are allotting parking areas, lot designs,
street and sewerage plans. The two main objectives of this Act are:
A) To co-ordinate subdivision design with the general plan, which
includes streets and utilities and;
B) To ensure that the areas of a subdivision which are meant four
public use are improved in a proper way initially, such as a public
park.
The Subdivision Map Act also provides for a tentative map, a final
map and a parcel map for most subdivisions.

79

Tentative Map: The initial map (with a legal description of the

property and proposed lot boundaries) which may not be based on a
final, detailed survey (unless demanded by local ordinance) of the
property to be subdivided is called a tentative map.
Usually its the developer/subdivider who is responsible for
installing street lights, public utilities and curbs while the
government maintains them. For the developer, an important aspect
is the land that remains after the streets, sidewalks, curbs and
other public utilities are accounted for. This remaining land is
called the commercial acre.
Final Map: After the approval of the tentative map from the
planning agency, the subdivider has to file a final map, depicting
the subdivision in its final form. For filing the final map the
subdivider has a limited time period of 24 months in general (in
addition to any extensions, if granted). Before the filing of the final
map, it is invalid to sell, lease or to make a contract of sale or lease
of any of the subdivided property. The signatures of the owners and
those of the representatives of each of the public utilities or the
approver of the tentative map are required on the final map.
Parcel Map: For subdivisions with less than five lots, a parcel map
can be filed instead of the tentative and final maps. If the local
ordinance does not preclude the preparation of a parcel map, then
the parcel map has to meet the requirements of the state and the
local bodies.
Subdivided Lands Law: Per this law, the subdivider has to
disclose certain information to his lot buyers. This law is applicable
to most of the subdivisions with five or more lots; these lots may not
be contiguous if they are part of one particular project.
The Real Estate Commissioner investigates the lots or units and
issues a final subdivision public report and only then can the lots
or units be sold, leased or financed. The report will not be issued if:
1) It is proved that the subdivision is not suitable for the use
proposed by the subdivider or developer; or,
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2) There is a lack of assurance that the purchaser will get what

he has paid for
The Commissioner will issue the public report once he is satisfied
that the subdivision has met all the legal requirements. A public
report includes:
- The name of the subdivider, project name, location and size
- Legal interest of the purchaser
- The amount of taxes and assessments
- The method of handling the purchasers money
- Hidden costs that the purchaser may have to bear
- Any private restrictions
- Environmental hazard issues
- Any financial or conveyance arrangements which may be
harmful in the future
Before entering into a sales agreement, all purchasers must obtain
a copy of the report. The purchaser must sign a receipt of this
public report as a proof. This signed receipt of the copy of the public
report must be preserved by the subdivider for at least three years.
If no material changes happen, then the final public report is valid
for five years. Some of the material changes that may occur in a
subdivision are:
- Physical changes like a new street or a new walkway
- The sale of five or more lots to a single buyer
- Any changes in the documents used to finance or transfer lots
- Or any other new conditions that may affect the value or use
of the lots
At times, before issuing the final report, the Commissioner issues a
preliminary report. The preliminary report expires after one year
but is renewable. A prospective buyer may reserve a lot based on
the preliminary public report, but he has the right to back out of
the sale with his advance refunded, until the final report is received
by the buyer.
A final public report may be used in an advertisement, in its
entirety. A subdivider cannot advertise any facilities or
81

improvements in an advertisement, which does not exist in reality.

Violations of any provisions of the Subdivided Land Laws may lead
the Commissioner to stop the violations or sale of the lots with a
desist and refrain order.
Out-of-State Subdivisions: A subdivision located in another state
whose developers wishes to sell its property in California has to be
registered with the California Department of Real Estate. It is also
necessary that the advertising and sales contracts must carry
disclaimers stating that the subdivision is not inspected or
approved by the Department of Real Estate.
The Interstate Land Sales Full Disclosure Act (ILSFDA) is a
federal consumer protection law which is concerned with
subdivisions of vacant land offered for sale or lease in interstate
dealings. The developers have to register their projects with the
Department of Housing and Urban Development (the registration
requirement is for subdivisions with 100 or more vacant lots) and
they are also required to disclose information to the buyers and
avoid misleading sales practices and advertising. This anti-fraud
provision is generally applicable to subdivisions with 25 or more
vacant lots.
ENVIRONMENTAL LAWS
To protect and preserve the physical environment, the federal and
state governments have enforced some laws. These laws have a
huge impact on the way the property owners use their land.
A federal law, National Environmental Policy Act is in place that
requires federal agencies to prepare an environmental impact
statement (EIS) for actions to be taken by the government. NEPA
applies to all the private agencies and developments that require
federal agency approval.
A planning or a zoning agency considers the EIS before approving a
project. The EIS determines the probable positive and negative
effects on the environment of a proposed project and discusses
alternative options to the proposal.
The Comprehensive Environmental Response, Compensation,
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and Liability Act (CERCLA) is a federal law. CERCLA is concerned

with liability for environmental cleanup costs. The federal
Environmental Protection Agency (EPA) enforces this law. In some
of the cases the contaminated property has to be cleaned up by the
property owner, even if he did not cause the contamination.
Through the Pollution Control Law, the federal government sets
forth national standards for the quality of air and water. The states
are expected to implement these set standards. The discharge of
pollutants into the air and water needs to be done only after
obtaining a permit.
The California Environmental Quality Act (CEQA) is similar to
the National Environmental Policy Act. The state or local agencies
prepare an environmental impact report (EIR) for CEQA for any
project, whether public or private, that may significantly affect the
environment. If the public agency inspecting the project affirms that
it wont have any harmful effects, an EIR will not be required.
A public hearing is held for each EIR. Depending on the findings of
the report, the developer may have to make correctional changes in
the project.
The California Coastal Act created the Coastal Commission. The
commissions aim is to protect the coastline and oversee
developments along the coast. There are several regional divisions
whose permit is required for any development in the coastal zones.
Through the Alquist-Priolo Act, certain areas are declared as
earthquake fault zones on the maps which are prepared by the
geologists. The potentially active faults are noted by the zones and
these are generally a quarter of a mile wide. The earthquake fault
zones are also referred to as special studies zones.
When selling a property in such a special studies zone the seller
has to inform the buyer about its designation. Any property which
is located in a fault zone must attach a geologic report in its
application for new development or construction

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EMINENT DOMAIN
Eminent domain is another governmental power that can affect
land use. The government takes away some or all of the rights of
ownership from private individuals by exercising its power of
eminent domain. The government justly compensates the
individual when it takes the property from an individual. The owner
receives the fair market value of the real estate for his condemned
property.
The process through which the private property is taken by the
government for public use is called condemnation. The power of
eminent domain may be used by the local government to bring into
effect its general plan. For example, parts of some of the private
properties may be condemned for use for building a bridge overpass
or construct/widen a road to facilitate the traffic movements in a
particular zone.
A property owner whose residential house is condemned is also
entitled to receive relocation payments and services as per the
Uniform Relocation Assistance and Real Property Acquisition
Policies Act of 1970. This act is applicable to all federal agencies
and the agencies that use federal funds for property acquisition.
When the nearby land of an owner is put to such a use that it
diminishes the value of the owners property, he can opt for inverse
condemnation. The Tucker Act of 1887 is a federal law which
allows the landowner to file such a suit against the federal
government.
TAXATION OF REAL PROPERTY
Property taxes create liens and it affects property ownership. If the
property owner fails to pay the taxes, the government may sell his
property to collect the money owed due to non-payment of taxes.
The taxation of real property is a good and comparatively easier
method of raising revenue since the land is non-concealable and
indestructible. Real property tax collection can be more easily levied
than other types of taxes and can be collected with or without the
property owners cooperation.
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These are the types of taxes on real property:

- General real estate taxes or ad valorem taxes
- Improvement taxes or special assessments
- Other special real property taxes, and
- The documentary transfer tax or an excise tax
General Real Estate Taxes: Revenues collected from levying this
tax are used for the general operation and services of government,
such as public schools, fire and police departments. Many
government agencies levy this tax such as counties, cities, water
districts and school districts. So a single property may be situated
in five to six taxing districts.
Assessment: is the valuation of property for the purpose of
taxation. As mentioned above, general real estate taxes are ad
valorem taxes, meaning the amount of taxes levied depends on the
value of the property.
In 1978, voters in California passed Proposition 13, an
amendment to the California Constitution which is now Section
110.01 of the Revenue and Taxation Code. The major provisions of
Proposition 13 are:
- Property is to be assessed by the county assessor at its full
cash value
- The tax rate, set by the countys Board of Supervisors, may
not exceed one percent of the propertys full cash value.
- For those who own the home for a long period of time, the
purchase price of the home becomes its base value.
- If the property is owned by the same person, without
improvements being made to the property, its assessed value
cannot increase more than 2% per year.
The propertys assessed value increases to the current full cash
value if there is a new owner or new construction on the property.
When a property is sold or transferred, a change in ownership
statement has to be filed by the new owner with the county
85

recorder or assessor within 45 days of the transfer. The purchase

price or the fair market value of the property at the time of transfer
now becomes the assessed value of that property, which is the new
base value. However, if the transaction is exempt from a
reassessment on a change in ownership, the assessed value
remains unchanged.
In case a property transfer takes place in the middle of a tax year,
the new owner has to pay a supplemental assessment for the
remaining part of the year. The supplemental assessment is done
by taking into account the difference between the previous assessed
value and the new assessed value. A seller or his agent has to give a
notice to the new buyer of the additional number of tax bills which
the buyer will be liable to pay.
Exceptions in reassessment: When a property is not sold for
profit, the law exempts such transactions from the reassessment of
property value. The following types of transfers are exempt from
reassessment:
- Transfers between parents and children
- Transfers between spouses/registered domestic partners
- Transfers in which method of holding title changes, not the
ownership
- A homeowner over 55-years old or permanently and severely
disabled sells his home and purchases another home in the
same county, so the assessed value of his old home is used as
the assessed value of his new home. The market value of the
new home must be equal to or less than the market value of
the old home and the new home must be purchased within
two years of selling the old home.
The property owner may appeal to the county if they are dissatisfied
with the assessment of their property. The appeals are generally
handled by the Board of Supervisors and in larger counties they are
handled by the Assessment Appeals Board. The Assessment
86

Appeals Board is also called the Board of Equalization, since it has

the power to adjust the assessed value of the property.
Collection of Taxes: Every year the general real estate taxes are
levied on or before 1st September. The tax year runs from July 1
through June 30 of the following calendar year. The tax lien
attaches to the property on the previous January 1. For example
the lien for the July 2011-June 2012 tax year is attached on
January 1, 2011.
A tax bill is sent to every property owner on or before the first of
November every year. The tax bill will include the propertys
assessed value minus any tax exemptions to which the property
owner is entitled. The payable tax amount is equal to the assessed
value multiplied by the tax rate (which is not more than 1%).
The property tax is payable in two installments, the due dates are
November 1 and February 1. The November payment is delinquent
after 5 p.m. on December 10 and the February payment is
delinquent after 5 p.m. on April 10. If these dates fall on a weekend
or a public holiday, the deadline becomes 5 p.m. of the next
working day. A 10% penalty is added to the delinquent
installments. After the second delinquent installment the property
is added to the delinquent roll for which $ 10 is charged.
For unpaid property taxes the tax collector can foreclose on the tax
lien. The process of foreclosure for nonpayment of taxes is as
follows:
First, a notice of impending default is published through which the
property owner is informed that he must pay the taxes by June 30.
Then, if the taxes still remain unpaid after June 30, the property is
considered in default which is followed by a five-year redemption
period. During this period the owner is allowed to keep possession
of his property and is given one last opportunity to redeem it by
paying up the taxes, costs, and other penalties. If the property is
not redeemed by the end of the fifth year, the tax collector
forecloses on the property at a tax sale and forwards the proceeds
to pay the tax debt. The surplus from the sale, if any, is paid to the
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former owner or to other parties who had an interest in the

property.
Tax Exemptions: There are many total or partial tax exemptions
on property. Federal, state or local government owned property is
all exempt from taxation. Also, property used for religious,
educational, charitable or welfare purposes is exempted from
taxation. Homes owned by veterans, senior citizens and disabled
persons are partially exempt from paying taxes.
Special Assessments: Also called improvement taxes, these are
levied to pay for specific improvements, such as installing street
lights or making pavements. Only those properties which are going
to benefit from the improvements are taxed, based on the theory
that the value of the properties is increased because of the
improvements.
Normally, a special assessment is a one-time tax. However, the tax
may be paid in installments. When a property which comes under
special assessment is sold, the assessment is considered to be a
part of the acquisition cost of the property.
Special Assessments also create liens just like general real estate
taxes. Non-payment of special assessments may result in the
government foreclosing on his property.
California has several statutes authorizing special assessment. One
example is the Street Improvement Act of 1911 which empowers
government entities to make street improvements and bill the
affected property owners. If the bills remain unpaid for more than
30 days, bonds are issued to pay for the improvements.
Special assessments require approval of two-thirds of voters. A local
governing body or an improvement district created by a city or
county (as provided by state law) proposes an assessment.
Other Special Taxes: California law allows some other types of
special taxes to be assessed against real properties apart from the
general real estate taxes and special assessments. These special
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taxes are similar to general real estate taxes in some ways (as in
they can be used to pay for ongoing government services) and they
are also similar to special assessments in other way (as in special
taxing districts may be made to cover the properties which benefit
from the improvements funded by the taxes).
A special form of property assessment created by the Mello-Roos of
1982 is one such example. This law expanded the type of
improvements, facilities and services as special assessments. MelloRoos assessments are also liens on property but they may be
foreclosed on after payment has been delinquent for only 180 days,
as opposed to the five-year redemption period in general real estate
taxes.
Whenever a residential property with up to five dwelling units is to
be sold, the seller must in good faith try to provide the buyer with a
notice of the special tax from each agency that assesses the
property to levy such a tax.
Documentary Transfer Tax: In California, an excise tax is levied
on every sale of real property. This excise tax is called a
documentary transfer tax. This tax is levied based on the
propertys selling price and normally the rate is 55 cents per $500
of value, or fraction of $500.
For instance, a real property is sold for $650,500.
$650,500/$500 = $1301.00
$1301 X $0.55 = $715.55
The documentary transfer tax payable by the seller is $715.55.
In the calculation of the documentary transfer tax, the
consideration paid for the property does not include any preexisting liens or encumbrances that were not removed by the sale,
i.e., an assumed loan.
If a portion of the purchase price is not subject to the documentary
transfer tax, the information has to be declared on the deed or
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separately on a paper with the deed.

Chapter Summary
The state government uses its police power to adopt and
enforce land use control laws.
All the development and land use regulations for the area has
to conform to the general plan.
Division of land for a specific use such as residential,
commercial, agricultural or industrial is done through zoning
ordinances.
The permission of building or maintaining a structure or use
which is actually prohibited by the zoning ordinance is called
a variance.
A property owner petitions a local zoning authority for a
rezone when he feels that his property is not zoned properly.
After the approval of the tentative map from the planning
agency, the subdivider has to file a final map, depicting the
subdivision in its final form.
Through the Pollution Control Law the federal government
sets forth national standards for the quality of air and water.
When the nearby land of a landowner is put to such a use that
it diminishes the value of the owners property, he opts for
inverse condemnation.

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Chapter Quiz
1. A comprehensive long-term development plan for a
community, which is brought about by zoning and other laws
is called:
a. A buffer
b. Zoning plan
c. Master plan
d. None of the above
2. Which of the following is NOT an exercise of the police power:
a. Condemnation
b. Zoning ordinance
c. Building code
d. Subdivision regulations
3. Which of the following may be controlled by a zoning
ordinance?
a. Constructing a building on a lot
b. Use of property
c. Building height
d. All of the above
4. ______________ is permission to build or maintain a structure
or use that is normally prohibited by the zoning ordinance.
a. A non-conforming use
b. A variance
c. A conditional use permit
d. A rezone
5. A _________________ can be constructed under the conditional
use permit.
a. Hospital
b. Departmental store
c. Restaurant
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d. Paper mill
6. Subdivisions are generally residential, but they may also be:
a. Commercial
b. Industrial
c. Recreational
d. All of the above
7. A timeshare is a type of:
a. Standard subdivision
b. Common interest subdivision
c. Undivided interest subdivision
d. None of the above
8. A property owner plans to add a room to his house. Before the
construction begins, he has to:
a. Request a zoning inspection
b. File a final map
c. Submit a proposal to the planning commission
d. Obtain a building permit
9. Which of the following federal laws requires the federal
agencies to prepare an environmental impact statement?
a. CERCLA
b. NEPA
c. CEQA
d. ILSFDA
10. General real estate taxes are ad valorem taxes, which means
that they are:
a. Sales taxes
b. Excise taxes
c. Charged once at the time of transfer of property
d. Charged in relation to the value of the property taxed
11.
As a general rule, the tax rate which is fixed by the
countys Board of Supervisors should not exceed ___________
percent of the propertys full cash value.
a. 1
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b. 2
c. 5
d. 10
12. The property tax year runs from:
a. January 1 through Dec 1
b. July 1 through June 30
c. April 10 through April 9
d. January 1 through December 31
13. If taxes remain unpaid after ________, the property is
considered in default and a five-year redemption period
begins to run.
a. November 1
b. January 1
c. April 10
d. June 30
14. The power to adjust the assessed value of property lies with
the:
a. Board of Supervisors
b. Board of Equalization
c. Department of Housing and Community Development
d. Planning Commission
15. An excise tax levied on each sale of real property in California
is called:
a. Federal Income Tax
b. Documentary Transfer Tax
c. General Real Estate Tax
d. Local Improvement Tax

93

CHAPTER 6
Contract Law
CHAPTER OVERVIEW
In this chapter, we examine a subject of fundamental significance to
real estate professionals: the different kinds of contracts which are
used in real estate transactions, how they are formed, the way they
operate and the penalties for their breach.

CONTRACTS
A promise made by one person to another to do something or
refrain from doing something is called a contract. The person
participating in a contract is referred to as a party to the contract.
Either the contract promise is made by only one of the parties or a
separate promise is made by each of the parties. The promise made
by each party is that partys contractual obligation. Performing a
contractual obligation is called a tender.
To be legally binding, a contract has to meet certain requirements.
In a valid contract, it becomes the duty of each party to fulfill their
specified contractual obligations. Whoever defaults (does not fulfill
the promise made) in completing the contract terms is liable to the
opposite party for breach of contract.
LEGAL CLASSIFICATIONS OF CONTRACTS
All contracts fall under a particular
classifications are:

classification.

These
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 Executory and executed contracts

Express and implied contracts
Bilateral and unilateral contracts
Executory and Executed Contracts: When a contract obligation is
yet to be performed or is in the process of being performed it is said
to be an executory contract. On the other hand, when a contract
obligation is fully performed it is called an executed contract. Here
the term executed and performed mean the same.
The term executed is also used in another context in the real
estate industry. Execution of a deed, a contract, a will or any
other legal document simply means signing those documents as
opposed to performing or fulfilling any terms it contains. In the
above context the parties who have executed a document have
simply signed it. The intended meaning in each case is normally
understood from its context.
Express and Implied Contracts: A contract that has been put into
words in writing or orally is termed an express contract. The
parties to the contract have declared what they are willing to do and
they have been told what is to be expected from the other party. An
implied contract is established by the actions of the parties,
without any oral or written agreement. Most contracts are express
contracts.
Bilateral and Unilateral Contracts: In a bilateral contract both
the parties promise to fulfill a duty, which both parties are obligated
to perform. In the unilateral contract only one party is obligated to
fulfill a duty.
A typical real estate purchase is an example of a bilateral contract
where the seller promises to transfer the right of ownership and the
buyer promises to pay the agreed price to the seller.
An open listing agreement is an example of an unilateral contract
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because the seller promises a commission to the real estate broker

for finding a buyer. The broker, however, has not promised to find a
buyer, but if he does finds a buyer, the seller is obligated to pay him
the commission.
ELEMENTS OF A VALID CONTRACT
A valid contract has five required elements:
1) Legal capacity to contract
2) Offer and acceptance
3) Lawful objective
4) Consideration
5) Writing
Legal capacity to contract:
The primary requirement of a valid contract is having legal capacity
to enter into a contract. A person has to be competent and at least
18-years-old to enter into a valid contract.
In California, anyone younger than 18 is a minor and cannot
make a contract concerning real estate. Such a contract will be
void. If a minor signs a contract, that contract is voidable by the
minor (it cannot be enforced against him).
This clause prevents people who are too young to understand the
consequences of entering into a legally binding contract.
- A legally emancipated minor may enter into any type of
contract. A minor can be emancipated by marrying, joining the
military services or by petition to a court of law. A married
minor may enter into a real estate contract to buy property.
When making a real estate transaction, a minor emancipated
by a court order must provide copies of the emancipation
document to the real estate agency for it to know that the
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minor has the capacity to make the transaction.

- Only a mentally competent person can enter into a contract. If
the court has declared a person to be mentally incompetent,
any contract signed by him becomes void. Even without a
judicial order, an incompetent person, so proved by evidence,
may be unable to form a contract. Anyone who makes a
contract while under the influence of drugs or alcohol may
later (within a stipulated time period) disaffirm the contract. It
is noteworthy that a person receiving psychiatric treatment
may not necessarily be incompetent.
- An exception to the capacity rules is that, if the minor or
incompetent person contracts to buy necessities like food or
medicine, such a contract cannot be voided.
- Whenever a minor receives a property as a gift or inheritance,
a guardian must be appointed for him. A guardian takes the
responsibility to handle the property conveyance, lease,
encumbrance and other transactions on behalf of the
unemancipated minor.
- The property of a deceased person is either handled by an
executor named in his will or by an administrator appointed
by the court (if no executor was named in the will of the
deceased). The actions of the representatives are subject to
approval from the probate court.
- An alien who is not a citizen of the U.S. has similar property
rights as a citizen. He may purchase or sell property freely,
although there are some property transfer reporting
requirements to be fulfilled.
- Convicts and those serving a prison sentence do have a right
to transfer or obtain real property. Their property is not
forfeited, either.
Offer and Acceptance:
Offer and acceptance is the second requirement for a valid contract.
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A contract can only be created when both the parties give their
mutual consent to its terms. A contract must be read and
completely understood before it is signed. Once the contract is
signed it is taken as consent granted. There has to be a sort of
meeting of the minds for creating a valid contract. This is achieved
through a process called offer and acceptance.
Offer: An offer exists only when an offeror -- the person making the
offer has communicated its term to the offeree -- the person
receiving the offer. It should be clear that an offer is being made.
Since there is a standard, detailed form which is used in almost all
real estate dealings, to know the intentions of the offeror is
relatively easy.
Termination of an offer: Either the offeror has a change of mind
and wants to terminate the offer or the offerees circumstances have
changed and he backs out. When the offer is terminated before
being accepted, then no contract is formed. Some of the situations
when the offer may terminate before being accepted are:
Revocation of an offer
Time lapse
Offerors death or incompetence
Rejection
Counteroffer
Revocation of an offer: The offeror can revoke the offer before it is
accepted by communicating the decision of revocation directly to
the offeree or through a reliable source (like the estate agent).
Lapse of time: Some offers include a deadline for their acceptance
after which the offer terminates automatically. If a time limit is not
set for an offer, a reasonable time is allowed. If a dispute between
the parties develops over what amounts to a reasonable time, the
court will decides what is reasonable.
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Offerors death or incompetence: An offer is terminated if the offeror

dies or if he is declared incompetent.
Rejection: An offer also terminates due to rejection by the offeree.
After rejecting the offer, the offeree cannot come back and create a
contract.
Counteroffer: A counteroffer is created by making any change to the
original offer. When some of the terms are unacceptable to the
offeree, he can accept the offer after the required modifications in
the original offer are made. When a counteroffer is made the roles
are reversed; the offeror becomes the offeree and he can either
reject or accept the revised offer. If a counteroffer is accepted, it
creates a contract and if it is rejected, the party making the
counteroffer cannot revert to the original offer and accept it. Issuing
the counteroffer terminates the original offer.
Acceptance: A contract is created only when the offeree has
communicated acceptance to the offeror, as mentioned and within
the time limit stated in the offer or before the offer is revoked.
The acceptance of the offer must not be made under any threat,
undue influence, fraud or duress. A contract is voidable if entered
into under threat of harm to a person or a thing. Misrepresentation
of a fact to someone who takes the misrepresentation as a truth in
deciding to enter into a deal is called a fraud or fraudulent act.
Actual fraud: It happens when the person knowingly makes a false
statement with an intention to deceive or does not know whether or
not the statement is true but makes it anyway.
Constructive fraud: Any misrepresentation
intention to deceive is constructive fraud.

made

without

an

Using ones influence to threaten or pressure a person into making

a contract or taking advantage of someones weakness of mind to
cause him to enter into a contract is called undue influence.

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Making a person enter into a contract against his will with use of
physical power or threatening to use physical power is called
duress.
Lawful Objective:
A lawful objective is the third requirement for a valid contract. A
valid contract cannot be made for any unlawful activity, such as
creating a contract to use real estate property for manufacturing
illegal drugs. A contract is void if the objective is not legal.
In a situation where the contract has a legal as well as illegal
objective, then the contract will be valid only to carry out the legal
objective.
Consideration:
Consideration is the fourth requirement for a valid contract.
Consideration is an obligation or a payment which each party must
abide by to enforce the contract. It may be in the form of money, a
service or a promise to do something -- or not do something -- in
the future.
For example, in a normal real estate purchase agreement, the buyer
promises to pay a certain amount of money to the seller (at a
predetermined time) and the seller, on his part, promises to convey
title to the buyer after obtaining his money. In this scenario, both
the parties have given and received consideration.
Writing:
For most contracts in real estate deals, there is a fifth element to
create a valid contract. It must be in writing.
A state law in California, the Statute of Frauds, requires certain
types of contracts to be written and signed. These are:
1. An agreement which will not be completed within one year.
2. An agreement for the sale of real estate or an interest in real
estate or a lease of real estate for more than one year.

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3. An agreement authorizing an agent to sell or purchase real

estate or lease it for one year or more.
4. An agency agreement authorizing an agent to find a purchaser
or seller of real estate, or a lessee or lessor of real estate where
the lease period is more than one year.
5. An agreement by a purchaser of real estate to pay a debt
which is secured by a mortgage or deed of trust on the
purchased property or if the purchaser is to assume the debt.
The writing, as required by the Statute of Frauds, could be in any
form, such as a note, a memorandum, or a series of letters, if:
a. The subject matter of the contract is identified.
b. There is an indication of the agreement between the parties
and its important terms.
c. It is signed by the binding party.
A contract will not be enforceable if it falls under the Statute of
Frauds, and it is not written. Only in rare cases does the court
enforce an unwritten agreement, therefore it is advisable to always
put a contract in writing.
In a dispute between a partly-handwritten and partly-printed
contract, generally the handwritten portion takes precedence. The
intent of the handwritten portion is considered to be more reliable
than the printed one.
In certain types of contracts made in Spanish, Chinese, Korean,
Tagalog, or Vietnamese between a business and a consumer, the
consumer must receive a translated copy before signing the English
version of the contract. This also applies to the financial institution
that negotiates the loan application of a residential real property in
one of the five languages listed above. In such a situation the
borrower must be given a translated copy of the contract within
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three working days after the loan application.

LEGAL STATUS OF CONTRACTS
There can be four legal statuses of a contract:
- Void
- Voidable
- Unenforceable
- Valid
Void: A void contract has no legal effect and it is not considered to
be a contract. This generally happens due to the complete lack of an
important element of a contract, like a mutual consent or a lawful
object.
A void contract may be ignored and neither party has to take any
legal action to disclaim the agreement.
Voidable: Although a voidable contract seems to be valid, it has
some fault which gives either one of the parties the power to
withdraw from the agreement. For example a contract entered by a
temporarily incompetent person may be voidable by that person
after regaining his mental competency.
A voidable contract cannot be disregarded. If legal action to
withdraw from the contract is not taken within a stipulated time,
the court may declare the contract as ratified. In cases where the
injured party desires to continue with the contract, he may ratify it.
Unenforceable: An unenforceable contract cannot be enforced in
court for one of the following reasons:
Its contents cannot be proven
It is voidable by the other party
The statute of limitations has expired
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Contents cannot be proven: This generally occurs with oral

agreements. Although the law allows certain agreements to be oral,
it is advised to always opt for a written agreement to avoid
confusion and misunderstandings, and to be able to more easily
prove the contract terms in court when required.
Vaguely written contracts are said to be illusory and unenforceable,
therefore a written contract must be clearly worded regarding all its
terms.
Contract voidable by other party: A contract voidable by one party is
unenforceable by the other party. The party with the option of
voiding the contract could instead choose to enforce the contract
against the other party.
Statute of Limitations expired: A law that sets a deadline for filing a
lawsuit is called a Statute of Limitations. If the lawsuit is not filed
by the injured party within the deadline set by the applicable
statute, he loses his legal claim forever. This laws purpose is to
prevent someone from suing another person after a long time has
passed since a particular incidence, when memories may be vague
and evidence gone missing.
In California, the statute of limitations allows lawsuits concerning
written contracts to be filed within four years after their breach, and
the period for filing a lawsuit for oral contracts is two years after
breach.
Similar to the concept of the statute of limitations is the Doctrine
of Laches. The court uses laches -- an equitable principle -- to
prevent someone from asserting a claim after an unreasonable
delay.
Valid: A valid contract is one including all the required elements,
which are free of negative influences and can be proved in court.
DISCHARGING A CONTRACT
A valid and enforceable contract may be discharged by:
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1. Full performance, or
2. Agreement between the parties
Full performance: It implies that the parties fulfilled all of the
obligations and thus the contract is executed. For instance, when
the deed to property is delivered to the buyer and the seller receives
the agreed-upon purchase price, their purchase agreement has
been discharged by full performance.
Agreement between the parties: Following are the ways in which the
parties to a contract may agree to discharge the contract:
- Rescission
- Assignment
- Cancellation
- Novation
Rescission: When both the parties agree to take back (rescind) the
contract they do it through a process called rescission. A rescission
is sometimes referred to as a contract to destroy a contract.
To rescind a purchase contract the buyer and the seller sign an
agreement to terminate the original agreement. If there was money
or other consideration involved, it is returned. In some cases,
rescission is carried out by court orders instead of agreement
between the parties.
Assignment: At times one of the parties to a contract assigns his
interest in the contract to another person by withdrawal. Unless the
terms of a contract prohibit assignment, a contract may be assigned
to another person. In an assignment, the assignee is the new party
who takes over the responsibilities of the assignor, the one who
makes the assignment. However, a personal service contract cannot
be assigned without the consent of the other party.
Cancellation: The parties agree to end the contract but previous
acts performed under the contract cannot be undone. For example,
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if the payment of money was one of the contract terms and was
paid before the cancellation, then it will not be returned.
Money given by the buyer to the seller, when entering into a
purchase agreement, is called the good faith deposit. It implies the
buyers intent of fulfilling the terms of the contract. The seller can
keep the good faith deposit if the buyer defaults on the contract.
With this action the contract is cancelled.
Novation: There are two types of novation. The first type is when a
new party is substituted in an existing agreement. The first party is
relieved of all liabilities attached with the contract. The second type
of novation is when the parties substitute a new agreement in place
of the original one which discharges the old agreement. Unlike
assignment, novation cannot be done without the consent of all the
parties.

BREACH OF CONTRACT
A breach of contract occurs when one of the parties fails to perform
some or all of the obligations of the contract, without a reasonable
legal excuse. The injured party is entitled to legal relief if the breach
is a material breach. A material breach is that unfulfilled
obligation which is an important part of the contract.
Time is of essence is mentioned in many standard contracts
which indicates that performing the obligations on time is
important and not meeting the deadline will be considered a breach
of contract. If a party fails to meet the deadline, the other party
decides whether to continue with the contract or to discharge it
using the time is of essence clause.
Legal Relief for Breach of Contract: There are four legal reliefs
for a breach of contract. They are:
Rescission
Compensatory damages
Liquidated damages, and
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 Specific performance
Rescission: To repeat, rescission takes both parties back to their
position before contracting The rescission can either be by
agreement, or by the courts intervention, when one of the parties
has breached the contract.
Compensatory Damages: Damages are those financial losses that a
party suffers because of a breach of contract. Compensatory
damages are the most common remedy for a breach of contract. The
court orders the breaching party to pay a sum of money to the
injured party for the losses incurred due to the breach of contract.
Liquidated Damages: When the parties to a contract agree in
advance to an amount that will serve as full compensation if ever
one of the parties breaches the contract, that amount becomes the
liquidated damages of the injured party.
The provision of the liquidated damages clause is beneficial to
both parties. They can settle their disputes without
approaching the judiciary. However the liquidated damages
provision limits the amount of compensation the injured party
would receive.
In a real estate transaction, if there is a breach of contract by the
buyer, the seller is entitled to keep the good faith deposit as
liquidated damages. Generally the seller cannot sue the buyer for
any further compensation.
There is no liquidated damages clause in a typical real estate
agreement if the seller breaches the contract instead of the buyer.
In this case, the buyer can sue the seller for compensatory
damages.
Specific Performance: Specific performance is the legal action
through which the breaching party is forced to fulfill the terms of
the contract. This action is normally taken as a remedy only if
monetary damages would not suffice.
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TENDER
An unconditional offer by one of the parties to a contract to fulfill
his part of the agreement is called a tender. It is also sometimes
referred to as an offer to make an offer good. Generally made
when it seems that the other party might default, the tender is
necessary before any legal action can be taken to remedy the breach
of contract.
Sometimes there is an anticipatory repudiation by one of the
parties. A positive statement by the defaulting party stating that he
cannot/will not fulfill the terms of agreement is called an
anticipatory repudiation. In this situation, there is no need to make
a tender and a legal action can be undertaken right away.

Chapter Summary
A promise made by one person to another to do something or
not do something is called a contract.
When a contract obligation is yet to be performed or is in the
process of being performed it is said to be an executory
contract.
In California, anyone younger than 18 is a minor and cannot
make a contract concerning real estate. Such a contract will
be void.
Money given by the buyer to the seller, when entering into a
purchase agreement, is called the good faith deposit. It
implies the buyers intent of fulfilling the terms of the contract.
Time is of essence is mentioned in many standard contracts
which indicates that performing the obligations on time is
important and not meeting the deadline will be considered a
breach of contract.
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 An unconditional offer by one of the parties to contract to

fulfill his part of the agreement is called a tender.

Chapter Quiz
1. A contract can be considered valid even if:
a. It does not have a lawful objective
b. It was not put into writing
c. It is not supported by consideration
d. There was no offer and acceptance
2. A sixteen-year old person can sign a contract if she:
a. Is an orphan
b. Is not living with parents
c. Has an adult cosign with her
d. Is emancipated
3. An _____________ contract is one that has not yet been
performed, or is in the process of being performed.
a. Implied
b. Express
c. Executory
d. Executed
4. ____________ is compelling a person to do something against
his will, with the use of force or constraint:
a. Actual fraud
b. Constructive fraud
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c. Undue influence
d. Duress
5. Which of the following is NOT a method of terminating a
contract:
a. Revocation by the offeror
b. Lapse of time
c. Offer and acceptance
d. Counteroffer
6. When both the parties agree to take back the contract they do
it through a process called:
a. Rescission
b. Novation
c. Cancellation
d. Assignment
7. Assignment is:
a. When one party is completely replaced by another, or one
contract is completely replaced by another
b. When one party transfers its rights and obligations under
the contract to another party, but remains secondarily
liable
c. When a contract is terminated but previous contractual
acts are unaffected
d. When a contract is terminated and any consideration given
is returned
8. A contract with a defect that gives one or both parties the
power to withdraw from the agreement is called a(n):
a. Void contract
b. Voidable contract
c. Unenforceable contract
d. Valid contract
9. As per the Statute of Frauds law:
a. Certain contracts are to be bilateral
b. Certain contracts are to be in writing and signed
c. All contracts are to be supported by consideration
109

d. Unlawful activities are to be severed from a contract

10. Financial losses that a party suffers due to a breach of
contract is referred to as:
a. Damages
b. Breach
c. Laches
d. Fraud
11.
If one of the parties fail to perform any of the promises
mentioned is the agreement, it is a:
a. Novation
b. Rescission
c. Cancellation
d. Breach
12. A law that sets a deadline for filing a lawsuit is:
a. The Statute of Limitations
b. The Statute of Frauds
c. The probate court
d. The doctrine of laches
13. In California, the Statute of Limitations requires the lawsuit
regarding the written contracts to be filed within___________
years after the breach.
a. 2
b. 3
c. 4
d. 5
14. What legal action is taken to compel a breaching party to
perform the contract as per the agreement?
a. Compensatory damages
b. Specific performance
c. Rescission
d. Liquidated damages
15. ____________ is an unconditional offer by one of the contract
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parties to perform his part of the agreement.

a.
Tender
b.
Contract
c.
Agreement
d.
None of the above

CHAPTER 7
Real Estate Contracts
CHAPTER OVERVIEW
In this chapter, we will learn how the laws of contracts are applied
to real estate listing agreements. The elements of forming, recording
and exercising of option agreements and lease agreements are also
explored.
LISTING AGREEMENTS
A listing is a contract through which the seller employs a broker to
sell a real estate property. Basically, a listing agreement is like an
employment contract between the seller and the broker. In this
bilateral agreement, the seller agrees to pay a commission (also
called a brokerage fee) if the broker finds a buyer for the property;
on his part, the broker promises to make a sincere effort to procure
a buyer. A listing agreement does not authorize the broker to accept
offers on the behalf of the seller, nor can he transfer title to the
sellers property.
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A listing agreement forms an agency relationship between the

broker and the seller. An agency has to act very responsibly and
keep the best interest of the seller as a priority while pursuing
buyers for his property.
The commission of the broker is normally calculated as a
percentage of the propertys purchase price. According to California
law, the broker cannot sue the seller for collecting a commission
unless there was a written listing agreement in place. An oral
agreement between brokers to split the commission is enforceable
but an oral listing agreement cannot be enforced. A broker has to
be appropriately licensed before offering his services and also fulfill
all the terms of the listing agreement that states under what
circumstances the broker is entitled to receive a commission from
the seller.
COMMISSION
A brokers commission may be paid by the listing agreement,
provided the terms of the agreement are such that they are
mutually acceptable to the broker and the seller. For example, if the
agreement has a clause of no sale, no commission by the seller,
then the brokers commission is payable only if the transaction
closes and the sale is completed. If a sale does not happen due to
circumstances beyond the sellers control, then the commission is
not payable to the broker. If, however, it does not happen due to a
fraud on the part of the seller (or because of bad faith) the broker
will still be entitled to a commission.
There are certain basic rules that apply regarding the payment of a
brokers commission: having ready, willing and able buyer and
those rules concerning the three types of listings.
Ready, Willing and Able Buyer: Normally, a listing agreement has
a clause by which the broker is entitled to a commission only if a
Ready, Willing and Able Buyer is found during a listing period.
Ready and Willing: When a buyer makes an offer which meets the
sellers terms of sale he is said to be ready and willing. According
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to the listing agreement the seller decides the terms (price, closing
date, payment arrangements) on which he wants to sell the
property. If a buyer makes a matching offer, the broker is generally
entitled to a commission, even if the seller decides to reject the offer
made.
However, if the offer made by the buyer does not comply with the
sellers term, the seller will not be obligated to pay the commission
to the broker.
Able Buyer: If a buyer has the financial ability to purchase and
capacity to contract, he is considered to be able.
Commission Without Closing: Once the broker finds a ready,
willing and able buyer, he should receive his commission, even if
the sale eventually fails to close. If the seller is responsible for a no
sale, the broker is still entitled to a commission, although he may
decide not to accept it. The broker will get a commission even if the
sale does not take place, in the following situations:
- The seller changes his mind and does not want to sell;
- The sellers title is not marketable;
- The seller is not able to hand over possession of the property
to the buyer; or,
- The seller and buyer reach a mutual agreement to end the
contract
If it is not mentioned in the listing agreement, it is not necessary for
the buyer and seller to prepare a written purchase agreement in
order for the broker to receive his commission. It is sufficient if both
parties have mutually agreed to the terms of the sale. The broker
can claim his commission even if the seller backs out before the
agreement is put into writing.
What happens if the seller and broker disagree as to whether the
buyer found by the broker is ready, willing and able? In California,
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a court will accept that buyer was ready, willing and able only if a
written purchase agreement was signed. The seller cannot claim
that the buyer was unacceptable since he has already entered into
the contract of sale. The same rule is applicable when the buyer
defaults due to financial problems and cannot proceed with the
purchase.
Also, if the contract is not signed and the agreement between the
two parties is not yet written and the deal collapses, the
commission will not be paid to the broker -- unless he proves the
buyer was financially able to fulfill the contract.
LISTING AGREEMENT TYPES
A brokers commission depends on the type of the listing agreement
made between the agency and the seller. There are three types of
listing agreements:
The open listing
The exclusive agency listing
The exclusive right-to-sell listing
Open Listing: An open listing gives a number of brokers the right
to sell a property. It is called a nonexclusive listing, which means it
can be given to different agents at the same time. The first broker to
find a buyer who agrees to all the terms of the listing and whose
offer is accepted by the seller is entitled to obtain the commission.
This agent is the procuring cause of the sale. The seller may even
sell the property directly, without the agents assistance and thus
owe no commission to any broker.
The open listing agreement comes with some disadvantages as well:
- If two brokers from different agencies negotiate with the same
prospective buyer who finally does buy the property, there may
be a dispute over which broker was the procuring cause of the
sale.
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- Since a broker with an open listing is not sure whether he will

ultimately receive any commission when the property sells, he
may only put minimum efforts into marketing the property
from his side, so it may take longer to sell.
- Generally, open listing agreements are used only when the
seller does not want to go with the exclusive listing agreement.
Multiple listing services normally do not accept open listings.
Exclusive agency listing: The exclusive agency listing does not
allow the seller to list the property with another broker at the same
time. However, he does have the right to sell the property himself,
without having to pay a commission to the broker. The broker is
entitled to a commission if anyone other than the seller procures a
buyer for the property. According to California law, the exclusive
agency listing is supposed to have a definite termination date,
without which the broker may have to face disciplinary actions.
Exclusive right-to-sell listing: This is the most commonly used
form of agreement, in which the broker is entitled to receive a
commission no matter who finds the buyer to purchase the
property. Even if the seller finds the buyer, the commission should
still be paid to the broker. The commission is sometimes shared
with a co-broker or a sub-agent who procures a buyer. Like all the
other listing types, the exclusive right-to-sell listing authorizes the
broker to only find buyers; the broker cannot actually sell the
property.
Generally in a right to sell listing agreement there is a safety clause
which protects the buyer even after the listing expires, if the broker
has registered that particular buyer with the owner.
One difference between open and exclusive listings regarding the
brokers obligations is that an open listing normally is a unilateral
contract by which the seller promises a commission to the broker if
he finds a buyer, without a commitment from the broker to find a
buyer. If the broker fails to procure a buyer, it does not amount to
breach of contract.
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On the other hand, an exclusive listing is a kind of bilateral

contract through which the seller promises to pay a commission
irrespective of who finds a buyer and the broker promises to make a
sincere effort to find a buyer. It is worth noting that if the seller is
successful in proving that the broker had no part in the sale of the
property, the court may waive the sellers obligation to pay the
broker.
ELEMENTS OF A LISTING AGREEMENT
All the elements of a valid contract must be available in a listing
agreement: offer and acceptance, competent parties, consideration
and a lawful intent. A listing agreement must be in writing and
signed by the seller to satisfy the Statute of Frauds, although the
brokers signature is not required.
Without a written listing agreement the seller cannot be sued by the
broker for an unpaid commission, even if it was orally agreed.
A listing agreement should definitely cover the following matters:
Description of the property
Acceptable terms of sale
A grant of authority to the broker
Fixing the brokers commission fee
Expiration of the agreement
Description of the property: A listing agreement must carry the
description of the property of the seller. It is advisable that a legal
identity of the property be attached to the agreement as a proof. To
demonstrate that any attachment is a part of the agreement, it
should be dated and initialed by the parties.
Acceptable terms of sale: It should be clearly and fully specified in
the agreement as to what the seller requires in the offer. For
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example, how much money is the seller expecting from the sale (the
listing price) and other terms which would be of importance to the
seller.
Grant authority to the broker: A brokers authority is stated in
the agreement for bringing a buyer for the property. Generally, the
broker has the authority to accept good faith deposits from the
buyer and hold them on the sellers behalf. In some cases when a
broker does not have that authority, he is only acting as a buyers
agent, as far as the deposit is concerned. In such a situation, if the
broker loses or misuses the deposit the seller cannot be deemed
liable to the buyer.
Fixing the brokers commission fee: This is a very important part
of a listing agreement: the clause that states the rate/amount of
commission the broker will receive. A percentage of the purchase
price is given as a commission and it should always be negotiated
between the seller and the broker. If the brokers between them
arrange a commission rate, it amounts to a violation of state and
federal antitrust laws.
Another way of obtaining a commission is a net listing. With a net
listing the seller sets his desired net amount from the purchase of
the property, while the broker on his part tries to sell it for more
than that net amount expected by the seller. After the sale of the
property the seller keeps the net amount he asked for and the
broker retains any excess payment as his commission.
A net listing may be an open listing, exclusive agency listing or
right- to-sell listing. According to California law, the broker using a
net listing has to show his commission to the seller prior to the sale
transaction, otherwise disciplinary action may be taken against the
broker.
Payment of commission: Generally the commission is paid by check
unless agreed to otherwise by broker and seller. It may be paid in
the form of an assignment of an existing note, a promissory note or
assignment of funds to be received from the buyer.

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Normally, the broker is entitled only to a commission and not to any

other expenses incurred during the selling of the property unless
such an arrangement is mentioned in the agreement.
Also, a salesperson cannot receive a commission directly from the
seller or from any other broker or agent. The commission can only
be obtained by the salesperson from the broker for whom the
salesperson works. A salesperson cannot even sue the seller if he
does not receive his share of the commission; only the broker can
sue for non-payment.
Commission Split: Multiple Listing Service (MLS) is an
organization of brokers who share information about each ones
listings. This is more common in urban and suburban areas. The
seller authorizes the broker through the listing agreement to share
the commission paid, with other brokers. This sharing of
commission is called a commission split. Normally in a MLS, the
listing broker pays half the commission to the selling broker (one
who finds a buyer).
Safety Clauses: Most of the listing agreements contain a safety
clause which is also referred to as a protection clause or a
protection period clause. This safety clause entitles the broker to
the commission on a property sold after the listing term expires,
provided the broker had negotiated with the same purchaser during
the listing term. The purpose of this clause is to protect the broker
from parties who try to save the commission amount (which they
would have to pay to the broker) by waiting for the listing term to
expire and then make the purchase deal. If a broker does not want
this to happen to him, he must provide the names of the parties he
negotiated with to the seller, on or before the listings expiration
date. This keeps the seller informed that he is liable to pay a
commission, if the property is sold to someone named on the
brokers list.
Expiration of the agreement: A listing agreement must have a
expiration date, which means that after that date the broker has no
authority to act on the sellers behalf. In California, it is compulsory
that every exclusive agency listing and exclusive right to sell listing
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include an end date. The Real Estate Law requires this clause,
although the law is not binding on the length of the listing period.
BUYER REPRESENTATION AGREEMENTS
A buyer representation agreement is actually a written agreement
between a property buyer and a broker, through which the buyer
who is looking to purchase a property employs a broker who will
help him find a suitable one.
A buyer representation agreement may be exclusive or it may be
nonexclusive. As per the exclusive agreement terms, the broker is
entitled to a commission if the purchase is made during the
agreement period even if the property was not found, or the sale
terms not negotiated, by the broker.
Following the Statute of Frauds, to be enforceable the buyer
representation agreement should be in writing and signed by the
buyer. According to the Real Estate Law, there should be an
exclusive buyer representation agreement, which would mention
the termination period.
Provisions in a Buyer Representation Agreement
Normally the following provisions are found
representation agreement:

in

buyer

- The basic characteristics of the property the buyer is looking

for
- The price range of the property
- The specific duties of the broker
- The brokers commission
The required property description should be precisely detailed in
the contract. The buyer becomes liable to pay the compensation to
the broker if he finds a property that fits the description and within
the price range given, even if he does not want to purchase the
property.
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At times a broker is hired by the buyer just to negotiate the price of

the property which the buyer has already found. Under this
situation the buyer representation agreement must mention a legal
description of the property involved.
The duties a broker may be required to fulfill in an agreement
include:
- Finding appropriate properties
- Preparing offer on behalf of the buyer and presenting it to the
seller
- Negotiating the deal with the seller
- Assisting a buyer to procure finance
- Providing other relevant guidance
The broker agrees to make a sincere and honest effort on behalf of
the buyer, under the exclusive representation agreement.
Generally the representation agreement does not prevent the broker
from working with other buyers or from showing multiple buyers
the same property. He may even negotiate the same deal with
different buyers at the same time. This does not amount to a breach
of contract on the part of the broker.
BROKERS COMMISSION
A brokers commission must be negotiable according to the Real
Estate laws. A buyer who is looking to buy a residential property up
to four units or more must mention in the agreement that the
compensation is negotiable.
The conditions under which the commission will be paid should be
specifically noted in the agreement, as well as how the payment
amount will be determined.
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There are many different ways by which a broker may receive a

commission. Many buyer representation agreements allow
payments by way of a commission split, which takes place when a
purchase is made through a multiple listing service. It was
discussed earlier that the listing broker may share his commission
with the other broker under the MLS listing agreement. Normally,
the listing broker pays half the commission received to the broker
who finds the buyer. This broker may represent any one of the
parties.
When a broker is working on behalf of the buyer and he accepts a
commission split, he is actually being paid by the seller and not by
his client, the buyer. According to California law, the brokers duties
towards his client remain unaffected, even though he is being paid
by the other party.
There may be a provision of a buyer-paid fee in a buyer
representation agreement in place of a commission split. The buyerpaid fee might be:
- Charged on a percentage basis, with the commission being a
percentage of the purchase price
- Based on a hourly basis, a fixed hourly rate is applicable (like
a consultancy fee)
- A specific amount which is fixed if the purchase is made
during the representation agreement term
Some buyer representation agreements allow the broker to accept a
commission split on listed properties or the broker will be paid a fee
by the buyer if the property is sold directly by the owner.
To insure that a broker does not waste his efforts, there is a
provision for the broker to collect a retainer when the buyer
representation agreement is made. The retainer is a nonrefundable
fee which is paid to the broker before the property hunting process
begins. This amount is later credited against a commission/fee
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payment that the broker is paid when a purchase is completed.

PURCHASE AGREEMENTS
A purchase agreement is made when a seller accepts an offer made
by a real estate buyer to purchase a property. A written contract
between a seller and a buyer, which states all the terms of the sale,
is called a purchase agreement.
There is a standard purchase agreement form which includes the
buyers offer with his signature and a good faith deposit, which is
presented to the seller. If the offer is acceptable to the seller, he
signs it and this signed form becomes a binding contract of sale as
well as the buyers receipt for the paid deposit. Therefore, a
purchase agreement is also sometimes referred to as a deposit
receipt.
Certain other tasks need to be performed before the sale transaction
can close. The purchase agreement is the legal document which
keeps the buyer and the seller committed during the period in
which other formalities are carried out. If one of the parties
breaches the contract by backing out, the other party may take
legal recourse which the agreement provides for. The tasks which
need to be done to complete the transaction include: inspection of
the property, arranging of finance, a title search and other duties.
Once the purchase agreement has been signed by the buyer and the
seller, the buyer is supposed to have equitable title to the
property. Having an equitable title means that although legal title to
the property is still held by the seller, the court will accept the
buyers interest in the property as well. In case of a breach of
contract on the sellers part, the court may issue an order of specific
performance, by which the seller will have to deed the property to
the buyer.
Elements of a Valid Purchase Agreement
According to the Statute of Frauds, the agreement to a purchase
and sale of real estate should be in writing and it must be signed by
both the parties. A valid purchase agreement has to:

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- Identify both parties

- Have a description of the property
- Mention the price and the mode of payment
- Have a closing date (transfer date of title and possession)
Most of the real estate contract forms mention many more details.
However, all real estate contracts must include certain agreed-upon
terms. Apart from the above mentioned provisions, a purchase
agreement also normally consists of contingency clauses,
warranties, disclosures and provisions in regards to escrow, title,
closing, deadlines, the buyers deposit and the brokers commission.
Identify both parties: The buyer and seller should be properly
identified in the agreement. The co-owners of the property should
also sign the contract as sellers. Both the parties should have the
capacity to enter a contract. If a community property is being sold,
then both spouses need to sign as sellers and if a property is
brought as a community property, both spouses need to sign as
buyers.
Description of the property: A proper description of the property
to be sold is a must. If a legal description cannot fit in the contract
form, then a copy of the legal description (with the initials of the
parties) can be attached to the purchase agreement as an exhibit.
Sales terms: All the terms of the sale must be clearly mentioned in
the purchase agreement such as the total purchase price, the
finances, mode of payments, items included/excluded in the sale.
The arrangement of finance should be clearly mentioned in the
agreement forms including the loan status, the interest rate, the
term of loan, how the loan will be paid off, and the principal
amount.
Contingency Clause: There is a contingency or a conditional clause
in most agreements. A contingency clause must clearly state the
condition of fulfillment of the particular clause. It must also
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mention how the parties will be informed of the fulfillment or

waiving of the clause. A conditional clause should come with a time
limit. For example, if a certain condition is not met or waived, the
agreement will be void. There should be an explanation of the rights
of the parties in case a condition is not met or waived.
If a real estate broker realizes that a condition which is imposed in
a purchase agreement might affect the closing date or the
possession date for the buyer, he must discuss the condition with
both parties. Otherwise it may account for a violation of the
California Real Estate Law and he may face disciplinary action.
Condition of the Property: Another provision found in many
purchase agreements is in regard to the condition of the property.
The agreement may state that the property is sold as is or else the
seller may warrant the condition of certain aspects of the property
like the roof, the flooring, the plumbing and so on in the purchase
agreement. Even if a property is being sold as is the material
defects in the property have to be revealed to the buyer as the seller
is legally obligated to do so. The contract may also have a provision
regarding the buyers right to inspect the property.
Disclosures: The law requires a seller to give the buyer certain
disclosures about the property and the areas surrounding it. This
may have an impact on the buyers decision to purchase the
property.
Conveyance and Title: The type of deed which will be used to
convey title to the buyer should be mentioned clearly in the
purchase agreement. The contract ascertains that the title is clear
and that the seller will get a title insurance policy which protects
the buyer.
Escrow and Closing: A purchase agreement should also include
arrangements for escrow. The identity of the escrow agent must be
known to both the parties. The escrow agent has to be chosen with
the consent of both the parties.
Possession: The buyer gets the possession of the property on the
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closing date. If the buyer wants to take early possession of the

property, an Interim Occupancy Agreement is used. This protects
the rights and obligation of both the parties.
When a property which is subject to a purchase agreement gets
damaged or destroyed, the Uniform Vendor and Purchaser Risk Act
law is in place which decides which party will absorb the loss. As
per the terms of the act, the risk of loss is the sellers, until the
possession of the property is transferred to the buyer.
The inclusion of a risk clause may allow the parties to apportion
the risk of loss in a different way.
Time is of the Essence: Time is a very important aspect of a
contract. If no time limit is determined in a contract, then a
reasonable time is permitted by law. If an act can be completed at
once, it must be done that way. Example: if a payment has to be
made, it must be made at once. Failing to meet a deadline in an
agreement is a breach of contract.
Good Faith Deposit: Receipt of the Good Faith Deposit from the
buyer should be mentioned in the purchase agreement. Conditions
due to which the deposit might be refunded or forfeited should be
clearly mentioned in the purchase agreement.
It is also important to state the form of deposit, which is normally in
the form of a check but it may even be in the form of a promissory
note. The seller must know the form of deposit before accepting the
offer.
Liquidated Damages: Generally, the amount of damages to be
paid in case of a breach of contract by either party is decided before
the contract is signed. Usually the contract would state that the
seller may keep the deposit as liquidated damages if the buyer
breaches the contract and the liquidated damages are not more
than 3% of the purchase price of the property (a single-family
residence) in case of the buyers default.
Brokers Commission: The provision of a brokers commission in a
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purchase agreement is just a written confirmation of the

commission pattern which is agreed upon in the listing agreement.
License Identification Number: A real estate agents license
number is required on the purchase agreement if a broker is
involved in the buying process. The purchase agreement must also
contain the identification number from the Nationwide Mortgage
Licensing System and Registry if the broker has a mortgage loan
originator endorsement (discussed in detail in Chapter 16).
AMENDMENTS
An amendment is also called a rider. After the purchase agreement
has been signed by both parties, the terms of the contract may be
modified in writing only. For the amendment to be enforceable it
must be signed by all the parties who signed the original contract.
An amendment is different from an addendum. An amendment is
done after the contract has been signed and must be in writing,
while an addendum is added to the contract before being signed by
the parties.
LAND CONTRACTS
A land contract is also called a variety of other names: a real estate
property sales contract, conditional sales contract, real estate
contract, installment sales contract or contract for deed. In a land
contract, the property is purchased by the buyer on an installment
basis and not by paying the full price of the property in one single
payment. The buyer is given possession of the property but the title
is conveyed only after the full price of the property is paid. However,
the buyer has equitable title to the property.
In a land contract the buyer is referred to as the vendee and the
seller as the vendor.
California laws specific definition of a land contract is:
.an agreement wherein one party agrees to convey title to real
property to another party upon the satisfaction of specified
conditions set forth in the contract and that does not require
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conveyance of title within one year from the date of formation of the
contract.
Vendor and Vendee: Rights and Responsibilities
During the period in which the vendee pays the installments, the
vendor may encumber or transfer the property without getting
permission from the vendee. This is permitted only if the title is not
transferred to the new owner.
Before creating any liens against the property, the vendor must
apply the vendees contract payments to amounts due on the liens.
This law protects the vendee from a possible default on the liens by
the vendor, due to which the property might be foreclosed upon.
Any liens must be paid off by the vendor before the deed is delivered
to the vendee. Once the full payment has been made by the vendee,
a clear and marketable title should be handed over by the vendor.
The vendors signature has to be acknowledged for recording the
land contract. The vendee is free to record the contract, the vendor
cannot stop him. There will be more statutory restrictions on the
rights of the vendor to create a lien, if the land contract is not
recorded.
The vendor cannot encumber the property with a lien if it adds up
to more than the unpaid contract balance, without the consent of
the vendee. Also, the monthly payments on those liens should not
be more than the monthly payments of the vendee on the land
contract.
The vendees primary responsibility is to pay the required
installments to the vendor and, secondly, to pay the insurance and
property taxes in a timely manner.
The vendor can disallow prepayment (paying off all or part of the
balance amount before the due date) of installments only for the
duration of the first twelve months after the sale, this is for the land
contract for residential property of up to four units. After that
period the vendee is legally free to prepay the installments fully or
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partly.
The vendee can legally encumber the property, but the vendees
equitable interest in the property is the only security for the lender
providing the loan. After the full payment of the contract price the
vendee may sell his interest in the property and assign the right to
receive the deed. The vendee may even devise (will) his interest to a
relative.
Remedies for Default
The vendee can sue the vendor for specific performance if, after
paying the purchase price in full, he does not obtain the property
title from the vendor.
The vendor can terminate the contract by sending a proper notice to
the vendee, if the vendee defaults by failing to pay the installments.
The amount paid to the vendor must be reimbursed to the vendee.
If there are any damages incurred by the vendor, the amount can
be reduced from the vendees reimbursement amount. Also, the
reimbursement amount can be reduced by the fair market rental
value of the property for the period the vendee was in possession of
the property.
If the vendee has already paid a major part of the purchase amount
then he has the right of redemption. He can even cure the default
and reinstate the contract.
The vendor may regain the possession if the vendee does not cure
the default or redeem the property. Since the land contract was
recorded, it becomes a cloud on the propertys title. The vendor will
have to obtain a quitclaim deed from the vendee or file for a quiet
title action so that the title may become marketable again.
Use of Land Contract
A land contract may sometimes be used as an alternative to a deed
of trust or mortgage in a real estate transaction which is financed
by the seller. The seller gives credit to the buyer and, as security,
holds the title to the property (instead of creating a lien) till the time
the debt is repaid. This way, it becomes easier to reclaim the
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property if the buyer defaults. However, California laws have

changed and now the vendees have the right to either reinstate,
reimburse or redeem the property. Therefore, land contracts are not
preferred for this purpose and a deed of trust is used instead by the
sellers.
There is the Cal-Vet program, which normally uses the land
contracts to finance homes brought by veterans. (The Cal-Vet
program will be further discussed in chapter 10)
OPTION AGREEMENTS
An option agreement is a contract to keep the offer open for a fixedupon period of time to purchase or lease a property. The owner of
the property is called the optionor and the one who intends to buy
the property is the optionee. An option is a written, unilateral
contract between the owner of the property and the probable buyer.
The agreement clearly states the right to purchase, a fixed price for
the property, and a fixed time frame. When the optionee exercises
his right to purchase, the option becomes a sales agreement. When
the option is exercised the real estate broker is entitled to a
commission.
Elements of a Valid Option:
Since an option is a contract, it must have all the elements of a
valid contract. It must also have a monetary consideration payable
to the optionor (owner) which may be in the form of cash, check, or
something valuable. In a lease agreement, the provisions of a lease
and payment of rent may be treated as the consideration.
Rights of the Optionor and Optionee:
The rights of the seller are restricted in an option contract as the
optionor cannot sell or lease the property during the option period.
During the term of the option, if the optionee backs out of the
contract the optionor retains the consideration. The option contract
is binding on the heirs and assignees of the optionor.
The optionee is not bound by the option for any performance, he
may or may not exercise the option. The option simply provides him
the right to demand performance from the optionor to sell the
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property if the optionee decides to buy it. The optionee does not
have a legal interest in the property and he cannot use the land
either. The optionee may assign or sell the option during the term of
the option, without the consent of the optionor.
Recording an Option
An option is essentially recorded to give the third parties an
indication of the option.
A recorded option, if not exercised. creates a cloud on the title of the
optionor. To remove the cloud the optionor will require a release
from the optionee and the release should be recorded.
RIGHT OF FIRST REFUSAL
Right of first refusal means a person is given the first opportunity to
purchase or lease a property whenever it is available. For example,
a tenant may get the right of first refusal if the landlord decides to
sell the property. The tenant who is the holder of the right of first
refusal must be given a chance to match the offer made by a third
party for the purchase of a property. The third party may be able to
purchase the property if the tenant (holder of the right of first
refusal) does not want to purchase the property or he is not willing
to match the offer made by the third party.
LEASES
A contract between an owner and a tenant which gives the tenant a
tenancy is called a lease. Tenancy allows a person (a tenant) to take
exclusive possession of land in consideration of rent through a
formal lease or an informal agreement. Conveying an interest in real
property through the terms of a lease is termed a demise. The
landlord (lessor) and the tenant (lessee) have a mutual interest in
one property, and hence they are said to be in privity. The lessors
interest is called a leased fee estate and the lessees interest is
referred to as a less-than-freehold estate in real property.
A lease contract which is sometimes referred to as a rental
agreement states the rights and responsibilities of the landlord and
the tenant. However, there are certain terms and conditions which
are implied by law in all leases irrespective of whether or not they
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are mentioned in the rental agreement.

A lease normally creates a term tenancy or a periodic tenancy. A
term tenancy will end automatically when the specific term is over;
so, for instance, a one-year lease will conclude at the end of the
year or it can be renewed if the tenant and the landlord agree. A
periodic tenancy renews itself automatically at the end of each
period or it can be terminated when one of the parties presents the
termination notice.
Elements of a Valid Lease
- Both the parties must be competent and mutually agree to all
the terms.
- Consideration is a must. The rent amount and the due date
must be mentioned.
- A lease longer than a year must be in writing. A lease which is
supposed to be written but is not converts into a periodic
tenancy.
- A written lease requires the signature of the lessor (landlord).
- A lessees signature is not required.
- A tenant possessing a property and paying rent is considered
to have accepted the terms of the lease.
- A proper legal description of the land must be mentioned in
the lease agreement.
RIGHTS AND DUTIES OF LANDLORD AND TENANT
The rights and responsibilities of the landlord and tenant are
determined by the terms of the lease agreement as well as by the
landlord-tenant laws. The state of California has some local laws
which convey greater protection to the tenant.
Use of the property: The law restricts the tenant to use the leased
property legally. If the landlord needs to make additional
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restrictions to the use of the property, the language used for

mentioning the restrictions in the lease agreement must be clear
and precise, otherwise the restriction may not be enforceable.
Paying of Rent: The rent is normally required to be paid at the
beginning of the rental period as per the lease agreement. If the
lease does not mention the specific time for paying the rent then
rent is due at the end of the rental period.
The rent is usually paid by the tenant by check but if the check is
dishonored due to insufficient funds or because the tenant stopped
payment then the landlord may ask the tenant to pay cash. If this
occurs, the landlord may give a notice to the tenant to pay three
months rent in cash.
A periodic (month-to-month) tenant should be given a 30-days
notice before a rent increase or any other change in the lease terms.
If the rent of a residential property of up to four units increases by
10% in a 12-month period, a 60-days notice is to be provided to the
tenant.
Security Deposit: According to California law, a security deposit may
be any payment, deposit, fee, or an advance rent payment which is
paid by the tenant to secure the lease agreement.
The total security deposit for a residential lease for a furnished unit
is normally three times the monthly payment and for unfurnished
units it is two times the monthly rental payment. But if the lease
term is six months or longer then the landlord has the right to
demand a deposit which is six times or more of the monthly rental
payment, provided it is considered as an advance payment of the
rent.
Once the tenant has vacated the leased premises, the security
deposit should be returned by the landlord within 21 calendar days
or the landlord must send the ex-tenant a written explanation as to
why the deposit (or portion of a deposit) was not returned. If within
21 days the deposit or a written explanation is not provided to the
tenant, the landlord may face a penalty of up to twice the amount of
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the security deposit. Note that it is illegal to label a deposit as

nonrefundable in a residential lease.
The tenant cannot be charged for normal wear and tear during his
stay in the leased apartment but a tenants security deposit may be
withheld to cover unpaid rent, to pay for cleaning the premises or
repairing other damages caused by the tenant.
Inspection: The landlord has the right to enter and inspect the
leased premises during the lease period, as per most lease
agreements. California law permits the landlord to enter residential
premises in an emergency, to make repairs, improvement, or to
show the premises to prospective buyers or tenants. During an
emergency there is no need for a notice, but otherwise the tenant
must be given at least a 24-hours notice by the landlord before
entering the premises. The landlord must enter during business
hours or at a different time as agreed upon with the tenant.
Repairs and Improvements: The tenant is supposed to return the
property to the landlord in the same condition as when he took
possession. Some wear and tear is allowed, though. The common
areas of the property need to be maintained by the landlord like the
staircase, elevator or passage way.
Improvement on the property is not required of the landlord or the
tenant. The improvements which the tenant makes may be removed
by him on expiration of the lease.
Renewal: A term tenancy created by a lease may have a provision
for the tenant to renew the lease upon the terms expiration. If a
tenant intends to renew the lease, he has to give a notice stating his
intension to exercise the option of renewal on or before a specified
date.
The parties have to sign a renewal agreement to renew a lease,
although a lease may be renewed by implication rather than
express agreement. When a landlord accepts payment from the
tenant after the lease has expired, it may be considered as an
implied renewal of the lease.
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Contact Information: The name, telephone numbers and the address

of the following persons should be in the residential lease:
- The owner of the property or the agent of the owner.
- The manager of the property (if there is one).
- The person/entity who will receive rent from the tenant.
In case there is no written lease then the above-mentioned
information must be conveyed to the tenant in writing within 15
days after the rental agreement is made. This information may be
posted in the building in two conspicuous places if not provided to
the tenant in writing. of a Lease
TRANSFER OF A LEASE
If the lease agreement permits, the tenant may transfer his
leasehold property to another party by way of assignment, sublease
or novation.
Assignment: In an assignment, the leaseholder assigns the
remainder of the leasehold property to the new lessee (called an
assignee). The assignee is responsible for paying the rent to the
landlord while the liability of the original tenant (the assignor)
becomes secondary. If the assignee does not pay the rent the
assignor is responsible for it.
Sublease: In a sublease the possession of the leasehold is
transferred to a new party (the sublessee). The primary
responsibility of paying the rent remains with the original tenant
(the sublessor). The sublessee is only liable to the sublessor. Such a
lease is also sometimes referred to as a sandwich lease.
Novation: In a novation, a new contract is made, terminating the
existing contract. The existing lease is replaced with a new lease
made between the same parties, or a new lease is made between
different parties. The liability of the original tenant is terminated
through the novation.
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TERMINATION OF A LEASE
Following are the ways by which a lease may be terminated:
Expiration of the lease
Notice of termination
Surrender
Breach of implied promise by the landlord
Non-payment of rent
Illegal/unauthorized use
Foreclosure
Destruction of the premises
Condemnation
Expiration of the lease: A term tenancy lease expires automatically
when the term ends. Notice of termination is not required.
Notice of termination: A written notice of termination by either the
landlord or the tenant may terminate the lease at any point of time
during the lease period. The notice period required is usually the
same as the term of the lease. For example, a week-to-week tenancy
requires a weeks notice and a month-to-month tenancy will require
a months notice for termination. An exception to that rule is that a
residential landlord has to give a notice of termination of 60 days to
a tenant who has been residing on the premises for a year or more.
Surrender: A mutual agreement from both the tenant and landlord
to end the lease is called surrender.
Breach of implied promise by the landlord: There is an implied
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covenant of quiet enjoyment in every lease. It is an implied

promise from the landlord to refrain from unlawful interference
while the tenant is in possession of the leased property. The tenant
is assured of exclusive possession and quiet enjoyment of the leased
property.
It is a breach of the covenant of quiet enjoyment when the tenant is
unlawfully evicted from the leased property. The tenant may be
evicted either by actual eviction or by constructive eviction.
Actual eviction means actually forcing the tenant to vacate the
premises while constructive eviction means causing major
interference with the tenants possession of the property. For
example, disconnecting the electricity or water supply may cause
constructive eviction.
If the covenant of quiet enjoyment is breached by the landlord by
evicting the tenant wrongfully, the tenant is relieved of his
obligations under the lease and he may treat the lease as
terminated.
The landlord in all residential leases makes an implied promise to
meet all the building and housing code regulations which affect the
health and safety of the tenants on the property. This is the implied
warranty of habitability. The tenant notifies the landlord of any
defects or codes that do not meet the required standards, the
landlord must then make corrective repairs within a stipulated time
limit as fixed by the statute. If the repairs are not carried out by the
landlord before the time limit lapses, the tenant may terminate the
lease.
The tenant may use the uninhabitable condition of the premises as
a defense if the landlord takes legal action to evict the tenant for
nonpayment of the rent.
Non-payment of rent: It is the duty of the tenant to pay the rent as
per the terms of the lease. In case of nonpayment, the law requires
the landlord to present a notice of nonpayment of rent to the
tenant. If the rent is not paid despite the notice then the landlord
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may file a lawsuit for unlawful detainer to evict the tenant from the
premises.
The court issues a writ of possession if it finds the tenant in
default. On receiving the writ of possession, the tenant must move
out of the premises peacefully or else the sheriff may have him
removed forcibly.
Although the process of legal eviction is often a slow one, the
landlord must refrain from using unlawful methods (cutting off
utilities or threatening to use force) of evicting the tenant, or else he
may end up defending an expensive lawsuit.
Illegal/unauthorized use: For using the premises in an unlawful
manner (for example, manufacturing illegal drugs), the landlord
may ask the tenant to stop the illicit activity or vacate the premises.
If the premises are being used in a manner which is not authorized
in the lease agreement, then the landlord may terminate the lease
on the grounds of violating the agreement.
Foreclosure: If the property is foreclosed because of the landlords
default on a loan payment or other obligation, the lease is
terminated. If the existing lease has a higher priority than the
foreclosed lien, the foreclosure purchaser has to honor the lease.
In 2009 a federal law was passed under which the foreclosure buyer
of the leased residential property must honor the lease for the
remainder of its term, if the buyer herself is not intending to reside
in the premises. However, if the buyer does intend to reside on the
property, she must give the tenant a notice of 90 days before
terminating the lease.
A residential tenant whose lease is not a specific term lease (such
as a month-to-month lease) is also entitled to receive a 90-days
notice (even if the buyer is not planning to move in the premises).
Destruction of the premises: If the lease is for the use of the land,
improvements on the land or for the use of the entire building, then
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the destruction of the building does not mean the termination of the
lease, unless there is such a provision in the lease. The use and
enjoyment of the land is not disturbed because of destroying the
building and so the purpose of lease is not lost. But if the lease is
only for a particular unit of the building, like an office, commercial
warehouse or an apartment, then the destruction of the building
causes a loss of purpose of the lease and the tenant will be relieved
from his duty to pay the rent.
Condemnation: Premature termination of a lease may take place
because of condemnation. (earlier discussed in chapter 5.)
TYPES OF LEASES
The five main types of leases are:
- The fixed lease
- The graduated lease
- The percentage lease
- The net lease, and
- The ground lease
The fixed lease: The tenant agrees to pay a predetermined amount
as rent and the landlord pays other expenses such as taxes,
maintenance and insurance. The fixed lease is also called a gross
lease, a flat lease or a straight lease.
The graduated lease: This type of lease is similar to a fixed lease,
except that it has a provision for periodic increases in the rent.
These rises in rent are normally based on the Consumer Price Index
(the cost-of-living index.) Adding an escalation clause makes this
increase in rent possible. The graduated lease is also called a stepup lease.
The percentage lease: This type of lease is common in a commercial
lease, especially in shopping malls. The tenant pays a percentage of
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the gross monthly income added to a basic rent amount.

The net lease: In a net lease, the tenant pays a fixed rent in addition
to some or all of the operating expenses (taxes, repairs or
insurance).
The ground lease: The leasing of land by a tenant to construct a
building on the land is called a ground lease. Ground leases are
normally long term leases and more common in urban areas.

Chapter Summary
A listing is a contract through which the seller employs a
broker to sell a real estate property.
Normally, a listing agreement has a clause by which the
broker is entitled to a commission only if a Ready, Willing and
Able Buyer is found during a listing period.
All the elements of a valid contract must be available in a
listing agreement, which are offer and acceptance, competent
parties, consideration and a lawful intent.
A brokers commission must be negotiable according to the
real estate laws.
In a land contract, the property is purchased by the buyer on
an installment basis and not by paying the full price of the
property in one single payment.
An option agreement is a contract to keep the offer open for a
fixed-upon period of time to purchase or lease a property.
Tenancy allows a person (a tenant) to take exclusive
possession of land in consideration of a rent through a formal
lease or an informal agreement.
.
The rights and responsibilities of the landlord and tenant are
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determined by the terms of the lease agreement as well as by

the landlord-tenant laws.
In 2009 a federal law was passed under which the foreclosure
buyer of the leased residential property is obligated to honor
the lease for the remainder of its term.

Chapter Quiz
1. The_______________ listing has a provision for a paid
commission to the broker irrespective of who finds the buyer
for the property.
a. Exclusive right to sell
b. Open
c. Exclusive agency
d. Net
2. Under which type of listing does the seller have to pay a
commission only if the broker is the procuring cause of the
sale?
a. Exclusive agency listing
b. Exclusive right to sell listing
c. Net listing
d. Open listing
3. The provision of a safety clause_______________
a. Entitles the broker to receive a commission even if he is not
the procuring cause of the sale
b. Entitles the broker to receive the commission if the property
is sold (after the expiration of the listing) to someone with
whom the broker had previously negotiated
c. Requires a buyer to share the cost of the brokers
commission with the seller
d. Warrants the safety of the premises by the seller
4. The amount of the buyers earnest money deposit when
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purchasing a property is decided by:

a. The location of the property
b. The state law
c. Agreement between the buyer and the seller
d. Agreement between the buyer and the broker
5. To be enforceable the buyer representation agreement
should be all of the following, except:
a. Written
b. Signed by the buyer
c. Include a termination date
d. Have a legal description of the property
6. The buyer-paid fee may NOT be:
a. Decided by the buyer alone
b. Based on hourly rate, whereby the broker is essentially a
consultant
c. A percentage of the purchase price of the property
d. A specified flat fee, which is paid if the purchase is made
during the term of the representation agreement
7. A provision in a purchase agreement which sets forth a
condition is called a ______________
a. Risk clause
b. Safety clause
c. Contingency clause
d. Escalation clause
8. An agreement to keep an offer open is called a_______
a. Option
b. Novation
c. Rider
d. Demise
9. ____________________ is an attachment added to the agreement
before it is signed by the parties
a. An amendment
b. A rider
c. An option
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d. An addendum
10. Under a land contract, initially the vendee gets:
a. Possession and title, but not the right to transfer title
b. Possession but not the title
c. Title but not the possession
d. The right to novate the contract without the permission of the
vendor
11. In order to be valid, a lease must be signed by the:
a. Landlord
b. Broker
c. Tenant
d. No need for a signature
12. What happens to the lease when the leased property is sold?
a. The lease terminates automatically
b. The lease is breached by constructive eviction
c. The lease is binding on the new owner
d. The lease is renegotiated by the new landlord and the tenant
13. What essentially is meant by the right of quiet enjoyment?
a. Non-interference from the neighboring tenant
b. Freedom from annoyance from noisy neighbors
c. Non-interference from the primary titleholder
d. Non-interference from the brokers
14. The transfer of an entire leasehold property to a new person,
whereby the primary responsibility of the lease lies with the new
lessee is called___________
a. An assignment
b. A sublease
c. A sandwich lease
d. A freehold lease
15 . A fixed lease is also called____________
a. A net lease
b. A ground lease
c. A graduated lease
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d. A gross lease

CHAPTER 8
Real Estate Agency Law
CHAPTER OVERVIEW
An agency has certain duties and liabilities, since it is a legal
relationship. Many features of a real estate agents relationships
with his clients are governed by the law of agency.
In this chapter we will study the agency relationship, and the
method of creating one. We shall also discuss agency duties and
liabilities, as well as the various types of agency relationships that
are possible in real estate transactions. This chapter also covers
Californias agency disclosure requirements and the relationship of
the brokers to salespersons.
WHAT IS AN AGENCY?
A principal authorizes an agent to act as his representative when
dealing with a third party. This legal relationship is called an
agency. An agency creates a fiduciary relationship between the
agent and the principal. A fiduciary relationship means a position of
trust and confidence, one which is between the agent and the
principal. The agent is bound by the agency law to act in the best
interest of the principal. There is also an obligation to act fairly and
honestly with third parties.

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AGENCY RELATIONSHIPS IN REAL ESTATE

An agency is created by mutual consent of the principal and the
agent. As per the agency law, there are four ways in which an
agency relationship may be formed:
- Express agreement
- Ratification
- Estoppel
- Implication
Express agreement: An express agreement is created when a
principal appoints someone to act as his agent, which is accepted
by the agent. A valid agency relationship does not have to be in
writing unless either required by law or if the agent is going to
perform a task on the principals behalf required to be in writing.
There is no requirement for consideration to establish an agency
relationship. Even if there is no obligation by way of a contract to
provide compensation for the principal, the agent still has rights,
responsibilities and liabilities regarding the principal.
Ratification: This is the acceptance of an act which has already
been performed. Ratification of an agency relationship is created
when acts are approved after they have occured. For example: a
seller accepts an offer from a licensee and agrees to pay a
commission although no authorized agency was involved. Thus, the
seller created an agency by ratification by accepting the act (offer)
from the licensee, after the fact.
Estoppel: An agency is said to be created by estoppel when the
principal leads the third party to believe that some other person is
the principals agent. For example, if a seller lets a buyer think that
a broker is representing the seller and the buyer believes that to be
so, the seller then cannot deny the presence of an agency, and will
be bound by the brokers actions.

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Implication: An agency is created by implication when someone

behaves towards another in a way that suggests (or implies) that he
is acting as the agent of the other person. If this other person
takes this suggestion to be true and believes there is an agency
relationship and the so-called agent does not correct this mistake,
he may owe agency duties to the other person.
Agency by estoppel and agency by implication seem to be similar
but there is a distinct difference. An agency by estoppel needs the
principal to accept the existence of the agency, to protect the third
partys interest. In contrast, the agency by implication needs the
agent to accept the existence of the agency to protect the interest of
the principal.
THE LEGAL EFFECTS OF AGENCY
After establishing the agency relationship the principal becomes
bound by the agents actions which are under his actual or
apparent authority. The general agency law states that the principal
may be held liable for the agents negligent or misleading acts which
may cause harm to the third party, under the assumption that the
information known to the agent is known to the principal as well.
General agent Vs. Special agent
To what degree a principal is bound by the agents actions depends
on the level of authority granted. The two main types of agents in
California are:
1) General agents, and
2) Special agents
A general agent is one who is given the authority to handle one or
more jobs of the principal. The agent conducts various activities on
an ongoing basis for the principal. For example, a business
manager employed and authorized to handle financial as well as
personal matters is considered to be a general agent. A special
agent, however, is authorized to complete a specific duty or
transaction. For instance, a real estate broker is appointed to sell a
property for a seller. The broker is said to be a special agent whose
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agency relationship will terminate once the property is sold.

A real estate agent who provides property management and
maintenance services on an ongoing basis is said to be a general
agent.
Actual Authority vs. Apparent Authority
The scope of authority given to the agent is determined by the
principal. The authority described in writing is called actual
authority. If the agents actions go beyond the written (actual)
authority, the principal cannot be held responsible for such actions
by the agent. Actual authority may be granted expressly or by
implication.
The agent with apparent authority has no actual authority to act,
but the principal ignorantly or deliberately makes it appear that the
agents action is authorized. This type of authority refers to an
agency created by estoppel. The apparent agent is also called an
ostensible agent.
It is the duty of the third party to make an effort to discover the
scope of the agents authority when dealing with an agent. The third
party cannot sue the principal if the agent has acted beyond his
scope of authority and which the principal does not authorize.
Vicarious Liability
A tort is an act which is negligently or wrongfully performed and
which causes a breach of a lawfully imposed duty. It is a financial
loss or injury to a person caused by misconduct, mistake or
accident. A person committing a tort may be sued by the injured
party and may have to compensate him.
The general agency law holds that a principal may be held liable for
the negligent and wrongful acts of the agent. This is called
vicarious liability. According to the doctrine of vicarious liability,
the principal will be held liable for the acts of the agent. As per
industry norms, the agent is authorized to hire people to perform
the terms of the agency. Thus, the principal will be liable for the
actions of the agents agent(s) as well.
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Imputed Knowledge Rule

As the general agency law states, the notice of information had by
the agent is supposedly known to the principal as well, even if the
agent has actually not conveyed it to the principal. This means that
the knowledge possessed by the agent is automatically imputed to
the principal. The impact of the imputed knowledge rule would be
that the principal can be held liable for not disclosing a problem to
the third party, even if not informed of the problem by the agent.
DUTIES OF THE AGENT IN AN AGENCY RELATIONSHIP
An agent has certain responsibilities towards the principal and the
third party as well. Let us study those in detail:
Duties of the Agent towards the Principal:
As mentioned earlier, an agency relationship is a fiduciary
relationship. A fiduciary relationship is one of trust and confidence.
As a fiduciary, an agent must serve the principal with utmost care,
integrity, honesty and loyalty.
Utmost Care: It is the duty of the broker to take utmost care and
use his skills while carrying out his duties. The broker will be liable
to the principal for any incompetent or careless action which harms
the principal.
Although the agent himself may not be an expert in all matters in
regard to a real estate transaction, he must be competent enough to
recognize the necessity of soliciting expert advice on issues of
taxation, finance, legalities or property conditions.
Integrity and honesty: Meeting the highest standards of integrity
and honesty is important in all dealings between the agent and the
principal. The agent must act ethically by not hiding facts and
information from the principal which can help the latter in making
correct decisions.
Any funds and valuables received by the agent on the principals
behalf should be accounted for. The status of the funds -- called
trust funds -- must be reported to the principal and should not be
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mixed (commingled) with the agents personal funds. State law

requires real estate agents to deposit all trust funds within three
business days of receipt into a special trust or escrow account to
avoid improper use of the funds.
Loyalty: Being loyal to the principal is very important in an agency
relationship. The interest of the principal must be placed above the
interest of the third party as well as the agents own interest. The
agent is not allowed to reveal the principals confidential
information to other parties or take advantage of the information
himself. This confidential information must be protected even after
the end of the agency relationship.
Loyalty to the principal should prevent the agent from making
secret profits from the agency. It is necessary to disclose any
financial gains to the principal. California real estate law prohibits a
real estate agent from buying an interest in the principals property
(without his knowledge or consent), not even through the agents
relative or friend.
The duty of loyalty also requires obedience. The instructions of the
principal must be obeyed and carried out in good faith. A broker
may end up being held liable for any losses incurred by the
principal through the agents disobedience.
Disclosure of Material Facts to the Principal: If the agent comes
across any material facts he must inform the principal about
them. Any information which may affect the decision of the
principal in a particular transaction is a material fact which must
be disclosed. According to the law, if the third party has provided
any information to the agent, it is taken for granted that the
principal is informed, too (even if he is not informed by the agent).
Therefore, the principal will be held liable for unfulfilled tasks which
the agent knew should be completed but did not inform the
principal. The principal will then hold the agent liable for any loss
incurred by him because of undisclosed material facts.
There are some disclosure issues which a real estate agent who is
representing a seller must always keep in mind:
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- Must present all offers to the principal

- Must inform the seller of the true value of the property
- Must disclose any relationship between the agent and the
buyer
- Should reveal if a dual agency exists
Even if an offer appears to be totally unacceptable, the agent must
present all offers to the principal. It is the principal who will
eventually decide to accept or reject an offer.
The agent has a duty to reveal the true value of the property to
the principal. It is unlawful for the agent to buy the principals
property without his knowledge and consent, and resell the
property for a higher price to gain a profit.
The agent must inform the principal if the prospective buyer is
in any way related to the agent. The agent must also disclose to
the principal if he has plans to split the commission with the buyer.
Whether there is a dual agency, when the agent is employed by
both the seller and the buyer, must also be disclosed. The
California law allows dual agency provided that both parties are
informed and have no objection. However, a conflict of interest is
inevitable in a dual agency. Since the buyer wants to pay the lowest
price possible and the seller wants the highest price possible, it is
difficult for the agent to please both at the same time.
DUTIES OF THE AGENT TOWARD THIRD PARTIES
The agent not only owes a duty of honesty, loyalty and utmost care
to the principal but also a duty of fair and good faith dealing to the
buyer (the third party). In residential property transactions the real
estate agent also has a duty to inspect the premises.
An agent must provide his services to the principal and the third
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party with skill and reasonable care. The agent has a legal and
ethical duty to be fair in his dealings with the third party. An agent
who is representing the seller has the responsibility to disclose all
material facts regarding the property to the prospective buyer. The
agent must give accurate statements to the prospective buyer.
An intentional material misrepresentation by the agent may be a
cause of actual fraud while an unintentional misrepresentation
could be deemed negligence or constructive fraud. Intentional as
well as unintentional misrepresentation may cause the buyer to
rescind the transaction and also sue for damages. This clause
applies to the real estate agent as well as the seller. The seller also
has equal responsibility to disclose material facts regarding the
property to the buyer so as to prevent misrepresentations.
Puffing is an exaggerated statement about a property which is not
factual. The buyer should never rely on such nonfactual
statements. Because it is unreasonable to rely upon puffing, such
actions cannot be the subject of a lawsuit.
Even though such statements may not be actionable, it is not
advisable for the real estate agent to make exaggerated statements
to the buyer, which he himself does not believe. In some instances,
an agent may say something he considers harmless sales talk, but
which a buyer accepts as a factual statement; this may sometimes
be judged as actionable by the court of law.
The principal and the agent have to not only try to prevent
misrepresentations but it is also their duty to disclose to the buyers
any latent defects in the property. A hidden defect which is not
noticeable by ordinary inspection is called a latent defect.
Sometimes there may be information which when revealed may
unfairly stigmatize the property. Such information need not be
disclosed to the buyer or tenant. California law provides that
property owners or the estate agent do not have to disclose if
someone died on their premises due to AIDS or that the person was
HIV-positive. If a prospective buyer raises a question about
someone having died of AIDS or if a HIV-positive person was staying
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on the property, the agent must decline to answer the question. In

fact, answering such a question may violate the fair housing laws
that prohibit any discrimination based on disability.
If someone has died on a property more than three years previously,
it need not be disclosed to the buyer, whatever the cause of death.
This is a provision of California law. However, if a prospective buyer
has asked about the death and the seller or his agent has
intentionally lied about it, it will be considered as a fraudulent
misrepresentation.
Previously the agents representing the seller were not required to
inspect the property and detect problems. But now the law has
made it mandatory for the agent of the seller of one-to-four units of
residential property to inspect the property and detect any defects
and inform the buyer of it. The inspection is not required if the
home is new and offered for sale for the first time.
If the property states that it is for sale as is, it does not relieve the
agent of the duty to inspect the property. Nor does an as is sale
change the requirement that an agent must disclose material facts
about the condition of the property.
If a property is a condominium or co-operative unit, the agent does
not have to inspect the common areas. Only the unit sold has to be
inspected. The agent only needs to inspect the areas of the property
which are visually accessible by him.
If the residential property is not inspected by the agent and the
disclosures are not made as required and the buyer is harmed
because of that, the buyer may sue the agent along with his broker.
Such a lawsuit must be filed by the buyer within two years of taking
possession of the property.
Although the agent has a duty to inspect the property, the buyer
must also be reasonably careful to protect himself.
Transfer Disclosure Statement: Once the agent completes his
inspection, he can make any necessary disclosures with a form
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including the real estate transfer disclosure statement. This form

must be presented to the prospective buyer only in transactions
which involve a one-to-four unit residential property.
Some of the sellers disclosures which may be found in a transfer
disclosure statement may be:
Inclusions in the sale
Any known defects in the property
Other issues like a neighbor whos a nuisance, structural
changes without necessary permits, or environmental hazards
The transfer disclosure statement has separate sections to be filled
by the listing agent and by the selling agent. Both the agents must
fill in any material facts which they find in their visual inspection of
the property. The listing agent must also add the material facts
regarding the property which are disclosed to him by the seller. It is
the selling agents responsibility to provide the completed disclosure
statement to the prospective buyer.
The agent must complete his portion of the form and the seller his
portion. The transfer disclosure statement should be delivered to
the buyer immediately. The buyer can subsequently decide to
rescind the purchase agreement within three days of receiving the
disclosure statement (within five days if it is mailed to him).
There are certain types of transactions of one-to-four unit
residential property in which a disclosure statement is not needed.
Transfers such as mortgages or trust deed foreclosures, divorce
settlements, probate proceedings or any legal court orders and sale
of new property also do not require disclosure statement.
Local laws of some cities and counties include a provision for the
seller to give to the buyer a local option transfer disclosure
statement along with the transfer disclosure statement.
Information about the neighborhood or the community is given in a
local option statement.
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Other State Property Disclosure Requirements: California law

requires other disclosures apart from the transfer disclosure
statement in certain transactions. Some disclosures are required
due to the physical condition of the property while some are
required due to its location. Normally these disclosures are required
in sales of one-to-four unit residential properties.
Natural Hazards Disclosures: This disclosure statement is used to
reveal whether the property lies in a specially designated zone prone
to floods, earthquakes, forest fires or earthquakes. It also discloses
if the property is in close vicinity to an airport or within a mile of a
farm. The seller or his agent or a consultant hired for the purchase
may complete this disclosure form. The information provided on the
form must be based on the maps from the state or federal
authorities.
Earthquake Guide: Even if the property is not in an earthquake fault
zone, a buyer intending to purchase a property built before 1960
and which is constructed using a light frame must be given a
booklet called A Homeowners Guide to Earthquake Safety. The
buyer must be informed whether the improvements mentioned in
the booklets have been made.
Taxes and Assessments: In case the residential property is subject
to assessments for bonds which are issued under the Improvement
Bond Act of 1915 or if the property is subject to special taxes under
the Mello-Roos Community Facilities Act, the seller has a duty to
make a sincere effort to obtain a disclosure regarding the lien from
the taxing district and provide the disclosure to the buyer.
If the buyer is going to receive a supplemental tax bill, the seller
must disclose this information as well.
Transfer Fees: At times a subdivisions CC&Rs have a provision that
when a property in the subdivision will be sold, the buyer will have
to pay a transfer fee towards the maintenance of the subdivision
amenities, improvements and other common areas. If the property
for sale comes under such a subdivision, then the information
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about the fee must be disclosed to the prospective buyer.

Sex Offender Information Website: A notice that the California
Department of Justice has made information about registered sex
offenders in the area available to the public on a website must be
given in a residential purchase agreement. This information is
called the Megans Law disclosure.
Drug Labs: After it is confirmed that a property has been
contaminated by methamphetamine manufacturing activity, the
local health authority may issue an order which prohibits the use
and occupation of the premises. The seller should provide a copy of
this order to the buyer, if such a property is put up for sale before
receiving a declaration from the health department that it is safe for
habitation.
Miscellaneous: The buyer must be informed:
- If the property he intends to purchase is within one mile of an
ordinance location. An ordinance location is an area once used
for military training which may contain live ammunition.
- If the property is adjoining an industrial use premises, zoned
for industrial use or will be affected by any industrial
nuisance.
- If there are any window security bars and how its safety
release mechanism works.
Lead-based Paint Disclosures: Lead-based paint is a health hazard
for children. Federal law requires that the seller must disclose the
location of the areas in the home and the common areas where
lead-based paint is used. If the home has been inspected, then the
report concerning the lead-based paint must be provided. The seller
must provide the buyer with the pamphlet on lead-based paints
which is prepared by the U.S. Environmental Protection Agency.
Apart from this, the buyer must also be offered ten days in which to
get the home tested for lead-based paint.
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Specific warnings and signed statements from the parties must be

included in the purchase agreement, which acknowledges the fact
that the requirements of this law were fulfilled. This
acknowledgement must be kept safely for at least three years.
BREACH OF DUTY
When an agent breaches any duties towards the principal or the
third party it is considered to be a tort (a wrongful act which is a
result of a breach of duty levied by the law). The injured party may
sue the agent for the breach of duty.
The remedy in a tort suit is generally compensatory damages. The
agent has to compensate the injured party for the financial loss
suffered. If a commission was collected during the transaction, it
may have to be returned, too. The court may allow the injured party
to rescind the agreement.
If a property is misrepresented by the agent, the buyer may sue the
agent in a tort suit. The seller may also be sued as per the vicarious
liability doctrine -- a principal is liable for torts committed by the
agent within his scope of authority. Therefore, the seller will be
liable to the buyer even though he was unaware of the
misrepresentation of the property by the agent.
Since most of the breaches of duty by an agent are violations of real
estate law, disciplinary action may be taken against the agent by
the Department of Real Estate even if the injured party does not file
a lawsuit against the agent. Disciplinary action may be in the form
of a fine or even license suspension or revocation.
TERMINATION OF AN AGENCY
After the termination of the agency relationship, the agent is no
longer authorized to represent the principal. According to general
agency law, there are two ways of terminating the agency
relationship:
- Termination by acts of the party

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- Termination by operation of law

Termination by Acts of the Parties: There are three ways by
which the parties may terminate the agency relationship.
1. By mutual agreement
2. By the principals revocation
3. By the agents renunciation
Mutual Agreement: The parties may decide mutually to end the
agreement. A written original agreement should also be terminated
in writing.
Revocation by Principal: The principal may revoke the agency by
dismissing the agent whenever he wishes. In cases where revoking
an agency breaches the contractual agreement, the principal may
be held liable for the losses incurred by the agent because of the
breach.
An agency is coupled with an interest if the agent has some
financial interest in the subject matter of the agency. Such an
agency cannot be revoked.
Renunciation by the agent: An agent may renounce the agency
whenever he chooses. Renunciation may lead to a breach in a
contractual agreement, in which case the agency may be liable to
the principal for the losses incurred due to the breach. However,
since an agencys contract is based on personal services, the
remedy of the damages cannot be in form of a specific performance.
Forcing the agent to perform personal services would violate the
constitutional prohibition against involuntary servitude.
Termination by Operation of Law: An agency relationship may
become terminated by itself, without any actions from the parties.
The following actions may lead to the termination of an agency
relationship:

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1. Expiration of the term of the agency

2. Purpose of the agency is fulfilled
3. Death or incapacity of one of the parties
4. When the subject matter becomes extinct
Expiration of the term of the agency: The agency relationship
terminates automatically when the agency term expires. If an
expiration date is not included in the agency agreement, then the
agreement will expire within a reasonable time. (Depending on the
type of agency, the court decides what a reasonable time would be.)
Purpose of the agency is fulfilled: The agency relationship terminates
when its purpose is fulfilled. For example, if the agent hired by the
seller to sell the property does so, the agency relationship
terminates.
Death or incapacity of one of the parties: The agency terminates
automatically when either the agent or the principal dies. If one of
the parties becomes mentally incompetent, the agency terminates.
On the death or incapacity of the principal, the agent becomes
unauthorized to act on the principals behalf, even though the agent
may be unaware of the principals death or incapacity.
When the subject matter becomes extinct: The property is the subject
matter in a real estate agency. If the property is destroyed or sold
the subject matter becomes extinct and the agency automatically
terminates.
REAL ESTATE AGENCY RELATIONSHIPS
A regular residential real estate deal may involve more than one real
estate agent. The normal process of house hunting proceeds this
way: a prospective buyer contacts a real estate agency in the area
where he is looking to purchase the property. A salesperson of that
agency interviews the prospective buyer to find out his budget and
the location where he prefers to buy the property. The agent shows
the buyer various properties which are up for sale. Most of the
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brokers are member of the multiple listing service, therefore the

agent shows the buyer the properties listed with his own agency
and also properties listed with other MLS members. Once the choice
of property is finalized by the buyer, the negotiations for the sale
will involve both the salesperson and the listing agent.
While the property sale is being finalized, the same property is
shown to other prospective buyers by different brokers. Therefore,
by the time the sale transaction is closed, it may involve a listing
agent and his salesperson, a selling broker and his salesperson,
and other cooperating agents who may have shown the property to
prospective buyers who either did not want the property or did not
match its selling price.
To understand the agency relationships in this particular
transaction, one must understand which party each licensee is
representing. It is important to know the following terms:
- Real Estate Agent: The term real estate agent refers to a real
estate licensee. The real estate agents who are authorized to
represent a buyer and a seller directly are the real estate
brokers. The real estate salespersons are performing on behalf
of the real estate brokers.
- Client: A client may be a buyer, seller, a landlord or a tenant
who has procured the services of a real estate agent.
- Customer: A real estate agent who is representing a
seller/landlord generally refers to the potential buyer/tenant
as a customer.
- Listing agent: The listing salesperson or the listing broker
may be referred to as the listing agent. The listing salesperson
is the one who takes the listing on a property. The listing
salesperson who works for the listing broker may or may not
be the one to find a buyer for the property.
- Selling Agent: The selling agent is the selling broker/selling
salesperson. The salesperson who finds a buyer for the
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property is the selling salesperson. The selling salesperson

works for the selling broker and he may or may not have taken
the listing for the property sold.
- Cooperating agent: A cooperating agent is a licensee who
tries to find a buyer for the property but who is not a listing
agent. A cooperating agent who finds a buyer for the property
becomes a selling agent.
- In-house sale: When salespersons working for the same
broker brings the buyer and seller together, there is an inhouse sale.
- Cooperative sale: A sale in which the listing agent and selling
agent are working for different real estate agencies.
A Historical Perspective of Agency Relationships
Organizations like the National Association of Realtors, Federal
Trade Commission, and the Association of Real Estate License Law
conducted studies of agency representation in real estate
transactions in the 1980s. It was found that the real estate buyers
and sellers were baffled about which party the real estate agent was
representing. The buyers thought that the agent who was
representing them was working for them, while actually the agent
spent most of the time representing the seller.
Unilateral Offer of Sub-agency: The confusion of the buyers and
sellers was the result of a standard provision found in MSL listing
agreements in those times. This provision held that any member of
the MLS who found a buyer for a listed property would, by default,
be a sub-agent (agent of an agent) of the seller.
This provision in the listing agreement made it inconvenient to
enter into a buyer-agency relationship. If the licensee wished to
represent a buyer in a MLS transaction, he had to reject the offer of
the sub-agency and then enter into a separate written agreement
with the buyer. This was done infrequently and so the licensees
involved represented the seller.

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Inadvertent Dual Agency: Since the selling agent was working

with the buyer on a regular and friendly basis, it was easy for the
buyer to wrongly believe that the selling agent was his agent and
not the sellers agent. The agent would even go out of his way to
satisfy the buyer by meeting his needs, so there was no reason for
the buyer to believe that the agent was working for the seller.
Believing in the loyalty of the agent, the buyer might provide him
with confidential information. However, the selling agent was
actually representing the seller, so the agent technically had the
responsibility to pass the buyers confidential information to the
seller. Of course, if the agent did that, the buyer would be shocked
and disturbed. Therefore, in these cases, the selling agent would
want to help the buyer by not disclosing his information, thereby
disregarding his fiduciary duties towards the seller. These
situations not only used to cause confusion but also sometimes
inadvertently created a dual agency.
Cooperation and Compensation: During the 1990s, new legal
requirements and many other considerations made real estate
transactions more complex, and so the buyers now wanted their
own agents to represent them. This gave rise to the popularity of
buyer agencies, with many multiple listing services replacing the
unilateral offer of sub-agency in their listing agreements with a
provision of cooperation and compensation. According to the
terms of this provision, other members of the MLS now act as
cooperating agents and not sub-agents. The duty of the cooperating
agent is to try to find a buyer. The listing agreement does not set
any type of agency relationship for a cooperating agent. The
cooperating agent would decide if he wants to represent the seller or
the buyer in a particular transaction.
Disclosure Laws: In an attempt to get rid of the confusion over
agency representation, agency disclosure laws were passed by
California and some other states. The agency disclosure laws
required the agency to disclose to the seller and the buyer whom
the agency was actually representing.
However, even the agency disclosure law does not prevent all the
potential issues. Real estate agents have to understand the effects
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of the different types of agency relationships and act accordingly to

avoid unnecessary problems.
TYPES OF AGENCY RELATIONSHIPS
In California, the three types of agency relationships which the real
estate agent can have with his clients are:
Seller agency
Buyer agency
Dual agency
Seller Agency: A seller-agency relationship is generally a written
listing agreement. The terms of this agreement state that the most
important task of a selling agent is to find a buyer who accepts the
asking price of the property. To achieve this sale the selling agent
helps the seller decide on the listing price of the property, advises
the seller on preparing the property for viewing by prospective
buyers, markets the property for sale and negotiates with the buyer
as well as other real estate agents on the sellers behalf.
A seller-agency relationship is sometimes created without a written
agreement, based on the words and conduct of the parties. In an
unwritten agency relationship it is impossible for the agency to sue
the seller for non-payment of commission.
Although the agent of the seller has the interest of the seller as his
primary duty, he also has to provide his services to the buyer. For
example, the sellers agent may assist the buyer in filling out a
purchase offer form in the absence of the buyers agent. Helping the
buyer in ways like this is in the sellers interest, too, so this is not
considered a violation of the agents duty to the seller. However, the
selling agent must inform the buyer that he is acting as the sellers
agent.
While the sellers agent has to treat the buyer fairly, he must not act
as if he is representing the buyer. The duty of the sellers agent is to
disclose all material facts and answer the queries of the buyer but
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he need not advise the buyer. For example, he doesnt have to

provide suggestions to the buyer on how much to offer for the listed
property; that might be a breach of agency duties.
Buyer Agency: A normal seller-agency agreement through which a
selling agent helps a buyer find a property when the buyer does not
have his own agent might be suitable for the buyer. The selling
agent gives the buyer the multiple listing inventory, as he is
required to do in order to provide full and honest information about
the properties. The agent then presents the offer of the buyer to the
seller. Yet, many buyers prefer to have their own agents
representing them because there are certain services and
advantages that a sellers agent cannot provide.
The advantages of a buyer agency are:
Buyers agent will be loyal and confidential towards the buyer
Buyers agent will give objective advice
Buyers agent will negotiate with the seller professionally
The most important advantage of a buyer agency is its loyalty and
confidentiality towards the buyer. The buyers agent has fiduciary
duties towards the buyer.
A buyers agent will give accurate advice on the advantages and
disadvantages of buying a particular property. He can warn the
buyer of significant issues, such as property value trends, property
conditions, or other hazards in the vicinity of the property. On the
other hand, the sellers agent will represent the property in a
positive light and may try to convince the buyer through sales talk
to accept the offer, regardless.
A buyer who is very interested in purchasing a particular property
may not be able to negotiate properly with the seller due to fear of
losing the offer. A buyers agent can negotiate with skill and use his
superior knowledge of the real estate market to procure a deal with
the best terms possible.
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The buyers agent has access to more homes. In fact, he may show
the buyer homes which have open listings and are put on sale
directly by the owners.
When a listed property is purchased by the buyer, the buyers agent
gets paid through a commission split with the listing agent. This
indicates that the seller is paying the buyers agent indirectly. As
per a state statute, a commission split payment option does not
create an agency relationship between the buyers agent and the
seller. Thus, the fiduciary duties of the buyers agent are not
violated.
Dual Agency: In a dual agency relationship the broker is acting as
an agent for both the seller and the buyer in a particular
transaction. The agent owes fiduciary duties to both the parties.
However, since the interest of the seller and the buyer usually
differ, it is a difficult task representing both the parties at the same
time without being disloyal to one or both of them.
The dual agency is also called a limited dual agency because it is
difficult to fully represent both parties at the same time with total
loyalty.
Disclosed Dual Agency: In California, a dual agency is legal,
provided the agency has written consent from both the seller as well
as the buyer. Not disclosing the dual agency to any one of the
parties is a violation of the Real Estate Law and may lead to
disciplinary action. The result of a legal action would be that
neither party would have to pay the commission and they could
rescind the transaction as well.
In a dual agency relationship, the agent cannot reveal confidential
information about one party to the other. Certain facts need to be
withheld from each party. Both parties have to be informed that
they will not receive full representation from the agent.
Real estate agents should take utmost care regarding the
disclosures of the dual agency. The buyers and sellers may accept
the verbal explanation given to them without understanding the
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agreement completely and sign the dual agency agreement. Later on

one of the parties may feel that the agent has breached his fiduciary
duties. This misunderstanding may be the cause of a lawsuit.
Inadvertent Dual Agency: Some dual agencies are created
accidentally or unintentionally in which the behavior of the agent of
the seller or the personal relationship between the selling agent and
buyer is such that an implied agency if formed with the buyer. To
protect himself against the inadvertent dual agency the agent must
strictly comply with the disclosure requirements and always act
within the boundaries of the disclosures. He must always remember
whom he is representing.
AGENCY DISCLOSURE REQUIREMENTS
According to California law, the real estate agents in residential
transactions need to disclose to their clients, as to who is
representing whom. This is a legal requirement for residential
property with one-to-four units.
For the disclosure process, an agency disclosure form is available,
which has a clear explanation of the duties of a sellers agent, a
buyers agent and a dual agent. The disclosure form must be given
to the parties and a signed copy must be taken from them as an
acknowledgement of the forms receipt.
A copy of the agency disclosure form must be given to the seller by
the listing agent before the seller signs the listing agreement. The
selling agent must give this copy to both the parties as soon as
possible. It is necessary that the buyer receives the copy before
signing the purchase offer and the seller must receive it before
presenting the offer.
The agents have to give the parties the general disclosure form
which explains the types of real estate agency relationships and
also disclose whether he is representing the buyer, the seller or
both the buyer and the seller in this transaction. The agents have to
make their disclosures as soon as practically possible. Each agents
disclosures have to be confirmed in writing and the parties must
sign the agency confirmation statement when they enter into a
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contract. The agency confirmation statement is normally included

in the purchase agreement.
AGENT-SALESPERSON RELATIONSHIP
This section will deal with the legal relationship between a real
estate salesperson and the broker with whom he is working.
According to law, a real estate salesperson is not supposed to act
directly as the agent of the principal in a real estate transaction.
The salesperson acts as an agent of the broker and the broker acts
as the agent of the principal. It is expressly provided in the state
law that a real estate salesperson can never be a sub-agent of the
brokers principal. In spite of this rule, vicarious liability may still
apply between the buyer or seller and a salesperson.
Independent Contractor vs. Employee
When a person is hired by another to perform some job, the hired
person (the worker) is called the hirers employee or an independent
contractor. An independent contractor, who is hired for doing a
particular task, normally does the task as per his own judgment.
An employee, on the contrary, is hired by the employer to perform a
particular task, in a particular fashion on the instructions of the
employer. The supervision and control exercised on the employee is
much higher than on the independent contractor. Employment and
tax laws are applicable to the employee but not to the independent
contractor.
A real estate broker in relation to his principal is almost always an
independent contractor. However, the relationship between the
broker and a salesperson is a complex one. The distinction between
the employee and independent contractor is difficult to establish.
When the salesperson is closely supervised and controlled by the
broker, when his activities are monitored and he is instructed on
how he must go about his tasks, he may be considered to be an
employee of the broker by law.
Most brokers in real estate agencies, though, are quite less
controlling of their salespersons. The primary focus is on listings,
closing the deals and satisfying the clients rather than on
salespersons exact activities. The broker normally does not monitor
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the whereabouts of salespersons because salespersons generally get

paid by commission according to their sales results, rather than the
amount of hours worked. Therefore a salesperson is more likely to
be considered an independent contractor rather than an employee
of the broker.
According to a provision in the Internal Revenue Code, a real estate
salesperson may be considered an independent contractor for
income tax purpose based on the following conditions:
- The real estate salesperson should be a licensee.
- His substantial income should come in the form of a
commission, not on a hourly basis.
- The service provided by the salesperson should be described
under a written agreement stating that he will not be treated
as an employee for federal tax purposes.
In California, if the salesperson is identified as an independent
contractor for tax purposes, it does not affect his compensation
requirements. The real estate broker must compensate his salaried
staff as well as his commissioned sales staff as per the
compensation coverage.
It is stated in the California Real Estate Law, that even though the
salesperson may be considered as an independent contractor for tax
purposes, it will not affect the requirements and the liabilities put
forth in the law. Therefore, whether the salesperson is an
independent contractor or an employee, the broker is eventually
responsible for the salespersons actions. The broker may be held
liable for any fault or fraud by the salesperson.
CONTRACTS BETWEEN BROKER AND SALESPERSON
According to California law, a broker should enter into a written
contract with any licensee he works with. The agreement must be
signed by both the parties.
The agreement must have the basic terms of the relationship
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mentioned in it, including:

- The duties of both parties
- The licensees compensation
- The type of supervision to be exercised by the broker
- Basis on which the contract may be terminated
- The contract should specify if the licensee will be treated as an
employee or an independent contractor for tax purposes

Chapter Summary
In an agency relationship, the principal is represented by the
agent to deal with the third party. The agent may be a general
agent or a special agent as per the scope of authority granted.
The agent owes fiduciary duties to the principal which are
utmost care, loyalty, honesty and integrity. The agent must
disclose material facts to the principal and obey his
instructions to avoid a conflict of interest.
The agent has a legal and ethical duty to be fair in their
dealings with the third party. An agent who is representing the
seller has the responsibility to disclose all material facts
regarding the property to the prospective buyer.
Once the inspection is performed by the agent he can complete
a disclosure form with the proper section concerning the real
estate transfer disclosure statement.
The agency disclosure laws require the agent to disclose to the
seller and the buyer whom the agent is actually representing.
In a dual agency relationship the broker is acting as an agent
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for both the seller and the buyer in a particular transaction.

In the state of California, a dual agency is legal, provided the
agency has a written consent from both the seller and the
buyer.
A broker should enter into a written contract with any licensee
he works with. The agreement must be signed by both the
parties.

Chapter Quiz
1. An agency relationship may be formed by all the following
except:
a. Ratification
b. Estoppel
c. Rescission
d. Implication
2. An agent normally owes duties to the:
a. Department of Real Estate
b. Principal
c. Sub-agent
d. Third party
3. A person appointed to carry out a specific transaction is called
a:
a. Special agent
b. Sub-agent
c. General agent
d. Secret agent
4. An agent acts on behalf of a seller without being authorized;
later, the seller approves of the actions taken by the agent.
This is an example of:
a. Ratification
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b. Express agreement
c. Estoppel
d. Implication
5. An agency relationship by _______________ requires the agent
to acknowledge that an agency relationship exists, to protect
the principals interests.
a. Estoppel
b. Express agreement
c. Ratification
d. Implication
6. According to general agency law, a principal may be held liable
for his agents negligent or wrongful acts. This is termed a:
a. Tort
b. Vicarious liability
c. Imputed knowledge
d. None of the above
7. A salesperson is a brokers:
a. Agent
b. Sub-agent
c. Principal
d. Partner
8. Which of the following events automatically lead to the
termination of an agency relationship, without any further
action required by either party:
a. Expiration of the term of the agency
b. Fulfillment of the purpose of the agency
c. Death or incapacity of either party
d. All the above
9. The statement, This is a dream house, the best you will ever
find is an example of:
a. Opinion
b. Prediction
c. Puffing
d. Misrepresentation
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10. The agent owes the principal the duty of:

a. Dual representation
b. Compensation
c. Loyalty
d. None of the above
11. The principal may be held liable for:
a. His own actions
b. The actions of his broker
c. The actions of his brokers salesperson
d. All the above
12. Disclosure of and consent to a dual agency:
a. Is not necessary
b. Must be in writing
c. Is required only for in-house transactions
d. Should come after the parties sign the purchase agreement
13. A real estate seller must not disclose:
a. Material facts concerning the propertys value or desirability
b. Only visible property defects
c. Only defects which will be revealed by property inspection
d. Structural additions/repairs which are done only by the
seller
14. A Real Estate Transfer Disclosure Statement is required in the
_______________ of one-to-four units residential property.
a. Lease
b. Sale
c. Foreclosure
d. All of the above
15. Regarding the environmental hazards, what should the listing
broker and seller disclose to a prospective buyer?
a. Disclose any known environmental hazards to the buyer
b. Give the copy of the Environmental Hazards booklet to the
buyer
c. Complete the Transfer Disclosure Statement
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d. All of the above.

CHAPTER 9
Financing in Real Estate
CHAPTER OVERVIEW
Financing, the lending and borrowing money is an integral part of
the real estate industry. Without financing buyers would have to
pay cash for the property, and few would be able to afford the
purchase. For closing transactions, real estate agents must possess
a good understanding of real estate finance.
In this chapter, we will discuss information about real estate cycles,
governments influences on real estate finance, and the secondary
market. We shall also learn about mortgages, the workings of other
financing instruments, the foreclosure process, and the different
types of mortgage loans.
REAL ESTATE FINANCE THE ECONOMICS
Buying a home would be unimaginable without the practical benefit
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of financing. Obtaining a loan depends partly on the buyers

personal financial condition and partly on national and local
economic conditions. To understand the economic factors affecting
real estate lending it is important to know the real estate cycles and
the role of the government in the economy.
REAL ESTATE CYCLES
For a lender, a loan is an investment. A lender loans money for a
return on their investment. The borrower repays the money
borrowed in addition to any interest. The interest earned is the
lenders return.
It is a general rule for investors to demand higher interest on risky
investments as compared to safer investments. The same is the
case with loan transactions. If the risk of the borrower not repaying
is high, then the interest rate charged will also be high.
Additionally, the interest rates charged by the lender depends on
market forces and real estate cycles.
The real estate market goes through a cycle of active periods
followed by slumps. These periodic highs and lows in the activities
of the real estate market are called real estate cycles. The real
estate cycles for residential properties could be very dramatic or
moderate. They could be local or regional. At times, there may be a
buyers market in a particular locale so that homes are available for
sale for a long period. At another time, in the same place, there may
be a sellers market, where many buyers are active and homes sell
quickly.
The law of supply and demand is what keeps the cycle changing.
The price charged for a product is raised when the demand is more
than the supply. This is typically a sellers market. As the price
increases, production also increases. As production rises, demand
gets fulfilled, until such time that the supply becomes more than
the demand. This creates a buyers market. This is the time for the
prices to come down and production to slow down, until the
demand catches up with the supply and the cycle starts again.
Changes in the supply and demand for mortgage loan funds
contribute to the creation of real estate cycles. The supply of
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mortgage funds depends on how much investors are willing to

invest in real estate loans. The demand for the mortgage funds
depends on the number of people willing to purchase real estate
who are in a position to borrow enough money for the purchase.
The price of mortgage funds is represented by the interest rates.
Interest rates affect the supply and demand of mortgage funds and
also tend to fluctuate if the supply and demand ratio changes.
Interest is also sometimes referred to as cost of money.
Normally, if the mortgage funds are easily available, interest rates
will be low. Scarcity of funds leads to higher interest rates. This
situation is referred to as a tight money market. Sometimes, in a
tight money market, the seller herself offers to finance a part of the
purchase price so that the sale can be closed.
If the economy is healthy, supply and demand will be more or less
balanced. This usually does not happen because the forces which
affect supply and demand are constantly changing. The economy
works well if the supply and demand remain close to each other,
but if the supply far outpaces the demand or vice versa then the
economy suffers.
Real estate cycles cannot be eliminated, but can certainly be
moderated by taking steps that will keep the interest rates in check,
directly affecting the supply of mortgage funds. In moderating the
real estate cycle, federal economic policy plays a major role.
INTEREST RATES AND FEDERAL POLICIES
Economic stability is directly connected to the supply and demand
for money. There will always be an increase in economic activities, if
there is a great deal of money and it can be borrowed at a cheap
rate. On the contrary, if money is scarce and expensive to borrow,
the economy will slow down.
Through fiscal and monetary policy, the federal government
influences real estate finance as well as the U.S. economy as a
whole.

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Fiscal Policy: Fiscal policy refers to the method by which the

federal government manages its money. Fiscal policy is determined
by the Congress and the President through federal budgets and tax
legislation. Fiscal policies are implemented by the U.S. Treasury,
which manages tax revenues, expenditures and national debts.
When the federal governments expenditures are higher than its
revenues, a shortfall called federal deficits results. The Treasury has
the responsibility of borrowing enough money to cover the deficit.
This is achieved by issuing U.S. government-based interest-bearing
securities which are purchased by private investors. These
securities are issued as follows:
- Securities issued for one year or less, called Treasury bills
- Securities issued for two-to-ten years called, called Treasury
notes
- Securities issued for five-to-twenty years, called Treasury
inflation-protected securities or TIPS, or
- Securities issued for thirty years, called Treasury bonds
Government securities are low-risk investments, so many investors
prefer to invest in them.
When the government borrows money, there is a competition with
private industries for the available investment funds. According to
some politicians and economists, the impact of heavy government
borrowing may result in economic slowdown. The greater the federal
deficit, the more money the government has to borrow and greater
is the effect on the economy. Some economists are of the opinion
that federal deficits do not have a very big impact on the interest
rates.
The supply and demand for money is affected by the governments
taxation policies. The same cannot be said about the effect of
taxation on the economy with regards to the deficit. When taxes are
low, taxpayers have more money to lend and invest; when taxes are
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high, taxpayers have less money to invest or lend. The taxpayers

are likely to invest their money in tax-exempt securities instead of
taxable investments. Real estate and real estate mortgages are
taxable investments, therefore this may have a major impact on the
real estate financing.
Monetary Policy: The direct control of the federal government over
the money supply and the interest rates is referred to as monetary
policy. To keep the U.S. economy healthy is the primary goal of the
monetary policy.
The Federal Reserve regulates the monetary policy and is referred to
as the Fed. Established in 1913, the Federal Reserve System is
the central banking system of the U.S. The Federal Reserve Board
and its chairman govern the Federal Reserve System. It has twelve
districts in the U.S. and a Federal Reserve Bank in each district.
The nations thousands of commercial banks are members of the
Federal Reserve.
The Fed has the responsibility for regulating commercial banks and
supervising the implementation of the Truth in Lending Act. Setting
and implementing the governments monetary policy is by far the
Feds most important job.
The main objectives of monetary policy are high employment,
economic growth, price stability, interest rate stability, and stability
in financial and foreign exchange markets. Most of these goals are
interrelated. What has a direct impact on the real estate industry
are the Federal Reserve policies which affect the availability and
cost of borrowed money. The tools which the Fed uses to implement
its monetary policy and influence the economy are:
- Key interest rates
- Reserve requirements, and
- Open market operations
Key Interest Rates: The Fed controls the federal funds rate and the
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discount rate. These two types of interest rates are charged when a
bank borrows money from another bank or from a Federal Reserve
Bank. When the Fed takes steps to raise or lower the interest rates
that its members have to pay, the banks, in turn, raise or lower the
interest rates they charge to their clients. Lower interest rates
accelerate the economy while higher interest rates slow it down. The
Fed may increase the rates, if it presumes that a slower pace might
keep price inflation in check.
Reserve Requirements: Commercial banks have to keep a
percentage of their customers funds on deposit with the Federal
Reserve Bank. These reserve requirements are imposed so that, in
case a financial panic occurs, banks can assure clients that their
funds are safe and accessible. The banks will have enough money
to meet the unusual demands of its clients.
The Fed also gains some control over the growth of credit through
the reserve requirements. The Fed can increase these requirements
in order to reduce the amount of money the banks available for
lending, causing increased interest rates. Contrarily, reducing the
reserve requirements frees more money for lending or investment,
causing decreased interest rates.
Open Market Operations: The transactions through which the Fed
buys and sells government securities are called open market
operations. These are the best means by which the Fed can control
the money supply, and along with it, inflation and interest rates.
Only money that is in circulation is actually a part of the money
supply. Therefore, the steps that the Fed takes to put money into
circulation increases the money supply and the opposite happens
when money is taken out of circulation.
The money supply increases when the Fed buys government
securities from investors, since the money used for the purchase by
the Fed goes into circulation. Money is taken out of circulation
when the buyer purchases government securities from the Fed,
thus decreasing the money supply. When the money supply
increases, interest rates tend to fall and vice versa.

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Impact of other Federal Agencies on Real Estate Finance: Apart

from the Federal Reserve, real estate finance is affected by some
other federal agencies and plans. These are:
Federal Home Loan Bank System: The 12 regional, privately
owned wholesale banks form the Federal Home Loan Bank System
(FHLB). The FHLB -- who are actually local community lenders -get loans funded by the banks and the FHLB, in return, accepts
their mortgages and other loans as collateral. The FHLB, headed by
the Federal Housing Finance Board, is actively involved in
promoting affordable housing.
Federal Deposit Insurance Corporation: To insure bank deposits
against bank insolvency, the FDIC was formed in 1933. In
situations when the bank or other lending institutions fail, the
FDIC steps in to protect the banks customers from losing their
deposited funds, up to a specified limit.
The Department of Housing and Urban Development: HUD is a
Federal Cabinet department. The major activities that come under
HUDs jurisdiction are: urban renewal projects, public housing,
loan programs insured by the FHA, enforcement of the Federal Fair
Housing Act and some others. The Federal Housing Administration
and Ginnie Mae (studied in detail later in this chapter) are part of
HUD.
Rural Housing Service: The Rural Housing Service, formerly
known as the Farmers Home Administration (FmHA) is part of the
Department of Agriculture. The RHS helps people living in rural
areas to purchase and improve their homes by giving loans and
grants; it also guarantees loans made by lending institutions. It
even finances the construction of affordable housing in rural areas.
Farm Credit System: The Farm Credit System was initially
developed by the federal government but it is now owned by a
private cooperative. It provides financial assistance to farmers and
ranchers and others in rural areas.

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REAL ESTATE FINANCE MARKETS

The two markets that make funds available for real estate loans are
the primary market and the secondary market. The federal
government has helped in regulating the harshness and the
duration of the real estate cycles by using its monetary policy to
control the money supply and interest rates and by founding a
strong nationwide secondary market. The adverse effects of local
economic circumstances on real estate lending may be controlled by
the secondary market.
Primary Market
In a primary market, the mortgage lenders make loans to home
buyers. The buyers are looking to procure a loan in a primary
market when they apply for a loan to finance their purchase.
Initially, the primary market was solely local. It was a combination
of various lending institutions in a community like the local banks,
and savings and loans associations. In the present day, however,
the primary market consists of interstate lenders, online lenders,
mortgage companies nationwide and others. The customary source
of funds for the primary market was the savings of the individuals
and businesses in the locality. The bank or saving and loans used
the savings deposits of the local community members to make
mortgage loans to members of the same community.
The local economy has a considerable effect on the amount of
deposited funds which are available to a lender and also on the
local demand for them. When employment rises, consumers tend to
borrow money for homes, cars or vacations. Businesses borrow
money to finance their growth. Simultaneously, fewer people are
saving, leading to decreases in deposits and scarcity of available
money for lending. This makes meeting the increased demand for
loans very difficult.
Contrarily, when there is an economic downturn, consumers tend
to save more and avoid borrowing. Businesses stop planning for
growth. This results in a drop in the demand for money and
consequently, the local lending institutions deposits grow.

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Too little money or too much money on deposit: either way is a

cause for concern to a lender. With too little money to lend, a
lenders main source of income is affected; too much to lend, and
the lender is paying interest to its depositors, so if the lender is not
able to reinvest the deposited funds quickly, money could be lost.
Secondary Market
The lenders had to look beyond their local area to find solutions to
these issues. When the local savings deposits are low, a lender has
to raise funds from other parts of the country to lend locally.
Alternatively, when the local demand for loans is down, the lender
must send funds to other parts of the country where the demand is
higher. Here, the secondary market steps in. Getting funds from
around the country for the lender is made easier by the secondary
market.
In the secondary market (which is a national market), private
investors, government agencies, and government-sponsored
enterprises buy and sell mortgages secured by real estate all over
the U.S.
Buying and Selling Loans: Just like other investments, such as
bonds or stocks, mortgage loans can also be bought and sold. The
value of a loan is determined by two factors: the rate of return on
the loan as compared to the market rate of return, and the degree of
risk connected with the loan (possibility of a default). For example,
a seasoned loan which has been paid on time over the years is more
attractive to an investor than a new loan for the same amount.
Mortgage loans are normally brought by investors at a discount
(less than face value). Yet, if a borrower defaults on a loan which is
purchased at a discount, the investor can foreclose for the full face
value price of the mortgage.
In a primary market, the availability of funds is hugely dependent
upon the existence of the national secondary market. Economic
balance is provided by the secondary market, which transfers funds
from areas where there is an excess to areas where a shortfall
exists. When the local demand for funds increases, loans which are
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already made by the lenders on the secondary market can be sold

off and the money from those sales can be used to make more
loans. When the local demand for the funds decreases, the lenders
could use their excess funds for purchasing loans on the secondary
market.
The secondary market stabilizes the local mortgage markets. The
lenders do not hesitate to make long-term real estate loan
commitments, though local funds may be scarce. They have the
option of raising more funds by liquidating their loans on the
secondary market.
Secondary Market Agencies: The federal government has played a
significant role in developing the secondary market for mortgage
loans. The federal government has set up three secondary market
agencies: Fannie Mae, Freddie Mac, Ginnie Mae (discussed later in
the chapter).
Large numbers of mortgage loans from primary market lenders are
brought by a secondary market agency and then securities are
issued using the loans as collateral. The agency then sells these
mortgage-backed securities to private investors. As the primary
loans are repaid by the borrowers, the secondary market agency
makes the additional payments to these investors, as a return on
their investments. Since the securities are guaranteed by the
secondary market agency, the investors will receive their payments
from the agency even if he borrower defaults on some of the primary
loan.
The secondary market agencies are not willing to buy loans that
come with a high risk of default. The agencies have set up their own
underwriting standards to prevent this contingency. Underwriting
standards are the measures taken to assess a loan applicant and
the property offered as security, to ascertain if the loan would be a
good investment or it would come with too much risk. Lenders
making loans may apply their own underwriting standards. As a
norm, however, lenders are able to sell a loan to the secondary
market agency only if the loan conforms to the agencys
underwriting standards.
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Most lenders would want to sell their loans on the secondary

market; therefore, the majority of standard mortgage loans in the
U.S. are being made in compliance with the agency standards.
Fannie Mae: The leading secondary market agency is the Federal
National Mortgage Association (FNMA), also known as Fannie
Mae. Starting out as a federal agency in 1938, its primary objective
was to provide a secondary market for FHA-insured loans.
Fannie Mae was later restructured as a private corporation,
commissioned by the Federal government. It is also called a
government-sponsored enterprise, or GSE. To use as a guarantee
for its mortgage-backed securities, Fannie Mae purchases
conventional FHA and VA loans.
Freddie Mac: In the year 1970, Congress created the Federal Home
Loan Mortgage Corporation (FHLMC) or Freddie Mac. Its main
purpose was to buy the conventional loans to aide savings and loan
associations which had suffered badly during the recession. Freddie
Mac has the authority to purchase and securitize conventional FHA
and VA loans from any lender. Freddie Mac is also a governmentsponsored enterprise.
Ginnie Mae: One of the federal agencies that make up HUD is
Ginnie Mae or the Government National Mortgage Association
(GNMA). Ginnie Mae also purchases and securitizes loans from the
FHA and VA. Unlike Freddie Mae and Fannie Mac, Ginnie Mae is a
government agency.
Secondary Market Agencies Current Status: The federal
government had no choice but to put Fannie Mae and Freddie Mac
into custodianship in late 2008 due to the severe financial blows it
suffered during the recession that began in 2007. This was basically
a government takeover of these two agencies, which will continue to
be in this mode until their solvency is restored.
The Congress formed a government supervisory body as a part of
the takeover, called the Federal Housing Finance Agency (FHFA).
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Therefore, now Ginnie Mae is the only secondary market agency

under the authority of HUD. Fannie Mae and Freddie Mac fall
under the authority of FHFA, which were previously also under
HUD.
REAL ESTATE FINANCE DOCUMENTS
This part of the chapter will deal with the legal aspects of real estate
financing. The buyer must sign finance documents once he is able
to find a lender willing to finance his property purchase on mutual
terms. The legal documents used to create a real estate loans are a
promissory note and a security instrument in the form of either a
mortgage or a trust deed.
Promissory Note
The borrower signs a promissory note -- or note, as it is
sometimes referred to -- when a loan is made. This note states that
a certain amount of money is borrowed, on a promise of repayment.
The promissory note thus becomes an evidence of the debt. The
borrower is referred to as a maker and the lender is referred to as
a payee.
The main provisions of a promissory note: The promissory note
states the principal amount (or the loan amount), the amount of
payments, time and method of payments, and the maturity date of
the loan (full repayment date of the loan). The note also states the
interest rate, which may be fixed or variable.
For some loans, the state usury law only allows the chargeable
interest rates to go up to a specified maximum. California law
exempts most loans secured by real property from the usury law,
although it can apply to a mortgage loan made by a private
individual with no involvement by a real estate agent/mortgage
broker.
Obviously, the names of the borrowers will be listed on the
promissory note. The note states that the borrowers will be jointly
and severally liable for the debt if each of the borrowers is to be
exclusively liable for the whole loan amount.
In a real estate transaction, the promissory note is only concerned
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with the debt and not the property, so it is unnecessary to attach

the legal description of the property to the note. However, the legal
description of the property is attached with the security instrument.
The promissory note doesnt have to be recorded since it does not
concern the property.
Normally, the note describes the results of a failure to repay the
loan on agreed terms. The real estate lenders know how to protect
themselves with late charges, acceleration clauses and other such
provisions. How they do so is discussed later in the chapter.
At times a promissory note may have a provision for the borrower to
keep a certain amount of money on deposit with the lender as a
condition of the loan. The amount of money which is to be
deposited is called a compensating balance.
Note Types: The different types of promissory notes are categorized
according to the way the principal and interest are paid off. In a
straight note, the normal periodic payments during the loan term
are interest-only payments. These payments cover the interest that
is accruing, but the principal amount remains unpaid. The full
principal amount (called a balloon payment) becomes due only
when the loan term ends. In an installment note, a part of the
principal and the interest are included in the periodic payment. The
periodic payments would be enough for paying off the entire loan
(both the principal and the interest) by the end of the loan term, if
the installment note is fully amortized.
The interest paid on a real estate loan is simple interest
irrespective of the fact that the payments are interest-only or
amortized. Simple interest is calculated annually on the
outstanding principal balance.
Since the unpaid interest on a real estate loan is calculated on the
outstanding principal balance, a straight note will cost the borrower
more in interest over the term of the loan as compared to an
amortized loan. The reason for this is that the balance of an
amortized loan is constantly getting smaller; the amount of interest
paid on the amortized loan is reduced with every payment.

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Signing and Endorsement of a Note: In the majority of cases, a

promissory note is a negotiable instrument. It means that the
payee (the lender) may choose to assign the right to the debt to
another person by endorsing the promissory note.
Since the note can be assigned by the payee to a third party, just
one copy of the note is signed by the maker. This protects the
maker by preventing the payee from assigning the note more than
once and avoiding a situation where more than one party might
demand payment from the maker. As the debt is paid off, the signed
copy is marked as paid and returned to the maker.
A negotiable promissory note has to state that it is payable to the
order of someone or to bearer. The payee endorses a note to a
third-party purchaser, if he wants to sell it at the secondary market
level. If the note is brought by the purchaser for value, in good faith
and without notice of defenses against it, then the purchaser is a
holder in due course. If the holder in due course is to sue the
maker for nonpayment, some defenses that could be raised by the
maker against the payee cannot be raised against the holder in due
course.
A note endorsed to a specific person is called a special endorsement
and any other endorsement is an endorsement in blank. The
payee may indicate the endorsement to be without recourse. By
this, it is meant that the issue of the future payments is only
between the maker and the third-party purchaser. The primary
payee is not liable to the holder in due course in case the maker
does not pay as agreed. An endorsement without recourse is also
referred to as a qualified endorsement.
SECURITY INSTRUMENTS
When money is borrowed to buy real estate, a promissory note is
signed in favor of the lender, as well as a security instrument which
is either a mortgage or a trust deed.
Note and Security Instrument: Lets study the relationship
between the promissory note and the security instrument. A
borrowers promise to the lender to repay the loan is the promissory
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note and a security instrument is a contract which makes the real

property a guarantee for the loan (a lien is created on the property
for securing the loan). The security instrument gives the lender the
right to foreclose on the property in case the borrower fails to repay
the loan amount as agreed.
A promissory note may be implemented even if the security
instrument is not included. In this case the lender may file a
lawsuit to get a ruling against the defaulter (borrower), for nonrepayment of the loan amount as agreed. Though without the
security instrument, the lender may not be able to collect the
judgment, because the borrower may have already sold off all his
property without anything left for the lender to procure a lien
against.
Title Theory and Lien Theory: The security instrument is
established as explained here. Traditionally, the lender is protected
against a borrowers default by having the title to the property
transferred to the lender for the term of the loan. The borrower
keeps possession and lives on the property but the title is held by
the lender until the loan is fully paid off. If the loan remains unpaid
at the end of the loan term, the lender may take possession of the
property.
This is called hypothecation, where the title to property is given to
the lender as a guarantee against loan repayment, but the borrower
keep possession. The transfer of title only as collateral (guarantee)
without possessory rights is called legal title, bare title or naked
title. The property rights kept by the borrower without the legal title
are called equitable rights or equitable title.
In some states, execution of the mortgage or trust deed is
considered a transfer of legal title to the lender or trustee. These
states are called title theory states. There is a lien theory which
is currently the followed by a majority of states. According to this
theory, the execution of the mortgage or trust deed just creates a
lien and not title transfer. The title to the property remains with the
borrower throughout the duration of loan term while the lender has
the right to foreclose on the lien if the borrower defaults.
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California is a lien theory state when it comes to mortgages and it is

a title theory state in regard to trust deeds. There is not much
difference, though, between lending and foreclosure rules in title
theory and lien theory states. Under both theories, the borrower will
lose his property to the lender if he fails to make loan repayments.
As collateral for the loan, personal property and real property may
be used. When part of the personal property is transferred by the
borrower to the lender as a pending repayment loan, it is termed a
pledge. Another way of handling this is when the borrower retains
possessions of the personal property but gives the lender a security
interest in it. For this procedure, the borrower must sign the
security agreement. The security agreement for the personal
property is similar to a mortgage or trust deed.
Mortgage and Trust Deed: The two types of real property security
instruments are the mortgage and the trust deed. These are
contracts by which the real estate property owner gives a security
interest in the property to someone else, generally as a guarantee
for a loan. The main distinction between a mortgage and a trust
deed is the rules for foreclosure in case the borrower defaults.
The two parties to a mortgage are the mortgagor or the property
owner (borrower) and the mortgagee or the lender. In a deed of trust
(also called trust deed) there are three parties: the trustor (grantor
or borrower); the beneficiary or the lender; and the trustee. The
trustee is a neutral party who handles the foreclosure procedure,
whenever it becomes necessary to take that step.
The trust deed is more preferable to lenders because foreclosure is
easily managed with a trust deed than with a mortgage. In
California, as in many states, the trust deed is a much more favored
instrument than mortgages.
The deed of trust conveys lawful title to the trustee while the trustor
takes equitable title as long as the loan term is not completed. The
trustees title remains inactive until a default takes place. On
repayment of the loan the title is reconveyed to the trustor.
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It is noteworthy that even if the security instrument essentially

used in the transaction is a trust deed (and not a mortgage), the
term used to describe the type of loan secured by real estate is
mortgage or mortgage loan.
Sign of the Borrower: To be valid, a mortgage or a deed of trust
must be in writing and signed by the borrower.
Recording: When the loan is made, the security instrument
(mortgage or trust deed) must be recorded by the lender. A lien may
be created even without the security instrument being recorded, but
only the borrower and the lender would know that the lien exists.
Also, if the trust deed/mortgage is not recorded, subsequent liens
would get priority.
The responsibility of recording the security instrument in a
transaction belongs to the real estate agent who also acts as a
mortgage loan broker. The recording is supposed to be done before
the loan funds are given out or within ten days of the funds
disbursal but with the written approval of the lender.
Instruments as Personal Property: A mortgage or trust deed
creates a lien against real property but it is categorized as personal
property, as is a promissory note.
Assignment: When selling a mortgage or trust deed to an investor,
the lender endorses the promissory note and also executes an
assignment of the mortgage/trust deed. The investor requests from
the borrower an offset statement by which the borrower confirms
the details of the loan, such as the interest rate and principal
balance. It also asserts any claims that may affect the investors
interest. A similar statement regarding the loan status collected
from the lender is called a beneficiarys statement.
Provisions in Finance Documents
There are some provisions in the legal documentation for a real
estate loan, some being compulsory, some optional or situational.
These provisions are stated in the promissory note and/or the
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security instrument. In certain cases there may be a difference

between the type of provisions available in a mortgage and type of
provisions in a trust deed.
Mortgaging or Granting Clause: It must be stated in the security
instrument as to what action the instrument will take, an indication
that the property is being taken as security for the loan. This is
called a mortgaging clause in a mortgage and a granting clause in a
trust deed. It states that the borrower grants and conveys title to
the property to the trustee.
After it has been agreed that a property is to be used as security for
a loan, it is necessary for the borrower to obtain permission from
the lender if any changes will be made in the property which will
affect the property value or the priority of the lien. Moreover, the
lenders lien shall add on to any title acquired in the future by the
borrower on the property. For instance, any improvement done on
the property will attach that improvement to the lien.
Property Description: The security instrument must be attached
with a complete and definite description of the property promised as
security for a loan.
Taxes and Insurance: The security instrument always requires the
borrower to pay general real estate taxes, special assessments, and
hazard insurance premiums as and when due. If the borrower
ignores paying the taxes and insurance premiums, the value of the
lenders security interest may fall severely, for example by a tax lien
foreclosure or by an accident which might damage the property.
According to the acceleration clause, if the borrower defaults on a
scheduled event, such a monthly payment, the lender may choose
to declare the entire loan balance -- all the principal amount still
owed due and payable without delay. This is called accelerating
the loan or calling the note or sometimes referred to as a call
provision. If the borrower does not pay the balance as asked, the
lender may sue on the note or otherwise foreclose on the property.
Normally the acceleration clause is provided in the promissory note
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as well as in the security instrument. Acceleration can be initiated

by non-payment of the loan amount as agreed in the note, or by
breach of a provision in the security instrument. An acceleration
clause in a promissory note is more attractive to investors than a
note with no acceleration clause.
Alienation Clause: The alienation clause is referred to as due-onsale clause, too. This provision gives the lender the right to
accelerate the loan. He may demand urgent payment of the full loan
balance, in case the borrower sells the property or alienates an
interest in it. Selling the property is allowed in the alienation
clause, but it also provides for the lender to force the borrower to
pay off the loan if the property is sold without the lenders
authorization.
The alienation clause may or may not be mentioned in the mortgage
or trust deed, but the sale of the property does not terminate the
lenders lien. The buyer takes title subject to the lien, if the loan is
unpaid at the closing of the sale. The buyer has the option of
assuming the loan.
When the borrower sells the security property to a buyer and the
buyer is willing to accept legal responsibility for repaying the loan
according to its terms, it is termed an assumption. The buyer
becomes primarily liable to the lender for paying back the loan, but
the seller/original borrower has the secondary liability if the buyer
defaults.
If the buyer takes title subject to a current mortgage or trust deed
without assumption, the seller remains completely liable for the
loan. The buyer does not have any personal liability to the lender
but in case of a default the lender may foreclose on the property.
Although the sale of the property does not terminate the mortgage
or trust deed lien, the lenders would want the opportunity to accept
or reject a prospective buyer. Therefore, an alienation clause is
included in most mortgages or trust deeds. Once the lender is sure
of the creditworthiness of the buyer, then he may accept an
assumption of the loan. The lender may charge an assumption fee
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and also increase the rate of interest on the loan. In most cases, the
lender releases the original borrower from any further liability; this
is called novation.
Late Payment Penalty: The penalty which is to be imposed for late
payment must be distinctly mentioned in the finance documents.
According to California law, loans that are secured by mortgages or
trust deeds on single-family, owner-occupied homes have
restrictions on potential late charges: the late payment penalty is
not to exceed 6% of the principal and interest installment due, or
five dollars (whichever is greater), and a payment can be considered
late only if it is paid ten days after the installment due date.
Late payment penalties are not deductible on the borrowers income
tax return, since it is not considered to be interest on the loan.
Lock-in Clause: With this clause in effect, the borrower is
disallowed from prepaying the loan. This means that the borrower
is locked-in to the loan for a definite number of months or years
or for the entire term so that the lenders expected return on his
investment may be protected. As per California law, the finance
documents for a loan on residential property with four units or less
cannot have a lock-in clause; the borrower is allowed to prepay at
any time. But, a prepayment penalty is not barred for such a loan
and is subject to restrictions as given below:
Prepayment Penalty: According to the terms of some loans, the
lender may levy a penalty if the borrower prepays all or part of the
loan balance. For instance, a promissory note could provide that
the borrower may prepay 20% of the original loan amount during
any one-year period without penalty. If the prepayment is for more
than 20%, a prepayment fee equaling six months interest on the
excess paid amount will be charged.
The purpose of a prepayment penalty is to reimburse the lender for
his expected interest, which he will not receive because the
borrower pays the loan off early. The prepayment of a loan without
a penalty does not actually cause a loss to the lender, though the
lenders profit becomes less than expected.
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If the market interest rates are high then the lender may agree to
waive a prepayment penalty. When the borrower prepays the loan,
the lender has the option of lending that money at a higher interest
rate.
There are some legal restrictions on penalties levied on prepayment
of loans which are secured by owner-occupied (up to four units)
residential property. The rule generally allows the lender to charge
prepayment penalties for the initial five years of the loan term. The
common rule for the first five years is that the borrower is allowed
to prepay up to 20% of the original principal amount in any twelvemonth period without penalty. Limits are applicable in penalty
amounts.
Prepayment penalty provisions are not provided for in many
mortgage loans. Such a loan is also called an open mortgage. The
promissory note generally states that the borrower can make the
mandatory payment or more on the payment date stated, when
prepayment is permitted without penalty.
Subordination Clause: Sometimes a subordination clause is
included in a security instrument, stating that the instrument will
have secondary lien priority as against another mortgage or trust
deed to be implemented in the future. Because of the clause, a later
security instrument could take a higher priority position (normally
first lien position), despite the earlier security instrument being was
recorded first.
Most subordination clauses are found in mortgages and trust deeds
securing purchase loans for unimproved land, when the borrower
plans to obtain a construction loan in the future. Lien priority is
normally established by the recording date, but when a
subordination clause is included in the earlier land loan, it permits
the later construction loan to take the first lien position. Therefore,
the construction lenders condition that it should receive the first
lien position can be fulfilled.
The subordination clause allows the borrower to acquire additional
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financing on the security property, so it is favored by most

borrowers.
Defeasance Clause: According to the defeasance clause, upon
payment of the debt the borrower regains title and the security
instrument is cancelled.
If a trust deed is used as the security instrument, the lien is
removed by way of a deed of reconveyance, when the trustor
repays the loan. The beneficiary or the lender must present a
request for reconveyance to the trustee within 30 days after the
loan is paid off. The trustee on his part must execute and record the
deed of reconveyance within 21 days of receiving the request.
If the above-mentioned requirements are not fulfilled, the trustor
could ask a title insurance company to execute and record a deed of
conveyance, once proper notice is served on the trustee and the
beneficiary. The trustee and the beneficiary will then be held liable
for damages caused to the trustor due to the failure to record the
reconveyance deed and may face a penalty of $500.
When a mortgage secured loan is paid in full, the mortgage loan is
released using a document called a certificate of discharge (also
called satisfaction of mortgage). The certificate of discharge must
be recorded by the mortgagee within 30 days or he otherwise faces
a penalty of $500.
A certificate of discharge or deed of reconveyance are both referred
to as a lien release. The mortgagee or trustee must return the
original note and security instrument to the borrower, once the
mortgage or trust deed lien is released upon the borrowers written
request.

FORECLOSURE
If a borrower is unable to repay a secured loan as per the
agreement. then the lender may foreclose on the property and
collect the debt from the sale of the foreclosed property. If any other
violation of the loan agreement occurs -- for example, not keeping
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the property insured, illegal use of the property or not maintaining

the property as agreed -- the lender may declare a default and
foreclose on the property. It is the main purpose of the security
instrument to allow the lender to use his right to foreclose.
Foreclosures are basically of two types, judicial and non-judicial.
Usually, judicial foreclosure is done in case of a mortgage and nonjudicial foreclosure is done in case of a trust deed.
Judicial Foreclosure: The court carries out the judicial foreclosure.
The lender files a lawsuit against a mortgage borrower who defaults.
The lawsuit is filed in the county where the secured property is
located. Any lower priority liens are also included in the foreclosure
action, so that steps can be taken to protect those interests.
The notice of a pending legal action, lis pendens (here it would be
the foreclosure action) is recorded by the lender. This could affect
the real property in question. Because of the lis pendens, the final
court judgment becomes binding on any person who has an interest
in the property while the foreclosure action is pending.
If the court finds a verdict of default, the judge issues a decree of
foreclosure, by which the court orders the property to be sold to
repay the debt. A receiver is appointed by the court to conduct the
sale. This sale is also referred to as a sheriffs sale and it is held in
the form of a public auction.
Reinstatement: The borrower has a chance to cure the loan
default by repaying the loan amount, along with the cost and fees of
the lawsuit, while the foreclosure action is pending. This is termed
as a reinstatement. On the reinstatement of the loan, the
foreclosure proceedings are ended and the mortgage continues as
before. If the decree of foreclosure is issued, however, the
reinstatement is no longer possible.
Redemption: Even after the sheriffs sale, the borrower may get a
last chance to redeem the property. He can do so by paying off the
full debt, including interest, fees and other costs. The time period
varies for this statutory right of redemption. If the sale proceeds
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were enough to pay off the debt, interest, costs and fees then the
redemption period continues for three months after the sale. It is
twelve months after the sale date if the sale amount was not enough
to pay off the full debt. On the other hand, if the lender decides to
waive the right to a deficiency judgment or is barred from obtaining
such a judgment then the statutory right to redemption becomes
non-existent.
Certificate of Sale: If the property sale is based on the statutory
right of redemption, the bid winner at the sheriffs sale is given a
certificate of sale and not a deed. During the redemption period
the borrower keeps the possession of the property but he must pay
a reasonable amount as rent to the holder of the certificate of sale.
Once the redemption period ends, the certificate holder gets a
sheriffs deed, transferring title and right of possession.
Investors usually prefer to immediately take title to a property so
this redemption period makes bidding at a sheriffs sale unattractive
to most investors. Consequently, most of the time there are no
bidders at a judicial foreclosure and the lender obtains the property
by bidding the amount owed by the borrower. This is known as
credit bidding.
In case the winning bid is made by an outside bidder, then the
excess sale amount left after satisfying all the valid liens against the
property belongs to the borrower.
Deficiency Judgments: If the sale amount is insufficient for the
debts repayment, then the lender can get a deficiency judgment
against the borrower, if the transaction is not bound by the antideficiency rules. A personal judgment favoring the lender against
the borrower for the difference between the amount owed on the
debt and the net profit from the foreclosure sale is called a
deficiency judgment.
There are anti-deficiency rules which bars deficiency judgment in
some situations:
In a non-judicial foreclosure (trustees sale)
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 When the fair market value of the property is more than the
debt amount
When the loan is a purchase money loan which is secured by
a trust deed or a mortgage
When a mortgage is given as a security instrument to a thirdparty lender for financing the purchase (four or less unit
residence, occupied by the owner)
It is understood that after the foreclosure on a standard home
purchase loan, a deficiency judgment would be disallowed.
Non-judicial Foreclosure: Deeds of trust have a special provision
which mortgages do not -- the . According to this clause, the
trustee has the authority to sell the property through non-judicial
foreclosure if the borrower defaults. For non-judicial foreclosures,
filing of a lawsuit is not required nor is a judges foreclosure decree.
The trustee may sell the property at an auction known as a
trustees sale. The proceeds from this sale will be used to pay off the
debt owed to the lender. Just like the sheriffs sale, at a trustees
sale the lender may credit bid and obtain the property for the
owed amount (if no one else bids higher). Any surplus from the sale
belongs to the borrower.
Notices of Default and Sale: A non-judicial foreclosure must be
held according to statutory rules. First, a notice of default should
be recorded by the trustee in the county where the property is
located. A copy of the notice must be sent to the borrower and the
other lien holders.
Next, the trustee must issue a notice of sale, but before doing so,
he must wait a minimum of three months after the notice of default
is served. It is necessary for the notice of sale to be recorded and
posted on the security property and also to be sent to all those to
whom the notice of default was sent. Also, the notice of sale has to
be published in a newspaper at least once in a week for three
weeks. The trustees sale may occur only after 20 days have elapsed
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from the first date of the notice of sales publication.

Reinstatement and Redemption: The borrower under a deed of
trust has a period in which he can reinstate the loan and avoid the
foreclosure action (just as in a mortgage foreclosure). The borrower
can reinstate the loan from the time after the notice of default is
served up until five business days before the sale. So, the
reinstatement period would be at least three months and 15 days.
By paying off all previously due installments, fees and other costs
the loan can be reinstated. If the loan is reinstated, the trustee
cannot sell the property, while the borrower may redeem the
property before the actual sale by paying off the full balance of the
loan amount and other fees and costs. The borrower also has the
right to keep possession of the property until the time of the sale.
Trustees Deed: The trustees deed is given to the successful bidder
at the trustees sale and this nullifies all the rights of the borrower
to the property. There is no provision for any after-sale redemption
period and the borrower has no right of possession as in judicial
foreclosure.
Deficiency Judgments: Once the non-judicial foreclosure of a deed
of trust ends, the lender can only recover the proceeds of the
trustees sale which may or may not cover the full amount owed on
the property. The lender cannot take any further action against the
borrower. As discussed above, a suit to recover the deficiency is
disallowed by the anti-deficiency rules. But if the deed of trust is
foreclosed judicially then a deficiency judgment may be possible.
Protection of Junior Lienholders: A trustees sale under a deed of
trust nullifies the borrowers interest as well as the junior lien
holders interest in the property. A junior lien holder will receive a
share of the sale amount only if funds remain after the senior liens
are paid off.
For the protection of the junior lien holder, the law states that the
senior lien holder must send a notice of default and notice of sale to
all those who have a recorded interest in the property being
foreclosed. The lien holder of record will not be bound by the
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trustees sale if these notices are not sent to him.

If a junior lien holder receives a notice of default, he can protect his
interest by paying off the balance amount due and cure the default.
He can add this payment amount to the balance due to him under
the junior lien. The junior lien holder can now foreclose on his own
lien. The successful bidder at the junior lien holders sale will take
title to the property bound by the senior lien.
Judicial Vs. Non-judicial Foreclosure: From the lenders
perspective, there are two major advantages of non-judicial
foreclosure over judicial foreclosure.
1. It is faster than judicial foreclosure, since court proceedings
normally take a longer time.
2. The trustees sale is decisive and there is no statutory
redemption period to follow.
The disadvantage of a non-judicial foreclosure from the lenders
view point is that there is no deficiency judgment once the trustees
sale is concluded. The lender has to bear the loss, if the proceeds of
the sale fall short of the debt amount. The lender cannot sue the
borrower to cover the deficiency.
SUBSTITUTES TO FORECLOSURE
There are three substitutes to foreclosure for defaulting property
owners.
- Loan workouts
- Deeds in lieu of foreclosure
- Short sales
Loan Workouts: In certain situations, the borrower might arrange
a loan workout with a lender. This is the simplest way to prevent a
foreclosure. In some workouts an adjustment in the repayment
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schedule is made, referred to as a forbearance. Here, the borrower

receives additional time to make good on a missed installment or
might be permitted to stop making any payments altogether for a
limited time period. (The skipped installments are added on to the
repayment schedule.)
If forbearance fails to solve the problem or if there is a significant
increase in the payment amount that goes beyond the means of the
borrower, the lender may want to modify the terms of the loan. The
effect of a loan modification could change an ARM into a fixed-rate
mortgage (to avoid the interest rate hike), reduce the rate of
interest, or reduce the principal amount owed.
Property owners who face a foreclosure sometimes use a business
or a person offering loan modification or forbearance services for a
fee, who can try to negotiate the workouts with lenders. To cut
down on fraud, it has been made illegal for these loan mod services
to demand an advance fee; once the service has been rendered,
then compensation can be paid. This protection provision is for
loans secured by residential property with four units or less.
Also before entering into a fee agreement, it is necessary for the
borrower to be given a notice which explains that paying for loan
modification/forbearance service is not compulsory. Direct
negotiation with the lender or receiving the same service for free
from a federal housing counseling agency is also an option.
Deed in Lieu of Foreclosure: A borrower who has defaulted and is
not opting for a loan workout may choose to give the lender a deed
in lieu of foreclosure, also called deed in lieu. The deed in lieu
satisfies the debt and terminates foreclosure by transferring title
from the borrower to the lender.
The title is transferred to the lender, subject to any other lien on the
property. Before accepting the deed in lieu, the lender will confirm
what other liens have become attached to the property since the
original loan was made.
Short Sales: A short sale is another option to a foreclosure, also
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referred to as a debt forgiveness sale. In a short sale, the borrower

sells the property for whatever amount he can obtain, even if it falls
short of the principal amount owed (because the market value of
the home has decreased). The lender relieves the borrower of the
debt after he receives the sale proceeds. The borrower will confirm
that the lender does not have the right to sue him for a deficiency
after the sale. The same concern holds true for the deed in lieu, too.
Even if a junior lien exists, the lender may still approve a short sale
since the lender in such a sale does not take responsibility for the
property or a lien on it. Nonetheless, the existence of junior liens
will make a short sale difficult because the consent of all lien
holders is required for a sale. Junior lien holders cannot expect to
receive anything from a short sale, so they are unlikely to give their
consent to it going forward. This condition will make a foreclosure
unavoidable.
If a real estate agent offers an opinion in regard to a residential
short sale with an intention of manipulating the lender into refusing
the proposed sale, or to get a listing, or to receive any other
personal financial benefit, he could face the suspension or
revocation of his license.
Foreclosure Prevention Act: Passed in 2009, Californias
Foreclosure Prevention Act has imposed particular requirements on
lenders who made mortgage loans which were secured by homes
occupied by owners from the period 2003 - 2007. This was the
period in which the sub-prime boom was at its height and so many
loans made during these years were highly vulnerable to default
and foreclosure. Before foreclosing on such loans the lender is
supposed to discuss with the borrower his financial situation and
present the available options for preventing foreclosure. A notice of
default can only be recorded after 30 days of the lenders contact
date with the borrower or his unsuccessful attempt to do so. Once a
notice of default is recorded, 90 extra days must pass in addition to
the usual three months period and only then can a notice of sale be
issued. It should be noted that a lender with a well laid-out loan
modification program which meets specified standards is exempt
from the above requirements.
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Foreclosure Consultants: A defaulting borrower may hire a

foreclosure consultant at the start of a foreclosure procedure. These
consultants offer to help the borrowers reinstate their loans,
terminate or postpone the foreclosure, or acquire additional
proceeds after a foreclosure sale for the borrower. Unfortunately,
improper practices are prevalent in this business, such as charging
high fees for providing very ordinary service and sometimes, no
service at all. There have been instances where the borrower stands
to lose his home and the foreclosure consultant himself purchases
the property at the trustees sale for a price much lower than the
market value.
To address these issues, California state law has provided that the
residential foreclosure consultant must sign a written contract with
the client. This provision gives the client the right to rescission
within five days after signing the contract. The consultant is not
allowed to have an interest in the clients property via foreclosure.
There is also is a set limit on the compensation that a consultant
can charge.
Loan Services Provided by Real Estate Agents: While real estate
agents are usually exempt from these foreclosure rules, there are
certain circumstances in which they are not. The real estate agents
who offer foreclosure consulting services or loan modification
services may probably require a mortgage loan originators
endorsement for their license, whenever the MLO endorsement
requirement is made compulsory.
Foreclosure and Bankruptcy: These are two very distinct legal
actions, but they can both happen to the same entity at the same
time. A real estate owner facing a foreclosure may not necessarily
be facing a bankruptcy. On the other hand, a real estate owner who
has declared bankruptcy may not necessarily have his property
foreclosed upon.
A federal court procedure which allows a debtor to decrease, amend
or remove debts which are no longer manageable is called
bankruptcy. If a borrower with a mortgage or deed of trust is going
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through a foreclosure and files for bankruptcy, the foreclosure

process is temporarily put on hold, as are any other actions by his
creditors.
The different forms of bankruptcy are specified by chapter in the
Federal Bankruptcy Code. As per Chapter 11 bankruptcy
(reorganization), the court approves a plan to repay the creditors.
According to Chapter 7 bankruptcy (liquidation), possession of the
debtors assets is taken by the court, which it sells and repays the
creditors on a pro rata basis. Finally, under Chapter 13
bankruptcy, an individual who earns a regular income can have his
debt reduced. Either the debtor voluntarily petitions for bankruptcy
or the creditors file an involuntary petition, by which they force
liquidation and distribution of the assets of the debtor.
There is a trustee in bankruptcy who holds title to the debtors
assets in a liquidation. It is the trustees responsibility to sell the
assets whenever necessary. He also issues the trustees deed to the
buyer of the property. All property is primarily subject to the claims
of the lien holders and some property is even exempt from the sale.
TYPES OF MORTGAGE LOANS
In this segment, we will look at the various types of mortgage loans,
loans that are secured by real estate and are used in different
situations or made to aid specific functions. As mentioned earlier,
in California the security instrument used for these loans generally
is a deed of trust instead of a mortgage (although it will normally be
referred to as mortgages or mortgage loans).
First Mortgage: Any security instrument holding first lien position
with the highest lien priority is called a first mortgage. A second
mortgage is the one holding second lien position and so on.
Senior and Junior Mortgages: A mortgage having a higher lien
position than another mortgage is known as a senior mortgage; the
other one becomes the junior mortgage. As a first mortgage is senior
to a second mortgage, so a second mortgage is junior to the first
mortgage, but is senior to a third mortgage.

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As mentioned in previous chapters, lien priority holds importance if

a foreclosure comes into play because the sale amount is used to
pay the first lien first. If a surplus is left then the second lien is paid
off, then the third and so on until the money is completely
expended.
Purchase Money Mortgage: There are two ways of using this term.
One meaning is that a buyer borrows money to buy property and
gives a mortgage on that same property to the lender to secure the
loan.
Another meaning derived from purchase money mortgage refers to
a mortgage which a buyer gives a seller in a seller-financed property
sale. Instead of paying the full price of the property at closing, the
buyer gives the seller a mortgage on the same property and pays the
sale amount in installments. In a situation like this, the seller is
said to take back or carry back the mortgage.
This constricted purchase money mortgage is also referred to as a
soft money mortgage, since the borrower receives credit instead of
actual cash. When the borrower receives cash (as in a bank loan) in
return from a mortgage from the lender it is called a hard money
mortgage.
Swing Loan: At times buyers cannot sell their current home but
are ready to purchase a new one. They have to pay the down
payment and closing costs immediately and are not in a position to
wait for the sale of the current property. At such times the buyer
may acquire a swing loan, which is generally secured by equity in
the property that is for sale and he will pay it off when the sale
eventually closes. A swing loan is also called a gap loan or a bridge
loan.
Budget Mortgage: In a budget mortgage, the borrower, in his
monthly installment pays part of the principal, interest on the loan
and one-twelfth of the years property tax and hazard insurance
premium. The tax and insurance payments are held by the lender
in an impound/reserve account till the time it becomes due. Many
loans are secured by the budget loan as it is a practical way for the
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lender to ensure that the property taxes and insurance premiums

are paid on time.
Package Mortgage: When personal property and real estate are
sold together, both of these may be financed with a single loan. This
is called a package loan.
Construction Loan: A construction loan is also sometimes referred
to as an interim loan. This is a temporary loan which finances the
construction of improvements on the estate. Upon the
constructions completion, the construction loan is replaced by a
take-out loan, the permanent financing. The promise of the lender
to make a take-out loan at a later date, when the borrower needs it
is called as a standby loan commitment.
If a definite date of maturity is not mentioned on the construction
loan, then the period of repayment shall run from the date stated in
the promissory note. Although construction loans are profitable,
they also have an element of risk. Therefore lenders tend to ask for
a high interest rate and loan fees on construction loans, while the
lenders also oversee the progress of the construction. There are
chances that the borrower might overspend on the construction and
the loan amount is expended before construction finishes. Then if
the borrower cannot afford to complete the construction, the lender
will be left with a security interest in an incomplete project.
The lenders have come up with various plans for disbursing
construction loan proceeds, guarding against overspending by the
borrower, the fixed disbursement plan being most preferred. Per
this plan, there is a set of fixed disbursements, which are called
obligatory advances, at different stages of construction. The
interest starts to accumulate with the first disbursement.
The lender generally holds back 10% or more of the loan proceeds
till such a time when the claim period for the mechanics lien has
expired. This is to protect against unpaid liens that may affect the
marketability of the property. Generally, it is stated in the
construction loan agreement that the lender may use the unused
part of the loan to pay off the valid mechanics lien (if it is recorded).
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Blanket Mortgage: A blanket mortgage is a term for when the

borrower mortgages more than one real property as security
instrument for a single loan. Blanket mortgages are often used in
subdivision developments. For example: when a twenty-acre parcel
subdivided into twenty lots is used to secure one loan made to the
subdivider.
There is a partial release clause also called a partial satisfaction
clause in a blanket mortgage. A provision in this clause states that
the lender must release some of the security property from the
blanket lien once a particular part of the entire debt is paid off.
(This clause in the blanket deed of trust is known as a partial
reconveyance clause.)
It is predetermined by the release schedule as to how much of the
loan must be paid off so as to have a portion released from the
blanket lien. Normally a substantial share of the debt has to be paid
off to release the first lots sold than to release the last ones sold.
The best lots usually sell first so this plan works well to protect the
lenders security interest.
There may be other blanket encumbrances, besides a mortgage. For
example, a supplier who supplies labor and materials on more than
one property of a single owner may acquire a mechanics lien.
Participation Mortgage: In a participation mortgage, the lender
gets to participate in the earnings produced by the mortgaged
property, apart from the collections from the interest payments on
the principal. At times a lender also participates by becoming a
part-owner of the property. In a participation loan the lender is
generally an insurance company or any large investor who invests
on large commercial projects.
Shared Appreciation Mortgage: The value of real property usually
appreciates (increases) over time. In general, the appreciation is
beneficial for the property owner, because it adds to his equity. The
difference between the propertys market value and the liens against
it is known equity. With a shared appreciation mortgage the lender
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is eligible to an agreed-upon share of the increase in the value of

the property. This is also called equity sharing arrangement.
Wraparound Mortgage: A new mortgage that includes (wraps
around) a current first mortgage on the property is a wraparound
mortgage. This mortgage is normally used only in seller-financed
deals. A wraparound mortgage is only possible when the original
loan is without an alienation clause, or else the lender will want the
seller to pay off the original loan before the sale. Once the original
loan is paid off before the wraparound, the buyers title will be
safeguarded against encumbrance by the sellers debt after the full
price has been paid by the buyer.
In case a deed of trust is used instead of a mortgage, as a security
instrument, then this financing is termed as an all-inclusive deed
of trust.
Open-end Mortgage: In an open-end mortgage there is a limit set
for the borrowing, although it allows re-borrowing whenever
required, without negotiating a new mortgage. The interest rate
applied is the usual market interest rate which rises and falls based
on the market situation. This mortgage is preferred mostly by the
builders and farmers.
Graduated Payment Mortgage: This mortgage type lets the
borrower make smaller payments initially and increase the payment
amount gradually. This arrangement is beneficial for the borrower
who anticipate an increase in their earnings in the coming few
years.
Growing Equity Mortgage: This mortgage is also referred to as a
rapid payoff mortgage. It is advantageous for borrowers who
presume their income will increase. With this type of mortgage, the
interest rate is fixed through the term but the payments increase
according to a prefixed schedule. The increased amount adds up to
the principal balance, thus helping the loan to be paid off quickly.
Subprime Mortgage: A borrower who is not eligible for a regular
loan -- because of the ratio of his income against the debt incurred,
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or because his credit history is unsatisfactory, or he is unable to

provide the necessary documentations -- has an option of a
subprime mortgage. A subprime lender takes an extra risk by
loaning to such a borrower, therefore the interest rate and other
fees he charges will be higher.
Home Equity Loan: A borrower can use the equity in property that
he owns as collateral for procuring a mortgage loan. This is termed
an equity loan; if the borrower resides on the property, it is called a
home equity loan.
As previously explained, equity is the difference between a
propertys market value and the liens against it. It means that the
portion of the property owned by the owner which is free and clear
of any lien may be used as collateral for another loan. A home
equity loan is basically a second mortgage. The primary mortgage
loan is the one which is used by the owner to purchase the
property.
A home equity loan is often taken to improve or remodel the
property. But sometimes they are also taken for other big
purchases, or to pay off medical bills, credit card dues and so on,
expenses which are actually unrelated to the property.
Some property owners have a home equity line of credit or
HELOC which they draw on in time of need. Its mechanism is just
like a credit card. Just like a credit card it has a credit limit and
minimum monthly payments and the debt is secured by the owners
property. A HELOC is a circling credit account whereas a home
equity loan is an installment-based loan which must be paid over a
fixed term.
Reverse Mortgage:. The main purpose of this is to give an income
option to senior citizen home owners. The property owner in a
reverse mortgage borrows money against his propertys equity and
receives a check from the lender rather than paying the lender on a
monthly basis. Generally a reverse mortgage borrower must be
above a specified age and there should be little or no mortgage
balance due. The property is sold off at the death of the owner so
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that the reverse mortgage can be paid off.

Refinancing: When the borrower refinances his loan he is, in fact,
acquiring a new loan by replacing the current loan. The current
loan is paid off by the funds acquired from the refinance.
The refinancing may be provided by the lender who initially
provided the current loan. Refinancing is usually chosen when
market interest rates fall, thereby making for considerable savings
in the long run. Another reason for refinancing could be that the
payoff date of the current mortgage is closing in and a large balloon
payment will be required soon.
There is also the cash-out refinancing, through which a borrower
gets a refinanced loan for more than the amount required to pay off
the loan so that there is cash amount left over after the loan pays
off. The additional funds are normally used for improvements on
the property, debt consolidation or any other objective depending on
the terms of the refinance loan.

LAND CONTRACTS
A land contract is a type of seller financing by which the buyer
makes the payments on the purchase and takes possession of the
property but does not take title for at least twelve months from the
date of possession. The amount of the purchase price that needs to
be paid before the title is conveyed is stated in the sales contract.
The land contract is an option for such buyers who do not qualify
for a regular mortgage loan.
The land contract is also called a contract for deed or an
installment sales contract. A land contract demands very little or no
down payment. The buyer takes possession of the property but the
title remains with the seller. This involves less risk for the seller,
since he keeps the title to the property. If the buyer defaults, the
seller does not have the right to restrict the buyers interest.
The courts do not allow harsh remedies against defaulting buyers
so that the buyer may realize an accumulation of equity in the
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property. Any seller opting for a land contract must do so in

consultation with an attorney so that all the legal formalities are
fulfilled.

Chapter Summary
The periodic highs and lows in the activities of the real estate
market are called real estate cycles.
Fiscal policy refers to the method by which the federal
government manages its money.
The direct control of the federal government exerted over the
money supply and interest rates is called monetary policy.
The 12 regional, privately-owned wholesale banks form the
Federal Home Loan Bank System.
The interest paid on a real estate loan is simple interest
irrespective of the fact that the payments are interest-only or
amortized.
The alienation clause is also referred to as due-on-sale clause.
This provision gives the lender the right to accelerate the loan.
Even after a sheriffs sale, the borrower may get a last chance
to redeem the property. He can do so by paying off the full
debt, including interest, fees and other costs.
Any security instrument holding first lien position has the
highest lien priority and is called a first mortgage.
A blanket mortgage refers to an instrument when the borrower
mortgages more than one real property as security instrument
for a single loan.
A borrower can use the equity in property that he owns as
collateral, for procuring a mortgage loan. This is termed as an
equity loan and if the borrower resides on the property, it is
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called the home equity loan.

Reverse mortgages are usually used by senior citizen home
owners to borrow money using their propertys equity.

Chapter Quiz
1. The Treasury issues interest-bearing securities for two to ten
years, which are called:
a. Treasury bills
b. Treasury notes
c. Treasury inflation-protected securities
d. Treasury bonds
2. Which of the following is NOT a tool used by the Fed to
implement its monetary policies to influence the economy:
a. Taxation policies
b. Key interest rates
c. Reserve requirements
d. Open market operations
3. ______________ started out as a federal agency in 1938 with the
purpose of providing a secondary market for FHA-insured
loans.
a. Ginnie Mae
b. Freddie Mac
c. Fannie Mae
d. Federal Deposit Insurance Corporation
4. A promissory note is:
a. Collateral for a loan
b. Necessary to be recorded
c. Security for a trust deed
d. Evidence of a debt
5. A mortgage loan provision which allows the lender to declare
the full loan amount balance due upon default by the
borrower is:
a. A forfeiture clause
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b. An acceleration clause
c. An escalator clause
d. A subordination clause
6. A provision which gives the borrower the right to regain title to
the security property when the debt is repaid is:
a. A subordination clause
b. A forfeiture clause
c. An escalator clause
d. A defeasance clause
7. A __________________ clause states that an instrument will
have lower lien priority than another mortgage or deed of trust
to be executed in the future.
a. Subordination
b. Alienation
c. Acceleration
d. Defeasance
8. While the foreclosure action is pending, the borrower has a
chance to cure the loan default by paying off all the previous
dues, costs and fees of the lawsuit. This is termed as a
_________
a. Redemption
b. Assumption
c. Reinstatement
d. Lien release
9. Which of the following is NOT an alternative to foreclosure:
a. Deficiency judgment
b. Loan workouts
c. Deed in lieu of foreclosure
d. Short sales
10. A _____________ loan is also called a gap loan or a bridge
loan.
a. Swing loan
b. Construction loan
c. Take-out loan
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d. Interim loan
11. After a trustees sale, any proceeds leftover after paying off
liens and foreclosure expenses belong to:
a. Sheriff
b. Trustee
c. Foreclosed owner
d. Beneficiary
12. ______________ is given by the mortgagee to the mortgagor,
when the mortgage debt is paid off, releasing the property from
the lien.
a. Certificate of discharge
b. Deed of reconveyance
c. Sheriffs deed
d. Partial release
13. When a buyer gives a mortgage to a seller instead of an
institutional lender, it is called a:
a. Participation mortgage
b. Reverse equity mortgage
c. Purchase money mortgage
d. Blanket mortgage
14. A ____________ mortgage sets a borrowing limit, but allows the
borrower to reborrow when required.
a. Wraparound mortgage
b. Participation mortgage
c. Open-end mortgage
d. Subprime mortgage
15. If a property does not provide sufficient collateral for a loan
and another property owned by the borrower is offered as
additional collateral, it is termed a:
a. Budget mortgage
b. Package mortgage
c. Blanket mortgage
d. Shared appreciation mortgage

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CHAPTER 10
Residential Loan Application
CHAPTER OVERVIEW
When it comes to choosing a lender the home buyer will look to the
real estate agent for counseling. Agents should be prepared to assist
the buyer in identifying which lender is offering what type of loan.
This chapter will explain the different types of lenders making home
purchase loans, the lenders fee, the Truth in Lending Act, and the
state finance disclosure laws. We shall also learn about the
application form, the underwriting process, and the main features
of a home purchase loan and residential financing programs. The
last part of the chapter will deal with predatory lending and
mortgage fraud.

TYPES OF MORTGAGE LENDERS

A home buyer chooses between lenders for the types of loans they
are offering, usually based on the rate of interest and the fees they
are charging. It does not matter if the loan providing body is a
savings and loan or a mortgage company.
Following are the sources that home buyers often use to procure a
loan for their residential finance:
Commercial banks
Thrift institutions
Credit unions, and
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 Mortgage companies

Commercial Banks: A commercial bank may be a national bank

chartered by the federal government or it may be a state bankchartered by a state government. In the U.S., commercial banks are
the largest providers for investment funds. Initially, commercial
banks were inclined strictly towards commercial lending activities,
such as giving loans to businesses on short-term basis, providing
loans for construction purposes and so on.
Previously, residential mortgages featured very little in the
commercial banks business. The reason was that demand deposits
were mainly used by customers, which they could withdraw on very
short or no notice at all. Thus, the government had restricted the
commercial banks from making long-term investments. But in the
present day, commercial banks have started to accept long-term
deposits and the demand deposits now have a very small share of
the banks total deposits compared to the past.
Commercial loans have continued to attract the banks focus along
with a significant importance being given to personal loans and
home mortgage, particularly to existing customers. Therefore, the
banks now have a substantial share of the residential finance
market.
Thrift Institutions: The savings and loans associations and
savings banks are sometimes collectively called thrift institutions or
thrifts. Thrifts are also chartered by the federal government or state
government, just like commercial banks.
Savings and loans: Savings and loans (S&Ls) started as residential
real estate lenders in the nineteenth century. Their fundamental
activity was investing the major part of their assets in purchase
loans for single-family homes. They became the countrys singlelargest source of funds for home financing by the mid-1950s,
dominating the local residential mortgage markets.
One of the reasons of the domination of savings and loans is that
the home purchase loans had become long-term loans (30-year
terms, generally). Saving deposits of their customers were mostly
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used as the primary source of loan funds by the S&Ls. S&Ls had
no problems in making long-term home loans because the majority
of the funds held by S&Ls were long-term deposits.
The main emphasis for the S&Ls was home mortgage loans,
although they were involved in other types of lending as well. Soon,
though, other lenders became involving in the residential finance
market and the S&Ls dominance lessened.
Savings Bank: The savings bank also started in the nineteenth
century. Financial services were offered by them to the small
depositors, immigrants and working-class people. Since they were
systematized as mutual companies which were owned by and
functioned for the benefit of the depositors, they were named
mutual savings banks (MSBs).
MSBs resembled savings and loans in that their customers were
mainly individuals, not businesses, and their maximum deposits
were savings deposits. The MSBs did make residential mortgage
loans also but they were not as focused on them as were S&Ls.
MSBs also engaged in other types of lending, including personal
loans.
In the present day, savings banks can be set up as mutual
companies or stock companies, while residential mortgages remain
an important aspect of their business.
Credit Unions: Like thrifts and banks, credit unions are depository
institutions. The major difference is that credit unions generally
provide services only for members of a certain group, such as
members of a professional association or union, or employees of a
large company.
Normally, credit unions give small personal loans to their members.
Credit unions now highlight home equity loans. Quite a few credit
unions make home purchase loans, too.
Mortgage Companies: These are not depository institutions like
banks, thrifts or credit unions. Mortgage companies dont lend out
the funds of the depositors. Rather, they act as loan
correspondents, agents between big investors and property buyers
looking for financing.
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An investors money is lent to the buyer through the loan

correspondent, who then services the loan by collecting and
processing the loan payments for the investors. The loan
correspondent receives servicing fee for the services rendered by
him. Banks and thrifts at times perform these duties of a loan
correspondent, while the mortgage companies are dedicated to this
role.
Mortgage companies usually function on behalf of big investors like
insurance companies or pension funds. Huge amounts of capital as
insurance premiums and employer contributions towards the
employees pensions are regulated by these investors. The investors
might well invest these funds in the long-term mortgages since this
money in not going to be withdrawn too soon.
Local loan correspondents are hired to interact with the borrowers
since big investors generally operate on a national level, they do not
have the time and resources to investigate the local real estate
market conditions and risk factors. These big investors are mostly
interested in investing in long-term commercial loans and keep
away from short-term construction loans which involve high risk of
default.
Money is borrowed by mortgage companies from banks on a shortterm basis and used to originate (make) loans. These loans are
packaged and sold to the secondary market agencies and private
investors. When short-term financing is used to make loans before
selling them to permanent investors, it is called warehousing.
Usually, banks and thrifts keep some of the loans made by them in
portfolio rather than selling them to investors. Mortgage
companies, on the other hand, keep none of the loans they make.
Either the loan is made on behalf of an investor or it is sold to an
investor. Sometimes the insurance companies, pension funds and
other big investors do not hire the loan correspondents but directly
purchase loans from mortgage companies.
During the 1990s, mortgage companies greatly increased and soon
they dominated the residential finance market. It is believed that
the subprime lending boom happened mainly because of the
involvement of mortgage companies. The recent issues impacting
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subprime market have put mortgage companies on the defensive

and diminished their market share.
Mortgage companies are often referred to as mortgage bankers.
There used to be a difference between a mortgage banker and a
mortgage broker. A mortgage broker negotiated loans by bringing
the borrower and lender together and took a commission for doing
so; the mortgage brokers participation ended once the loan was
arranged. On the other hand, a mortgage banker made loans using
investors funds or borrowed funds, sold/delivered loans to an
investor and also serviced the loan until its term ended. They
received servicing fees for doing this. However, as a result of
changes in the mortgage industry, the distinguishing features
between the two became unclear and the term mortgage company
came to be used in place of mortgage banker.
Mortgage Loan Originators: A mortgage loan originator (MLO)
would probably assist a home buyer who is looking to apply for
financing to a bank, a thrift, a credit union or a mortgage company.
A MLO might be a bank officer at bank, a mortgage broker who
works for a mortgage company, and likewise. The duties of a MLO
are to discuss the financing options with the buyer, help in filling
out a loan application form, collect the necessary documentation,
and once the application is complete, submit it for processing and
underwriting.
According to the definition in the S.A.F.E. Act (Secure and Fair
Enforcement for Mortgage Licensing Act) of 2008, a mortgage loan
originator is a person who takes a residential mortgage loan
application or offers or negotiates the terms of a residential
mortgage loan and takes compensation for it. The MLO must be
licensed and/or registered through the Nationwide Mortgage
Licensing System and Registry, as required by the S.A.F.E. Act.
MLOs working for a federally-insured depository institution or a
subsidiary must be registered, though need not be licensed. Most of
the other MLOs have to be registered and licensed by the state.
A real estate licensee providing only real estate brokerage services is
not normally considered to be a MLO and so is exempt from the
S.A.F.E. Act requirements. Conversely, a real estate licensee who
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gets any compensation from a lender, a mortgage broker or another

MLO would not be exempt from the Acts requirements.
Private Lenders: There are real estate limited partnerships, real
estate investment trusts and other kinds of private investment
groups which put a lot of money into real estate. Normally, they
finance big residential developments and commercial projects like
shopping centers and office buildings. They do not offer loans to
individual home buyers.
For a buyer, the home seller is probably the most important type of
private lender. At times, the seller is the one providing all the
financing required for the purchase of the home, or even
supplementing the financing which the buyer procures from an
institutional lender. It is true that for home purchases, the sellers
are the most common source of second or junior mortgages. When
institutional loans are difficult to obtain or market interest rates are
high then sellers become a very important source of financing for
the buyer.

LOAN COSTS
The cost of the loan which the buyer will need to procure is the
most important consideration in choosing a lender. The rate of
interest has the maximum impact but the other charges which the
lender levies also greatly affect the cost of the loan. The two most
important charges are the origination fees and discount points.
These two are usually looked at together and referred to as points.
The term point actually is the short form used for percentage point.
A point is one percent of the loan amount.
Origination Fees: The term used for processing loan applications
and making loans is loan origination. A loan origination fee is
used to pay the administrative costs which the lender incurs in
processing a loan. This fee is also called a service fee, an
administrative charge or a loan fee. In almost all mortgage loan
transactions the institutional lender charges an origination fee
which is usually paid by the buyer.

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Discount Points: Discount points are charged by the lenders so

that their upfront yield on a loan may increase. The return/profit
on an investment is called yield. When discount points are
charged, a lender gets interest throughout the loan term and also
gets an additional sum of money up front, at the time of loan
funding. For these reasons the lender settles with charging a lower
interest rate than it would have without the discount points.
Effectively, the lender receives a lump sum amount at closing and
the borrower does not pay more interest later on. A lower interest
rate also means a lower monthly installment payment.
Discount points, though common, are not charged in all residential
loan transactions. How the loans interest rate compares to the
market interest rate determines the number of discount points
charged. Generally, a lender who offers a low interest rate charges
more points to balance it.
The number of discount points needed to add to the lenders yield
on a loan by one percentage point fluctuates according to the
market conditions, the loan terms length, and other elements. For
a predetermined interest rate reduction, how many points a certain
lender will charge can only be determined by that particular lender.
There may be instances where the seller agrees to pay the discount
points on the buyers loan so that the buyer may qualify for
financing. Sometimes the seller offers to pay points to bring the
loan within the means of the buyer (even though the lender does
not charge discount points). This kind of a deal is called a
buydown. The lender receives points from the seller to buy down
the interest rate on the buyers loan.
Rate Lock-ins: When a lender quotes an interest rate to the
borrower, the borrower may want the lender to lock-in the quoted
rate for a certain period. If the interest rate is not locked-in, the
lender can change it at any given time up until the loan term ends.
The lender may increase the interest rate on the loan whenever the
market interest rate increases. This may prove very costly for the
borrower over the long term, or may leave the borrower totally out of
the transaction.

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On the contrary, if the market interest rates are expected to go

down, then locking in may prove to be undesirable to the borrower.
Usually the lender will charge the locked-in interest rate even if the
market interest rate goes down during the loan term.
A fee for locking-in the interest rate is charged by the lender. This
fee is added to the closing costs of the borrower if the transaction
closes. The fee is refunded to the borrower, if the lender rejects his
application, but if the borrower himself withdraws from the
transaction, the fee will be forfeited.

TRUTH IN LENDING ACT

The cost of a mortgage loan may increase substantially due to an
origination fee, discount points, and other charges. These aspects
make comparisons between different lenders complicated. For
instance, one lender offers 6% interest, 1% origination fee, and 1
discount point and another lender offers 5.50% interest, 1%
origination fee and 2 discount points. It is difficult to judge at a
glance as to which offer will be more beneficial for the borrower in
the long term. (A proper calculation confirms that the second option
will prove a bit less expensive).
The Truth in Lending Act (TILA) is the federal consumer protection
law which deals with this issue of comparing loan costs. This act
makes the lender divulge the entire cost of the credit to the
consumer loan borrower. The TILA also regulates the way in which
consumer loans are advertised. Regulation Z implements the Truth
in Lending Act. This Regulation Z is issued by the Federal Reserve
Board. The regulatory agencies that supervise financial institutions
and the Federal Trade Commission are the bodies which enforce the
requirements of TILA and Regulation Z.
Loans Covered by TILA: If a loan is used for personal, family, or
household purposes it is called a consumer loan. The Truth in
Lending Act covers the consumer loan if:
- It is to be repaid in four or more installments, or it is subject
to finance charges, and
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- It is for $25,000 or less or secured by real property

Therefore, any mortgage loan is covered by the Truth in Lending Act
if the proceeds are used for personal, family, or household purposes
like purchasing a home, paying medical bills or paying childrens
college fees.
Loans Exempt from TILA: Loans made to corporations and
organizations are not covered by the TILA Act. Even loans for
business, commercial and agricultural purposes are exempt from
TILA. The loan is also not covered if it is not secured by a real
property and is above $25,000. Real estate loans for personal,
family, or household purposes are covered by TILA, irrespective of
the loan amount. Most of the seller financing is also exempt, since
providing credit is not a part of the sellers normal business
activities.
Required Disclosures: In TILA-subjected transactions, lenders
must provide a disclosure statement to prospective borrowers. The
important terms of the loan, annual percentage rate, finance
charges, payment terms and information about any variable-rate
feature must be provided in the disclosure. The finance charge is
the sum of the total cost of credit including the direct or indirect
charges as a condition of acquiring credit (which are interest, loan
fees, finder fees, credit report fees, insurance fees, and mortgage
insurance fees). In real estate loan transactions, the appraisal fee,
credit report fees, inspection fees, and title fees are not included in
the finance charges. Other charges which will be paid by anyone
else but the borrower are also not included, such as points paid by
the seller.
The annual percentage rate (APR) is the relative cost of credit
expressed as a yearly rate. It is the difference between the total
finance charge and the total amount financed, specified as a
percentage. This important figure allows the borrower to compare
loans more precisely. The annual percentage rate is also called the
effective rate of interest.
Along with the total finance charge and APR, the disclosure
statement also should list good faith estimates of all the loan costs,

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plus provide information on whether the borrower incurs a

prepayment penalty if the loan is paid off early.
Disclosure Timings: The lender must also give a TILA disclosure
statement when he receives a written application for a consumer
loan secured by the borrowers home, whether it is a purchase loan,
a home equity loan or refinancing. This disclosure may be delivered
or mailed to the prospective borrower within three business days.
The lender is disallowed from charging any fees to the borrower
before the above requirement is fulfilled. However, he may charge a
fee for providing his credit report.
Applicants of mortgage loans must receive the TILA disclosure
statement at least seven days prior to closing, so that they may
have enough time to consider the information provided. In case any
original estimate happens to be wrong, the corrected information
must be offered by the lender at least three business days before
closing.
Right to Rescind: The right to rescind a real estate loan may
apply to most consumer credit loans (hard money loans) or
refinance loans. Loans used for the purchase or construction of the
borrowers personal home (purchase money loan) cannot be
rescinded. The borrower who is entitled to rescind must be provided
with a written rescission disclosure by the lender. The borrower
may rescind the loan agreement up until three business days after
signing it, receiving the disclosure statement or receiving the notice
of the right of rescission, whichever comes latest. In case the
borrower does not receive the disclosure statement or the notice,
the right of rescission does not expire for three years.
Advertising Under TILA: Advertising of the credit terms is strictly
regulated by TILA. Its advertising rules apply to lenders as well as
others who advertise consumer credit.
Stating the cash price or the annual percentage rate in an
advertisement is always legal. On the other hand, if certain loan
terms called trigger terms, such as down-payment or the interest
rate is mentioned in any ad, then all the other terms of repayment
must be added, too. Nonetheless, use of unspecific terms like, low

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down payment, easy terms, attractive interest rates, and so on

do not prompt the full disclosure requirement.

CALIFORNIA FINANCE DISCLOSURE REQUIREMENTS

Along with the Truth in Lending Act which is a federal law, there
are some state laws too that support the California property buyers
right to obtain the necessary information needed to make an
informed decision about financing. The Mortgage Loan Broker Law
and the Seller Financing Disclosure Law are laws addressing this
right.
Mortgage Loan Broker Law: It is already clear that real estate
agents at times help the buyer in acquiring finance for their
purchase. As per state law, a real estate agent arranging or
negotiating a loan for a fee is said to be acting as a mortgage loan
broker. The agent is required to comply with the Mortgage Loan
Broker Law, also called the Real Property Loan Law, or Article VII of
the Real Estate Law.
According to the Mortgage Loan Broker Law, the real estate agent
who is acts as a loan broker must give a disclosure statement to the
borrower. For the loans secured by residential property with up to
four units, there is a lawful restriction on the size of the fees and
commissions which is paid by the borrower or received by the loan
broker. Here is a look of some of the laws important provisions
Disclosure Statement: There is a form approved by the Real Estate
commissioner on which the disclosure statement as required by the
Mortgage Loan Broker Law must be provided. There are different
kinds of disclosure forms issued by the Department of Real Estate:
1. For traditional mortgage products, and
2. For non-traditional mortgage products, whereby the borrower
is allowed to defer repayment of principal or interest.
The complete cost of procuring the loan and the actual amount the
borrower will eventually receive after all of the costs and fees are
deducted from the loan is disclosed in the statement. The borrower
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must either receive the disclosure statement before he signs the

note and security instrument, or within three days after the lender
receives the loan application of the borrower, whichever happens
first.
Whenever a real estate agent negotiates a loan or executes services
for a borrower or a lender with regards to a loan, then a disclosure
statement becomes a necessity. This requirement is for loans
secured by commercial as well as residential property. The real
estate agent must keep the disclosure statement on file for at least
three years.
In a loan transaction which is bound by the Real Estate Settlement
Procedures Act, the Mortgage Loan Broker Laws disclosure
statement requirement may be satisfied by the good faith estimate
which is required by RESPA.
Commissions, Costs, and Terms: The commissions and costs that
a real estate agent may demand from a borrower for arranging an
Article VII loan secured by residential property with one to four
units are limited by the Mortgage Loan Broker Law. An Article VII
loan is one of the following two:
- A first deed of trust for less than $30,000, or
- A junior deed of trust for less than $20,000
For the above kind of loans, the highest commissions a loan broker
can charge are:
- For the first deed of trust:
5% of the principal amount if the loan term is less than
three years, or
10% of the principal amount if the loan term happens to
be three years or more
- For the junior deed of trust:
5% of the principal amount if the loan term is less than
two years,

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 10% of the principal amount if the loan term is at least

two years, but less than 3 years, or
15% of the principal if the term is three years or more
The costs of making these loans, for example the escrow fees or
appraisal fees cannot be more than 5% of the loan amount or $390,
whichever is more. However, the costs charged to the borrower can
never be more than $700 and must not be more than the actual
costs.
Balloon Payments: In Article VII-loans that need to be paid off in
less than three years, balloon payments are prohibited by the
Mortgage Loan Broker Law. If the property is owner-occupied and
the loan term is less than six years, balloon payments are similarly
not allowed. However, these rules are not applicable to sellerfinanced loans. (A balloon payment is one which is more than twice
as big as the smallest payment required by the loan plan).
Violation Penalties: A real estate agent has to refund any
compensation he receives as a result of a loan negotiated in
violation of the Mortgage Loan Broker Law. This refund has to be
made within 20 days of a written demand delivered or mailed to the
agent/loan broker from the borrower. If the 20-day deadline
expires, then the borrower may sue the loan broker for the actual
damages or for two times the compensation amount taken by the
broker, whichever is more, plus costs and attorney fees.
Seller Financing Disclosure Law: The Seller Financing Disclosure
Law is also called the Residential Purchase Money Loan Disclosure
Law. When a seller takes back a purchase money loan on
residential property, there is a state law requiring particular
disclosures to be made to both the buyer and the seller if an
arranger of credit is a part of the loan. For the purpose of this law,
an arranger of credit is anyone apart from the buyer and seller
who:
- Takes part in negotiating the credit agreement,
- Assists in preparing the documents, or

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- Is directly or indirectly receiving compensation for organizing

the finance or the property sale that is aided by the financing.
Escrow agents and attorneys representing either of the party are
not considered to be arrangers of credit. However, if an attorney or
a real estate agent is a part of the transaction, he will be considered
as an arranger of credit if none of the parties are represented by a
real estate agent.
Coverage of the Law: When the seller gives the buyer credit for all
or part of the purchase price, the disclosure law will apply in the
following conditions:
When the transaction involves residential property with one to
four units
When the credit facilities includes a finance charge or provide
for more than four payments (excluding down payment), and
When an arranger of credit is involved
If the transaction is already covered by a disclosure law such as the
TILA, RESPA or the Mortgage Loan Broker Law, then it is exempt
from this particular law.
Disclosure Requirements: In the Seller Financing Disclosure Law,
the required disclosures need to be made before the note or security
instrument is signed by the buyer. The seller has to make
disclosures to the buyer and the buyer has to make disclosures to
the seller. It is the responsibility of the arranger of credit to
ascertain that all the necessary information is disclosed by each
party to the other.
Some of the required disclosures according to the statute are:
The terms of the note and the security instrument
Details of the terms and conditions of the senior
encumbrances (the first deed of trust that the buyer will
assume)

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 If the finance will result in a balloon payment then the buyer

needs to be warned that obtaining refinancing to cover the
balloon payment may be difficult, and
Employment, income, and credit information about the buyer
or otherwise a statement that the arranger of credit has not
made any representations in regards to the creditworthiness of
the buyer.

LOAN APPLICATION PROCESS

After the loan costs have been compared and a lender has been
selected, the next step is to apply for the loan. The buyer normally
enlists the help of a loan originator (a loan officer or a mortgage
broker) to fill out a loan application form and provide necessary
documentation to the lender. This application is submitted to the
lenders underwriting department, which after evaluating the
application either rejects or approves the proposed loan.
Preapproval
In the past, a buyer would find a desirable property first and then
apply for a loan. However, getting preapproved for a mortgage loan
has increasingly become a regular practice in many places. To
become preapproved, the prospective buyer -- before searching for a
property -- submits a loan application to a lender. If the application
is approved by the lender, the buyer is preapproved for a particular
maximum loan amount.
A preapproval helps the buyer know how costly a house he can
afford. If a lenders standards are met and the house is in the
preapproved price range, it can be purchased by the buyer. The
preapproval simplifies the closing process once a right house is
found by the buyer.

The Application Form

A mortgage loan application form questions the prospective
borrower about his financial condition. The lender needs to have
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this information since he wants his investment to be a profitable

one. A loan will not be produce a profit if the borrower is financially
unable to make the payments on time or if the borrower is in the
habit of defaulting on debts. The application helps the lender to
identify and reject potential buyers who may be inadequately
prepared to make timely payments.
The Uniform Residential Loan Application form which is developed
by Fannie Mae and Freddie Mac is generally used by mortgage
lenders. The following information is required in the form:
1) Personal information, such as the social security number, age,
education, marital status and number of dependents of the
applicant.
2) Current housing expense such as the monthly rent or house
payment (principal and interest, property taxes, hazard
insurance, any mortgage insurance and any homeowners or
condominium association dues included).
3) Employment information (like job title, type of business and
tenure of employment) regarding applicants current position
and if the current job is less than two years, then the previous
job details.
4) Other income sources apart from the employment, such as
wages, bonuses, and/or commissions, investments (dividends
and interest) and pensions.
5) Assets including money in bank accounts, stocks and bonds,
real property, life insurance, retirement funds, jewelry, cars
and any other personal property.
6) Liabilities including credit card debts, car loans, property
loans, spousal maintenance or child support payments and
unpaid taxes.
The lender may verify the applicants information regarding income,
assets and liabilities. He may do so by contacting his employer and
his bank.

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Underwriting the Loan

After the loan application is submitted and the information verified,
the loan is ready for the underwriting process. In the loan
underwriting process, the evaluation of the applicant and the
property he plans to buy are done to verify whether they meet the
minimum standard set by the lender. The person conducting the
evaluation is called a loan underwriter or a credit underwriter. The
underwriter uses some set instructions to decide whether an
applicant qualifies for the loan, called underwriting standards or
qualifying standards.
Usually, a lender has freedom to set its own underwriting
standards. But in actuality, most lenders apply underwriting
standards set by the major secondary market agencies, Fannie Mae
and Freddie Mac. Similarly, for FHA and VA loans, standards set by
HUD or the Veterans Administration is used.
Qualifying the Buyer: While evaluating a loan applicants financial
situation, an underwriter has to consider various factors, these
factors fall into three main groups: credit history, income, and net
worth.
Credit History: The first main element of creditworthiness is credit
history or credit reputation. An underwriter naturally requests
credit reports on the loan applicant from more than one credit
reporting agency. The report shows how consistently the applicant
has paid bills and other debts, and if the applicant has had any
major defaults ,such as being bankrupted or foreclosed upon.
Apart from analyzing credit reports, underwriters also use credit
scores, which help in assessing if the loan applicant is likely to
default on the proposed loan. An applicants credit score is
calculated by the credit reporting agency using the credit report and
a statistical model that correlates different types of negative credit
information with actual loan defaults.
Credit issues may be a sign of financial irresponsibility, but at times
they happen because of a personal crisis like a job loss, divorce or
hospitalization. A loan applicant with a poor credit history should
explain any mitigating circumstances to the lender.
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The Federal Fair Credit Reporting Act and the California Consumer
Credit Reporting Agencies Act regulate the actions of credit
reporting agencies. California law requires the credit reporting
agency to provide the copy of the credit information to the
consumer, if requested. If the agency fails to provide the copy of
credit information, the consumer may sue the agency for actual
damages, disciplinary damages of up to $5,000, attorneys fees, and
court costs. A consumer may challenge the information in their
credit reports. The agencies must probe and make corrections
where required.
Income: The loan applicants monthly income is another major
consideration for the underwriter, regarding whether his income is
enough to cover the proposed monthly mortgage payment, plus
other expenses of the applicant. Therefore, the underwriter must
verify the applicants income.
In the underwriters view, not all income is equal. The income must
meet the standards of quality and durability, to be able to be taken
into account for deciding whether the applicant qualifies for the
loan. The income that meets this test is called the loan applicants
stable monthly income.
A regular income from permanent employment or Social Security
retirement benefits is considered a stable monthly income, while
occasional overtime pay from a permanent job or wages from a
temporary job will not be taken into account as stable monthly
income since there is no guarantee that it will continue.
After having calculated the monthly income of the applicant, the
next step the underwriter is to find out the adequacy of the income:
Whether the stable monthly income will be sufficient for the
applicant to be able to afford the proposed monthly mortgage
payment. For this the underwriter uses the income ratios. The
reasoning behind the ratio is that if the borrowers expenses goes
beyond a certain percentage of his monthly income, then he may
find it difficult to make the payments on the loan.
The two main types of income ratios are:

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- A housing expense to income ratio: it measures the

proposed monthly mortgage payment against the applicants
stable monthly income, and
- A debt-to-income ratio: measures all of the applicants
monthly commitments (the proposed monthly mortgage
payments, car payments, credit card payments, and so on)
against the stable monthly income.
To calculate these, the monthly mortgage payment comprises the
principal, interest, taxes, and insurance (also called PITI). Each
ratio is articulated as a percentage; for instance, a loan applicants
housing expense-to-income ratio would be 32% if the proposed
mortgage payment represented 32% of his stable monthly income.
Considering the type of loan applied for, the lender would decide if
that ratio would be considered too high. All of the main residential
financing programs -- conventional, FHA and VA -- have their own
income ratio limits.
Net Worth: The third part of the underwriting procedure is
evaluating the applicants net worth. The applicants net worth is
calculated by subtracting his total personal liabilities from his total
personal assets. If a loan applicant has collected a substantial net
worth from earnings, savings, and other investments, it is a sign of
creditworthiness. The applicant evidently is capable of managing
his financial affairs.
By assessing net worth, the underwriter also needs to ascertain
that the applicant has enough funds to make the down payment,
the closing costs, and other costs involved in purchase of the
property.
It is also advisable that a loan applicant have cash reserves left over
after closing. Reserves will be useful at a time of a financial
emergency like an unexpected bill or a temporary stoppage of
income, to avoid defaulting on the mortgage. Sometimes lenders
need an applicant to have enough reserves to cover a specified
number of mortgage payments. Reserves strengthen the loan
application, even though they may not be required.

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Qualifying the Property: The underwriter must confirm that the

buyer is a good risk, and also confirm that the property which he
wishes to purchase is a good risk, too. He has to determine whether
the propertys value will be enough to serve as collateral for the loan
amount. To address this, the underwriter uses the appraisal report
specified by the lender. In the appraisal report, an expert provides
an estimate of the propertys value. (Appraisal will be studied in
detail in the next chapter.)
Automated Underwriting: Staying within the limits set by the
underwriting standards, the underwriter uses his own experience
and judgment in deciding if he would recommend a certain loan for
approval or rejection. Therefore, underwriting is described as an art,
rather than a science. However, automated underwriting (AU) has
taken this art a little closer to a scientific scale. In automated
underwriting, a computer program carries out an initial analysis of
the loan application and the credit report of the applicant and
recommends approving or rejecting the loan application. A human
underwriter then evaluates the application, referring the AU
recommendation.
The statistics of the performance of millions of loans whether the
borrowers have made timely payments or defaulted -- are the basis
of AU systems. Evaluation of these statistics strongly suggests the
factors in a loan app which make defaulting more or less likely.
Through AU, the underwriting process can be streamlined, since
the requirement of paperwork is substantially less. As a result, the
lenders can make approval decisions more promptly.
Loan Commitment: After the completion of the underwriting
analysis, a report which summarizes the characteristics of the
prospective borrower, the property and the proposed loan is made.
This report is also called a mortgage evaluation. This is submitted
to a loan committee which makes the final decision of approving or
rejecting the loan. If the committee decides to approve the loan, the
lender issues a loan commitment, thus agreeing to make the loan
on certain terms.

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SUBPRIME LENDING
The home buyers whose credit history does not meet the standard
underwriting requirement may acquire a loan by applying to a
subprime lender. Subprime lenders make riskier loans than prime
(or standard) lenders.
Many subprime mortgage buyers have impaired credit histories and
average credit scores, but it is not always the case. Sometimes,
subprime financing may be an option for buyers who:
* Cannot (or prefer not to) meet the income and asset
documentation requirements for prime lenders, orn
* Have good credit but have more debt than allowed by the prime
lenders, or
* Wish to purchase a nonstandard property that a prime lender
doesnt consider as acceptable collateral
The underwriting standards of a subprime lender are more flexible
but would charge a higher interest rate and fees than a prime
lender. Apart from these higher rates and fees, a subprime loan
may also come with features such as balloon payments,
prepayment penalties, and negative amortization. These features
help the subprime lenders to compensate for some of the extra risks
involved in their loans, though they might be difficult for the
borrower to meet.
A boom in subprime lending which began in the 1990s continued
in the following century as well. But a substantial number of
subprime loans made in the boom period happened to be poor risk
loans. Calling for low monthly payments initially but increasing
steeply a few years into the loan term, these sudden increases (this
problem is referred to as payment shock) could not be handled by
the borrowers. This resulted in a foreclosure epidemic, which began
in the year 2008. It not only affected the mortgage industry but also
the entire economy.

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After this, the secondary market agencies and other government

agencies have taken steps to dissuade high-risk subprime lending.
One such steps was the Conference of State Bank Supervisors and
the American Association of Residential Mortgage Regulators
issuing two publications, the Statement on Subprime Lending and
Guidance on Nontraditional Mortgage Products. According to state
law, the state-licensed lenders and mortgage brokers must now
adopt policies and procedures intended to achieve the objectives set
forth in those publications.

BASIC LOAN FEATURES

This section deals with the basic features of a home mortgage loan.
These comprise the loan term, amortization, loan-to-value ratio, in
some cases a secondary financing arrangement, and a fixed or
adjustable interest rate. A property purchaser is presented with
many options in regards to these various loan features. Each of
them has an effect on how big a loan the buyer can qualify for, and
eventually on how costly a home the buyer is able to purchase.
Loan Term: A mortgage loans term, known as the repayment
period, has a huge influence on both the monthly mortgage
payment and the total amount of interest paid over the term of the
loan. The longer the term, the lower the monthly payment, and
higher the interest paid.
From the 1930s onward the standard term for a mortgage loan was
30 years. Because of the length of the repayment period, the
monthly payments became affordable, thus reducing the risk of
default.
Even though the 30-year loans remained most prevalent, 15-year
loans also became popular. A 15-year loan comes with higher
monthly payments than an equivalent 30-year loan, but the 15-year
loan offers considerable savings for the borrower in the long run.
Lenders generally offer lower interest rates on 15-year loans, since
shorter term means less risk for the lender. The borrower will save a
substantial amount of money in the total interest charges over the
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term of the loan. Another advantage of a 15-year loan is that it

offers free and clear ownership of the property in half the time.
On the other hand, higher monthly payments for a 15-year loan
would mean that the borrower would have to settle for a much
lesser expensive property than a 30-year loan would en able him to
afford.
There are available options to 15- and 30-year loans. For some
borrowers a 20-year loan is a good compromise choice between the
two, it has some of the advantages of both.
Normally, 30 years is the maximum repayment period in most loan
plans, but some plans allow borrowers to select a 40-year term, so
that the borrower may maximize his purchasing power.
Amortization: Most of the mortgage loans are fully amortized. A
fully amortized loan is one which is repaid within a certain period of
time by making regular payments which comprises part of the
principal and a part of the interest. As each installment is made, a
certain amount of principal is deducted from the debt and the
remaining payment, which represents the interest, is kept by the
lender as his profit. As the payments are made, the amount of debt
is reduced and the interest due with the next payment is
recalculated on the basis of the lower principal balance. The total
payment remains the same through the loan term, but each month
the interest portion of the payment is reduced and the principal
portion is increased. As the final payment is made, the loan is paid
off, the principal balance is zero and no further interest is owed.
There are two options to fully amortized loans:
- partially amortized loans, and
- interest-only loans
In a partially-amortized loan, regular payments of both principal
and interest will be required, but those payments are not sufficient
to repay the entire principal. At the end of the loan term the
borrower will need to make a big balloon payment, which is the
remaining principal balance.
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In an interest-only loan, regular payments of the borrower during

the loan term cover the interest accumulating on the loan, while the
principal remains unpaid. The principal amount remains due until
the end of the loan term.
The interest-only loan term is also used to describe a loan that is
planned to allow interest-only payments during a certain period at
the beginning of the loan term. Once the initial period is over, the
borrower must start making amortized payments (which will
include the principal and the interest) till the end of the term.
The interest-only loan was much favored during the subprime
boom, since the low payments in the beginning of the term enabled
borrowers to purchase more expensive properties than they
otherwise could have. But for many of the borrowers this interestonly loan eventually caused a payment shock -- when the interestonly period ended and amortized payments had to be made -- which
resulted in foreclosure.
Loan-to-Value Ratio: The loan-to-value (LTV) ratio for a specific
transaction defines the relationship between the loan amount and
the value of the property. If the LTV is low, it means that the loan
amount will be smaller and the down payment will be bigger.
The down payment denotes the borrowers initial investment or
equity in the property. The lower the loan-to-value ratio, the greater
the borrowers equity. Appreciation of the property benefits the
borrower, because an increase in the property value increases the
borrowers equity interest.
The loan-to-value ratio affects the extent of risk (the risk of default
and the risk of loss in case of a default) involved in the loan. A
borrower with a considerable investment in the property, i.e., a
substantial amount of equity, will try to avoid a foreclosure. In the
event of a foreclosure, the lender is most likely to recover the full
debt if the LTV is reasonably low.
If a loan is made with a 100% LTV, the lender can recover the
unpaid loan balance and their entire cost in a foreclosure sale only
if the value of the property has appreciated and the property sells
for much more than its original purchase price. The reason for this
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is that the foreclosure procedure itself costs a huge amount of

money to the lender.
The higher the LTV, the greater the lenders risk. At times the
lender may apply special rules to high-LTV loans for the extra risk
they pose. Therefore the lenders use loan-to-value ratios to set
maximum loan amounts.
Secondary Financing: At times a buyer acquires two mortgage
loans at one time - a primary loan to pay off most of the purchase
price, and a second loan to pay part of the down payment or closing
costs needed for the first loan. This second loan is called secondary
financing. Secondary financing can be acquired from an
institutional lender, the seller, or a private third party.
Generally, the primary lender allows secondary financing only if it
fulfills certain requirements. For instance, the borrower should be
able to qualify for the combined payment on the first and second
loans. A minimum down payment has to be paid by the borrower
from his own funds, and the second loan must be payable at any
time, without a prepayment penalty.
Fixed and Adjustable Interest Rates: In a fixed-rate loan, the
repayment is done over its term at a rate of interest that remains
unchanged.
The fixed-rate loan works well for the borrowers and lenders when
market interest rates are comparatively low and stable. On the
other hand, when interest rates are high and unstable, borrowers
and the lenders are both uncomfortable with fixed-rate loans; at
such times, many borrowers opt out of the loan market, while
lenders prefer not to tie up their funds for long terms at a set
interest rate when market conditions are fluctuating rapidly.
There is a type of a loan which sorts out both these issues, the
adjustable-rate mortgage (ARM). This is also called the variablerate loan. An ARM allows the lender to adjust the loans interest
rate periodically, so that it more closely reflects the changes in the
cost of money. If market interest rates go up, the borrowers interest
rate and monthly payment also rise, and if interest rates come

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down, the borrowers interest rate and monthly payment also

decline.
Subject to economic conditions and other factors, the lender may
offer ARMs at a lower opening interest rate than the rate they
charge for the fixed-rate loans.
How ARMs Function: In an ARM, the borrowers interest rate is
determined initially by the cost of money at the time of making the
loan. When the rate is set, it is tied to a published statistical rate
which is a reliable indicator of changes in the cost of money called
an index, such as the one-year Treasury bill index and the Eleventh
District cost of funds index. When a loan is made, the lender
chooses the index he prefers and then the loans interest rate will
rise and fall with the rates reported for the index.
As the index is an indication of the cost of money of the lender, it is
important to add a margin to the index to ascertain sufficient
income for the administrative expenses and profit. The lenders
margin may be somewhere close to 2% or 3%. The index added to
the margin equals the interest rate payable by the borrower.
The index that fluctuates during the loan term is tied to the
borrowers interest rate rise and fall, while the lenders margin
remains unchanged.
Adjustment Periods: The interest rate of the borrower is not
adjusted each time the index changes, rather each ARM has a rate
adjustment period. This period governs how often its interest rate
is adjusted. A one-year term is the most common rate adjustment
period.
An ARM has a payment adjustment period, too, which decides how
often the borrowers monthly mortgage payment is to increase or
decrease (as per the changes in the interest rate). In the case of
almost all ARMs, payment adjustments and rate adjustments are
made at the same intervals.
Caps: A rapid rise in the market interest rates will also mean a
rapid rise in an ARMs index. This might lead to a steep increase in
the interest rate charged by the lender to the borrower; a higher
interest rate means a higher monthly payment. This may ultimately
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result in payment shock. This means that the monthly payments

on an ARM may end up going up so drastically that it may become
unaffordable for the borrower.
For protecting the borrowers from payment shock and lenders from
default, ARMs have caps on interest rates and payments. An
interest rate cap puts a limit on how high an interest rate can go
for a lender, irrespective of the rise in the index. A mortgage
payment cap puts a limit on the increase a lender can make in the
monthly payment.
Negative Amortization: At times the payment increases may not
keep up with increases in the loans interest rate, so monthly
payments would not cover all of the interest owed. The lender then
settles this by adding the unpaid interest to the principal balance of
the loan, a process called negative amortization. Normally, the
principal balance of a loan declines steadily, though gradually. But
the principal balance in negative amortization goes up rather than
comes down. The borrower ends up owing more to the lender than
the original loan amount. Currently, most lenders organize their
ARMs to avoid negative amortization and reduce the chance of
default and foreclosure.
Hybrid ARMs: The interest rate with the hybrid ARM is fixed for a
certain number of years at the beginning of the loan term, with the
rate later becoming adjustable. For instance, a 4/1 hybrid ARM has
a fixed rate during the first four years, then annual rate
adjustments can be made after that. It is a general rule that the
longer the initial fixed-rate period, the higher the initial interest
rate.

RESIDENTIAL FINANCING PROGRAMS

The residential financing programs may be divided into two main
groups, conventional loans and government-sponsored loans. There
are four government-sponsored loans:
- The FHA-insured loan program
- The Rural Housing Service loan program
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- The VA-guaranteed loan program and,

- The Cal-Vet loan program

Conventional Loans
Any institutional loan that is not insured or guaranteed by a
government agency is a conventional loan.
The rules for conventional loans explained here point towards the
principles set by the secondary market agencies that purchase
conventional loans, Fannie Mae and Freddie Mac. Any loan that
does not meet the secondary market principles is considered
nonconforming and generally cannot be sold to the secondary
market agencies. As most of the lenders wish to sell their loans on
the secondary market, they customize their standards for
conventional loans to match those set by Fannie Mae or Freddie
Mac.
Conforming Loan Limits: If the loan amount is over the applicable
conforming loan limit then it will not be eligible for sale to Fannie
Mae or Freddie Mac. The conforming loan limit is different for
properties with one, two, three or four dwelling units. The basis of
the conforming loan limits is the median housing prices in the
country. These are adjusted annually to indicate changes in median
prices.
Loans exceeding the conventional loan limits are called jumbo
loans. It is normal for lenders to charge higher interest rates and
apply stringent underwriting standards while making jumbo loans.
Conventional LTVs: Traditionally, the standard loan-to-value ratio
for a conventional loan is 80% of the appraised value or sales price
of the property (whichever is less). Lenders believe that a borrower
paying a 20% down payment with his own funds is not likely to
default. Even if the borrower was to default, a foreclosure sale
would probably generate at least 80% of the purchase price.
While an 80% LTV may still be considered as the traditional
standard, many conventional loans now have a much higher loan239

to-value ratio. LTVs of up to 95% are allowed by many lenders.

Loans with a 97% LTV may even be available through special
programs, although conventional loans with such a high LTV are
rarely seen.
Since the risk carried by the lender is greater when the down
payment of the borrower is smaller, lenders need borrowers to
acquire private mortgage insurance (discussed later in this chapter)
for any conventional loan with an LTV over 80%. For conventional
loans with higher LTVs, the lenders charge higher interest rates and
larger loan fees. The rules for the loans with LTVs more than 90%
are obviously very strict.
Owner-Occupancy: There is a distinguishing feature between
owner-occupied homes and investment properties made by
residential lenders. An owner-occupied home is obviously the one in
which the owner/borrower has plans to live, either as his main
residence or as his second home. On the other hand, an investment
property is a house that the owner has decided to rent out to
tenants. Borrowers are considered less likely to default on selfoccupied properties than on tenant-occupied properties.
Owner-occupancy is a requirement only for loans made through
some special programs (for example, affordable housing programs);
owner-occupancy is not a requirement for conventional loans. At
times, lenders do apply more strict rules to investors than to owneroccupants. As an example, a lender might allow 95% as its
maximum LTV for owner-occupants, but limit investors to a 90%
LTV.
Private Mortgage Insurance: PMI or Private Mortgage Insurance is
issued by private insurance companies, in contrast to the
governments FHA mortgage insurance program. PMI is structured
to protect lenders from the greater risk of high-LTV loans. The
reduced borrower equity is made up by the insurance. PMI is
normally needed on all conventional loans with an LTV over 80%
(whenever the borrowers down payment is less than 20%)
When a loan is insured, the mortgage insurance company takes
responsibility for only a portion of the risk of default. It essentially
covers only the upper 20% to 25% of the loan amount, not the full
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loan amount. The higher the LTV, higher goes the coverage
requirements and the premiums, because the risk of default is
much greater.
If a foreclosure becomes necessary on account of a default, which
then causes losses to the lender, he can either sell the property or
renounce it to the insurer (and make a claim for the reimbursement
of losses up to the extent of the policy limit). Losses are generally in
the form of principal and interest, property taxes, attorneys fees,
sale costs, and maintenance of property costs during the
foreclosure and resale.
The loan-to-value ratio will decrease, as the loan is being paid off by
the borrower and as the value of the property increases. As the LTV
lessens, the risk of loss for the lender also declines, so the purpose
of the private mortgage insurance is satisfied.
As per the federal Homeowners Protection Act, lenders are
supposed to cancel the PMI once 80% of the propertys original
value has been paid down. As the loan balance reaches 78%,
cancellation is necessary, even if it is not requested.
Conventional Qualifying Standards: Fannie Mae and Freddie
Mac have comprehensive guidelines for evaluating a conventional
loan applicants credit history, income, and net worth. Minimum
credit scores are set by the agencies for the loans they buy. A
borrower is charged a risk-based loan fee called a delivery fee or a
loan-level price adjustment (LLPA), if his credit score is above the
minimum, yet relatively low. The fee amount can be large, as
additional LLPAs may be charged for other risk factors in the
transaction. For instance, a LLPA could be charged for a loan with
an adjustable interest rate (in an ARM there is a risk of default due
to the payment shock involved).
To ascertain whether the applicants monthly income stability is
sufficient, an underwriter might consider both the housing expenseto-income ratio and the debt-to income ratio.
There are cases where the underwriter considers only the debt-toincome ratio since debt to income takes into account all of the
applicants monthly obligations. It is supposed to indicate the
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creditworthiness more reliably than the housing expense-to-income

ratio.
Sometimes the lenders need a conventional loan applicant to
maintain the amount of two months mortgage payments in reserve
after the down payment and all closing costs are paid. A lender
might need three months of mortgage payments in reserve, for loans
with LTVs over 90%.
Assumption: In most conventional loans, an alienation clause is
included in the security instrument used, meaning the borrower
cannot sell the property and let the buyer assume the loan without
the lenders permission. Usually, the buyer is evaluated by the
lender with the same qualifying standards which are applied in a
new loan application. If the assumption is approved by the lender,
an assumption fee is charged while the interest rate is adjusted to
the current rates at that time.

FHA-Insured Loans
In 1934, the Congress created the Federal Housing Administration
(FHA) in the National Housing Act. The National Housing Act and
the FHA were designed with the intention of creating new jobs by
way of increased construction activities, to stabilize the mortgage
market and to promote the financing, repair, improvement and the
sale of real estate in the country. The establishment of minimum
housing construction standards was an additional byproduct of the
FHA housing program.
The FHA is now a part of HUD. Insuring mortgage loans is its main
function. The FHA reimburses lenders who make loans through
FHA programs and have suffered losses resulting from borrower
default. The FHA does not construct houses or make loans.
Effectively, the FHA performs as a huge mortgage insurance agency.
Its insurance program, also called the Mutual Mortgage Insurance
Plan, is funded with the FHA borrowers-paid premiums.
FHA approved lenders (for making insured loans) either have to
submit applications of the prospective borrowers to the local FHA
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office for approval or they may perform the underwriting functions

themselves, if they are authorized by the FHA to do so. The lenders
authorized to underwrite their own FHA loan application are called
direct endorsement lenders.
It is noteworthy that the FHA does not accept applications directly
from the prospective borrowers. The borrower must first apply to a
lender such as a bank or a mortgage company for an initial loan
commitment. It is also called a conditional commitment.
The FHA, as an insurer, is liable to the lender for the full amount of
losses (and eventual foreclosure) which are the consequences of a
default by the borrower. The FHA insures a loan and in return
regulates many of the terms and conditions of the loan.
Characteristics of FHA Loans: A regular FHA-insured loan comes
with a 30-year term, though the borrower may get an option of a
shorter term. The property purchased with a FHA loan must be the
borrowers main residence and it may have up to four dwelling
units. All the FHA-insured loans need to have first lien position.
A FHA loan down payment is comparatively less than for a
conventional loan financing the same purchase. All FHA loans need
mortgage insurance, irrespective of the size of the down payment. A
FHA loan may be paid off at any time without any prepayment
penalties.
FHA Loan Amounts: The intentions of the FHA programs are to aid
low and middle income individuals to buy a home. Therefore, HUD
sets maximum loan amounts and limits the size of loans that can
be insured under its programs. FHA maximum loan amounts are
based on median housing costs in every area, so they vary from one
place to another. An area with expensive houses has higher
maximum loan amount than an area with lower-cost homes.
A ceiling for the FHA loan amount applies countrywide, irrespective
of how high the prices in any particular area may be. FHA loans
cannot go beyond that ceiling. The FHA loan ceiling is attached to
the conforming loan limits for conventional loans and is bound by
annual adjustments.

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The size of an FHA loan for a certain transaction is limited by the

maximum FHA loan amount in the area where the property is
located and also by the minimum cash investment requirement
(discussed below).
Minimum Cash Investment and LTV: The FHA needs the borrower
to make a down payment of at least 3.5% of the sale price of the
property. This is referred to as the borrowers minimum cash
investment.
Due to this requirement, the maximum loan-to-value ratio for an
FHA loan is 96.5% of the appraised value or sale price of the
property, whichever is less.
Since the loan-to-value ratio is comparatively high, the amount of
cash a FHA borrower may need for closing will be much less than
what a conventional borrower would need for the same purchase.
FHA Qualifying Standards: Just as with any other institutional
mortgage loan, the underwriting for a FHA-insured loan also has to
go through the evaluation process of the applicants credit history,
income, and net worth. But the underwriting standards of the FHA
loans are less stringent than the Fannie Mae/Freddie Mac
standards used for conventional loans. It is easier for a low- or
middle-income individual property buyer to qualify for a mortgage
loan via the FHA standards.
Income: Two ratios are applied by the underwriter who is evaluating
an application for a FHA loan to determine the sufficiency of the
applicants income. First is the housing expense-to-income ratio,
second is the debt-to-income ratio. The maximum income ratios of
the FHA are higher than those set for conventional loans. This
indicates that the FHA borrowers mortgage payment including his
other monthly obligations could compose a larger portion of his
income as compared to a conventional borrowers.
Though the FHA programs are aimed at low- and middle-income
buyers, there is no set maximum income limit. Even a high income
individual could qualify for a FHA loan provided that the requested
loan does not go beyond the maximum loan amount for the area.

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Funds for Closing: A FHA borrower, at closing, must have enough

funds to cover the minimum cash investment, any discount points
he may have agreed to pay and any other closing costs. Reserves
after closing are not required from a FHA borrower.
FHA Insurance Premiums: Mortgage insurance premiums for FHA
loans are normally called MIPs. One-time premium and annual
premiums, both are paid by the FHA loan borrowers. There is an
option of paying the one-time premium either at closing or finance it
along with the loan amount and pay it off over the loan term.
Assumption of FHA Loans: FHA loans that were made before 1990
can be assumed without the lenders approval, provided that the
seller does not need a liability release. Loans made after 1990 can
only be assumed by a buyer who meets the FHA underwriting
standards. The property must be the buyers primary residence.

Rural Housing Service Loans

The Rural Housing Service (RHS) is a federal agency with the U.S.
Department of Agriculture which makes and guarantees loans.
These loans are used to purchase, build, or rehabilitate homes in
rural areas. These loans are termed as Rural Development Loans
or RD loans.
The definition of a rural area is a town not adjacent to, or a suburb
of a city, with a population of 10,000 or less. Some specified
conditions allow a town with a population of up to 20,000 to be
considered as rural, too.
A borrower must be without a sufficient housing facility to qualify
for a RHS program. He must have a reasonable credit history and
should be able to afford the proposed mortgage payments. A home
purchased, built, or improved with a Rural Housing Service loan
must not be lavish in size and design.
Direct Loans: Borrowers in the low-income category (those who
have income no more than 80% of the area median income) may
obtain financing from RHS for 100% of the purchase price. As per
the income level of the borrower, the loan term may be as long as
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38 years. The interest rate is set by RHS and the loan, too, is
serviced by RHS.
Guaranteed Loans: Loans made by approved lenders to the
borrowers (whose income is not more than 115% of the area median
income) are guaranteed by the Rural Housing Service.
Approved lenders comprise state housing agencies, FHA and VAapproved lenders, and lenders taking part in other RHS-guaranteed
loan programs. Loan amounta may be the full purchase price of the
property. The interest rate is fixed by the lender, its term 30 years.
VA-Guaranteed Loans
The VA-guaranteed home loan program was set up to help veterans
finance the purchase of their homes with affordable loans. There
are many advantages of VA financing over conventional financing.
The program is controlled by the U.S. Department of Veterans
Affairs (the VA).
Eligibility for VA Loans: The basis of eligibility for a VA home loan
is the length of active duty service in the U.S. armed forces.
Depending on when the veteran served, the minimum requirement
varies from 90 days to 24 months. (Longer periods will be needed
for peacetime service than for wartime service.) The basis of
eligibility may also be longtime service in the National Guard or
Reserves. The military personnel who were dishonorably discharged
are not eligible for a VA loan.
The surviving spouse of a veteran may be eligible for a VA loan,
provided that he or she has not remarried and that the veteran died
in action or died of service-related injuries. A veterans spouse is
also eligible if the veteran is listed as missing in action or if he/she
is a prisoner of war.
Application Process: A veteran is supposed to apply to an
institutional lender and provide a Certificate of Eligibility issued
by the VA, in order to acquire a VA-guaranteed loan. The loan
application will be processed by the lender and will be forwarded to
the VA. It is noteworthy that the Certificate of Eligibility is not a
confirmation that the veteran will qualify for the loan.
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The veterans desired property for purchase must be appraised in

compliance with the VA guidelines. The appraised value is provided
in a notice of value document (NOV). This is also termed as a
Certificate of Reasonable Value (CRV).
An approved VA loan is guaranteed by the federal government. In
case the borrower defaults, the VA has to reimburse the lender for
all or part of the losses suffered as a result of the default. The loan
guaranty functions just like mortgage insurance, it protects the
lender from suffering huge losses due to non-payment of the loan
by the borrower.
Characteristics of VA Loans: Financing the purchase or
construction of a single-family residence or a multi-family residence
with up to four units can be done through a VA loan. The veteran
must occupy the home or at least one of the units.
VA-guaranteed loans appeal to borrowers for reason such as:
A VA loan does not require a down payment (unlike most other
loans). The amount of the loan may be as much as the sales
price or the appraised value, whichever is less. This means
that the loan-to-value ratio may be 100%.
VA loans are not confined to low- or middle-income buyers,
neither does it set a maximum loan amount nor impose any
income restrictions.
VA underwriting standards are more
conventional underwriting standards.

lenient than

the

Under VA loans, mortgage insurance is not required.

A VA borrower needs to pay a funding fee which is currently 2.15%
of the loan amount for many first-time VA borrowers. This fee is
less if the borrower agrees to pay a down payment of 5% or more.
VA Guaranty: The VA guaranty covers just a part of the loan
amount, as set by the government. The maximum guaranty amount
is increased periodically. The amount of guaranty available to a
particular veteran is also called the vets entitlement.

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Since the guaranty amount is limited, a large loan amount may

pose some extra risk for the lender. Many lenders ask the borrower
to make a small down payment if the loan amount goes beyond a
certain limit (generally four times the guaranty amount). This limit
is set by the lender and not by the VA.
Reinstatement: A veteran is entitled to a full reinstatement of
guaranty rights for future use if he sells the property which was
financed with a VA loan and repays the loan in full from the sale
amount. But because of the owner-occupancy requirement, the
veteran has to prove a need for new housing in order to acquire a
new VA loan.
Substitute of Entitlement: In case a home purchased with a VA
loan is sold and instead of being repaid the loan is assumed, the
veterans
entitlement
may
be
restored
under
specified
circumstances. The buyer assuming the loan has to be an eligible
veteran and he/she must be willing to substitute his entitlement for
the sellers. The loan payments have to be current and the buyer
should be an acceptable credit risk. Only if these conditions are
satisfied can the veteran officially request a substitution of
entitlement from the VA.
A non-veteran who meets the VAs standards of creditworthiness
can also assume a VA loan, although the entitlement of the veteran
seller cannot be restored if the buyer who assumes the loan is a
non-veteran.
Qualifying Standards: The VA only uses the debt-to-income ratio.
The VAs maximum debt-to-income ratio is comparatively much
higher than the maximum normally permitted for a conventional
loan.
The underwriter also considers the veterans residual income along
with his debt-to-income ratio. The calculation of the residual
income is done by deducting the proposed mortgage payment, any
other recurring obligations, and some taxes from the veterans gross
monthly income. The residual income has to meet the VAs
minimum requirements. These requirements differ based on the
region of the country where the veteran resides, his family size and
the size of the proposed loan.
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For at least some loan applicants, it can be much easier to qualify

for a VA loan than for a conventional loan. Eligible veterans who are
looking to purchase a home should consider the option of VA
financing.
Cal-Vet Loans
Attractive loans are offered to eligible veterans by the state of
California. The program is known as the California Veterans Farm
and Home Purchase Program. The loans are called Cal-Vet loans,
which are used to purchase either a farm or a single-family home
(even a mobile home or a condominium unit).
The loans are processed, originated and serviced until they are fully
paid off by the California Department of Veterans Affairs.
The Cal-Vet program and the federal VA guaranty program work
differently from each other. With the Cal-Vet program, the state
purchases and takes title to the home which the veteran applicant
plans to purchase. Then, the state sells the property to the
applicant under a land contract. Throughout the contract term, the
title of the property is retained by the state and during this period
the veteran has an equitable interest in the property. After the
payment of the contract price, the state gives the veteran a grant
deed, which transfers the legal title.
Eligibility: For Cal-Vet eligibility, the veteran should have been
honorably discharged and should have served at least 90 days of
active duty. Veterans who are discharged from duty before 90 days
for service-connected disability are also eligible.
Even members currently on service are eligible for a Cal-Vet (on
completion of 90 days of active duty). Members of the California
National Guard or the Reserves are eligible only if they have served
for a minimum of one year of a six-year obligation. If a veteran has
expired due to injuries sustained while on duty, his surviving
spouse may obtain a Cal-Vet loan. The surviving spouse may also
be eligible for a loan if the veteran is designated as missing or as a
prisoner of war, or if he died after applying for a Cal-Vet loan.
Restrictions: There are some restrictions in some of the Cal-Vet
loans. They are:
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- The borrower has to either be a first-time home buyer or else

his purchase must be in an area which is deemed as
economically distressed,
- The purchase price of the property shall not go beyond a
specified limit, based on the average prices in the area,
- The family income of the borrowers shall not be more than a
specified limit and this varies depending on the size of the
family and the county where the property is situated.
Note that these restrictions are not applicable to all applicants. The
borrower interested in a Cal-Vet loan must check with the
California Department of Veterans Affairs to determine whether
they apply to him or not.
Cal-Vet Loan Application: Submission of a Cal-Vet loan
application can be made to the Department of Veterans Affairs
directly or to a mortgage broker who is expressly authorized to deal
in Cal-Vet loans.
Rules & Requirements of Cal-Vet: The Cal-Vet loans normally
apply the following rules and regulations:
Occupancy: Either the borrower or his immediate family has to
occupy the property within 60 days of closing the deal.
Transferring, encumbering, or leasing the property without proper
approval is prohibited.
Loan Term and Prepayment: The regular contract term for a CalVet loan is 30 years. The borrower has the option of paying off the
loan sooner than its term period. Cal-Vet loans are pre-payable
without any penalties. However, Cal-Vet loans cannot be assumed
by a buyer.
Guaranty or PMI: Even though the state sells the property to the
veteran under a land contract, the state acquires either a federal VA
guaranty or private mortgage insurance for the protection of its
interest, except if there is a down payment of 20% or more.
The borrower is charged a percentage of the loan amount as a
funding fee to pay for the VA guaranty or the PMI coverage. The
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percentage depends on the program and the size of the borrowers

down payment.
Loan Amount, Down payment, and LTV: The Cal-Vet loan
amount cannot go beyond the maximum loan amount fixed by the
state. There is no need for a down payment, if the loan has a VA
guaranty. Without such a guaranty, a down payment of a minimum
3% is needed, so that the maximum loan-to-value ratio is 97%.
Secondary financing is permitted, but the total borrowed amount
cannot be more than the appraised value.
Interest Rate: For Cal-Vet loans, the state sets an interest rate that
is below the market rate. This rate may vary over the term of the
loan but it cannot go more than 0.5%.
Other Fees and Points: The Cal-Vet borrower has to pay an
application fee, an appraisal fee, and 1% origination fee. There are
no discount points chargeable with Cal-Vet loans.
Life Insurance: Life insurance through the Cal-Vet program is to
be purchased by any new Cal-Vet borrower under the age of 62. In
case of the death of a borrower, the insurance pays from one to five
years of principal and interest installments on the loan. Once the
insurance proceeds have been applied, the heirs of the borrower
can go on with the loan payments if they choose, instead of selling
off the property to pay off the loan.
PREDATORY LENDING
The methods that corrupt mortgage lenders and mortgage brokers
use to take advantage of nave borrowers for their own profit is
referred to as predatory lending.
Real estate agents, appraisers, and home improvement contractors
at times have taken part in predatory lending schemes. Sometimes
a buyer or a seller also plays a role in deceiving the other party.
There is a greater likelihood of predatory lending to occur in the
subprime market. It is more common in refinancing and home
equity, and also affects home purchase loans.
Following are instances of predatory lending methods:
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 Predatory steering: Steering a buyer in the direction of a more

expensive loan when there is a possibility for the buyer to
qualify for a much cheaper one.
Fee packing: Charging interest rates, points, or processing fees
which are more expensive than the normal market rates.
Loan flipping: Incite a homeowner to refinance again and again
within a short period, without having any real benefit for the
buyer.
Equity stripping: Stripping away the equity of a homeowner
by overcharging fees on repeated re-financings.
Predatory property flipping: Purchasing a property at a
discount because a seller is looking for a quick sale, and then
quickly reselling it to a nave buyer for an inflated price. When
a real estate agent, appraiser, mortgage broker, and/or a
lender cheat the seller or the buyer by concealing the true
value of the property, it is an illegal act.
Disregarding borrowers ability to pay: The predator makes a
loan just on the basis of the value of the property, without
using proper underwriting standards to ascertain if the
borrower can afford the loan payments. In such scenarios,
most of the time the predator is someone who will not be
affected if the borrower defaults; a mortgage broker, for
example.
Fraud:
When
a
predator
misrepresents
or
hides
disadvantageous loan terms or charges exorbitant fees,
fabricates documents or uses other fraudulent means to
persuade prospective borrowers to enter into loan agreements.
Balloon payment abuses: When a predator makes a partially
amortized or interest-only loan with low monthly payments,
and does not reveal to the borrower that a big balloon payment
will be required in the near future.
Unfair prepayment penalties: Levying an abnormally large
penalty, unable to limit the penalty period to the first few years
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of the loan term, and/or charging the penalty even if the loan
is prepaid since the property is about to be sold.
Predatory lenders and mortgage brokers purposely target potential
borrowers who do not understand the deal they are entering into, or
are unaware that better options are available. Borrowers who are
elderly citizens, have a limited income, are less educated, or
unfamiliar with the English language are more likely to be targeted.
Elderly victims who have a great deal of equity in their homes but
are mentally impaired are the most common targets of refinancing
and equity stripping schemes.
There are federal and state laws enacted to restrain predatory
lending. The federal Home Ownership and Equity Protection Act
(HOEPA) passed in 1994 which added special restrictions on highcost mortgage loans to the Truth in Lending Act. Its scope was quite
limited and it applied only to very high-cost home equity loans and
refinancing. It was not applicable to home purchase loans.
In 2008-2009, Congress and the Federal Reserve made changes to
the Truth in Lending Act and Regulation Z that made them
applicable to more types of loans along with high-cost home
purchase loans (bound by special restrictions). This was in reaction
to the subprime crisis and the foreclosure epidemic.
Lenders charging high rates and fees on loans secured by the
borrowers principal residence have to make special disclosures,
they are not allowed to be involved in certain practices, and cannot
have certain provisions in their loan agreements.
The state of California even has its own predatory lending law. It
requires special disclosures and disallows certain practices and
provisions for high-cost loans. Similar to current federal law, the
state law applies to purchase loans, home equity loans, and
refinancing secured by the principal residence of the borrower.
MORTGAGE FRAUD
Mortgage fraud occurs when deception is used to obtain a mortgage
loan by defrauding the lender. It may be executed by borrowers, by
professionals in the mortgage industry or in the real estate
industry. In certain cases, the borrowers and professionals together
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carry out a fraudulent plan. Mortgage fraud is generally committed

by borrowers by providing false information on a loan application,
to acquire a loan they are not actually qualified for and purchase a
property. On the other hand, a real estate agent, an appraiser, or a
mortgage broker, generally commit mortgage fraud to make a profit,
by manipulating nave borrowers or property sellers.
In California, mortgage fraud is a felony, leading to a one-year
imprisonment. As per the relevant provision in the Penal Code, a
mortgage fraud is committed by a person if he does any of the
following during the mortgage lending process with an intention to
defraud:
- Purposely makes a misrepresentation or excludes information,
- Purposely uses or enables the use of a misrepresentation or
exclusion, being aware of the fact that it is deceptive,
- Receives any funds connected with a closing that he is aware
was due to a deliberate misrepresentation or exclusion, or
- Records a document, knowing it contains a deliberate
misrepresentation or exclusion.

Chapter Summary
A commercial bank may be a national bank chartered
(approved for doing business) by the federal government or it
may be a state bank chartered by a state government.
The savings and loans associations and savings banks are
sometimes collectively called thrift institutions or thrifts.
In the loan underwriting process, the evaluation of the
applicant and the property he plans to buy is done to verify
whether they meet the minimum standard set by the lender.
The Truth in Lending Act (TILA) is a federal consumer
protection law dealing with the issue of comparing loan costs.

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 Whenever a real estate agent negotiates a loan or executes

services for a borrower or a lender with regards to a loan, then
a disclosure statement becomes a necessity.
Any institutional loan that is not insured or guaranteed by any
government agency is a conventional loan.
The FHA has become part of the Department of Housing and
Urban Development (HUD), with insuring mortgage loans its
main function.
The VA-guaranteed home loan program began to help veterans
finance purchasing their homes with affordable loans.
The methods that corrupt mortgage lenders and mortgage
brokers use to take advantage of nave borrowers for their own
profit is referred to as predatory lending.

Chapter Quiz
1. A mortgage company:
a. is the same as a mortgage broker
b. is also called a mortgage banker
c. services loan but does not make them
d. arranges loans but does not service them

2. Which of the following will involve a balloon payment?

a. Fully amortized loans
b. Partially amortized loans
c. Fixed rate loan
d. Variable rate loan

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3. A fee that a lender may charge to increase the upfront yield on

the loan is called:
a. Discount points
b. Origination fees
c. Points
d. PMI

4. Unpaid interest rate when added to a loans principal balance

is called a:
a. Payment shock
b. Partial amortization
c. Negative amortization
d. Full amortization

5. In comparison to a 25-year amortized loan, a 30-year

amortized loan has:
a. lower monthly payments of principal and interest
b. higher monthly payments of principal and interest
c. more principal over the term of the loan
d. less interest over the term of the loan

6. An ARM is a:
a. Growing equity mortgage
b. Reverse annuity mortgage
c. Graduated payment mortgage

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d. Mortgage with interest rates that periodically change based

on an index

7. Most adjustable-rate loans are:

a. assumable
b. not assumable
c. disallowed for federal institutions
d. held by sellers

8. Once the quantity of the loan applicants stable monthly

income is determined, an underwriter measures the adequacy of
the income by:
a. Income ratios
b. Credit scoring
c. The consumer price index
d. Federal income tax tables

9. The main purpose of the FHA is to:

a. Provide a source of home-loan funds at low rates
b. Raise building standards on a national basis
c. Promote homeownership by insuring home loans
d. Provide stabilization to the housing market

10. Which of the following statements about the FHA is false:

a. Borrowers are not required to have reserves after closing
b. Mortgage insurance is a must on all loans
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c. The borrower must occupy his property as a primary

residence
d. A down payment is not required

11. A California veteran may have a home loan insured by:

a. Cal-Vet
b. VA
c. FHA
d. Fannie Mae

12. Excluding the down payment, a property buyer would pay

the lowest closing costs if the buyer was to secure a ___________
loan.
a. Cal-Vet
b. VA
c. FHA
d. Conventional

13. A Cal-Vet purchase loan must be applied for:

a. Before closing
b. Before a contract of sale is signed
c. Within one year of buying the property
d. before talking to a property seller

14. A VA loan can be assumed by:

a. Any buyer who has passed the credit check
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b. Any buyer, irrespective of creditworthiness

c. An eligible veteran only
d. An eligible veteran who agrees to a substitution of
entitlement

15. Which of the following is not a part of the primary mortgage

market?
a. Fannie Mae
b. Cal-Vet
c. FHA
d. VA

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CHAPTER 11
Real Estate Appraisal
CHAPTER OVERVIEW
Property value is the foundation of all real estate transactions. A
propertys value affects its selling price, financing terms, rental rate,
property tax assessment, and insurance coverage, and the income
tax that will be payable.
Apart from any emotional or personal considerations, the parties to
a transaction must also know how much the property is worth. For
this purpose the parties depend upon an appraisal. In this chapter
we shall study the concept of value and the different methods used
by the appraisers to estimate value.
An unbiased estimate or opinion of the property value on a given
date is termed as an appraisal. The appraisal report is the written
statement, stating the appraisers opinion of the value of the
property as of a given date. The appraisal is also called a valuation.

APPRAISAL: PURPOSE AND FUNCTION

The main purpose of an appraisal is to estimate value. Generally
the appraiser estimates the propertys market value (discussed later
in this chapter). The function of an appraisal refers to the reason
for which the appraisal is being made. For instance, the function of
the appraisal may be to help a seller decide on a fair listing price, or
to help a buyer decide what price will be a competitive one for a
particular property. Usually, the function of an appraisal is to help
a lender confirm that the property a buyer has chosen provides
suitable security for a loan, and if so, what should be the maximum
loan amount.

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Apart from helping to ascertain a fair price or a maximum loan

amount, an appraisers services are also generally required to:
Identify the highest and best use of raw land
Estimate the value of the property for taxation purposes
Establish rental rates
Estimate the relative value of properties being exchanged
Find out the necessary amount of hazard insurance coverage
Estimate the remodeling costs or their contribution to value
Help to establish fair compensation in a condemnation
proceeding, or
Estimate the value of properties included in the liquidation of
estates, corporate mergers and acquisitions, or bankruptcies.

The Appraiser-Client Relationship

An appraiser works for one of the following:
- A financial institution,
- A government agency,
- A private corporation,
- An active real estate department, or
- An appraisal company
An appraiser may even be self-employed. A self-employed appraiser
is hired to appraise a property for a fee, and he is sometimes called
a fee appraiser.
The person employing the appraiser is the client and the appraiser
is his agent. Thus, a principal-agent relationship is formed and the
laws of agency apply (discussed in chapter 8). Since a fiduciary
relationship exists between the appraiser and his client, the
appraiser is bound by the duty of confidentiality and is expected to
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discuss the results of the appraisal process only with the client
(unless he has the permission to discuss it with the third party).
Because of the duties imposed by the agency relationship, an
appraiser must disclose in the appraisal report if he has any
interest in the property being appraised. Also, if the appraiser is not
sure about any feature of the appraisal -- for example whether to
categorize a particular item as real or personal property -- then that
information should also be mentioned in the appraisal report.
The appraisers fee is fixed in advance, on the basis of the expected
difficulty of the appraisal and the amount of time it is likely to take.
The fee cannot be calculated as a percentage of the appraised value
of the property. It can also not be calculated according to the
clients satisfaction with the appraisal report.
Fannie Mae and Freddie Mac do not allow appraisers to have any
significant communication with the mortgage loan originator (MLO)
in a transaction. This is to ensure that the appraisers can prepare
their reports in an independent and impartial atmosphere. The
appraisals for the loans that are to be sold to the secondary market
agencies need to be arranged through an independent appraisal
management company or through a different department within the
lenders organization. They should not be done through an MLO or
anyone in the loan production department. Also, real estate agents
are not permitted to choose or compensate the appraiser in
transactions which involve loans which are to be sold to Fannie Mae
or Freddie Mac.
According to California law, it is illegal for someone with an interest
in a property to try to wrongfully influence the appraisal through
coercion, extortion, or bribery. On the other hand, it is permissible
to to ask the appraiser to consider extra information regarding the
property, explain the basis for his value estimate more clearly, or
correct mistakes in the appraisal report.

APPRAISERS LICENSING AND CERTIFICATION

Appraisers are licensed and certified by the state of California,
According to federal law only those appraisals that are prepared by
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state-licensed/certified appraisers in accordance with the Uniform

Standards of Professional Appraisal Practice (USPAP) are to be used
in federally related loan transactions. USPAP is a set of guidelines
adopted by a non-profit organization called the Appraisal
Foundation. An appraiser who does not abide by these standards
and defrauds a federally insured lender might be charged with a
felony. Most real estate loans are federally related, because the
category comprises loans made by any banks or savings and loan
association which is regulated or insured by the federal
government. However, this requirement is not applicable to
transactions for $250,000 or less.
It must be noted that for the purpose of the California appraisal
licensing law, the definition of an appraisal excludes opinions of
value given by real estate licensees in the normal course of their
real estate activities. So, a competitive market analysis made by a
real estate agent for listing purposes would not be considered as an
appraisal.
In California, appraisers are examined and issued a license by the
Office of Real Estate Appraisers. There are four levels of appraisal
licenses and for all these levels there is a 15-hour National USPAP
course completed as part of the educational requirements
mentioned below:
1. Certified General Real Estate Appraisers: may appraise any
kind of real estate. For this license, 300 hours of appraisalrelated education and 3,000 hours of appraisal experience
(including 1,500 hours of appraising non-residential
properties) is required. The appraisal experience should have
been gained over at least 30 months. There is also a
requirement for a bachelors degree, though 30 semester
credits in particular subject areas may be substituted for a
degree. An applicant for this license has to pass the Uniform
State Certified General Real Property Appraiser Examination.
2. Certified Residential Real Estate Appraisers may appraise
any one-to-four unit residential property, and any nonresidential property which is valued up to $250,000. For this
license, 200 hours of appraisal education and a minimum of
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2,500 hours of appraisal experience gained over at least 30

months is required. There is also a requirement of an
associate degree or 21 semester credits in specific subject
areas. An applicant has to pass the Uniform State Certified
Residential Real Property Appraiser Examination.
3. Residential License holders may appraise any one-to-four
unit residential property whose transaction value is up to $1
million and any non-residential property worth up to
$250,000. For obtaining this license, 150 hours of appraisal
education and a minimum of 2000 hours of appraisal
experience over at least 12 months (or 1000 hours of
experience for a California real estate broker license holder)
are required. An applicant is required to pass the Uniform
State
Licensed
Residential
Real
Property
Appraiser
Examination.
4. Trainee License holders have to work under the technical
supervision of a licensed appraiser. He may assist on any
appraisal within the scope of the supervisors appraisal
license. For this license, the applicant should have given 150
hours of instruction within the past five years and must have
passed the Trainee Level Appraiser Examination.
The validity of the appraisal license is two years. Renewing the
license requires the appraiser to pay a renewal fee and complete a
seven-hour National USPAP update course during the license term.
Plus, 14 hours of continuing education are necessary every
calendar year, with documentation of its completion to be
submitted every four years.

VALUE
A common definition of value is the present worth of future
benefits. Another definition is the ability of an item or service to
command other items or services in exchange. Value is generally
measured in terms of money.
Elements of Value
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To have value, a product must have the following four attributes,

known as the elements of value: Utility, scarcity, demand,
transferability.
In order to have value, a product must provide a service or fulfill a
need -- utility. But utility must co-exist with the other elements of
value, otherwise the product has zero economic value. For instance,
the utility of air is high but it is easily available and lacks scarcity,
so it does not command any economic value.
Normally, a scarcer item has greater value. For instance, if gold was
to become much more plentiful, its value would come down.
Another essential part of value is demand. If an item creates a
desire to own it, there is a demand for that item. When this desire is
matched with purchasing power, there is an effective demand.
Then again, if an item cannot be transferred from one party to
another, it will not have any economic value. Transferability is the
ability to transfer possession and control of the rights which
establish ownership of property.

Types of Value
There are two general classifications for value, for the purpose of
appraisal: value in use and value in exchange. The subjective
value that a person places on a property is the value in use while
the objective value of the property as noted by the average person is
the value in exchange. According to the circumstances, a
propertys value in use and value in exchange may greatly differ.
The more important of the two types of value is the value in
exchange. The value is exchange is commonly known as market
value. The purpose of most appraisals is to estimate a propertys
market value.
Market Value: The most accepted definition of market value is
taken for the Uniform Standards of Professional Appraisal Practice.
The most probable price which a property should bring in a
competitive and open market under all conditions requisite to a fair
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scale, the buyer and the seller each acting prudently and
knowledgeably, and assuming the price is not affected by undue
stimulus.
Note that as per the definition, market value is the most probable
price and not the highest price that the property should bring and
not will bring. Appraisals are more akin to estimation and
probability than certainty.
It should also be noted that market value is the most probable price
which needs to be paid if the purchase of the property is made
under regular conditions. The regular conditions imply:
- That the sale happened between unrelated parties,
- That the property was on offer in open market for a good
length of time,
- That both parties acted cautiously and knowledgeably, and
- That neither party was incited or abnormally pressurized.
A concise explanation of market value is offered by the Federal
Housing Administration as, The price which typical buyers would
be warranted in paying for the property for long-term use or
investment, if they were well informed and acted intelligently,
voluntarily, and without necessity.
Market Value/Market Price: Lets examine the difference between
market value and market price. Market price is the actual price
paid for the property, irrespective of the kind of scenario in which
the sale took place (for example, if the sale was done under any
pressure, or if the parties to the sale were well informed). Market
value, on the other hand, is the price that that should be paid if the
sale of the property was done under normal conditions.

Principles of Value
There are four main factors that influence our attitudes and
behavior to create, support, or destroy property value:
Social ideals and standards,
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 Economic fluctuations,
Government regulations, and
Physical and environmental factors.
A change in the thought process regarding family size and the
advent of the two-car family are instances of social forces that affect
the value of homes (here it would be homes with many bedrooms
and single-car garages). Economic forces would be employment
levels, interest rates and other factors affecting the peoples
purchasing power. Government regulations like zoning ordinances
are there to promote, stabilize or diminish the demand for property.
The physical and environmental factors affecting property values
are climate, earthquakes and flood control measures.
All of these four factors independently affect the value regardless of
the efforts of the owner. For example, inflation (an economic force)
causes an increase in the value of the property, even though the
owners has put forth no effort to improve the property. An increase
in the value of the property due to an outside force is referred to as
an unearned increment.
Since the last few years, appraisers have created a reliable body of
principles, called the principles of value which considers these
forces and accordingly guides appraisers in making decisions in the
valuation process. These principles are valid in any appraisal
method which is used to derive an estimate of value.
Principle of Highest and Best Use: The most profitable use a
property can be put to, the use that shall provide the best net
return to the owner over a period of time is the propertys highest
and best use. Net return generally refers to net income, but not
necessarily measured in terms of money. For example, in a
residential property, net return might be in the form of amenities -the feeling of satisfaction and pleasure of living on the property.
Deciding the highest and best use is basically a matter of
confirming that deed restrictions or an existing zoning ordinance
limit the property to its ongoing use. Usually the ongoing use of the
property is its highest and best use. Nevertheless, change is
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inevitable; for example, a warehouse site which was profitable at

one time might have stopped generating a strong net return.
Principle of Change: The principle of change maintains that real
estate values are fluctuating, moving up and down in response to
changes in the various social, economic, governmental, and
environmental forces affecting value. The property value also
changes according to the improvements or deterioration of the
property. Since the value of the property continually changes, it
becomes necessary that estimates of value should be attached to a
given date, termed the effective date of the appraisal.
In relation to the principle of change, there is the theory that
property has a four-phase life cycle: integration, equilibrium,
disintegration, and rejuvenation. Integration is also called growth or
development in the early stage, at the time when the property is
being developed. The period of stability, when the property goes
through very little change is called equilibrium. The period of
decline when the propertys economic usefulness is close to an end
and continual care-taking is required, is called disintegration. The
period of renewal, when the property is born again, probably with a
new highest and best use, is called rejuvenation (or revitalization).
The property can take different forms during the phase of
rejuvenation or revitalization. For instance, if the building is
reinstated to good condition without changing, it is called
rehabilitation. When the floor plan is altered or redesigned, it is
called remodeling. An entire neighborhood can be renewed by
redevelopment, when old buildings are demolished and rebuilt in
an urban renewal project.
In every property there is a physical life cycle and an economic life
cycle. The period when the land and its improvements are profitable
is the propertys economic life (or useful life). Before the physical
life begins, the economic life generally ends. These life cycles must
be taken into account by the appraisers while estimating the
present worth of any property.
Principle of Anticipation: The principal of anticipation states that
value is created by the expectation of future benefits. The present

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worth of future benefits is estimated by an appraiser, when he

assigns a value based on anticipated returns.
According to what knowledgeable buyers and sellers expect to
happen to the property in the future, anticipation may help or hurt.
The normal expectation is that the value of the property will
increase, but at times the anticipation is for the value to decrease
as a result of a recession.
Principle of Supply and Demand: Like all other marketable
commodities, real estate, too, is affected by supply and demand. In
the real estate industry, supply refers to the total number of a given
type of property for sale/lease, at different prices, at a given point of
time. Demand refers to the need and ability to acquire goods and
services through purchase or lease.
Increase in supply or decrease in demand will reduce the price in
the market. More supply and less demand will create a buyers
market. More demand and decreased supply will lead to a sellers
market.
Decrease in the property prices will lead to an increase in the value
of money since a given amount of money has more purchasing
power. Thus, the property buyer will get more for his money.
Principle of Substitution: The principle of substitution is the basis
of all three methods of the appraisal process. In simple terms, the
principle of substitution states that if two properties for sale are
desirable equally -- in terms of their use, design, or their projected
generated income -- the less expensive one will be in greater
demand.
Principle of Conformity: The principle of conformity states that
the more that structures are in harmony with each another, then
more will be the value of each of those structures. A propertys
maximum value is realized when its surrounding land use is
compatible and the nearby homes are similar in design and size.
This similarity is called conformity, and it maintains neighborhood
values. Non-conformity may work to the benefit or to the
disadvantage of the nonconforming home.

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The value of a much lower quality home than those around it is

increased by its association with the higher quality homes, referred
to as the principle of progression.
The principle of regression, on the other hand, is when the value of
a large, expensive home in a neighborhood of small, inexpensive
homes decreases because of its surroundings.
Principle of Contribution: This principle refers to the value of an
improvement as well as what it adds to the market value of the
entire property, irrespective of the actual cost of the improvement.
A remodeled basement may raise the value of the home, but
generally will not increase it as much as the remodeling costs, while
pa a new family home will increase the value of the home by more
than the cost of building it. Homeowners should keep in mind the
principle of contribution before they plan to change the character of
their home in such a fashion that it no longer fits in the
neighborhood.
Principle of Competition: Competition is another economic
principle which affects valuation. Buyers compete with each other
to buy the property while the sellers compete with one another to
attract those potential buyers. When two or more buyers compete
with each other to acquire a particular property, the one presenting
the best offer to the seller will be the one to obtain it. Here, buyers
are competing with one another to acquire a property.
Principle of Balance: This principle states that the maximum value
of real estate is achieved when the agents in production -- labor,
coordination, capital and land -- are in proper balance with each
other.
To confirm whether the agents in production are in proper balance,
the appraiser deducts a dollar figure which can be attributed to
each agent from the propertys gross earnings. First, the appraiser
deducts the wages (labor) which are allocated for the propertys
operating costs. Then, the appraiser subtracts the cost of property
management (coordination). After that, the appraiser deducts the
expense of principal and interest (capital), representing the funds
invested in the building and equipment. Whatever earnings remain
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after the first three productive agents have been deducted are
credited to the land for its participation in the production of the
gross income. This is termed the surplus productivity.
The credited amount to the land will reflect the lands value under
its current use. If there is an imbalance and much of the gross
earnings are credited to the land, the buildings are most probably
an under-improvement and the land may not be serving its highest
and best use. Also, if too little income is credited to the land, the
buildings might be an over-improvement, again implying that the
land is not serving its highest and best use.

THE APPRAISAL PROCESS

If it is carried out neatly, the appraisal process is orderly and
systematic. Though it is not an official procedure, the appraisers
normally carry out the process as follows:
1. Define the problem: Every client needs an appraiser to solve
a particular problem, to estimate the value of a particular
property, on a specified date and for a specified purpose.
Defining the problem to be solved is the first step in the
appraisal process. The subject property has to be identified, as
in what property and what traits of the property need to be
appraised. Usually, all of the elements of real property are
considered by the appraiser, such as the land and its
improvements, rights of landownership, and the property
utility. The value of land combined with its improvements is
called the improved value. The appraiser also has to
determine the function of the appraisal and how the client
plans to use it. The appraiser estimates the propertys value as
of the date the appraisal is performed (if not instructed
otherwise).
2. Determine the required data and where to find it: The data
on which the value estimate will be based on is divided into
two categories: general and specific.
General data: is related to matters outside the subject
property that affect its value. These are: population
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trends, zoning, predominant economic circumstances,

and proximity to amenities like schools, shopping,
transport and so on, and also the condition and quality
of the surroundings.
Specific data: is concerned with the property in question
itself. The appraiser has to collect information about the
title, the building and the site.
3. Collect and verify the general data.
4. Collect and verify the specific data.
5. Select and apply the valuation methods: Sometimes, the
appraiser tackles the problem of estimating value in three
different ways: with the sales comparison approach, the cost
approach, and the income approach. At other times, he uses
the method which might be the most appropriate one, for the
problem to be solved. Which approach is used depends on that
particular appraisers judgment.
In certain cases, a particular method cannot be used. For
instance, the cost approach cannot be used to appraise raw
land.
6. Reconcile value indicators for the final value estimate: The
figures produced by the three different approaches are called
value indicators. These give an indication of how much the
property is worth, though they are not final estimates by
themselves.
The appraiser considers the purpose of the appraisal, the type
of the property being appraised and the reliability of the data
collected for the three approaches. The appraiser then gives
maximum importance to the approach which appears to be
the most reliable indicator of value.
7. Issue appraisal report: The value estimate is presented
formally, with an explanation of the basis on which the value
estimate was made mentioned in the appraisal report.

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Gathering Data
Gathering necessary data is the next step after the appraiser has
found out what property is being appraised and the purpose of the
appraisal. The data is divided into general data and specific data (as
mentioned previously). Lets look at the two data types in detail:
General Data
General data consists of general economic data regarding the
community and neighborhood where the property is located.
Economic trends: The economic trends are surveyed by the
appraiser to discern clues as to the direction the propertys value
might take in the future. A series of related developments that form
a pattern is called a trend. Economic trends may happen at local,
regional, national, or international levels. Local trends have the
most substantial impact on the value of a property. Usually, when
the conditions are prosperous there is a positive effect on property
values while economic downturns have a reverse effect.
The economic forces comprise:
- Population growth shifts,
- Employment and wage levels (buying power),
- Price levels,
- Building cycles,
- Personal and property tax rates,
- Building costs, and
- Interest rates.
Neighborhood analysis: The value of a property is definitely tied to
its surrounding neighborhood. A neighborhood may be a
residential, industrial, commercial or agricultural area that includes
similar types of property. The property boundaries are established
by physical barriers like highways and water bodies, land use
patterns, the age or value of homes or other buildings, and the
economic status of the residents.
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Neighborhoods change constantly. Like the individual properties

that compose them, they have a four-phase life cycle: integration,
equilibrium, disintegration, and rejuvenation. When the appraiser
evaluates the neighborhoods future, he needs to consider its
physical, social and economic characteristics, and the governmental
influences, too.
The following factors are considered by the appraiser when he
gathers data concerning a residential neighborhood:
1. Percentage of home ownership: Are there more of owneroccupied homes or there is a predominance of rental
properties? It is a generally observed that owner-occupied
neighborhoods are better maintained and less prone to
deterioration.
2. Vacant homes and lots: If there are a large numbers of vacant
homes/lots it suggests a low level of interest in the area. This
has a negative effect on the property values. Conversely, busy
construction activities in a neighborhood indicate a strong
interest in the area and a positive impact on property values.
3. Conformity: The neighborhood homes must all be similar in
size, style, age and quality. Strict enforcement of zoning and
private restrictions encourages conformity and protects
property values.
4. Changing land use: If the neighborhood is in between a
transition from residential use to another type of use, then the
properties may lose its value.
5. Land
contour:
The
topography
should
neither
be
uninterestingly flat nor very hilly. Slightly rolling topography is
generally preferred.
6. Streets: The neighborhood streets should be hard-surfaced
and well maintained. Streets which are wide and gently
curving with short dead-ends are always better than narrow,
straight streets.
7. Utilities: The neighborhood must be well serviced by electricity,
water, gas, sewerage, telephones and cable TV.
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8. Nuisances: Nuisances in/near the neighborhood exert a big

drag on property values. Nuisances could be in the form of
odors from a near-by industry, noise or air pollution, exposure
to unusual winds, smog or fog and so on.
9. Prestige: If the neighborhood is more prestigious compared to
others in the community, its property value will increase.
10. Proximity: Whether the neighborhood is close to the traffic
arterials, and important locations such as schools, hospitals,
shopping, and employment centers.
11. Public Services: The neighborhood needs to be properly
serviced by public transport, police and fire stations.
12. Government influences: Determine whether zoning in and
around the neighborhood is aiding residential use and
insulating the property from nuisances. Also, whether property
taxes are comparable with those of other neighborhoods in the
vicinity. If the property taxes are high, new constructions may
be discouraged.

Specific Data
Specific data concerns the property itself. Generally, the appraiser
evaluates the site which includes the land, utilities and the
improvements to the site which apply separately to the buildings.
This is standard in certain perspectives. For instance, a property
tax assessment proves the distribution of value between the land
and the improvements. Land is appraised separately to determine
whether it is worth too much or too little compared to the value of
the improvements. And, if an imbalance is there, then the land is
not serving its highest and best use. The main objective of site
analysis is to ascertain highest and best use.
Site Analysis: A detailed site analysis would mean collecting a good
amount of data concerning the propertys physical features and also
the factors that affect its use or the title. The following are all
included in a sites physical features:

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1. Width: Width is the lots measurements from one side boundary

to the other. Width may vary from front to back, for instance if
the lot is triangular in shape.
2. Frontage: This is the length of the front boundary of the lot,
which usually lies adjacent to a street or a water body. The
frontage of a lot is of more significance than the width because it
measures the approachability of the property, or its approach to
something desirable.
3. Area: Area is the size of the site which is measured in square feet
or acres. While comparing lots the focus is generally on the
features of frontage and area.
Commercial land-retail property in particular, is often valued in
terms of frontage. This means that it is worth a certain number
of dollars per front foot. Industrial land, on the other hand, is
generally valued in terms of square feet or acreage. The
residential lots are measured in both ways, i.e. by square feet or
acreage most of the times and by front feet if the property is
adjacent to a lake or river or any other desirable feature.
Sometimes, newly subdivided land is measured in commercial
acres. By commercial acre, it is meant the buildable portion of
an acre that is left after the part of the land is dedicated for
streets, sidewalks, and parks.
4. Depth: Depth is the distance between a sites front boundary and
its back-side boundary. The greater the depth (more than the
norm), usually, the higher the value. For instance Lot A and Lot
B have a similar amount of frontage along a river, but Lot B is
deeper than Lot A. However, Lot B is not necessarily more
valuable than Lot A. The extra square footage of Lot B may be
simply considered as excess land.
Every situation needs to be analyzed independently. Remember,
even if greater or lesser depth affects value, the increase or
decrease in value is generally not proportional to the increase or
decrease in depth.
There are many rules of thumb regarding the relationship
between depth and value. The most common of these is the 4-3276

2-1 rule. According to this rule, the front quarter of a lot holds
40% of its overall value, the second quarter holds 30%, the
quarter after that holds 20%, and the rear quarter holds 10% of
the value. (This is because the accessibility of the rear part of the
lot is less, so its value is also less.)
Sometimes a depth table is used to evaluate how the depth of a
lot affects its value. This table uses mathematical factors that
can be multiplied by the front foot value of a standard lot to
estimate the value of a lot with a specified depth. Depth tables
are not thought to be accurate enough for the majority of
appraisal purposes. Yet, depth tables are used sometimes by tax
assessors when they evaluate commercial property for tax
purposes.
In some cases, two or more adjoining lots are combined together
to achieve greater width, depth or area to make the parcel more
valuable than the sum of the values of its singular parcels. The
increase in the property values that results when two or more
lots are combined is called plottage. Usually, it is industrial or
commercial land development projects that are involved in this
process of assembling lots to increase their total value.
5. Shape: Lots that are uniform in width and depth, such as
rectangular lots are always more useful than irregularly shaped
lots. This holds true for residential, commercial or industrial lots.
6. Topography: An aesthetically appealing site is usually more
valuable. Rolling terrains are more preferable to flat, boring
land. Conversely, if the site is located well above or below the
street or is extra hilly, it would cost more to develop so its value
would lessen.
7. Utilities: Site analysis also involves an investigation of the
availability and cost of utility connections. Parcels located
remotely lose value because the cost of bringing utility lines to
the site may be too high or even unaffordable.
8. Site in relation to area: The location of the lot in relation to its
surrounding areas influences its value. For example, a
restaurant which is located on a corner will often be worth more,
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since it will enjoy more exposure and its customers will have
access to it from two different streets. The effect of the corner
location on the value of a business site is called corner
influence.
On the other hand, a residential propertys value is lower if it is
located on a corner, since a corner lot is exposed to more
thorough traffic than a lot in the middle of the block.
Building Analysis: The improvements to the site and special
amenities, if any, must also be analyzed. Amenities are appealing
features like a beautiful view, or a lovely landscape and so on.
Although the functional utility of a home is based on the
requirements and choices of its occupants, certain basic
considerations that apply to the majority of homes.
Quality of construction: Determining whether the quality of the
materials and workmanship is good, average or bad. Other factors
are:
1. Age and condition: How old is the home is and is its overall
condition good, average or bad. In case the foundation shows
signs of cracking, or doors and windows do not open and close
neatly, the appraiser might suggest a soil engineers report (to
check the soil stability).
2. Size of the property: The square footage is calculated using the
outside dimensions of the house. In the square footage, the
improved living area is included, but not the garage, basement,
and porches. Commercial buildings and warehouses, too, are
measured using square feet.
3. Orientation: This means the positioning of the building on the
property in regards to its views, privacy factor, exposures to
sunlight, wind and noise.
4. Basement: An operational basement, especially a finished one,
adds to value. But as mentioned before, the amount a finished
basement contributes to value is generally, not enough to cover
the cost of the finished work.

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5. Layout of the interiors: The floor plan is analyzed regarding

whether it is purposeful and convenient. The plan should not be
designed so that it becomes necessary to pass through a public
room to access other rooms, or pass through one bedroom to
reach another room.
6. Number of rooms: The appraiser adds up the total number of
rooms on the property, without counting the bathrooms and
often, any basement rooms.
7. Number of bedrooms: The number of bedrooms will have a huge
influence on value. A two-bedroom property will be worth much
less than a three-bedroom property.
8. Number of bathrooms: The number of bathrooms does have a
reasonable effect on value. A full bathroom consists of a lavatory
(wash basin), toilet, bathtub and shower; a three-quarter
bathroom has a lavatory, toilet, and either a bathtub or a shower;
and, a half bathroom consist of a lavatory and toilet only.
9. Air conditioning: In hot regions of the country, the presence or
absence of air conditioning system holds importance.
10. Energy efficiency: With energy costs constantly rising, an energyefficient home will surely be more valuable. The energy-saving
features that increase value are double-paned windows, good
insulation, and weather stripping.
11. Garage: Generally an enclosed garage is believed to be much
better than a carport. An appraiser looks at how many cars the
garage can accommodate, if the garage also has work and storage
facilities, and whether it is possible to enter the house from the
garage directly (protected from the weather).

METHODS OF APPRAISAL
After collecting the necessary general and specific data, the
appraiser starts to apply one or more of the three methods of
appraisal:
The sales comparison approach
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 The cost approach, and

The income approach
Different appraisal methods are used to appraise different types of
properties. For instance, older residential properties and vacant
land are generally appraised through the sales comparison method.
Buildings like churches, public libraries, and court houses do not
generate income and are not sold in the open market, therefore the
cost approach is always used. The income approach is generally
used for appraising an apartment complex.

Sales Comparison Approach to Value

The sales comparison approach is also known as the market data
approach. This is considered to be the best method for appraising
residential property, and also the most dependable method of
appraising raw land. This method compares the subject property to
similar properties which have been recently sold. These are referred
to as comparable sales or comparables.
The appraiser collects relevant information about comparables and
then makes point-by-point comparisons with the property in
question. The findings of the appraiser are then translated into an
estimate of the market value of the subject property. This method is
used by the appraiser whenever possible since the sales prices of
the comparables (which reflects the choices of informed buyers and
sellers in the market) are the best indicators of market value.
An appraiser needs at least three dependable comparable sales to
mine sufficient data for the sales comparison approach for
residential property appraisal. It is normally not difficult to find
three suitable comparables, but when the market is inactive,
finding three suitable comparables becomes problematic. The
appraiser then can then turn to the alternative appraisal methods,
either the cost approach or the income approach.
Essentials of Comparison: To confirm if a certain sale can lawfully
be used as a comparable, the appraiser checks the following

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features of the transaction, also called the primary elements of

comparison:
Date of comparable sale: The comparable sale should have been
made within the past six months, if possible. Only recent sales are
likely to provide an accurate depiction ofthe the latest happenings
in the market. In an inactive market when it is impossible to obtain
three lawful comparable sales from the previous six months, then
the appraiser may go back further. However, comparable sales
which are over one year old are usually not acceptable. Also, if the
market is going through a big time shift, like a rapid downward
swing during a recession, then comparable sales should not be
more than three months old.
When a comparable is used which is six months old (or three
months old in a fast-declining market), adjustments have to be
made for the time factor, keeping allowances for inflationary or
deflationary developments or other factors that may affect area
prices.
Location of comparable sale: Comparables should preferably be
selected from the same neighborhood where the subject property is
located. If legal comparables are not available then the appraiser
may look elsewhere, but at least the selected properties must come
from comparable neighborhood.
A comparable chosen from an inferior neighborhood may be
structurally identical to the subject property but will likely be less
valuable, as opposed to a comparable structurally identical to the
subject property in a superior neighborhood being more valuable
than the subject property. It is universally accepted that location
contributes more to the value of real property than any other
feature. A superior quality property cannot trump the adverse
effects on value caused by an inferior quality neighborhood.
Conversely, the value of a comparatively weak property is boosted
by a stable and desirable neighborhood.
Physical Characteristics: A property, to be qualified as a
comparable, must have physical characteristics -- construction
quality, design, amenities and so on -- that match those of the
subject property. The comparables price will be adjusted by the
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appraiser in case the comparable has a feature that is lacking in

the subject property or the comparable lacks a feature of the
subject property.
Terms of sale: The price that a buyer pays for a property can be
affected by the terms of sale. Attractive financing privileges, such as
seller-paid discount points or seller financing with special low
interest rates, may induce a buyer to pay a higher price than he
otherwise would have.
An appraiser must consider the influence the sale terms may have
had on the price paid for a comparable property. If the property was
offered on very favorable terms by the seller, then it is quite possible
that the sales price did not represent the comparableactual market
value of the comparable.
According to the Uniform Standards of Professional Appraisal
Practice, an estimate of the market value given by an appraiser
must clarify that its the most credible price:
- In terms of cash,
- In terms of financial arrangements equal to cash, and
- In other terms, specifically defined.
For the estimate based on pecial financial incentives and
concessions, the terms of those finances must be presented and the
appraiser has to estimate their effect on the value of the property.
Market data that supports the value estimate (comparable sales)
must also be similarly explained.
Conditions of sale: Lastly, a comparable sale can only be trusted as
an indication of the worth of the property only if took place under
normal conditions. Simply put, it is a deal between independent,
unrelated and well-informed parties, both free of unwanted
pressure, with the sale of the property made on an open market for
a good length of time.
The appraiser must probe the circumstances of each comparable
sale to determine if the price paid was influenced by conditions
which render it unreliable as an indication of value. For instance, if
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the property was sold just a few days before a preplanned

foreclosure sale, the sales price would invariably reflect the
pressure affecting the seller. Or if the buyer and seller were friends
or relatives, the price would be less than between two strangers. Or
the house may have been underpriced if it was sold on the same
day as it was listed. These few cases provide reasons to doubt that
the sales price would probably reflect the actual property value,
therefore the appraiser would not make use of these transaction for
comparable sale.
Comparing properties and making adjustments: An appropriate
comparison between the subject property and each comparable is
necessary to achieve an accurate estimate of value. If there are
more common aspects between the comparables and subject
property, it is easier to compare them. It will give an almost perfect
indication of the market value of the subject property. However, if a
subdivision is new, and the houses there are similar to one another,
the appraiser cannot find such ideal comparables. There are
possibilities of some significant differences between the
comparables and the subject property. Therefore, the appraiser
needs to make adjustments, considering the differences in time,
location, physical features, and sales terms, so as to get an
adjusted selling price for each comparable.
It is obvious that the more adjustments an appraiser has to make,
the less trustworthy will be the estimated value result. The
adjustments are a necessary part of the sales comparison approach,
which the appraisers try to keep to a minimum by choosing the best
available comparables.
The appraisers estimate of the subject propertys value is based on
the adjusted prices of the comparables, though the value estimate
is not an average of those prices. It must be kept in mind that the
original cost of the subject property is immaterial to the appraisal
process.
Use of listings: When a market is coming up from a dormant
period and comparable sales are hard to find, the appraiser may
compare the subject property to properties that are currently listed
for sale. The appraiser has to note that listing prices are generally
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high and represent the ceiling of the market value range. The
appraiser may also use the prices offered by the buyers (not
necessarily accepted by the sellers), although these cannot always
be confirmed because the records of the offers are not always kept.
Offers are mostly at the low end of the range of value. Actual market
value is usually somewhere between the offers and listing prices.
Remember, assessed values established for tax purposes are not to
be used in place of comparable sales.

Cost Approach to Value

The second method of appraisal is the cost approach method which
is based on the idea that the value of the property is limited by the
cost of replacing it. This school of thought follows from the principle
of substitution, i.e., if the price asked for a home is more than it
would cost to build a new one just like it, no one would buy it. The
estimate of value determined through the cost approach normally
represents the upper limits of the propertys value.
In the cost approach, an estimate is prepared on the cost to replace
the subject propertys existing buildings, and then the estimated
value of the site is added to it. The cost approach method is also
called the summation method because the value of the land and
the building are estimated separately, and then added up.
The three steps to the cost approach are:
Estimate the cost of replacing the improvements.
Estimate and deduct any ensued depreciation.
Add the value of the lot to the depreciated value of the
improvements.
Before going through these steps, let us first understand the
difference between replacement cost and reproduction cost.
Reproduction cost refers to the cost of building an exact replica of
the subject property, at current prices. Replacement cost is the
current cost of building a property with utilities equal to the subject
property, i.e. a building that can be used in the same style as the
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subject. If the subject property is a new home then the reproduction

cost and replacement cost may be the same. If the building is older
and was built exquisitely with expensive materials, then the
reproduction cost and replacement cost will be very different.
Therefore it is advisable for the appraiser to use the replacement
cost as his basis for estimating value. The reproduction cost would
be restrictive and would not represent the current market value of
the improvements.
Estimating replacement cost: This may be done in three ways:
1. The square foot method,
2. The unit-in-place method, and
3. The quantity survey method.
The square foot method: This method of estimating replacement
cost is the simplest of the three methods. This is also called the
comparative cost method. The average cost of construction per
square foot of a recently built comparable property is analyzed so
that the appraiser can calculate the square foot cost of replacing
the subject home. The number of square feet in a property is
calculated by measuring the outside dimensions of each floor of the
building.
The replacement cost of the subject propertys improvements is
calculated by the appraiser by multiplying the estimated cost per
square foot by the total number of square feet in the subject
property.
Obviously, the comparable property is not going to be exactly the
same as the subject property. There may be a variations in design,
size and the quality of construction which will affect the square foot
cost to some extent. If recently constructed comparables are not
available, then the appraiser depends on the current cost manuals
for estimating the basic construction costs.
Unit-in-Place method: In this method, the cost of replacing
particular components of the building, like the floor, ceiling,
plumbing and foundation are estimated. For instance, a certain
amount of dollars may be estimated per one hundred square feet of
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flooring. A second component estimate would be a certain amount

of dollars per square feet of water-proofing the roofs. All the
estimates are then added up by the appraiser to arrive at the
replacement cost of the entire building.
Quantity Survey method: This method comprises a detailed
estimate of the quantities and prices of construction materials and
labor. These are added to the indirect costs like building permits,
surveys and so on, to achieve an accurate replacement cost
estimate. This method is a complex and a lengthy one, so it is
mostly used by experienced contractors and price estimators.

Estimating Depreciation: Depreciation is a loss in value due to

any cause. When a used home is being appraised, it is presumed
that its value is less than a comparable new home, since it has
depreciated. Therefore, once the replacement cost is estimated (this
shows the worth of the new improvements), the appraiser estimates
depreciation.
Remember, the appraisers approach to depreciation is different
from that of an accountants. The accountants concern is with book
depreciation for taxations, while the appraiser looks at the actual
losses in the value of real property.
Note that the land never depreciates, only the property
improvements do. For an appraiser, land is indestructible and does
not lose its value.
Depreciation Types: Loss of value may be a result of physical
deterioration, functional obsolescence, or economic obsolescence.
Physical Deterioration: This loss in value happens as a result of
wear and tear, damage or structural defects. This type of
depreciation is easier to detect than the other ones. It is even easier
to estimate its effect on value.
Physical deterioration may or may not be curable. Depreciation will
be regarded as curable when the cost of rectifying it could be
recovered, at the time of the sale of the property. When the
depreciation becomes impossible to correct or the cost of correcting
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would be too much to be reasonable to do so, then it is considered

incurable. Physical deterioration that is curable is also referred to
as deferred maintenance.
Functional Obsolescence: Loss in value attributed to functional
inadequacies generally caused by age or poor architectural design.
For instance, a five-bedroom property which has only two
bathrooms might be considered functionally obsolete. Functional
obsolescence may or may not be curable.
Economic Obsolescence: This is also called external obsolescence.
This is a result of conditions outside the property like neighborhood
deterioration, zoning changes, traffic problems, poor access to main
centers like downtown areas and school or employment centers,
under-supply of buyers, over-supply of homes, recession or
legislative restrictions and other such problems. The main objective
of an appraisers neighborhood analysis is identifying external
obsolescence. Economic obsolescence is almost always incurable
because it is not in the control of the property owner.
It is noteworthy here that functional and external obsolescence
cause more loss of value than physical deterioration.
Computing Depreciation: The toughest part of the replacement
cost approach is an accurate estimation of how much depreciation
has accrued. Depreciation estimates are most of the time highly
subjective so they are only as reliable as the judgment and skills of
the appraiser making the estimates.
The two methods of estimating depreciation are direct methods and
indirect methods. The capitalization method and the market data
method are the indirect methods. The straight-line method and
the engineering method are the direct methods.
The capitalization method: When the capitalization method to
estimate depreciation is applied, the appraiser uses the income
approach to value (explained later) to estimate the current value of
the building. This statistic is called the capitalized value and it
should be lower than the replacement cost estimated by the
appraiser because the replacement cost implies what the buildings
would be if it were new. The amount of depreciation that has
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accrued is the difference between the replacement cost and the

capitalized value.
The market data method: In this method, the appraiser uses the
market data approach (sales comparison approach) to estimate the
current value of the building. Here too, the appraiser subtracts this
value estimate from the replacement cost estimate, to get the
depreciation amount.
The straight-line method: This method of depreciation estimation is
the easiest to use. The appraiser estimates the economic life (useful
life) of the property, assuming it were new. Then he divides the
estimated useful life by the buildings replacement cost to find out
how much depreciation would occur each year, if it is assumed that
the improvements lose value equably over the years. The annual
depreciation amount is then multiplied by the age of the property.
Note that while considering the age of the property, the appraiser is
concerned with its effective age, not its actual chronological age.
The effective age is that which the appraiser trusts will be the
productivity of the structure in its current use. For instance, if the
appraiser believes a 100-year old property has 30 productive years
to go, and similar properties have a 40-year useful life, then the
buildings effective age would be 10 years old, and not 100 years
old. A buildings physical life is essentially longer than its useful
life.
Straight-line depreciation is also articulated as a percentage of the
propertys useful life. The useful life (40 years) is divided by the
propertys replacement cost (100% of its value) to arrive at the
percentage of its original value it will lose every year; 100% 40 =
2.5% per year.
The straight-line method is also called the age-life method, since the
depreciation estimate is based on the propertys effective age in
relation to a standard economic life.
The engineering method: This method is also called the observed
condition method. With this technique, the appraiser inspects the
structure and make observations regarding actual depreciation. The
results are based on the judgment and skills of the appraiser. This
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method of estimating depreciation is generally considered the most

reliable.

Adding Land Value: This is the last step of the replacement cost
process, with the value of the land being added to the depreciated
value of the improvements. The estimation of the value of the land
is done through the sales comparison method. Recently paid prices
of lots similar to that of the subject lot are compared, to arrive at
the worth of the subject lot. (This topic is discussed later in the
chapter.)

Income Approach to Value

The third method of appraisal, the income approach method is also
known as the capitalization method. Its notion is that the income
generated by a property (or the productivity of the property) is
related to its market value to an investor. Actually, the income
approach tries to ascertain the present value of the future income of
the property.
Gross Income: To use the income approach, the appraiser first
figures out the gross income of the property. This is achieved by
estimating the rent the property would demand if it were to be
rented out on the open market. The rent it would earn on the open
market is called the economic rent, while the rent which is
actually being earned is the historical rent or the contract rent. A
propertys earnings potential can be measured by the economic
rent. The track of rent increases or decreases is a strong sign of
whether the rent is on par with the economic rent.
The economic rent of the property is also called its potential gross
income or gross scheduled income. This would be the income of the
property if it was fully occupied and all rent were duly collected. But
it is not possible that rental properties are occupied all the time
throughout their productive life. There are bound to be times when
there were some vacancies. There may be tenants who do not pay
their rent. Therefore, the appraiser has to allow for deductions from
the potential gross income for recurring vacancies and unpaid
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rents. This is called a bad debt and vacancy factor, and it is a

percentage of the potential gross income. For instance, a 4%-5%
deduction may be made by the appraiser for the potential gross
income as a bad debt and vacancy factor. After the deduction of the
bad debt and vacancy factor, the appraiser now has a reliable
income figure which is called the effective gross income.
Operating Expenses: The appraiser deducts the expenses
connected with operating the building from its effective gross
income. Expenses fall into three divisions:
1. Fixed expenses: These comprise property taxes and hazard
insurance.
2. Maintenance expenses: These would be tenant services, utilities,
cleaning, repairs, supplies, administrative costs, and building
employee salaries.
3. Reserves for replacement: These are regular allowances which are
kept reserved to replace structures and equipment that may wear
out, like roofs, air conditioners, heaters and kitchen ranges and
refrigerators in residential units.
The income left after the deduction of the operating expenses from
the effective gross income is the net income. The net income is
capitalized to find out the value of the property.
From the appraisers point of view, certain expenses such as the
owners income taxes, the depreciation reserves and the mortgage
payments are not considered to be operating expense. Thus, these
are not deducted from the effective gross income to get the net
income.
Capitalization: Capitalization is the process of converting the net
income into a meaningful value. Mathematically the formula of the
procedure is:
Annual Net Income Capitalization Rate = Value
The capitalization is the rate of return a potential buyer (investor)
would expect to get on the money invested by him in the property
(i.e. on the purchase price). When the rate of return is chosen by
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the investor, it is inserted into the formula given above. When the
net income is divided by the desired rate of return, the investor can
ascertain how much she can pay for the property and also achieve
the desired return.
Recapture: Generally, a capitalization rate has to take into account
the investors desired rate of return on the investment and also the
return of the investment. Interest is a return on an investment. It is
the investors profit on the money he invested in purchasing the
property. The return of an investment relies on the investors
proficiency in regaining the purchase price of the property at the
end of the ownership term. This return of the investment is termed
as recapture.
The part of the purchase price accredited to the land does not need
to be recaptured during the investment period as land is
indestructible and its value can be regained when the property is
sold. However, improvements will wear out. Since the purchase
price of the improvements will not be recovered when the property
sells, the majority of the investors want to include a provision for
recapturing their original investment in their capitalization rate.
This means a provision of recapture is added, in the expectation of
the accrual of future depreciation. A capitalization rate providing for
interest and recapture is called an overall rate.
Selection of capitalization rate: When the appraiser uses the
income approach to appraise a property, he should be aware of the
rate of return that normally the investors would demand for similar
properties.
There are many ways by which the appraiser may arrive at a correct
capitalization rate for a property. For example, the appraiser can
analyze recent sales of comparable income properties and suppose
that the subject property will have a similar capitalization rate. This
is the direct comparison method.
There is also the band of investment method of selecting a
capitalization rate. According to this technique, the current
mortgage interest rates are taken into account, and applied to the
investors loan, in addition to the rate of return needed on the
investors equity investment.
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Summation method is the third method of selecting a

capitalization rate. In this process, the capitalization rate is built up
for the subject property by taking into account the four elements of
a capitalization rate and assigning an appropriate percentage to
each element. These are then added up together and a total rate is
achieved. These four elements are:
- Safe rate: This is the rate paid on secure investments like
savings accounts or long-term government bonds.
- Risk rate: This is the part of the rate made to repay the
investor for the hazards that are distinctive to the investment.
This element may increase or decrease depending on the
degree of risk involved.
- Nonliquidity rate: This is the extra return an investor expects
from a non-liquid investment such as real estate.
- Management rate: This part of the rate compensates the
investor for managing the investment and reinvesting the
money gained from the investment.
Regardless of the method used for the selection of the capitalization
rate, the two most important aspects are the quality and durability
of the income from the investment property. The risk factor is
influenced by quality, the reliability of the tenant and durability,
how long can the income be expected to last. If the risk is high, the
capitalization rate will also be high and the propertys value will be
lower. While if the risk is small, the capitalization rate will be low
and the property value will be high.
Methods of Capitalization: After the net income of the subject
property is calculated and a capitalization rate is chosen by the
appraiser, the third step in the income approach is capitalizing the
income of the property to reach an estimate of value. Depending on
the situation, the appraiser uses one of the three capitalization
methods which are: building residual technique, the land residual
technique, and the property residual technique.
In the first two methods, the land and the building are separately
valued. The reason why the capitalization methods are called
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residual techniques is because something left over,

capitalized.

residual,

is

The building residual technique: The first step in the building

residual technique is that the land is valued separately from the
building. The appraiser then deducts the portion of the income
which must be attributable to the land from the propertys annual
net income to justify its value. The remaining amount left over is
the income that will be credited to the building. The eventual step
will be to divide the net income attributable to the building by a
suitable overall capitalization rate to compute the value of the
building.
When the land values are reasonably stable and can be determined
easily (due to a preponderance of comparable sales and market
data), the building residual method is most reliable. This method is
also chosen to appraise older buildings for which depreciation is
difficult to measure.
The land residual technique: In this technique, the building is
separately appraised. After that, the attributable net income of the
building is deducted to figure out the net income to be credited to
the land. The earnings of the land are then capitalized to state the
value of the land. It should be noted that here the capitalization
rate used is just an interest rate, without a recapture provision,
since the land does not depreciate.
This method of appraisal is particularly used when the value of the
land cannot be estimated by the sales comparison method due to
the unavailability of comparable sales. The land residual technique
is also used when the buildings built on the land are new and
symbolize its highest and best use.
The property residual technique: This technique treats the land
and the building as one. When using the land residual or building
residual technique is difficult or unreasonable to apply, then
property residual technique is used.
Gross Income Multipliers: Normally, residences are not considered
as income-producing properties, so the usual income analysis
techniques are not applicable here. If the income approach is at all
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used by the appraiser for residential homes, he implements a

simpler version called the gross income multiplier method. This
method can be applied only to appraise rental properties. This
method is also referred to as the gross rent multiplier method,
because rents are the only mode of income produced by rental
properties.
According to this method, the appraiser considers the relationship
between a rental propertys income and the price paid for the
property.
A market for rental property will develop where some rental
properties contend with each other for tenants. Because of the
competition, the rents charged for similar properties are almost the
same within the same market. So, if one rental property has a
monthly income which is 1.5% of its selling price, comparable
properties will have similar income-to-price ratios.
A monthly multiplier is found by dividing the sales price by the
monthly rental income.
Once a minimum of four comparable residential rental properties
are located, the appraiser can find out their monthly or annual
gross income multipliers (appraiser may choose either of the two) by
dividing the rents by their respective selling prices.
The multipliers of the comparables are used by the appraiser to
obtain an appropriate multiplier for the subject property,
considering the similarities and differences between the properties.
After that, the rent that the subject property is generating is
multiplied by the chosen multiplier for an approximate estimate of
its value as income-generating property.
A major drawback of the gross income multiplier method is that its
basis is gross income figures, with vacancies or operating expenses
unaccounted for. For instance, if two rental properties have the
same rental income, according to the gross income multiplier
method they would be worth the same. But if one of the properties
is older and has a high maintenance cost, the net return for the
owner will be less while the property value will also be less.

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The appraiser preferably uses the subject propertys economic rent

rather than the contract rent (actual rent received by the owner)
while calculating the gross income multiplier.
SITE VALUATION
There are many conditions when an appraiser values a site, apart
from any improvements. A client may also ask that an unimproved
property (also known as vacant land or raw land) be appraised.
Conversely, when the improved property is being appraised, the
appraised may be asked to treat the site and the building
separately. (Such a request frequently arises while assessing the
property for taxation purposes.) Sometimes, the appraiser is asked
to appraise a property, on which a building needs to be torn down.
In such a case, the appraiser must appraise the site at its highest
and best use, and eventually deduct the cost of demolishing the
building.
There are four ways in which a site may be appraised:
- The sales comparison method,
- The land residual technique,
- The distribution method, and
- The development method.
The sales comparison method: Most appraisers prefer using this
method because it reflects the actions of educated buyers and
sellers in the market. In this method, the appraiser uses the sales
prices of recently sold vacant sites that are similar to the subject
propertys site to get an estimate of its value.
The land residual technique: As discussed before, this method is
site valuation by income approach and is used for improved
property. The appraiser finds the income attributable to the land,
and calculates the value of the land by capitalizing its income.
The distribution method: This method is also called allocation or
abstraction. Here, the appraiser analyzes the recent sales of
improved properties to determine the percentage of their sales
prices which include the land costs. If the lots account for around
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18% to 20% of the cost of the properties, the appraiser might

assume that the part of the subject propertys overall value
attributable to the land is around 18% to 20%.
The distribution method is less reliable than the sales comparison
method. The main drawback of this method is that in most cases
there are no stable land-to-property value ratios on which the
appraisers can rely.
The development method: This method is also called the
anticipated use method and it is employed often. It is used to
evaluate vacant land when the highest and best use of the land is
for subdivision and development. Here the appraiser evaluates the
future value of the developed lots and then deducts the costs of
development to derive the current value of the land.

RECONCILIATION AND FINAL ESTIMATES OF VALUE

During the course of the appraisal process, the appraiser is
gathering details on which the conclusion -- the final estimate of
the propertys value -- will be based. In most cases, the facts only
require simple verification, which is undisputable. In some other
cases, they may need expert analysis. Appraisers call the collection
and analysis of all the facts that affect the value of a property as
reconciliation. The experience and judgment of the appraiser is
most critical at this point of the appraisal process.
The final value estimate is that figure which signifies the expert
opinion of the subject propertys value after the assembling and
analyzing of all the data.
Once the final estimate of value is done, the appraisal report is
presented to the client by the appraiser. The reports are of two
types, the narrative report and the form report. In the narrative
report, a complete, detailed presentation of the facts and reasons
underlying the appraisers estimate of value is given in writing,
while a form report is a concise, standardized form used by lending
institutions and government agencies like the FHA and VA. The
form report report presents only vital data and the conclusion of the
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appraiser; it is the most common type of appraisal report, and

called the Uniform Residential Appraisal Report form.

Chapter Summary
An unbiased estimate or opinion of the property value on a
given date is termed an appraisal.
A self-employed appraiser is hired to appraise a property for a
fee, and he is sometimes called a fee appraiser.
A common definition of value is the present worth of future
benefits.
The purpose of most appraisals is to estimate a propertys
market value.
Sometimes a depth table is used to evaluate how the depth of
a lot affects its value.
Physical deterioration that is curable is also referred to as
deferred maintenance.
Economic obsolescence is almost always incurable because it
is not under the control of the property owner.
Capitalization is the process of converting the net income into
a meaningful value.
Appraisers call the collection and analysis of all the facts that
affect the value of a property as reconciliation.
Once the final estimate of value is done, the appraisal report is
presented to the client by the appraiser. The reports are of two
types, the narrative report and the form report.

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Chapter Quiz
1. An appraisal is :
a. An estimate of a propertys value as of a specified date.
b. A mathematical analysis of a propertys value.
c. A propertys average value, as indicated by general and
specific data.
d. A scientific determination of a propertys value.

2. The four element of value of real estate are:

a. Demand, depreciation, scarcity, and utility.
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b. Cost, demand, transferability, and utility.

c. Demand, scarcity, transferability, and utility.
d. Cost, feasibility, demand, and scarcity.

3. The owner of a vacant lot employs an appraiser to find out the

propertys:
a. Growth
b. Highest and best use
c. Replacement cost
d. Reproduction cost

4. The ultimate test of functional utility is:

a. Marketability
b. Utility
c. Design
d. Maintenance cost

5. The primary phase of a propertys life cycle at the time of its

development is called:
a. Equilibrium
b. Rejuvenation
c. Disintegration
d. Integration

6. The method of appraisal based on the principle of substitution

is the:
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a. Cost approach
b. Sales comparison approach
c. Summation approach
d. Income capitalization approach

7. The cubic-foot method of estimating construction cost is best

used for:
a. Industrial properties
b. Single-family residence
c. Multi-family residence
d. Manufactured homes

8. If an appraiser estimates all direct and indirect construction

costs of a particular building separately and then totals them.
He will most probably use the:
a. Index method
b. Quantity survey method
c. Unit-in-place method
d. Cost averaging method

9. General data is gathered by an appraiser in a:

a. Neighborhood analysis
b. Building analysis
c. Site analysis
d. None of the above

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10. The upper limit of a propertys value is generally found using

the:
a. Market comparison approach
b. Cost approach
c. Income approach
d. Sales comparison approach
11. The main cause behind the loss of value of real property is
normally due to:
a. Obsolescence
b. Deterioration
c. Passage of physical life
d. Lack of maintenance

12. Which of these would the appraiser use, if he has chosen the
income approach to determine the value of an apartment
building:
a. Excess rent
b. Percentage rent
c. Contract ren
d. Economic rent

13. While using the capitalization approach for appraisal, the most
challenging part is to determine the:
a. Capitalization rate
b. Net rate
c. Gross income
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d. Effective net income

14. When net income is calculated, ___________________ is not
deducted.
a. Vacancy losses
b. Mortgage interest
c. Management fees
d. Maintenance expenses
15. Of the four main ways of appraising a site, which one is also
known as the anticipated use method:
a. Sales comparison method
b. Development method
c. Distribution method
d. Land residual technique

CHAPTER 12
Settlement of Real Estate Transactions
CHAPTER OVERVIEW
There are certain matters that need to be finalized before a real
estate transaction can be closed. The services of real estate agents
are equally important during the closing of the deal as during the
marketing of the property prior to the sale. The guidance of the
agent throughout the closing period avoids unwanted delays and
should reflect her professional attitude.
In this chapter, we shall learn about the purpose of escrow and the
closing procedure. We will discuss the workings of the settlement
statements, the allocation of the closing costs, income tax aspects

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of closing, and the Federal Real Estate Settlement Procedures Acts

requirements.

CLOSING
After signing the purchase agreement, the parties and their agents
begin preparations to finalize the transaction. The process of
finalizing the real estate transaction is called closing or
settlement.
Every state has a different closing process. Some states have all the
parties involved in the transaction come together in person to sign,
exchange legal documents and transfer funds. In California and
some other states, the closing process is taken care of by a neutral
third party, by creating an escrow.
ESCROW
When money and documents are held by a neutral third party on
behalf of the buyer and the seller until the transaction is about to
close, it is called an escrow arrangement. The neutral third party is
called an escrow agent. An escrow agent is a dual agent, since both
the buyer and the seller are represented by him and he owes
fiduciary duties to both the parties.
Written escrow instructions are given by the parties to the escrow
agent, which detail under what conditions and the times when the
agent will distribute the money and the documents to the proper
parties. The escrow instructions are a bilateral contract, which is
between the buyer and the seller. Escrow agent (or the terms and
conditions of the escrow) cannot be chosen by one party without the
consent of the other party.
The escrow instructions generally are a reflection of the
requirements for the transaction which were mentioned in the
purchase agreement. In case of a conflict between the purchase
agreement terms and the escrow instructions, the escrow agent
usually complies with the latter of the two contracts -- the escrow
instructions. To avoid such a conflict, the escrow instructions can
be assimilated into the purchase agreement.
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The aim of the escrow is to make sure that the seller obtains the
purchase price, the buyer receives clear title to the property, and
the lenders security interest in the property is protected. The
parties are protected by the escrow, of any parties change of mind.
For instance, if the seller suddenly refuses to sell the property as
per the agreement, he cannot simply refuse to deliver the deed to
the buyer. When a deed has been given to an escrow agent, and if
the buyer fulfills all of the conditions stated in the escrow
instructions and deposits the purchase price into the escrow, the
escrow agent must deliver the deed to the buyer. Another plus point
of escrow is convenience, since the parties do not need to be
present at the closing of the transaction.
Escrow Services
To prepare a transaction for closing, the escrow agents carry out a
wide range of services. The following steps are involved in almost all
escrow closings:
- Ordering a title report from the title insurance company,
- Ordering inspections,
- Paying off existing loans secured by the property,
- Preparing the deed and other documents,
- Depositing funds from the buyer (and the seller too, if
required),
- Requesting the funding of the buyers loan,
- Allocating expenses and closing costs,
- Preparing settlement statements,
- Acquiring title insurance policies,
- Recording of documents, and
- Disbursing funds and delivering documents.
The escrow agents services are specific in nature. For instance, an
escrow agent will order a title report according to the escrow
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instructions, but he will not examine the report for the parties and
discuss any unexpected problems revealed by the report. It is up to
the parties to review reports and deciding whether to proceed with
the transaction.

Escrow Termination
When the transaction closes, the escrow terminates. The escrow will
also terminate if the terms of the escrow instructions have not been
fulfilled by the pre-arranged closing date (if no closing date has
been fixed, then within a reasonable time). It is a general rule that
the escrow can be terminated earlier only when both the buyer and
the seller mutually agree to the termination. None of the parties can
singly terminate the escrow, without the others consent. Even the
death or incapacity of a party cannot in itself terminate the escrow.
In case of a failed transaction, there might be a conflict between the
buyer and the seller over which of them is entitled to funds and/or
other items placed into the escrow. If the conflict between the two
parties is not resolved, then the escrow agent files an interpleader
action, taking the matter to the judiciary. The court will then decide
on the rightful owner of the items in escrow. The escrow agent is
not authorized to adjudicate a dispute between the parties.

Escrow Agents
In northern California, the title companies are generally the escrow
agents and in southern California, the independent escrow agents
normally close most of the transactions. Many institutional lenders
have their own escrow departments to close their own loan
transactions.
According to the California escrow law, all escrow companies must
be licensed by the state Department of Corporations. Individuals
are not eligible to be licensed as escrow agents, only corporations
are. Banks, savings and loans, insurance companies, title
companies, attorneys and real estate brokers do not require this
license since they are regulated by other agencies.
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The exemption from the escrow licensing requirement for real estate
brokers is actually limited to activities that requires a real estate
license which takes place in the course of a real estate transaction
in which one of the parties is represented by the broker or the
broker is herself one of the parties. Due to this exemption, brokers
are able to provide escrow services to their clients. The broker may
even charge for these services. The exemption does not allow real
estate brokers to act as escrow agents for transactions in which
they do not have any legal interest other than that of providing
escrow services.

CLOSING COSTS AND SETTLEMENT STATEMENTS

Apart from the purchase price -- inspection fees, title insurance
charges, loan fees, and so on -- there are a variety of other costs in
a real estate transaction known as closing costs. Some of these
closing costs are paid by the buyer, some by the seller. Some costs
are paid by one party to the other, as when the buyer may have to
repay the seller for property taxes the seller already paid. Some
closing costs are paid by one of the parties to a third party. For
instance, the seller may have to pay a pest inspectors fee.
There are also other payments to be made in regards with the
closing. For example, the seller may have an existing mortgage or
other liens to pay off. Confirming who needs to pay how much and
to whom at a closing might be a very complex issue.
Thus, for each transaction the escrow agent prepares a settlement
statement. A settlement statement is also called a closing
statement, and it lays out all of the financial aspects of the
transaction in detail. It states the exact amount that the buyer will
have to pay at closing and how much the seller will take away from
closing.

Preparing a Settlement Statement

The items listed on the settlement statement are debits or credits.
A charge payable by a particular party is a debit. A purchase price
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is a debit for the buyer while a sales commission is a debit for the
seller. Items payable to a party are a credit. For example, a buyer is
credited for a new loan and a seller is credited for the purchase
price.
There is more to a settlement statement than just ascertaining what
charges and credits apply to a said transaction and assuring that
each one is allocated to the appropriate party. While apportioning
expenses, an escrow agent usually follows the terms of the
purchase agreement or the escrow instructions. The allocation
could be determined by custom, too, assuming that the custom will
not conflict with the terms of the parties contract. For instance, in
most deals the buyer is the one who pays for the appraisal cost, so
that cost will be charged to the buyer by default. Nevertheless, if the
seller has agreed in the purchase agreement to pay the appraisal
fee, then the agreement takes precedence over custom and the
expense will be a debit for the seller on the statement.
Note that custom or agreement between the parties will not be
honored if they are against the local, state, or federal law.
It is true that a real estate agent normally will not be called upon to
prepare a formal settlement statement, but she should know what
closing costs are expected to be involved in a transaction and how
they are usually apportioned. The buyer and the seller may look to
negotiate the allocation of particular costs. The buyer and seller
should always know all the costs before signing a contract. A real
estate agent must have the ability to make a preliminary estimate of
closing costs for the parties.

Guide to Settlement Statements

The double entry accounting method is used in the simplified
settlement statement, so that each party may have a credit column
and a debit column. The total of the buyers credits should equal
the total of the buyers debits. Imagine the settlement statement to
be a check register for a bank account. The debits resemble the
checks written against the account, while the credits resemble the

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deposits into the account. At the closure of the transaction, the

balance in each partys account must be zero.
A payable item by one party to the other will appear on the
settlement statement as a debit for the party who is paying and a
credit for the receiving party. A good example is the purchase price,
which is a debit for the buyer and a credit for the seller.
If an item is paid by one of the parties to a third party, it shows on
the settlement statement in the paying partys debit column, while
it does not show in the other partys column at all. For instance, the
seller pays the documentary transfer tax to the county treasurer,
which is a debit for the seller, but it is not a credit for the buyer.
In the same way, some items are reflected as a credit for one party,
but not as a debit for the other party, an example being an impound
account for the sellers loan. If the sale terms call for the payoff of
the existing mortgage of the seller, any property tax, insurance, or
any other reserves held by the sellers lender are refunded. They are
a credit for the seller, but theyre not a debit for the buyer.
Settlement Charges: The following items might be reflected on the
settlement statement of a typical residential transaction:
Purchase price: It is paid by the buyer to the seller, listed as a debit
for the buyer and a credit for the seller.
Good Faith Deposit: In many transactions, the buyer gives the seller
a good faith deposit when the purchase agreement is signed. At the
closing of the transaction, the deposit is carried forward toward the
purchase price. Since the buyer has already paid the deposit, it
reflects on the settlement statement as a credit for the buyer. But,
because the full purchase price is a debit for the buyer and a credit
for the seller, there is no entry on the seller-side of the statement.
Sales Commission: The commission of the real estate broker is
generally paid by the seller, therefore it is entered as a debit for the
seller.
New Loan: To finance a part of (or all of) the sale price, the buyer
secures a new loan. The loan amount is listed as a credit for the
buyer. Like the deposit, the buyers loan is also part of the purchase
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price which is already credited to the seller, therefore again no entry

is made on the seller-side of the statement.
Assumed Loan: If the sellers existing loan is assumed by the buyer,
a part of the money is used to finance the transaction. Thus, it is
credited to the buyer. The assumed loan balance is a debit for the
seller.
Seller Financing: If a buyer gives a mortgage or deed of trust to the
seller for a portion of the purchase price, this shows up in the
buyers credit column, similar to an institutional loan.
Simultaneously, a seller financing arrangement reduces the amount
of cash receivable by the seller at closing, and so is listed as a debit
for the seller.
In case the property is sold under a land contract, the contract
price (minus the down payment), is a credit extended by the seller.
The sellers net at closing is reduced and is used by the buyer to
finance the purchase, so it is a debit for the seller and a credit for
the buyer.
Sellers Loan Payoff: If the seller has a loan to pay off, the escrow
agent requests for a beneficiarys statement from the sellers
lender. The loans remaining principal balance is stated in this
document. The loan payoff is a debit for the seller, while no entry is
made on the buyers side of the settlement statement.
Prepayment penalty: A sellers lender may impose a prepayment
penalty charge on the seller for paying off the loan before the end of
its term. This would be a debit for the seller on the settlement
statement.
Impound Account of Seller: As discussed before, the seller generally
has reserves or impounds on deposit with the lender to cover some
of the property-connected expenses. These expenses are referred to
as the recurring costs, which can include property taxes and
insurance, assessments, homeowners or condominium association
fees, or other periodic charges. However, the principal and interest
payments on the mortgage are not considered as part of the
recurring costs.

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During the loan term, the borrower may be requested by the lender
to make regular payments towards the recurring costs. These
payments are usually kept in an impound account, also called a
reserve account or an escrow account. The funds in the impound
account are used by the lender to pay taxes, insurance, and other
charges whenever they are due.
When the sellers loan is paid off, the unused amount in the
impound account is refunded back to the seller. This is reflected as
a credit on the seller-side of the settlement statement. In case a
buyer is assuming the loan and the impound account, the reserves
would reflect as a credit for the seller and a debit for the buyer.
Appraisal Fee: The appraisal fee is a debit for the buyer, since
appraisals are usually required by the buyers lender.
Credit Report: This is also a debit for the buyer because the lender
of the buyer charges him for the credit analysis.
Survey: At times, a lender needs a survey as a condition for making
the loan. Most often, the cost of the survey is a debit for the buyer.
Origination Fee: This is a one-time charge for the lender, from the
borrower, for setting up the loan. This fee is a debit for the buyer.
Discount Points: If the seller has not agreed to pay for a buydown,
the discount points will be a debit for the buyer. But in case of a
buydown payment from the seller, the discount points will be a
debit for the seller.
Assumption Fee: When the buyer is assuming the sellers existing
loan, a lender then charges an assumption fee, which is a debit for
the buyer.
Mortgage Insurance Premiums: In transactions with mortgage
insurance, the lender may need a certain number of premiums to
be paid in advance. These premiums are a debit for the buyer.
Owners Title Insurance Premiums: In northern California, the
premium for the owners title insurance policy which protects the
buyer is generally paid by the buyer, while in southern California it
is the seller who pays the premium.
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Lenders Title Insurance Premiums: The buyer is asked by the lender

to furnish an extended coverage policy to protect the lien priority of
the lender. The premium for this policy is a debit for the buyer,
unless agreed otherwise.
Sale of Personal Property: If the seller sells some personal property
along with the real property to the buyer, the price of these items
will be a credit for the seller and a debit for the buyer. At closing,
the seller must sign a bill of sale along with the deed to be delivered
to the buyer.
Inspection Fee: The cost of an inspection is allocated between the
parties by agreement. For instance, the cost of the pest inspection
may be paid by the buyer, while the seller pays for repairs, if
necessary.
Hazard Insurance Policy: The buyer is expected to pay for one to
three years of hazard insurance coverage by the lender in advance,
which is a debit for the buyer.
Documentary Transfer Tax: This tax is imposed on every sale of real
property in California, called an excise tax. It is generally paid by
the seller so it is listed in the sellers debit column.
Attorneys Fee: If a buyer or a seller appoints an attorney in the
transaction, he is responsible for the attorneys fees. The fees will be
reflected as a debit for the appropriate party on the settlement
statement.
Recording Fees: The recording fees for the various documents in the
transaction are always charged to the party who benefits from the
recording. For instance, fees for recording the deed and the new
mortgage are debits for the buyer, while the fee for recording a
satisfaction of the old mortgage is a debit for the seller.
Escrow Fee: This is also called a closing fee or a settlement fee. An
escrow fee is the charge for the services provided by the escrow
agent, generally split between the buyer and the seller. Therefore
half of the fee appears in each partys debit column.

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PRORATION
There are different recurring expenses involved in the ownership of
real estate. These may be property taxes, mortgage interest
payments, and hazard insurance premiums. Generally, it is the
responsibility of the seller while he is the owner of the property to
pay these expenses. When the settlement statement is prepared, the
escrow agent checks whether the seller will be current in arrears, or
paid in advance with respect to these expenses on the closing date.
The expenses are then prorated by the escrow agent to determine
the portion for which the seller is responsible. Prorating an expense
means dividing and allocating them proportionately as per time,
interest, or benefit.
If the seller will be in arrears regarding a particular expense on the
closing date, the amount owed by him is entered as a debit on the
settlement statement. The seller is entitled to a partial refund if he
has paid in advance, which will be reflected as a credit on the
statement. If the expense is going to continue after closing, the
buyer is responsible for it at the point his period of ownership
begins. This reflects as a buyers credit (if the seller is in arrears) or
as a debit (if the seller has paid in advance) on the settlement
statement.
The first step in prorating an expense is dividing it by the number of
days it covers to find out the per diem rate. So, an annual expense
would be divided by 365 days or 366 days if it is a leap year. A
monthly expense would be divided by the number of days it is
applied in the month in question.
The next step is to find out the number of days during which a
party will be responsible for an expense. The last part is to multiply
that number of days by the per diem rate, to get the share of the
expense that a party is responsible for.
Property Taxes: Until the closing day, the seller is responsible for
the property taxes. The buyers responsibility starts on the day of
closing and thereafter. If the property taxes have been paid by the
seller for the year, he will be entitled to a prorated refund at closing.
This will reflect as a credit for the seller and a debit for the buyer on

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the settlement statement. As mentioned earlier, the property tax

year in California runs from July 1 to June 30.
If the taxes are in arrears, the amount that was payable by the
seller before closing will be a debit for the seller on the settlement
statement.
Hazard Insurance: The premiums for hazard insurance or
homeowners insurance are paid in advance. The seller is entitled to
a refund for the unused portion of the policy at the time of closing.
For instance, if the seller has paid the premium for the full year but
there are three months left in the year, the seller will get a refund of
of the premium. This will reflect as a credit on the settlement
statement for the seller. If in case the buyer assumes the policy, the
seller will be credited while the buyer will be debited for the
appropriate amount.
Interest on Sellers Loan: A real estate loans interest is paid in
arrears. Meaning the interest accruing during a given month is paid
as part of the next months payment. For example, a loan payment
due on December 1 includes the interest that accrued during
November. If a transaction closes in between a payment period, the
seller owes some interest to the lender.
Prepaid Interest on Buyers Loan: Another expense prorated by the
escrow agent is the interest on the buyers new mortgage loan.
Generally, the first payment date of a new loan is not the first day of
the month directly following closing, but the first day of the next
month after that.
Although the first payment is not due until that extra month,
interest starts accruing on the loan on the date of closing. As stated
above, the first regular payment will cover the interest of the
previous month. So if the transaction closes on August 25, the first
payment will be due on October 1, with the payment covering
interest accrued in February but not the interest accruing between
August 25 and August 31. Rather, the lender needs the buyer to
pay the interest of those seven days in August at closing. This is
termed as prepaid interest or interim interest and will be
reflected as the debit for the buyer on the settlement statement.

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Rent: Thus far only prorated expenses have been discussed. But
there is also income to be prorated at closing in some transactions.
If rental income is generated by the property and the tenants have
paid for some period after the closing date, the seller is debited
while the buyer is credited for this rent paid in advance. In case the
rent is paid in arrears, the seller will be credited for the amount due
until closing and the buyer will be debited for the same amount.
Note that the security deposits of the tenants are not prorated. The
seller has to transfer all of the deposits to the buyer as the leases
will continue after closing.
Cash at Closing: As mentioned earlier, the sum of one partys
credits should always equal the sum of that partys debits on the
settlement statement, so that the final balance is zero in each
partys account. For the statement to operate in this way, it should
list the amount of cash that the buyer brings to closing, and also
the sum of cash the seller will take away from closing.
Balance Due from Buyer: All the buyers credits and all the buyers
debits should be totaled, then the buyers credits should be
subtracted from the buyers debits to calculate the balance due.
This is the amount of cash which the buyer will have to pay at
closing. This amount is to be entered as a credit for the buyer. Now
the buyers credits column must add up to exactly the same
amount as the buyers debits column.
Balance Due to Seller: All the sellers credits and all the sellers
debits should be added up, then the sellers debits should be
subtracted from the sellers credits. This will show the amount of
cash the seller will receive at closing. This amount should be
entered as a debit if credits total more than the debits, but as a
credit if debits exceed than the credits. Now the credits column of
the seller must add up to exactly the same amount as the debit
column of the seller.
Remember that the buyers two column totals should match each
other, as should the sellers. Nevertheless, the buyers column totals
may not necessarily match the sellers column totals. Yet, there is a
slight possibility that the buyers totals may match the sellers
totals in a particular transaction (although, normally they do not).
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INCOME TAX ASPECTS OF CLOSING

Almost all real estate transactions have taxes applied on the parties
and obviously, it is up to the parties to meet their tax obligations.
There are some requirements in connection with income taxes that
should be dealt with at the closing of a transaction.
1099-S Reporting
Each sale of real property should be reported to the Internal
Revenue Service by the escrow or the closing agent. To report the
sellers name and social security numbers and the gross profits
from the sale, Form 1099-S is used. No extra charges are paid to
the escrow agent for filling out this form.
Reporting of 1099-S is the major responsibility of the escrow agent.
In case the escrow agent does not report the sales to the IRS, the
mortgage lender must do so. If the mortgage lender, too, fails to
report the sale, the real estate broker has the responsibility to do it.
FIRPTA
To prevent foreign investors from evading their tax liabilities on
income from the sale of real estate, the Foreign Investment in Real
Property Tax Act (FIRPTA) was enacted. A property buyer needs to
confirm if the seller is a foreign person, i.e., someone who is not a
U.S. citizen and not a resident alien. If the seller happens to be
foreign, the buyer should reserve 10% of the net income of the sale
and provide that amount to the IRS. This payment needs to be done
within 10 days after the transfer date. Most of the time, it is the
escrow agent who takes care of these requirements on behalf of the
buyer. Some residential transactions are exempt from FIRPTA.
California Withholding Law
There is a state law in California for real estate buyers to withhold
funds for taxation purposes. To fulfill this legal requirement, a
buyer or his escrow agent should withhold 3.33% of the total sale
price from the seller and send this amount to the Franchise Tax
Board. Or, the seller has a choice to keep a certain percentage of
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the gain on the sale withheld. The percentage is the maximum

applicable tax rate.
The state withholding requirement will apply to an individual seller
if his last known address is outside of California (although the seller
might be a U.S. citizen).
The transaction is exempt if the property sold was the sellers
principal residence, or if the sales price was $100,000 or less. If the
seller is not an individual but a company or an organization, the
withholding requirement will apply even if the seller has a California
address. However the seller may qualify for a specific exemption
from the withholding law.

REAL ESTATE SETTLEMENT PROCEDURES ACT

The Real Estate Settlement Procedures Act (RESPA) is a federal law
that was passed in 1974. It influences the closing in most
residential transaction that are financed with institutional loans.
The two main goals of this law are:
To give information to borrowers about their closing costs and
to help them make better choices for settlement services.
To prevent kickbacks and referral fees which unwantedly
increase the costs of settlement.
RESPA Covered Transactions
RESPA applies to federal loan transactions. A loan is said to be
federal when:
1. It is secured by a mortgage or deed of trust against:
Property with a dwelling with four or less units.
A condominium unit or a cooperative apartment.
A lot with a mobile home.

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2. The lender is regulated federally, has federally insured

accounts, has assistance from the federal government, makes
loans in a federally connected program, sells loans to Fannie
Mae, Ginnie Mae, or Freddie Mac, or makes more than
$1,000,000 worth real estate loans per year.
In other words this act applies to almost all institutional lenders
and to most residential loans.
Exemptions: RESPA is not applicable to the following loan
transactions:
A loan used to purchase 25 acres or more,
A loan used mainly for a business, commercial, or agricultural
purpose,
A loan used to purchase empty land, or a one-to-four unit
home built on it or a mobile home on it,
Temporary finance, as in a construction loan, or
An assumption for
required/acquired.

which

lender

approval

is

not

It should be noted that RESPA is also not applicable to sellerfinanced transactions, because those are not federally regulated.
RESPA Requirements:
Following are the RESPA requirement for federally-related loan
transactions:
1. In a span of three days after receiving the writers loan
application, the lender/loan originator must give all
applicants:
A copy of the booklet about settlement procedures
which is prepared by HUD, which explains RESPA,
closing costs, and the settlement statement,
A mortgage servicing disclosure statement, which
states the intention of the lender to either service the
loan or transfer it to another lender, and
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 A good faith estimate of closing costs that discloses

the cost that the buyer will be paying in the transaction.
Until the good faith estimate (GFE) has been provided, a lender
or loan originator may not charge any fees to a loan applicant
other than a credit report fee.
2. If the lender/settlement service provider wants the borrower to
use the particular appraiser, title company, or other service
provider, he must disclose this requirement to the borrower
when the loan application or service agreement is signed.
3. If a borrower is referred by a settlement service provider to an
affiliated provider, this joint business relationship, along with
the fee estimates, need to be fully disclosed, along with the
fact that the referral is optional.
4. The closing agent must itemize all loan charges on a uniform
settlement statement form.
5. If the deposits have to be made to an impound account
(escrow or reserve account) by the borrower to cover taxes,
insurance, and other recurring costs, the lender cannot ask
for excessive deposits (more than necessary to cover overdue
expenses, in addition to a two-month cushion).
6. A lender, a real estate agent, a loan originator, a title
company, or any other settlement service provider may not:
Pay or receive kickback or referral fees for referring
clients.
Pay or receive fees which are not earned, such as fees for
settlement services that were not actually provided.
Charge preparation fees for the uniform settlement
statement, an impound account statement, or a
disclosure statement required by the Truth in Lending
Act.
7. The seller may not need the buyer to use a particular title
company.
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Uniform Settlement Statement: The escrow agent/closing agent

needs to provide completed uniform settlement statement forms to
the borrower, the seller, and the lender on or before the closing
date. In case the borrower has signed a written waiver of the right
to receive the statement by closing, the forms must be provided by
the parties as soon as possible after closing. The escrow agent
should allow the borrower to inspect the statement one business
day before closing, if he has so requested.
A copy of the uniform settlement statement form which is also
called a HUD-1 form does not have the same format as the
simplified settlement statement (with the credit and debit columns
of the buyer and the seller side by side), although the same
information is presented.
Each partys closing costs are itemized on the second page of the
form on the uniform settlement statement, with the buyers costs in
the left column and the sellers costs in the right column. The costs
of each party are added and the total is transferred to the first page
of the form. The buyers total costs are entered on line 103, and the
sellers total costs on line 502.
On the first page of the uniform settlement statement, lines 101120 correspond to the buyers debits column on the simplified
version. Lines 201-220 correspond to the buyers credits column.
Lines 401-420 are same as corresponding to the sellers credits
column and 501-520 corresponds to the sellers debits column.
Line 303 shows the amount of cash that the buyer needs to bring to
closing and line 603, the amount of cash receivable by the seller at
closing.
Estimate v. Actual Charges: At the beginning of the loan
application process, some charges are listed on the good faith
estimate form which is given to the buyer. These are only estimates
and therefore may not match buyers actual charges at closing.
Nevertheless, RESPA disallows certain charges on the GFE to be
increased, and it also limits raises on certain other charges. The
three categories of charges are:

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1. Charges that cannot increase at closing. These are all the

lenders/loan originators points and fees, and the transfer tax
as well
2. Charges for necessary services, such as appraisal and title
insurance, if the service provider was selected or
recommended by the lender. The total amount of these
charges cannot increase more than 10%
3. Charges that can change since they are not possible to predict
in the beginning, like hazard insurance
The categories are fully explained on the third page of the good faith
estimate form. A side-by-side comparison of the estimated and the
actual charges are given on the third page of uniform settlement
statement.

Chapter Summary
The process of finalizing the real estate transaction is called
closing or settlement.
If the conflict between the two parties do not resolve, then the
escrow agent shall file an interpleader action, taking the
matter the judiciary.
In northern California, the title companies are generally the
escrow agents and in southern California, the independent
escrow agents normally close most of the transactions.
Apart from the purchase price: inspection fees, title insurance
charges, loan fees, and so on, there are other variety of costs
in a real estate transaction, known as closing costs.
The items listed on the settlement statement are: debits or
credits.

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 The premiums for hazard insurance or homeowners insurance

are paid in advance.
Almost all real estate transactions have taxes applied to the
parties and obviously, it is up to the parties to meet their tax
obligations.
RESPA disallows certain charges on the GFE from being
increased, and it also limits the increase on certain other
charges.

Chapter Quiz
1.

In a rental property sale, which of the following will not be

prorated at closing?
a. Interest on buyers new loan
b. Interest on sellers existing loan
c. Security deposit
d. Prepaid property taxes

2.

To create an escrow, there must be:

a. Unconditional delivery
b. A binding contract
c. Real property
d. All of the above

3.

The escrow holder acts as a:

a. Advisor on the transaction.
b. Surety
c. Mediator
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d. Agent of both parties.

4.

Which of the following items would most likely appear as a

credit in the sellers closing statement?
a. Title insurance premium
b. An assumed loan
c. Delinquent assessment lien
d. Prepaid taxes

5.

If a buyer assumes an existing loan when purchasing a

single-family residence, the settlement statement at close of
escrow would show the assumption of the loan as:
a. A debit to the buyer
b. A debit to the seller
c. A credit to the lender
d. Neither a credit nor a debit

6.

Which of the following is normally one of the sellers closing

costs?
a. Origination fee
b. appraisal fee
c. Credit report fee
d. Sales commission

7.

How would a loan for the purchase of a residence appear on

the buyers closing statement?
a. Debit to the buyer
b. Credit to the buyer
c. Debit to buyer, credit to seller
d. Credit to buyer, debit to seller
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8.

Which of the following is considered as a recurring cost in a

closing statement?
a. Premiums for title insurance
b. Impound accounts
c. Recording fees
d. Escrow fees

9.

On a settlement statement, prepaid interest will normally

reflect as a:
a. Sellers debit
b. Sellers credit
c. Buyers debit
d. Buyers credit

10.

The legal action that may be taken by an escrow holder is:

a. Interpleader
b. Quiet title
c. Adverse possession
d. Injunction

11.

A buyers settlement statement contains:

a. All encumbrances of record
b. Loan origination fees
c. The borrowers loan application
d. Only prorations chargeable to the buyer

12.

Title insurance protects a buyer against:

a. All claims except those excluded by the policy
b. All claims from any source
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c. Claims arising from the buyers future actions

d. Any claims the buyer is already aware about
13.

Under RESPA, a loan is consider to be federally related if:

a. The lender is federally regulated
b. The property has up to four dwelling units
c. It will be used to finance purchase of real property
d. All of the above

14.

When as item is prorated it means that:

a. It is not paid until closing
b. It is deleted from the cost of the sale
c. The escrow agent must pay the fee
d. It is calculated on the basis of a certain time period

15.

Under FIRPTA:

a. Escrow agents must notify the real estate broker if the

buyer is a foreign investor
b. A foreign investor purchasing property in the US must
pay an additional 10% along with the purchase price and
submit it to the IRS
c. A foreign investor cannot buy or sell property without
special authorization
d. If a seller is not a U.S. citizen or a resident alien, the
escrow agent must deduct 10% of the net sale proceeds and
send it to the IRS

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CHAPTER 13
Real Estate Taxation
CHAPTER OVERVIEW
In the U.S., the income of individuals and businesses are taxed by
the federal government on an annual basis. This chapter will deal
with how the transfer or acquisition of real estate can affect the
federal income taxes that a seller or a buyer is required to pay.
Before that, though, we will learn some basic terms and theories
regarding real estate taxation, along with certain types of
transactions that receive special treatment. This chapter will also
cover the tax deductions available to real estate owners.

PROGRESSIVE TAX
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Depending on how the burden of a tax is distributed among

taxpayers, the taxes may be proportional, regressive, or
progressive. If the same tax rate is applied to all levels of income,
it is called a proportional tax. A regressive tax refers to when the
rate applied to higher levels of income is lower than the rate applied
to lower levels. The federal income tax is a progressive tax, meaning
that the more a taxpayer earns during a tax year, the higher will be
his tax rate. This implies that a person earning a large income is
usually required to pay more taxes than someone who earns a
smaller one, and also is expected to pay a greater percentage of his
income in taxes.
An increase of tax rates in uneven steps is call tax brackets. When
a taxpayer earns more money, exceeding his bracket, he may be
taxed at a higher rate than the money earned just before it, simply
because it crosses the line into a higher bracket. The increase in
taxes will not apply on dollars previously earned, but rather only
apply on the additional money earned. The tax rate that applies to
the last dollar that a taxpayer earns is called a marginal tax ratem.

INCOME
Many people think about income only in terms of wages or salaries
they earned at a job. However the Internal Revenue Service (IRS)
has a broader outlook of income. The IRS considers any economic
benefits attained by a taxpayer as part of his income, unless it is a
kind of benefit particularly excluded from income by the tax code.
Deductions and Tax Credits
Certain expenses are authorized by the tax code to be deducted
from income. For instance, if a business suffers monetary losses in
a particular tax year, the business owner may be allowed to deduct
the loss. A taxpayer who is entitled to deductions can subract a
specified amount from his income before it is taxed. By reducing the
amount of income taxed, the amount of tax the taxpayer owes is
similarly lowered.
As opposed to deductions, tax credits are subtracted directly from
the tax amount owed. The income of the taxpayer is added up, the
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tax rate is applied, and after that any applicable tax credits are
applied to find out how much the taxpayer will actually have to pay.
Deductions and tax credits are often used by the government for
implementing social and economic policy. For example, the
government might allow homeowners to deduct mortgage interest
from their taxable income to make homeownership more affordable.
(we will study the mortgage interest deduction later in this chapter).
Gains & Losses
Whenever there is a sale or exchange of an asset real estate, for
example it almost always results in either a gain or a loss. Gains
are always considered as income, therefore any gain is taxable
unless the tax code states otherwise. Conversely, a loss may be
deducted from income only if the tax code authorizes the deduction.
Generally, the losses incurred in a trade or business or in
transactions entered into for profit are deductible losses. A business
entity can deduct all of its losses. An individual taxpayer can
deduct a loss only if it was incurred in regards to:
1. The taxpayers trade or business,

2. A transaction entered into for profit, or

3. A casualty, loss, or theft of the property of the taxpayer.

Deduction is not allowed for a loss incurred on a sale of the
taxpayers principal residence or other real property owned for
personal use.
Capital Gains and Losses: A capital gain or a capital loss is a
gain or loss on the sale of an asset held for personal use or as an
investment. Capital gains and capital losses are netted against each
other; if there is a net gain it is taxed as a capital gain. Favorable
tax treatment is given to capital gains, so the maximum tax rate
applied to most capital gains is much lower than the rate for normal
income. But there is an annual limit on the deductibility of capital
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losses; in a single tax year, net capital losses deducted cannot be

more than $3,000. Capital losses in excess of the limit may be
carried forward and deducted in the coming years.
Note that the losses of personal use property are not deductible,
therefore they are not netted against capital gains.

Business and Rental Property: Gains and losses on the sale of real
property used in a business or for the production of income (as in
rental property) are treated differently than gains and losses on the
sale of personal use and investment property. A gain on the sale of
a business property or a rental property which is owned for more
than a year and then sold is considered a capital gain. But a loss on
such a sale is deductible as an ordinary loss and not a capital loss.
This is a benefit, since the $3,000 annual limit on the deduction of
capital losses does not apply. The full amount of the loss can be
deducted in the year in which it is incurred.

Basis
For the purpose of income tax, the property owners basis is the
investment he has made in the property. If an asset is sold by a
taxpayer, the basis is the maximum amount received for the asset
without realizing a gain. It is important to know the taxpayers basis
in the property in question, so as to determine gain and losses.
Initial Basis: Generally, a taxpayers initial basis (which is also
called cost basis or unadjusted basis) is equal to the original cost of
acquisition (the cost of acquiring the property). For example, if she
paid $580,000 for a rental home in addition to $20,000 in closing
costs, she has an initial basis of $600,000 in the property. If the
taxpayer sells the property for $600,000, she does not have to
report a gain to the IRS.

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Adjusted Basis: To achieve an adjusted basis, a propertys initial

basis may be increased or decreased. This reflects capital
expenditures and any permissible depreciation deduction.
Capital expenditures are those expenditures which are made to
improve the property, like when a homeowner spends money on
adding an extra room or modifies the kitchen. The value of the
property increases or its useful life is substantially extended
because of capital expenditures. These are added to the initial basis
while calculating the adjusted basis.
Maintenance expenses like repainting, roof cleaning, and replacing
sanitary fittings are not capital expenditures. Basis is not affected
by maintenance expenses.
For some property types, a taxpayers initial basis is also adjusted
to take into account depreciation deductions. (This will be explained
later in this chapter). In calculating the adjusted basis, these
deductions are subtracted from the initial basis.

Realization
All gains are not taxable immediately. A gain is only considered
when it is realized. Ownership of an asset appreciating in value only
will involve a gain, and not otherwise. During a sale or exchange of
an asset, the gain is separated from the asset, for tax purposes.
The difference between the net sales price, which is called the
amount realized in the tax code and the adjusted basis of the
property equals the gain or loss realized on a transaction.
Net sales price (amount realized) Adjusted basis = Gain or Loss
While calculating the amount realized, the sales price consists of
money or other property received in exchange for the property, in
addition to the amount of any mortgage debt that is eliminated.
Therefore, if the buyer takes the property subject to the sellers
mortgage or assumes it, the amount of that debt is regarded as part
of the sales price for taxation.

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The selling expenses, such as the brokerage commission and the

sellers other closing costs, are deducted from the sales price to
achieve the amount realized.
Money received + Market Value of other property received +
Mortgage debt eliminated - Selling Expenses = Net sales price
(amount realized)

Recognition and Deferral

A gain is recognized in the year it is taxed, unless there is a
particular exception in the tax code permitting the taxpayer to defer
tax payment on the gain for a later tax year or for a later
transaction, or to omit the gain from income and totally avoid taxes
on it. For instance, the tax code allows an individual selling his
rental property on an installment basis to defer taxation of part of
the gain to the year in which it will be received (and not the year in
which the sale takes place). The tax code provisions allowing
recognition of a gain to be deferred are termed as non-recognition
provisions.
We shall discuss non-recognition provisions
provisions in detail later in the chapter.

and

exclusion

REAL PROPERTY CLASSIFICATIONS

The type of property involved determines whether that real estate
transaction qualifies for special tax treatment or not. The tax code
classifies real property into:
1. Principal residence property,

2. Personal use property,

3. Unimproved investment property,

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4. Property held for producing income,

5. Property used in a trade or business, and

6. Dealer property.
Principal residence property: A principal residence property which
is also called a main home is the taxpayers ownership home which
he occupies as his primary dwelling. This might be a single family
home, a duplex, a condominium unit, a cooperative apartment, or a
mobile home. In case the taxpayer owns more than one home and
lives in both of them, the principal residence will be the one in
which he resides more often. A taxpayer cannot have two principal
residences at the same time.
Personal use property: Real property owned by the taxpayer for
personal use (other than the principal residence) will be classified
as personal use property. A second home or a vacation home will
come under this category.
Unimproved Investment Property: Vacant land that does not
produce any rental income is called unimproved investment
property. The only reason for holding such a land is the expectation
that it will appreciate in value.
Property Held for Producing Income: This includes residential,
commercial, and industrial property that is used to generate rental
income for the owner.
Property Used in a Trade or Business: In this category the land
and buildings owned by the taxpayer is used for his business or
trade, such as a factory owned by the manufacturer.
Dealer Property: Dealer property is not held for a long term
investment but rather mainly for sale to customers. If a developer is
subdividing the land for the sale to customers, the lots will normally
be a part of this classification till the time they are sold.
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Non-recognition Transaction
As discussed earlier, when a non-recognition provision in the tax
code is applied to a particular transaction, the taxpayer does not
have to pay taxes on a gain in the year it is realized. Recognition of
the gain is deferred to a later time. The types of real estate
transactions that are covered by non-recognition provisions are:
Installment sales,

Involuntary conversions, and

Tax-free exchanges.
Remember that a non-recognition provision does not totally exclude
a gain from taxation. Instead, it merely defers the tax consequences
to a later tax year. These are not actually tax-free transactions.
The realized gain is determined and taxed in the following year.

INSTALLMENT SALES
According to the tax code, an installment sale is that sale in which
less than 100% of the sales price is received in the year in which
the sale is made. Almost all seller-financed sales are installment
sales. Installment sale reporting permits the taxpayer (seller) to
defer recognition of part of the gain to the year (or years) in which it
is received. Effectively, taxes are only paid on the part of the profit
that is received each year. The gain is prorated over the term of the
installment contract. Installment sale reporting is allowed for all
categories of property, although dealer property is eligible only
under special conditions.
The calculation of gain recognized in a given year, in installment
sales, is based on the ratio of the gross profit to the contract price.

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The difference between the sales price and the adjusted basis is the
gross profit.
For calculating the gross profit, the sellers adjusted basis at the
time of sale is taken and added to the amount of commission and
other selling expenses, with this sum then being subtracted from
the sales price.
To calculate the gross profit ratio (also called the gross profit
percentage), the gross profit is compared to the contract price. The
total amount of all principal payments which the buyer will pay to
the seller is essentially the contract price. If the buyer is not
assuming the sellers existing loan, then the contract price will
almost always be the same as the sales price.
Gross Profit Contract Price = Gross Profit Ratio
It is noteworthy that the gross profit ratio is not applied to the
interest the buyer pays to the seller. All the interest payments are
counted as taxable income in the year received.
In case the buyer assumes (or takes subject to) a mortgage that is
larger than the sellers basis in the property, the excess will be
taken as payment received from the buyer. Also, in case the
property is subject to recapture provisions because of depreciation
deductions, the amount re-collected will also be treated as a
payment received in the year of sale. (Depreciation deductions will
be discussed later in this chapter)
Involuntary Conversions
When an asset is converted into cash without a deliberate action on
the part of the owner -- for example, the asset is condemned,
destroyed, stolen, or lost and the owner gets a condemnation award
or insurance proceeds -- it is said to be an involuntary
conversion. A sale which is under the threat of condemnation is
also considered an involuntary conversion. Normally, the award or
proceeds represents the replacement cost or market value of the
property, and therefore the owner almost always realizes a gain on
an involuntary conversion.

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Nevertheless, on an involuntary conversion, the recognition of a

gain can be deferred if the taxpayer uses the money received to
replace the property during the course of the replacement period set
up by the IRS. In general, the replacement period lasts for two years
from the date the property was destroyed/lost. In case of a
condemnation, it is two years after the end of the tax year in which
the gain was realized. The condemnation award or insurance
proceeds have to be re-invested in the replacement property, for the
recognition of the gain to be deferred. The portion of the gain used
for purposes other than purchase of replacement property is taxable
as income.

TAX-FREE EXCHANGES
There is section 1031 of the tax code in connection with property
exchanges. The so-called tax-free exchanges are actually just taxdeferred exchanges. Recognition of any realized gain will be
deferred, if unimproved investment property, income property, or
property used in trade/business is exchanged for like-kind
property. This type of deferral is not applicable to a principal
residence, personal use property, and dealer property.
The current tax expenses can be reduced or eliminated using the
tax-free exchanges. In doing this, the taxpayer may be able to
obtain a property in an exchange which would have been unfeasible
as a purchase with the after-tax proceeds from selling the old
property.
The property received by the taxpayer in exchange must be likekind, meaning it must be similar to the property given. This
requirement is concerned with the nature of the property and not
the quality of it. For the purposes of the exchange deferral, most
real estate is contemplated to be of like kind, irrespective of the fact
that it might be improved, unimproved, residential, commercial, or
industrial. For instance, if a taxpayer is to exchange an apartment
complex with a strip shopping center, the transaction can qualify as
a tax-free exchange. Both the exchanged properties should be
located in the U.S. so that they are considered like-kind property. If
only like-kind properties are exchanged, then in this case no gain or
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loss is recognized in the year of the exchange. Taxpayers involved in

a like-kind exchange may receive cash, stock or debt relief -- known
as boot -- besides the like-kind property. (Debt relief is the
difference between mortgage balances)
Remember that boot is taxable only to the amount of the gain. The
amount of the gain alone will be taxed (and not the entire amount of
the boot) if the boot received exceeds the taxpayers realized gain on
the transaction.
The basis in the property exchanged is transferred to the property
that the taxpayer receives. There is no need of adjustments if
nothing other than like-kind property is exchanged. In case that
boot is involved in the exchange, the basis needs to be adjusted for
any boot paid or received and also for any gain or loss which was a
result of the boot.
Note that in some conditions, an exchange of real property may be a
tax-deferred transaction for only one of the parties. For instance,
taxpayer X exchanges his personal use property for a rental home
owned by taxpayer Y. Both taxpayers intend to rent out their new
properties. However, this transaction will be a tax-free exchange
only for taxpayer Y because he has traded one income property for
another, not taxpayer X since personal use property is not eligible.
An agent arranging a tax-free exchange, also called a 1031
facilitator, may get compensation from both the parties. A 1031
facilitator has bonding requirements imposed on him by California
law, along with other rules.

EXCLUDING GAINS FROM THE SALE OF A PRINCIPAL RESIDENCE

There is a particular exclusion from capital gains taxation that will
be of great interest to many homeowners. This is the exclusion of
gain on the sale of a principal residence.
Until 1997, taxpayers who sold their principal residence were
usually eligible for the rollover deferral of taxation. If the sale
proceeds were used within two years to buy another home then the
seller was permitted to defer taxation of the gain. Sellers who were
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55 or older could take a one-time exclusion of gain from the sale of

the principal residence, and it was not necessary to invest the gain
in a new home. In 1997, though, these two benefits were replaced
with a single, less complicated exclusion from taxation.
Amount of Gain Excluded: As per the existing aaw, a taxpayer
may exclude all of the gain on the sale of her principal residence, up
to $250,000 if the taxpayer is filing a single return, or $500,000 in
a joint return.
In case the amount of gain on the sale of the home goes over the
$250,000 or $500,000 limit, the excess amount of the limit will be
taxed at the capital gains rate.
Eligibility: To meet the requirements for this exclusion, the seller
should have owned as well as used the property as a principal
residence for at least two years during the five-year period that ends
on the date of sale. Due to this rule, the availability of this
exclusion occurs only once every two years.
Note that if the sellers are spouses and are filing a joint return, only
one spouse needs to meet the requirement of ownership, but both
the spouses need to meet the use test. If only one of the spouse
meets the ownership as well as the use test, the maximum
exclusion which the married couple can claim is $250,000, even if
they are filing jointly.
If the seller owned and used the property as a principal residence
for less than two years for instance, if he sold the property after
only a year due to a change in employment or health -- the seller
may still be allowed to claim a reduced exclusion.

DEDUCTIONS USED BY PROPERTY OWNERS

As previously explained, a deduction is subtracted from a
taxpayers income before the tax rate is applied. The deductions
allowed in income tax to real property owners are a great benefit of
ownership. The deductions can be for:
Depreciation (cost recovery),
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 Uninsured casualty and theft losses,

Repairs,
Real property taxes,
Mortgage interest,
Points paid to mortgage lender, and
Operational losses from rental property
Depreciation Deductions
The depreciation deduction is also called the cost recovery
deduction. It allows a taxpayer to recover the cost of an asset over a
period of years. Property used for producing income or property
used in a business or trade are only eligible for depreciation
deductions. A principal residence, personal use property,
unimproved investment property, or dealer property are not eligible
for depreciation deductions.
Depreciable Property: Usually, only property that wears out and
will need to be replaced is depreciable, i.e. eligible for depreciation
deductions. Examples of depreciable property are apartment
buildings, business and factory equipment, and trees in commercial
orchards, since they all need to be replaced. Land does not wear
out, and therefore is not depreciable.
Time Period: The full expense of purchasing an asset cannot be
deducted in the year of its purchase, though it is allowed with many
other business expenses such as wages, supplies, and utilities. The
expense can, however, be deducted over a number of years for
almost all real estate. The recovery period is between 27.5 and 39
years. The length of the recovery period has nothing to do with the
actual length of time during which the property will be economically
useful, rather the period is an indication of the legislative policy.
This depreciation deductions subject has been repeatedly modified
by Congress.
Effect on Basis: Any permissible depreciation deductions reduce
the adjusted basis on the taxpayers property. Remember, this
reduction will be done even if the taxpayer takes the deduction or
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not. If the taxpayer was entitled to take the deduction, the basis will
be reduced. The taxpayers subsequent gain or loss on resale of the
property is affected by the deductions, since the basis is reduced.
Uninsured Casualty or Theft Loss Deductions
The property owner will generally be allowed to deduct the
uninsured loss from the taxable income, if the property is damaged
or stolen and the loss is not covered or only partly covered by the
insurance. The amount of the deductible loss is calculated first by
subtracting the estimated fair market value of the property after the
loss from its estimated value before the loss. This reduction in value
is compared to the owners adjusted basis in the property. From the
figure that is the smaller of the two, any insurance reimbursement
that the owner has received or is expecting to receive is subtracted.
For almost all types of property, the result is the amount of the
deductible loss.
The amount of the deductible loss is reduced by some additional
calculations in case of personal use property and principal
property. After following the above mentioned steps, further
subtract $100 from the loss. Then, subtract 10% of the taxpayers
adjusted gross income. This amount will be the deductible loss of
the taxpayers personal use property/principal property.
In case of the taxpayer having more than one casualty loss for the
personal use property in a given tax year, he must deduct $100
from each loss. But the 10% of the adjusted gross income is
subtracted from the total amount of those losses (and not from each
loss).
Repair Deductions
The expenditure incurred to maintain the property in normal and
efficient operating condition is called a repair expense. In almost all
property types the repair expenditure is deducted in the year paid.
Note that repair expenses are not deductible for principal
residences or other personal use property. Expenditures for
maintenance, regular wear and tear, repair and also condominium
assessments are included in this.
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Remember, capital expenditures and repair expenses are two

different things for any type of real property. As previously looked
at, capital expenditures add to the value of the property and often
extend its economic life. Capital expenditures are added to the basis
and not deducted in the year made. This increase in the basis will
ultimatley affect the gain or loss on the subsequent sale of the
property. Also, if the property is eligible, it will also increase the
allowable depreciation deductions.

Property Tax Deductions

There are general real estate taxes that are deductible for any type
of property. Special assessments for repairs and maintenance are
deductible, but there are no deductions for improvements such as
sidewalks.
Mortgage Interest Deductions
Interest paid on a mortgage or deed of trust is normally totally
deductible for almost all property types. Only for personal
residences, i.e. principal residences or second homes, are there
some limitations on interest deductions.
Interest payments on mortgage debts may be deducted by a
taxpayer, up to $1,000,000 and up to $500,000 for a married
taxpayer filing separately. This mortgage debt may be used to buy,
build or improve a first or second residence. Also, interest on a
home equity loan of up to $100,000 and up to $500,000 for a
married taxpayer filing separately can be deducted regardless of the
loans purpose. If the loan amount is in excess of this amount, then
the interest on the excess amount is not deductible.
At times, a condominium project may borrow money by mortgaging
the common areas, and the unit owners have to pay a share of the
mortgage payment. In this situation, the unit owner is allowed to
deduct the interest portion of his share from his taxable income.
The homeowners generally use a home equity loan to pay off credit
card debts because of the deductibility of mortgage interest. Interest
on a home equity loan is deductible but the interest on credit cards
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is not. At present, the only type of consumer interest that is

deductible is the mortgage interest.
Lenders Points Deduction and Other Loan Costs
Points (including discount points and origination fee) paid to a
lender in the context of a new loan is considered to be prepaid
interest by the IRS. The borrower is usually allowed to deduct them,
even if it were paid by the seller on behalf of the borrower. The
borrowers basis in the property should be reduced by the amount
of the seller-paid points.
Notably, the fees that a lender charges to cover specific services are
not deductible, in spite of the lender referring to them as points.
The examples of such fees are appraisal fees, document preparation
fees and mortgage insurance premiums.
While paying off a loan, if a seller is charged with a prepayment
penalty, the amount of this penalty is deductible. For taxation
needs, a prepayment penalty is regarded as a form of interest.
Deduction of Operational Losses from Rental Property
A taxpayer who is an owner and active manager of a rental property
is allowed to deduct up to $25,000 of operational losses from his
ordinary income. To understand this rule we need to know the
difference between an ordinary income and a passive income.
Generally, rules say that a passive income is income which a
taxpayer earns from an enterprise
without his material
participation, such as a limited partnership The IRS always
considers rental income as passive income, although the taxpayer
plays a part in the management of the rental property.
Passive losses that are incurred from passive activities can be
deducted from passive income only, not from ordinary income. For
instance, if a loss is incurred on a real estate investment trust
(passive loss), it cannot be deducted from the salary earned from a
job (ordinary income).
Nonetheless, losses from the operation of rental property receive
special treatment if the taxpayer is actively involved in the
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management of the property and certain other requirements are

met. Operational losses up to $25,000 from rental property are
allowed to be deducted from ordinary income.
The advantage of this rule cannot be available to every rental
property owner who is an active participant in management of the
property. There are some major restrictions, such as the taxpayer
should not be involved in any other passive activity and his
adjusted gross income should not exceed a certain limit.
Income lost due to rental property vacancies is not to be considered
as an operational loss. The lost income from a vacant rental
property for all or part of the year is not deductible. The deductible
figure is the overall difference between a rental propertys annual
income and the annual operating expenses. This is an operational
loss.
As discussed before in this chapter, losses resulting from the sale of
a rental property are conditional on different rules. Therefore, these
losses should not be confused with an operational loss.
Lastly, if the taxpayer happens to be a real estate professional and
is materially participating in rental property activities, then those
activities are not to be considered as passive activities. This implies
that the limit of $25,000 is not applicable on the amount of
operational losses that the real estate professional can deduct from
his ordinary income.
Rental Payment Deductions
There is a deduction in connection with real estate that is applied to
tenants rather than property owners. The rent that is paid for
property used in a business or a trade is deductible as a business
expense. But rent paid for property that is not used in a business or
a trade is not deductible, like rent for a home.

CALIFORNIA INCOME TAX

Along with the federal income tax, there is also a California state
income tax. The California income tax laws provisions are much the
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same as the Internal Revenue Code. For instance, the California

statutes refer (with limited exceptions) to the federal law regarding
such items as the definitions of gross income, adjusted gross
income, itemized deductions, and taxable income. There is a
different customary deduction under state law for those who dont
itemize and obviously, the tax rates on taxable income are different.
Just as in federal law, the state income tax law is a progressive tax
under which higher rates are imposed on the higher income levels.
Based on the California Consumer Price Index, the income tax
brackets and the standard deduction are adjusted for inflation
every year by the California Franchise Tax Board.

Chapter Summary
Depending on how the burden of a tax is distributed among
taxpayers, the taxes may be proportional, regressive, or
progressive.
The IRS considers any economic benefits attained by a buyer
taxpayer as part of his income, unless they are the kind of
benefits particularly excluded from income by the tax code.
Deduction and tax credits are generally used by
government for implementing social and economic policy.

the

A capital gain or a capital loss is a gain or loss on sale of an

asset held for personal use or as an investment.
For the purpose of income tax, the property owners basis is
the investment he has made in the property.
During a sale or exchange of an asset, the gain is separated
from the asset for taxing purposes.
According to the tax code, an installment sale is a sale in
which less than 100% of the sales price is received in the year
in which the sale is made.
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 Current tax expenses can be reduced or eliminated using the

tax-free exchanges.
Interest paid on a mortgage or deed of trust is normally totally
deductible for almost all property types.
The California income tax laws provisions are considerably the
same as the Internal Revenue Code.

Chapter Quiz
1. Property taxes are ad valorem taxes, meaning _________
a. They are charged in relation to the value of the property
b. They are sales tax
c. They are use taxes
e. They are charged once at the time of the property transfer

2. A property owners basis in his principal residence would be

adjusted to indicate:

a. The mortgage interest paid

b. The cost of adding a bathroom
c. Depreciation deductions
d. The expenses incurred to repair the property
3. Which of the following can be deducted on the federal income
tax return by the owner of an unimproved investment property?
a. Depreciation deductions
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b. The depreciation of the land

c. A loss on the sale of the property
d. Any one of the above
4. The rate of federal income tax paid depends on the taxpayer
a. Source of income
b. Location of the property
c. State income tax paid
d. Tax bracket
5. Property that can be depreciated for the purpose of income
tax is called:
a. Like-kind property
b. Boot
c. Tax basis
d. Recovery property

6. The State of California collects:

a. Estate tax
b. Gift tax
c. Federal income tax
d. Inheritance tax

7. All of the following is boot, except:

a. A commercial fishing boat
b. Vacant land on the outer boundary of a city
c. Cash
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d. Antique furniture
8. As per the federal income tax code, income is usually taxed in
the year it is:
a. Realized
b. Recovered
c. Deferred
d. Recognized

9. Which of the following exchanges will NOT qualify as a taxfree exchange:

a. Farming land for farming equipment
b. A lot in the city for a ranch
c. An apartment for a warehouse
d. A hotel for an office building.
10. Money spent on improvements to property, which adds to its
value or prolongs its economic life is called:
a. Boot
b. Capital expenditures
c. Repair expense
d. Depreciation deductions
11. If a taxpayer is buying a home as her principal residence
through a mortgage loan of $300,000, how much of the interest
paid on this loan can she deduct from her income?
a. 50% of it.
b. All of it.
c. Up to $100,000 in interest.
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d. None of it.

12. The following types of real estate transactions are covered by

nonrecognition provisions:
a. Installment sales
b. Involuntary conversions
c. Tax-free exchanges
d. All of the above
13. The federal income tax is a___________ tax.
a. Progressive
b. Regressive
c. Proportional
d. None of the above

14. In most cases, a taxpayers _________ basis is NOT equal to its

original cost of acquiring the property.
a. Initial
b. Cost
c. Unadjusted
d. Adjusted
15. Under current law, a taxpayer may exclude the entire gain on
the sale of his principal residence, up to __________, if the tax
payer is filing a single return:
a. $200,000
b. $250,000
c. $300,000
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d. $350,000

CHAPTER 14
Civil Rights & Fair Housing
CHAPTER OVERVIEW
Civil law is a legal system based on laws and regulations, without
the influence of judicial decisions as in the common law system.
The intention of the civil rights laws is to encourage fairness and
freedom. In the context of real estate, the primary aim of these laws
is to insure equal housing opportunity for all. The civil rights laws
are also in place for nonresidential real estate.
It is important for real estate agents to understand the federal and
state laws that prohibit discrimination in real estate transactions
and business activities connected to it. It is one of the professional
duties of the real estate agent to comply with these laws and also
encourage others to comply with them.
This chapter will deal with the federal and California state antidiscrimination laws affecting real estate.

FEDERAL ANTI-DISCRMINATION LAWS

The federal laws prohibiting discrimination
transactions and related activities are:

in

real

estate

- The Civil Rights Act of 1866

- The Civil Rights Act of 1964
- The Fair Housing Act
- Federal Fair Lending Laws, and
- The Americans with Disabilities Act

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The Civil Rights Act of 1866

The Civil Rights of 1866 prohibits racial discrimination in all
property transactions. This law was ignored for almost a century
before being upheld in 1968 by the U.S. Supreme Court in the
landmark case of Jones v. Mayer. A constitutional basis for the
1866 Act was found by the court in the 13th Amendment to the U.S.
Constitution that prohibited slavery.
Under this Act, a private individual may file a lawsuit in the federal
courts alleging racial discrimination. An injunction can be issued by
the court, ordering the defendant not to discriminate, or to take
positive measures to correct the violation. The court may even order
the defendant to sell or lease property to the plaintiff. The defendant
may also be asked to pay the plaintiff compensatory damages to
compensate for losses and suffering due to discrimination as well as
punitive damages, an additional fine to punish the defendant for
wrongdoing.
The Civil Rights Act of 1964
The federal governments initiative to promote equal opportunity in
housing brought about the Civil Rights Act of 1964. The aim of this
act was to prohibit discrimination on the basis of race, color,
religion, or national origin in programs and activities for which
financial assistance was provided by the federal government.
However, the effect of this on housing was very limited, since most
FHA and VA loans were not covered. The estimates say that less
than 1% of all property purchases were covered by this law. Most of
the progress made towards fair housing goals only came after the
Civil Rights Act of 1968.
The Fair Housing Act
The Federal Housing Act, which is also called Title VIII of the Civil
Rights Act of 1968, makes it illegal to discriminate on the basis of
race, color, religion, sex, national origin, handicap, or familial
status in the sale or lease of residential property or even in the sale
or lease of vacant land for the construction of residential homes.
Discrimination in advertising, lending, real estate brokerage, and
other services which have anything to do with residential real estate
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transactions are also prohibited by this law. The Fair Housing Act
does not apply to nonresidential transactions, as in those involving
commercial or industrial properties.
Exemptions: there are four types of transaction that are exempt
from the Fair Housing Act:
1. The law will not apply to the sale or rental of a single-family
home by the owner, if:
- The owner does not own more than three homes of that kind,
- There is no involvement of a broker or real estate agent in the
transaction, and
-

No discriminatory advertising is used.

2. The law will not apply to the rental of a unit or a room in a

dwelling with up to four units, if:
- The owner occupies one of the units as his residence,
- There is no involvement of a broker or real estate agent in the
transaction, and
- No discriminatory advertising is use.
3. (The exemption is also called the Mrs. Murphy exemption.)
Transactions that involve preferences to members of religious
organizations or societies or affiliated nonprofit organizations,
when dealing with their own property, and provided that
membership is not restricted on the basis of race, color, or
national origin, and
4. Transactions that give preference or limitation to members of
private clubs with lodgings that are closed to the public and
are not operated for a commercial purpose.
These exemptions are rarely applied. Note that the 1866 Civil Rights
Act prohibits discrimination based on race or color in any property
transaction, irrespective of any exemptions prevailing in the Fair
Housing Act. Plus, these exemptions are not applicable in
transactions which involve a real estate licensee. Additionally, the
Fair Housing Act exemptions are particularly irrelevant in states
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like California, a state whose civil rights laws are much stricter
than federal law.
Prohibited Acts: The following acts are prohibited by the Fair
Housing Act if they are done on the basis of race, color, religion,
sex, national origin, handicap, or familial status:
Refusing to rent or sell residential property on receiving a bona
fide offer,
Not negotiating for the sale or rental of residential property, or
else making it unavailable,
Altering the terms of sale or lease for different potential buyers
or tenants,
Advertising with an indication of a preference or intent to
discriminate,
Expressing that the property is not available for inspection,
sale, or rent when it is actually available,
Using criteria that is discriminatory, when making a housing
loan,
Putting a limit on participation in a multiple listing service or
similar service,
Pressuring, intimidating, threatening, or interfering with
anyone owing to his/her enjoyment, attempt to enjoy, or
encouragement or assistance to others in enjoying the rights
given by the Fair Housing Act.
The discriminatory practices
redlining are also prohibited.

of

blockbusting,

steering,

and

Blockbusting: Blockbusting occurs when someone tries to

persuade homeowners to list or sell their homes by forecasting that
people of another race, or people with a certain disability, or people
with a particular ethnic background or other such group will be
moving into the neighborhood, resulting in undesirable
consequences such as lower property values. By doing this the
blockbuster gains a profit by buying the properties at reduced
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prices or a real estate agent may collect commissions on the

induced sales. Blockbusting is also called panic selling or panic
peddling.
Steering: Steering means directing prospective buyers or tenants
toward or away from specific neighborhoods on the basis of their
race, religion, national origin, etc. so as to maintain or change the
character of the particular neighborhoods.
Redlining: Denying to make a loan because of the racial or ethnic
structure of the neighborhood where the security property is located
is termed as redlining. The prohibition against redlining is enforced
through the Home Mortgage Disclosure Act. (This is discussed later
in the chapter)
Disability and Familial Status: The classification of prohibiting
discrimination based on disability or familial status was added to
the Fair Housing Act only in 1988.
Disability: Discriminating against someone because of his disability
is a violation of the Fair Housing Act. A disability or a handicap (as
it is mentioned in the act) is defined as a physical or mental
impairment that substantially limits one or more major life
activities. This also includes people who are chronic alcoholics,
mentally ill, or HIV/AIDS patients. However, this act does not cover
those who are a direct threat to the health or safety of others, or
those who are presently using controlled substances.
A landlord has to permit a disabled tenant to make necessary
practical modifications to the property (at the expense of the
tenant), which the tenant can fully use and enjoy. However, the
tenant could be asked to restore the premises to its original
condition at the end of the tenancy period. The landlords may also
be required to make rational exceptions in their rules to assist
disabled tenants. For instance, pets may not be allowed in the
premises by the landlord but she cannot refuse to rent to someone
because he has a guide dog.
After 1991, under the Fair Housing Act, new residential
constructions with four or more units had to follow wheelchair
accessibility rules.
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Familial Status: This discrimination refers to discriminating against

someone because a child (someone who is under 18 years of age)
is/will be living with him/her. Parents, legal guardians, pregnant
women, and those who are about to obtain custody of a child are
covered against discrimination on the basis of their familial status.
Although the Fair Housing Act does not disregard local laws that
limit the number of occupants allowed in a house, it is illegal to
discriminate in selling, renting or lending money to buy a
residential property for the reason that the applicant is pregnant or
intends to live with a child. Adults Only apartments or
condominium complexes are not allowed and also complexes that
are divided into adult and family sections are similarly
prohibited.
But the Fair Housing Act has an exemption for properties that
qualify as housing for old people. Children may be prevented from
staying in properties that come under one of the following
classifications:
1.

Properties that are developed

government program to assist elderly citizens,

under

2.

Properties that are intended for and solely

occupied by people who are 62 or above, or

3.

Properties that observe the policies that show

an intention to accommodate persons who are 55-years old or
above, if a minimum 80% of the units are taken by at least one
person who is 55 or more.

Enforcement: The Department of Housing and Urban Development

(HUD) enforces the Fair Housing Act, through its Office of Fair
Housing and Equal Opportunity. A distressed person may file a
lawsuit in federal or state court, or else has a choice of filing a
complaint with the HUD.
A complaint with the HUD can be filed within one year after the
occurrence of the discriminatory act. The investigation of the case is
done by the agency and it tries to advise the parties in order to
settle their differences and coax the violator to abide by the law.
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If the dispute is not resolved by this method and the complainants

allegations are found to be fair, an administrative hearing is held
where HUD attorneys contest the case on behalf of the complainant.
The U.S. Attorney General can file a suit in the federal court if an
involvement of discriminatory act/action is found in the case.
When someone is found guilty of violating the Fair Housing Act, the
court or the administrative law judge may issue a ruling that orders
the violator to refrain from the discriminatory conduct or take
positive steps to correct a violation. The violator may also be
required to pay compensatory damages and the attorneys fees to
the complainant. The violator may even be ordered by the federal
court to pay punitive damages to the complainant. Note that an
administrative law judge cannot impose punitive damages, but he
can impose a civil penalty to be paid to the government. The
maximum penalty that can be imposed is $16,000 for a first offence
and up to $65,000 for a third or following offence.
In a case contested by the Attorney General, the court can impose a
civil penalty ranging from a maximum of $55,000 for a first attempt
and up to a maximum of $110,000 for a third or following attempt.
In California, where the state fair housing laws are quite similar to
the federal law, HUD might refer the cases to the equivalent state
agency, which in California is the Department of Fair Employment
and Housing.
Federal Fair Lending Laws
As earlier discussed, the Fair Housing Act disallows discrimination
in residential mortgage lending. However, this does not apply to
other types of credit transactions.
The Equal Credit Opportunity Act (ECOA) applies to all credit
transactions, including mortgage lending. This act disallows any
lenders, loan originators, mortgage brokers, and anyone else
involved in financing to discriminate on the basis of race, color,
religion, national origin, sex, marital status, or age (provided
applicant is not a minor), or if the income of the applicant (partly or
wholly) comes from public assistance.

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The Home Mortgage Disclosure Act provides a solution to evaluate

whether lenders are satisfying their obligation to serve the housing
requirements of the communities where they are located. This act
facilitates the enforcement of federal laws against redlining.
The Home Mortgage Disclosure Act requires the large institutional
lenders in metropolitan areas to submit annual reports on the
residential mortgage loans, including purchase and improvement
loans, that they originated or purchased during the fiscal year. This
information is classified by number and dollar amount, type of loan
(FHA, VA, others) and geographic location by census tract or
county. Through this report, some areas may be found where less
or no home loans have been made, signaling a possibility of
redlining in those areas.
Americans with Disabilities Act
The federal law, Americans with Disabilities Act (ADA,) has been
effective since 1992. The intent of this law is to ascertain that
disabled people have equal access to public facilities.
Under the ADA, it is unlawful to discriminate against any individual
on the basis of disability in any public place or public
accommodation. The definition of disability given is the same as the
one in the Fair Housing Act, i.e. any physical or mental impairment
that substantially limits one or more of an individuals major life
activities.
A public accommodation is a private entity with facilities open to
the public, if the operation of the facilities is commercially affected.
Real estate offices, along with hotels, restaurants, banks, shopping
malls, retail stores, and offices of attorneys, accountants and
doctors are all considered to be public accommodations.
To ascertain that public accommodations are accessible, the ADA
needs each of the below mentioned to be done, provided that it is
readily achievable

Architectural
barriers
and
communication
barriers should be removed for goods and services to be
accessible to disabled people.
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Auxiliary aids and services should be provided so

that no disabled person is excluded, segregated, denied
services, or in any way treated differently from another
individual.

If
structurally
possible,
new
commercial
construction should be accessible to people with disabilities.

For example, a commercial building owner may have to add grab

bars to restroom stalls, or may be required to alter the height of a
pay phone to make it accessible to a disabled person in a
wheelchair.

CALIFORNIA ANTI-DISCRIMINATION LEGISLATION

We discussed the federal laws with which real estate agents, sellers,
landlords, and others involved in real estate activities need to
comply. But there are state laws that also prohibit discrimination.
In California, the following acts are designed for fair and just real
estate transactions:
-

The Unruh Civil Rights Act,

The Fair Employment and Housing Act,

The Housing Financial Discrimination Act, and

The Real Estate Law

The Unruh Civil Rights Act: Under this act, all people are entitled
to the full use of any services provided by a business enterprise,
regardless of sex, race, color, religion, ancestry, national origin,
disability, mental condition, marital status, or sexual orientation. In
housing-related transactions, business enterprises are not
supposed to discriminate on the basis of age or familial status
(except in qualified housing for senior citizens).
The Unruh Act disallows real estate licensees from discriminating
while performing their work, as a brokerage firm is a business
enterprise. A broker is not supposed to refuse a listing or reject a
prospective buyer for discriminatory reasons.
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Under the Unruh Act, apartment houses, homeowners and

condominium associations, and real estate developments are all
considered as business enterprises. Therefore, this act makes it
illegal for most condominiums or apartment complexes to have a
No Children rule. Nevertheless, certain qualifications that are
fulfilled by developments for senior citizens may need at least one
member of each household to be 55-years old or above and, with
some exceptions, may exclude those younger than 45 years old.
This particular state law should be interpreted with the federal
rules in mind that concern housing for senior persons, explained as
above. If the state law gives more protection against discrimination
than the federal law, then state law should be applied. Conversely,
if the federal law provides more protection, then it will trump state
law.
Anyone who has violated the Unruh Act will be imposed a penalty of
paying the injured partys actual damages and the attorneys fees.
Over and above this, the violator may be asked to pay the injured
party up to three times the amount of actual damages or $4,000,
the higher of the two amounts. In some case even civil penalties
may be imposed.
The Fair Employment and Housing Act
This act is also known as the Rumford Act. This act is designed to
generally prohibit all housing discrimination in the state of
California on the basis of race, color, religion, sex, sexual
orientation, marital status, ancestry, familial status, national origin,
disability, or source of income (public assistance receipt).
Discriminating in selling or renting any housing accommodation by
an owner, landlord, assignee, managing agent, real estate licensee,
or business enterprise is unlawful. It is particularly prohibited by
law for a seller or landlord from asking about the race, color,
religion, sex, sexual orientation, marital status, ancestry, familial
status, national origin, or disability of any prospective buyer or
tenant. However, the landlord may request documents that verify
the identity and financial qualification of a prospective buyer to
rent. A real estate licensee should refrain from answering a
prohibited question from a landlord or a seller.
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The Fair Employment and Housing Act also disallows anyone from
advertising housing for sale or rent in terms that are discriminating
in nature, including any ads that implies a preference for a certain
group. For example, an advertisement from a landlord that
indicates a preference for women or married couples as tenants.
The act also disallows discrimination in the financing of housing.
This act prohibits any bank, mortgage company, or any other
financial institution to discriminate against any person for his race,
color, religion, sex, sexual orientation, marital status, ancestry,
familial status, national origin, disability, or source of income.
There are some exemptions to this act. It does not apply to
accommodations managed by nonprofit religious, fraternal, or
charitable organizations. This act does not apply to the rental of a
portion of a single-family owner-occupied home to one occupant.
Also, when a rental arrangement includes shared living space, it is
allowed to state in the ad that it is available just to women, or just
to men.
The Department of Fair Employment and Housing takes care of the
housing discrimination complaints. The staff of the department
investigates the complaints. If it seems that a violation has ensued,
the department attempts to encourage the violator to stop or rectify
the violation. If this does not work, then the department issues an
accusation and a hearing will be held by the Fair Employment and
Housing Commission or in a superior court. On being found guilty,
the violator may be asked to:

Sell or lease the property in question to the

injured party (if it is still available),

Sell or lease similar property to the injured party

(if available), or

Arrange financial assistance or other benefits that

were denied previously.

Apart from the above the violator may also have to pay the injured
party actual damages, and civil penalties starting from $10,000 up
to $50,000. If the case has gone to superior court then instead of a
civil penalty the court may impose punitive damages on the violator.
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The Housing Financial Discrimination Act

This act is also referred to as the Holden Act. Under this act the
lender must make lending decisions based on the worthiness of the
borrower and the security property, and not on the fact that the
property is in a certain neighborhood. According to this act, it is
against the public policies of California to refuse mortgage loans or
to impose stricter terms on loans due to neighborhood
characteristics that are unrelated to the creditworthiness of the
borrower or the value of the property.
According to this law, financial institutions are not supposed to:

Discriminate while providing financial assistance

to purchase, construct, rehabilitate, improve, or refinance
housing based on the characteristics of the neighborhood in
which the property is located, except if the lender can prove
that such consideration is necessary to avoid a problematic
business practice,

Consider the racial, ethnic, religious, or national

origin composition of the neighborhood in which the property
is located, or

Discriminate while providing financial assistance

for housing on the basis of race, color, religion, sex, marital
status, national origin, or ancestry.

Real Estate Law and Regulations

The California Real Estate Law as well as the Real Estate
Commissioners regulations disallows discriminatory behavior by
licensees. The licensees involved in discriminatory behavior are
subject to disciplinary action, and their licenses may be suspended
or revoked.
It is the duty of the brokers to supervise their affiliated licensees
and take proper steps to ensure that they are familiar with the
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requirements of the federal and the state laws that prohibit

discrimination.

DISCRIMINATORY RESTRICTIVE COVENANTS

It used to be common in the U.S. for a propertys deed or a
subdivisions CC&Rs to include restrictive covenants disallowing the
sale or lease of property to non-whites or non-Christians. These
discriminatory restrictions were usually considered legal and
enforceable until the Supreme Court decided the case of Shelly V.
Kraemer in 1948. It was ruled by the Court that it was
unconstitutional, a violation of the Fourteenth Amendment, for
state or federal courts to involve themselves in the enforcement of
racially restrictive covenants. Due to this decision, those covenants
became legally unenforceable.
Although discriminatory restrictive covenants still exist in some
older documents, it is a violation of both federal and state laws to
try to enforce them or abide by them. According to California law,
restrictive covenants are illegal if they discriminate on the basis of
race, color, religion, sex, sexual orientation, familial status, marital
status, disability, national origin, source of income, or ancestry.
A requirement concerning illegal covenants is imposed by state law
on those who provide copies of recorded documents to others while
in the course of their work. County recorders, title company
employees, escrow agents, homeowners association representatives,
and real estate agents are included. Whenever a copy of a
previously recorded deed or declaration of restrictions that contains
a discriminatory covenant is given to someone, the provider of the
copy should stamp the document or attach a cover page mentioning
that the restriction is void and may be removed by recording a
Restrictive Covenant Modification.
Remember that if an illegal restriction is included in a new deed,
even though the restriction is void and unenforceable, the
conveyance remains valid.

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Chapter Summary
The Civil Rights Act of 1866 prohibits racial discrimination in
all property transactions.
The federal governments initiative to promote equal
opportunity in housing brought about the Civil Rights Act of
1964.
The Federal Housing Act, which is also called Title VIII of the
Civil Rights Act of 1968, makes it illegal to discriminate on the
basis of race, color, religion, sex, national origin, handicap, or
familial status in the sale or lease of residential property or
even in the sale or lease of vacant land for the constructing
residential homes.
The classification of prohibiting discrimination based on
disability or familial status was added to the Fair Housing Act
only in 1988.
The Department of Housing and Urban Development (HUD)
enforces the Fair Housing Act through its Office of Fair
Housing and Equal Opportunity.
The Americans with Disabilities Act (ADA), a federal law, has
been in effect since 1992.
The Fair Employment and Housing Act also disallows anyone
from advertising housing for sale or rent in terms that are
discriminating in nature, including any ads that implies a
preference for a certain group.
Although discriminatory restrictive rovenants still exist in
some older documents, it is a violation of federal and state
laws to try to enforce them or abide by them.

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Chapter Quiz
1. Which of the following is NOT a federal antidiscrimination law?
a. The Civil Rights of 1866
b. The Civil Rights of 1964
c. The Unruh Civil Rights Act
d. The Fair Housing Act
2. The illegal practice of telling people that the property values in
a particular neighborhood will fall because of a certain event,
like the purchase of homes by minorities, is called:
a. Panicking
b. Blockbusting
c. Steering
d. Redlining
3. Channeling prospective buyers away from or toward a specific
neighborhood based on their race, religion, or national origin
so as to maintain or change the character of that
neighborhood is __________.
a. Steering
b. Blockbusting
c. Redlining
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d. Panic peddling
4. Initially, the Fair Housing Act did not prohibit discrimination
based on disability or familial status, these classifications were
added to the law later in the year_______.
a. 1968.
b. 1978.
c. 1988.
d. 1998.
5. The California law prohibiting discrimination in the sale,
rental or financing of almost all types of housing is the________
Act.
a. California Fair Employment and Housing
b. Holden
c. Fair Housing
d. Unruh Civil Rights
6. The ______________________ is also called the Rumford Act.
a. Unruh Civil Rights Act
b. Fair Employment and Housing Act
c. Housing Financial Discrimination Act
d. Americans with Disabilities Act
7. The _________________ is also called the Holden Act.
a. Unruh Civil Rights Act
b. Housing Financial Discrimination Act
c. Fair Employment and Housing Act
d. Americans with Disabilities Act

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8. The ____________________Act guarantees people with physical

or mental disabilities equal access to public accommodations.
a. Fair Housing
b. Unruh Civil Rights
c. Americans with Disabilities
d. Civil Rights Act of 1964
9. The Home Mortgage Disclosure Act aids to enforce the
prohibition against which of the following?
a. Steering
b. Redlining
c. Flipping
d. Blockbusting
10.

The Fair Housing Act:

a. Prohibits discrimination based on race or color in all real
estate transactions
b. Prohibits discrimination based on race, color, religion, or
national origin in some programs that receive financial
assistance from the federal government
c. Prohibits discrimination based on race, color, religion,
sex, national origin, disability, or familial status
throughout the U.S. and it applies only to residential
properties
d. Guarantees people with physical and mental disabilities
equal access to public accommodations.

11.
Which of the following Act is a federal law and NOT a
California state law:
a. Fair Employment and Housing Act.
b. The Civil Rights Act of 1964.
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c. Unruh Civil Rights Act.

d. Housing Financial Discrimination Act.
12.
Not allowing a person to rent or lease a property on the
basis that he will be staying with a child amounts to a
discrimination based on:
a. Sexual orientation
b. Marital status
c. Disability
d. Familial status
13.
Which Act prohibits lenders, loan originators, mortgage
brokers, and others involved in financing from discriminating
on the basis of race, color, religion, national origin, sex,
marital status, or age, or that the applicants income comes
from public assistance?
a. The Equal Credit Opportunity Act.
b. The Home Mortgage Disclosure Act.
c. The Holden Act.
d. The Rumford Act.
14.
Under the _______________ Act, large institutional lenders
in metropolitan areas have to submit yearly reports on the
residential mortgage loans that they originated in that fiscal
year.
a. Holden
b. Rumford
c. Home Mortgage Disclosure
d. Housing Financial Discrimination

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15.
The Law that prohibits the licensee from discriminatory
behavior is:
a. The Housing Financial Discrimination Act
b. California Real Estate Law
c. The Rumford Act
d. Unruh Civil Rights Act

CHAPTER 15
Real Estate Construction, Ownership
and Investment
CHAPTER OVERVIEW
When it comes to bringing a buyer and a seller together, the real
estate agent needs to be familiar with the following factors: property
values, contracts, financing, the fundamentals of residential
construction, the advantages of buying a home, the essentials to
look for in a home, and also the benefits of investing in real estate.
In this chapter we shall cover:
- Some features of residential construction, especially wood
frame construction,
- The comparative merits of renting or buying a home, and the
facts to consider when selecting a home as a home or as an
investment, and lastly
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- An introduction to real estate investment.

CONSTRUCTION
A real estate agent is not a home inspector or an architect. A real
estate agent should not give the impression that he is an expert in
residential construction. Yet California law does impose a duty on
every licensee to do a visual inspection of the homes they sell.
Moreover, home buyers trust their real estate agent for advice on
the structural quality of homes they are interested in buying.
Therefore, it is important that the agent is able to evaluate the basic
completeness of a homes construction.
It is a good practice for an agent to support his initial evaluations,
whenever possible, with the opinions of professional inspectors.
This should especially be done when it comes to the structural
integrity and the safety and correctness of the plumbing and
electrical fixings of the building.
To evaluate the basic completeness of a home, a real estate agent
should be familiar with the features of a residential construction as
follows:

Local building codes and regulations,

Architectural styles,

The role of the architect,

Plans and specifications, and

Construction methods and terminology.

ARCHITECTURAL STYLES
There are various types of architectural styles used for homes. The
style affects the cost of construction, although the style of a home
does not define the quality of a home. A particular style is not
essentially more desirable over another. The value of the style is
totally dependent on the personal preferences of the buyer.
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Homes have their own unique styles and sometimes two or more
styles are combined to provide a desired effect. Some of the popular
architectural styles in California are split-level, Spanish, California
ranch, and modern (or contemporary).
In a split-level type home, hilly terrains are effectively used and
these are also visually very attractive.
Spanish-style homes are normally one- or two-story homes and
with exteriors that are white or pastel stucco with red-colored roof
tiles. In the heat of southern California, this style looks cool and
comfortable.
These modern-style homes are generally built with large windows
and glass doors and are designed to have open interiors. The
modern homes are so flexible in design that they can be easily built
on hilly areas and other hard-to-reach sites.
California ranch homes are usually one story and low-pitched or
flat-roofed. The exteriors are wooden, masonry, or stucco.
The simplest to construct and maintain is the one-story ranch
home, but it requires more land in terms of living space than a twostory or split-level home. Where land prices are high, a one-story
home may not be economical. A split-level construction is
comparatively more expensive, but because of its effective
utilization of land (with varying topography), it is quite popular. As
with the per square foot of living space, a two-story building is most
economical, as twice the living space can be provided with one
foundation, roof and same size of land. The main drawback of the
two-story home is the inconvenience of staircases and the exterior
maintenance for the upper story.
Local Building Codes and Regulations
The types of material to be used in residential construction,
appropriate methods of construction, and the quantity and
placements of items like electrical outlets, plumbing fixtures, and
windows are all specified by the local building codes. Also the size
and placement of a building on its lot are controlled by the building
codes and other local regulations.
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The building codes help maintain a level of uniformity in

construction. A minimum standard of quality is met with the help of
the construction guidelines, especially safety issues. For instance, a
home should be able to resist fire or earthquake, this is of utmost
importance to both the homeowner and the neighboring
community.
For information regarding local regulations, the key sources are
local planning and building departments, architects, and
construction contractors.
The Role of the Architect
A real estate agent is most likely to work with an architect, who is a
construction industry professional. Generally, an architect is
considered to be someone who designs buildings, but a good
architect is one who also provide other services throughout the
construction process.
According to standard contracts, an architect initially works with
the owner to develop a design which meets the owners needs. Then
the architect prepares detailed drawings, where he describes all the
components of the building and with it an estimate of the possible
cost of construction. Once the design is approved by the owner, the
architect draws up the official plans and specifications. He also
helps the owner obtain bids from the contractor and permissions
from the government agencies.
Lastly, the architect acts as the owners representative through the
entire construction phase. He visits the site to inspect the work,
approves periodic payments to contractors, and explains the plans
and specifications.

PLANS AND SPECIFICATIONS

The technical drawings and text that explains in detail about how a
building is to be constructed are called plans and specifications.
The drawings of the vertical and horizontal cross-sections of the
building are called the plans. They indicate the placement of
foundations, floors, walls, roofs, doors, windows, fixtures, and
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wiring. The text that accompanies the plans

specifications. These prescribe the type of materials
the quality of workmanship that is required.
specifications take the form of blueprints, and
prepared by an architect.

is called the
to be used and
A plans and
are normally

WOOD FRAME CONSTRUCTION

The wood frame building is the most common type of home
construction. It is preferred due to its low cost, ease and speedy
way of construction, and flexibility of design. One-story, two-story,
and split-level homes may be constructed as wood frame homes.
Since wood frame buildings are the most common type of
construction, we will focus on it here.
Elements of Wood Frame Construction: Knowledge of the
elements of construction will make it easier to judge the quality of
the home. The local building codes normally specify the material
required for each element. The basic elements of residential wood
frame construction are the:
Foundation: Generally all modern building foundations are made
with reinforced concrete. The advantages of concrete are its lowcost, plasticity, and high compressive strength. Also, when concrete
is reinforced by steel bars or mesh, it becomes resistant to bending
or cracking.
The foundation walls wider part of the base is called a footing. This
supports the weight of the structure. A board attached to the top of
the concrete foundation is called a sill plate. The framing of the
house rests on the sill plate.
Framing: The framing is generally made of wooden boards and
dimensional lumber, although the use of metal framing has become
more common in some areas. Depending on its moisture content,
lumber is classified as either green or dry. For framing purposes,
dry lumber is considered to be superior to green lumber, because it
is less prone to warping. (Warping is the deformity in shape caused
by uneven shrinking.)
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Depending on their particular application as girders, joists, studs,

rafters, and so on, the size and length of framing members varies.
The parallel boards that are used to support the load of the floor
and the ceiling are called joists. Studs, which are vertical members,
are attached to the sole plate. The sole plate is a horizontal board
that rests on the floor joists.
The purpose of the wall is to: (a) provide structural support, and (b)
separate the interior space for creating individual rooms. The walls
providing support are called load-bearing walls. A vertical load such
as a floor or the roof is supported by load-bearing walls. The loadbearing walls are always built to be stronger than the non-load
bearing walls, and they are hardly ever moved during remodeling.
Exterior Sheathing and Siding: Exterior sheathing is the covering
that is applied to the outside of the frame. The plywood panels that
are four feet wide and eight feet long are the most common form of
exterior sheathing. An additional function is served by plywood for
adding shear strength to the walls. The capacity of a wall to resist a
sideways racking force is its shear strength. This is usually
provided by corner bracing in the frame.
Exterior siding is the noticeable finish layer applied to the outside of
the building. It might be plywood, boards, vinyl siding, shingles, or
other materials. The two most important features of siding are (a)
its resistance to weathering, and (b) its aesthetic appeal.
Interior Sheathing: This is a covering which is applied to the
inside of the frame, on the walls, and ceilings. Previously, the most
common form of sheathing was lath and plaster (a cement-like
mixture applied over a matrix of wood strips attached to the frame).
These days, the buildings use drywall construction for interior
sheathing. It is called drywall because water is not required to be
added to the material before application. The drywall products
normally come in the form of large sheets (as plywood sheets) and
they are fastened to the frame with glue, nails, or screws. The two
most common drywall products are sheetrock and wallboard. The
joints between the panels are hidden by covering them with a strip
of tape embedded in plaster-like filler. The process is called taping
the joint.
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Roofing: The highest structural member of the house -- the roof -is made up of the ridge board, rafters, and plywood or boards
arranged perpendicular to the rafters. This sheathing is then
covered with roofing felt, made of tar-impregnated paper. The last
layer of roofing could be wood shingles, tiles, or composition roofing
(tar-like shingles or rolls of material). Often hot tar is combined with
more layers of felt. This is referred to as a built-up roof. Metal
sheeting called ing is installed on top of the roofing material around
chimneys and other openings to avoid water seepage.
Floor Covering: The strength of the floor comes from the tongueand-groove floor boards or plywood attached to the floor joists, this
is called the sub-flooring. This sub-flooring is then covered with
finished flooring. Finished flooring may be carpet, tiles, linoleum,
hardwood strips, or other such materials.
Plumbing: The drain pipes, supply pipes, and fixtures are all part
of plumbing. The drain pipes may be made up of plastic, concrete,
or cast iron. Plastic, copper, or galvanized steel is used for making
supply pipes. Plumbing fixtures may be made of either cast iron or
pressed steel that is coated with enamel or fiberglass.
Electrical: Generally, modern wiring is in the form of cable. A cable
is a cord-like material consisting of two or more strands of copper
or aluminum wires. These electrical cables are enclosed in metal or
plastic piping called a conduit.
There is a supply source, such as a fuse box, or a breaker panel,
from which the electrical cables run in circuits to the various
outlets for plugs or light fixtures. A breaker panel is a series of
circuit breakers that automatically cuts off the current in a circuit
in overload conditions. The majority of outlets supply 110 volts of
power, apart from certain outlets designed for major appliances like
ranges, water heaters, dryers, and so on, which supply 220 volts.
Heating, Ventilation, and Air Conditioning (HVAC): These are
systems comprising heating and/or cooling appliances. These
appliances provide warm, cool, or fresh air to the rooms of a home
through a sequence of galvanized sheet metal tubes called ducts.
The ducts open at different places in the building called registers.
The registers may be shut off singularly in order to direct the heat
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or air conditioning to areas where it is needed. HVAC systems often

have an energy-efficient ratio (EER) rating. A higher EER indicates a
more efficient system.
The use of insulation makes HVAC systems less costly to operate.
Insulation is that material which is resistant to the transfer of heat.
It comes in loose formcalled batts and rolls which is inserted
between wall studs and between the joists of floors and ceilings.
Insulations also come in sheets that can be secured to the
sheathing of the structure. The effectiveness of insulating materials
is assessed by an R-value. A high R-value would mean the
material is more resistant to the transfer of heat, and it is also
better for insulation purposes. According to local building codes,
insulation with a minimum R-value should be used in all new
construction. An adequate insulation would mean that the inside
surface of an exterior wall will be almost the same temperature as
the surface of an interior wall.
Structural Pest Problems: A major problem with wood frame
buildings is their vulnerability to damage by wood-eating insects,
termites. To minimize the nuisance of the damages caused by
termites, many techniques are used such as:
To keep the termites away from the foundation, the ground
under and around the building may be treated chemically,

Lumber that comes in contact with the soil or the foundation,

such as sills or beams, may be treated chemically to avoid
termites from gaining access to the frame of the building, and

Metal shields may be inserted between the foundation and the

superstructure to prevent the physical entry of termites from
reaching the wood.
Before a sale closes, it is advisable to have the home inspected by a
licensed structural pest control inspector. In California, lenders
require such an inspection to be done and in some termite-prone
areas of the state, pest control inspection is required by the FHA
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and VA. The inspector produces a thorough report on the structural

soundness of the building. The report lists any defects that are
caused by moisture and fungus and also by insects.
Generally, a pest control inspection is ordered by the seller when
the property is first listed. The inspection reports copy must be
given to the seller or his agent within ten working days. Real estate
agents must make sure to provide a copy of the report to the buyer
as soon as practically possible. The report has to be filed with the
state Structural Pest Control Board, where it will be retained for two
years.
Unless otherwise agreed by the parties, the seller is normally the
one who is has to pay for correcting the existing pest control
problems, although he is not responsible for work to prevent
infestation. Any preventive work done should be paid for by the
buyer.

RENTING AND BUYING

Real estate agents are often asked whether buying property has
advantages over renting property. Some concerns are basically
emotional, such as security, pride of ownership, freedom to keep
pets, or to able to do remodeling according to personal preferences.
These concerns cannot be weighed neutrally by a third party; the
importance of this can be measured by the prospective buyer
himself. But the financial aspects of the comparison can surely be
evaluated for the prospective buyer with the help of the real estate
agent.
Advantages of Renting
A brief summary of the advantages of renting over buying is given
below. When compared to buying, renting:
- Is less risky, and needs limited financial commitment,

- Gives greater mobility to the tenant, and

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- Comes with fewer responsibilities.

Financial Risk: Rental premises require little financial investment
from the renters, so the risk is also small. For instance, if the value
of a property in a neighborhood declines and it becomes
undesirable and rundown, the renter has the option of giving the
required notice or wait for the lease period to end and move out.
Conversely, a homeowner in the same situation faces a risk of
losing some or all of his investment in the property.
Financial Commitment: As compared to the funds required for
buying a home, the money needed to rent a home is much less.
Generally a security deposit and a one-to-two months advance rent
payment is enough. Even if the down payments are low, the cash
required for purchasing a new home (the down payment amounts,
loan fees, closing costs) will invariably exceed the cost of renting a
home. Also, the monthly rental payments are far less than the
monthly mortgage payments.
Mobility: Moving homes is faster, easier and cheaper for a renter
than for a homeowner. A renter has to provide a necessary notice or
wait until the lease period is over before moving out. Even if a
renter has to leave suddenly, he will only lose the security deposit
and the advance rent. This is much less than the cost of selling one
home and buying another. Selling a home is a long and expensive
procedure; it typically takes a few months (longer, in a slow market)
and costs about 10% of the value of the home.
Maintenance and Repairs: The owner has the responsibility of
repairing and maintaining the property. In the case of a renter, the
cost of repair and maintenance is usually included in the rent. A
renter has no direct responsibility for repairing and maintenance
work. A renter is free from the liability of sudden and unexpected
repair expenditures.
Amenities: Recreational facilities like swimming pools and tennis
courts are normally beyond the reach of most homeowners, which a
renter can enjoy.

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Advantages of Buying
For many people, buying a property offers an advantage of security
and personal satisfaction along with the financial advantages of
equity appreciation and tax deductions.
Security: There is a certain amount of security in knowing that you
can stay in the home as long as the mortgage payments are made. A
renters security is limited to the term of the lease. Once the lease
term expires, he may have to vacate the premises. A month-tomonth tenant has even less security.
Privacy and No Restrictions: Mostly, a homeowner has more
freedom to use the property and greater privacy than a renter. A
homeowner is free to redecorate or remodel his house, keep pets,
and engage in other activities that may be disallowed in many
rental agreements.
Monthly Payments: Usually, a homeowners monthly mortgage
payment is higher than the rental payment for a similar rental
home. But, as time goes by, rents are likely to increase at a faster
rate than mortgage payments, especially if the mortgage has a fixed
interest rate. In such a case, the monthly payment will only
increase if the property tax or insurance portion of it increases
(which does not happens frequently). If the mortgage interest rates
are adjustable, the payment amount increases at a faster pace but
will decrease if the interest rates come down. So, eventually a
monthly rental payment may be larger than a monthly mortgage
payment.
Investment Appreciation: It is not possible to forecast whether a
particular home will appreciate in value and how much it will
appreciate. It is possible that, due to financial conditions,
maintenance issues, and neighborhood decline, it may depreciate
instead. In the past however, average home values have overtaken
the average inflation rate. With the appreciation of a home, the
homeowner generally enjoys an increase in home equity, and as a
result, increases in net worth. Contrarily, a renter can see his rent
payments increase with the appreciation of the property.

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Tax Advantages: In connection with home ownership, the federal

income tax laws allow tax deductions for property taxes and for
mortgage interest. The only consumer interest that is eligible for tax
deduction from federal income taxes is the interest paid on a loan
secured by a personal residence. Also, the part of the gain realized
on the sale of most principal residences is not taxed at all. A similar
tax benefit is not given to someone who rents his principal
residence.
Comparison of Renting and Buying
Worksheets are sometimes used by real estate agents to compare
the net costs of renting and buying for prospective customers. The
comparison worksheets show how the overall cost of buying a home
may be less than the cost of renting a home (in the long run, at
least). The worksheet form calculates the monthly mortgage or
rental payments along with the homeowners increases in equity
and the benefit of income tax deductions.
Elements to Consider When Selecting a Home
When a home is shown to the buyer by the real estate agent, both
the buyer and the seller trust the agent to indicate the positive
features of that home. Therefore it is necessary for the real estate
agent to understand the factors that are important to the
prospective home buyer. These features have an effect on the
propertys attractive aspects to a home buyer and the propertys
value as projected by an appraiser.
Neighborhood factors: should be given careful consideration,
since the surroundings of a property have a huge impact on the
value and overall appeal of a home.
The neighborhoods that have a majority of owner-occupied homes
are usually better maintained, less prone to loss in value, and have
a greater chance to appreciate in value.
Conformity: Neighborhoods with a higher degree of consistency
have their value protected. The consistency should be in styles,
ages, prices, sizes, and quality of structures.

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Changing Land Use: The neighborhood land use should appear

stable and it should not signal a transition from residential to some
other type of land use.
Street and Sidewalks: The neighborhood streets should have good
access to traffic arterials. If a property is not facing a publicly
dedicated and maintained street, the buyer should inquire if there
is an enforceable road maintenance agreement signed by the
property owners.
The condition of the driveway should also be looked at as well as
the street lights and fire hydrants on the block. There should be
sanitation and/or storm sewers and if so, are they already paid for
or are homeowners assessed a fee for them.
Utilities and Public Services: Basic utilities such as water, gas,
telephone service, electricity, and sewers, should all be readily
available Cable television, high-speed internet service and good
mobile phone reception should be also be accessible. Check if the
utility lines are above the ground or there is underground wiring.
The neighborhood must be sufficiently served by public
transportation, police, and fire protection.
Schools: The schools should not be too far away. The quality of the
local schools or school district has a huge impact on the value of
the property and it can be a very important basis for making a
decision for most buyers with children in the school-going age
group.
Social Services: There should be places of worship, hospitals and
health-care facilities and other social services in the neighborhood.
Neighborhood Values in General: It should be determined whether
the overall condition of homes in the neighborhood and the property
values are stable, improving, or declining.

THE HOME
Obviously, the aspects to be reviewed with a prospective buyer
regarding the home itself are its size, condition, and amenities. Here
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we shall discuss the qualities of a single-family home, but the

majority of these considerations apply to other types of homes as
well.
Location: The first step is for the agent to look at the lot on which
the house is situated, its size, shape and whether it is on the
corner. Rectangular lots are preferred over odd-shaped lots. Steep
lots are prone to soil instability. The water runoff and drainage need
to be good. The quality and extent of landscaping should be looked
at. Any landscaping such as the lawn, shrubbery, and trees may
not be done at a new home and the buyer might have to do it, and
its cost may be much more than the home buyer anticipates.
A propertys appeal and value can increase greatly due to the view
from and around the home.
Exterior Appearance: This depends on the age of the house and
whether it was has been painted recently. To know the age and
condition of the roof and flashing, gutters, downspouts, siding,
windows, doors and weather stripping is also very important. There
should not be any cracks or other evidence of settling in the
foundation. In the absence of a basement, there should be sufficient
vents and crawlspace.
Plumbing and Electrical Systems: If the home is not new, then
the plumbing and electrical systems age should be considered.
Whether the plumbing is of copper, plastic, or any other material
should be kept in mind.
Heating Ventilation and Air Conditioning: The type of heating
system used in the home should be assessed electric, gas, or oil;
forced air, floor furnaces, and base-board heaters. Examine the size
and type of water heater. In an older home, an important element is
the age and evident condition of the heating, hot water, and air
conditioning systems. Also check with the current owner of any
problems, inadequacies, or defects.
Garage/Carport: A garage is usually considered to be better than a
carport. Assess the size of the garage or carport, and if there is
extra work or storage space along with the parking space. Note if

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there is an entrance from the garage to the house that can protect
from bad weather.
Basement/Attic: Note if the attic or basement is connected well
through the main house and also if there is extra space for the
storage or work area. See the possibility of converting the basement
into an extra room or bedroom.
Energy-saving Features: Ever-increasing energy costs and
concerns regarding the environment have led to an increased
demand for energy-efficient homes. Some of the energy-saving
features are clock-controlled thermostats, insulation-wrapped water
heaters, insulated ducts and pipes in unheated areas, sufficient
insulation for floors, walls and attic, and weather stripping for the
doors and windows. Solar energy equipment is gaining in
popularity.
Interior Design on the Whole: A real estate agent should be aware
of some of the features of a well-designed and an efficient floor plan.
For example, a good plan will have a toilet in every bedroom.
Other design factors that are to be considered are the number and
the size of bedrooms, closets, and bathrooms. There should be
enough rooms with regard to the square footage of the home. A
good design will have a separate dining room or should have a
dining area in the kitchen or living room. The kitchen of a welldesigned home will be spacious and have good sunlight. A storage
room and a laundry room will add to the value of the home.
Considerations for Each Room: Some features are important to
the comfortable and efficient use of each room.
Living Room/Family Room: The size of the living rooms is a
factor along with if there are any family rooms. Also, note the
shape of each of the rooms for optimum furniture placement.
Dining Room or Area: The dining area should be convenient to
the kitchen, and adequately large in relation to the room size.
It should be big enough to accommodate the number of people
living there.

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 Kitchen: The location of the kitchen should be conveniently

placed near to an outside entrance or garage/carport. The
cabinet space and counter area should be in good condition.
Check if any appliances are going to be a part of the sale and if
so, then inspect their quality.

Bedrooms: The number of bedrooms and their size should be

sufficient for the number of people who are going to live in the
house. The closets of the bedroom should be adequately sized.
A good plan will always have bedrooms apart from the family
room, living room, kitchen and other recreational areas of the
home.

Bathrooms: In a house with more than two bedrooms, there

should be at least two bathrooms. The type and condition of
tiles, floor, and wall covering in a bathroom should be checked
out properly. There should be sufficient ventilation in
bathrooms.
Design Deficiencies: The most common design deficiencies when
buying a home are:
- No front hall closet,

- Front door opening directly in the living room

- Difficulty in reaching the back door from the kitchen,

driveway, or garage,

- Inaccessibility of the dining room from the kitchen,

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- No space provided near the kitchen for the family to sit and
eat,

- Bedrooms and bathrooms are visible from the living room or

foyer,

- The staircase to the upper floors is in a room rather than in

the hallway or foyer,

- Basement is inaccessible from outside the house,

- The family room is not visible from the kitchen,

- The bedrooms are not separated by a bathroom or by a closet

wall for soundproofing,

- The kitchen is inaccessible from the outdoor living area.

INVESTING IN REAL ESTATE

Some people are interested in buying real estate not for its livability,
but for investment purposes. They understand that while the value
of real estate fluctuates, property that is in good condition and welllocated in a good neighborhood will certainly increase in value in
the long run.
Note that real estate agents should avoid acting as an investment
counselor. In fact, agents should refer their clients to an
accountant, attorney, or investment experts for investment advice.
An investment is that asset which generates a return a profit. A
return on an investment may be in various forms like interest,
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dividends, rents, or appreciation. An asset appreciates because of

inflation and also if there is high demand for the asset.
Types of Investments
The two broad categories in which investments are divided are:
1) Ownership investments, and

2) Debt investments.
In ownership investments, the investor has an ownership interest
in the asset. Examples of ownership investments are real estate and
stocks. Here the returns will be in form of dividends or appreciation
(or both in certain cases). Ownership investments are also called
equities.
A debt investment is actually a loan that an investor makes to an
individual or an entity. For instance, a bond is a debt owed by a
government entity or a corporation to an investor. The investor
lends the entity money for a certain amount of interest, for a set
period of time to an entity who promises to repay the loan by its
maturity date. An ordinary mortgage loan is also an example of a
debt investment.
These investments are generally diversified by the investors,
meaning they do not invest in just a single type of investment, but
rather in different types. The different types of investments that a
person/company owns in addition to any cash reserves, is called a
portfolio.
For taxation purposes, investment income like dividends, interests,
or rents is always separated from earned income like salary, wages,
or self-employment income.
Characteristics of Investment
The investment opportunity is evaluated by an investor in terms of
three possible advantages: safety, liquidity, and yield (a yield is the
total return on the investors investment). All three characteristics

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are co-related. While safety and liquidity go hand-in-hand, for a big

return, an investor usually sacrifices safety or liquidity, or both.
Safety: When the risk of losing the investors money is small, it is
considered to be a safe investment. In case the investment does not
produce the return she hopes for, the investor will nevertheless
recover the money initially invested.
The investments that carry a guarantee are obviously very safe,
such as the protection of funds up to $250,000 in a bank account
by federal deposit insurance. As long as the coverage limit of
$250,000 is not exceeded, it is very unlikely that a depositor will
suffer a loss of the money placed in an insured bank account. Then
again, there are some types of investments that are essentially
risky. Putting money into a relatively new enterprise, for example,
means there are chances the investor will lose his money if the
company doesnt succeed.
Liquidity: A liquid asset is one which can be converted into cash
quickly. Money is extremely liquid when in the bank. To convert it
into cash, the investor only needs to present the withdrawal slip or
check in the bank. On the other hand, mutual funds, stocks, and
bonds are less liquid, and they may take a little longer to convert
into cash. Items such as jewelry or coin collections are not at all
liquid, since the investor may have to wait for weeks or months to
find a buyer and exchange the assets for cash. Real estate, too, is
not a liquid asset.
Generally, assets with more liquidity have lower returns. For
instance, money in an ordinary bank account is very liquid, but its
return is very humble (in the form of a low interest rate). If funds
are deposited for a specified period of time, as in a certificate of
deposit, a marginally higher rate can be acquired. Normally, the
rate will be higher if the period is longer.
Liquidity is beneficial because the investor can cash in the
investment in a short time if money is required for an unanticipated
expense, or if a better investment opportunity arises. Money in a
non-liquid investment is essentially locked up and cannot be used
for other purposes. Real estate and other non-liquid assets can be

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good investments, but lack of liquidity might have consequences

that should be taken into account by the prospective buyer.
Yield: Safe and liquid investments generally offer the lowest
returns. If the investor wants to get a higher return from his
investment, he must risk some or all of the money initially invested.
The investor may also have to relinquish the liquidity and allow the
money to be tied up for some time.
Also, the yield is never fixed at the time the investment is made
(except with the safest type of investments). With a change in the
market conditions, the yield also changes. For example, an increase
or decrease in the market interest rates.
Generally, a high risk investment will return a higher potential
yield. Investors also expect to get a high yield for long-term
investments. With some types of investments, like a real estate
investment, the return will be much higher, if the investor keeps the
investment for a long time and takes advantage of good market
conditions.
Advantages of Real Estate Investment
Appreciation: The appreciation of a property indicates that it is
increasing in value due to economic changes and other external
factors. It is true that real estate values fluctuate but over a period
of some years, real estate generally appreciates at a rate equal to or
higher than the rate of inflation. For this reason, real estate is
usually considered to offer e a hedge against inflation. With
scarcities in available property, the value of properties in prime
locations increases quickly.
The property owners equity increases due to appreciation. The
difference between the value of the property and the liens against it
is called equity. Thus an increase in the value of the property
increases the owners equity in the property. The equity also
increases, as each monthly mortgage payment is paid, since each
installment paid reduces the loans principal balance. Equity also
adds to an investors (owners) net worth and can be used to secure
an equity loan. Therefore, although real estate is not considered a
liquid asset, equity in real estate is used to generate cash funds.
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Leverage: Leverage is using borrowed money to invest in an asset.

Real estate investors can make use of the advantage of leverage.
When the asset appreciates, the investor earns money on the
amount invested as well as the money borrowed.
Cash Flow: A positive cash flow is generated by many real estate
investments along with appreciation in their value. The spendable
income that is left after all the propertys expenses have been paid
(including operating costs, mortgage payments, and taxes) is called
the cash flow. An investors monthly income increases when a real
estate investment generates a positive cash flow. Therefore, a real
estate investment increases the investors net worth through
appreciation and his income through positive cash flow.
There is a sale-leaseback arrangement which helps generate cash
flow for a property owner. A sale-leaseback means that an owner of
a building (especially a commercial property) sells the building to an
investor, and then leases the same property back from the investor
for his use. The money that is generated from this sale could be
used for expansion, acquiring inventory, and investing in other
projects. The seller can deduct the rent paid to lease the property
from his income taxes as a business expense. At times a saleleaseback arrangement is made with a buy-back agreement. This
means that it is mutually agreed by both parties that the seller will
buy back the property for its fair market value after a certain
number of years.
The term cash-on-cash is used by investors, which means that the
propertys first year cash flow is divided by the initial investment.
This is an indication of the ratio between cash invested (equity) and
cash received.
Tax Benefits: Real estate investment includes tax benefits such as
reducing taxes owed with deductions for depreciation, mortgage
interest, and operating expenses, and deferring payment of taxes
with tax-free exchanges and installment sales. We have already
discussed the income tax implications of real estate ownership in
the Chapter 13.

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Disadvantages of Real Estate Investment

Just like other investments, real estate investment also comes with
some disadvantages that need to be considered.
First, expert advice is normally required when investing in real
estate. Real estate investment is generally more complicated than
investing in mutual funds and savings accounts, and it is also more
time consuming. The initial purchase can a great deal of time and
effort and then the property needs to be managed after it is
acquired. Rental rates need to be fixed, tenants found, rents
collected, and maintenance and repair works done. Some property
owners hire property managers to manage the property but there
are certain decisions needed to be made by the investor.
As explained, real estate investments are not liquid. To convert real
estate into cash, time is required. There is a possibility that the
investor might lose some or all of his down payment. The chance is
always present that a propertys value could decline due to national,
regional or local, economic conditions.
Also, the operational expenses of the property may greatly exceed
the income generated by the property. A negative cash flow may
lead to a hurried sale of the property, and the investor could end up
selling the property for less than its purchase price.

Choices in Real Estate Investment

There are two basic ways of investing in real estate. One way is to
do so as an individual investor. The other way is to invest indirectly
by buying securities, putting money in an investment syndicate, or
making or buying mortgage loans.
Purchasing Real Estate as an Investment: When purchasing real
estate directly, the investor must first decide on the type of property
to invest in and then the particular piece of property he intends to
buy.
Type of Property: There are many types of property that an
investor can choose: residential properties which include single386

family homes, duplexes, triplexes, four-plexes, town-houses,

condominiums, and apartment buildings; commercial properties,
such as office buildings, retail properties, and industrial parks. The
investor may also choose to acquire vacant lots and develop them or
hold them for the benefits of appreciation.
The investor must be aware the potential investment will require
property management. Generally, a commercial property or a multifamily residential property does need an on- or off-site
management. This may be managed by the investor himself or by a
professional property manager.
Most investors start by investing in residential property, some of the
most popular choices being single-family homes or duplexes. Some
of the advantages of investing in a rental property are that they are
usually more affordable for first-time investors than other types of
income property. There are few of them in most communities, so
they are easier to rent. Single-family residences are appealing to
single professionals or young families who are are generally stable
tenants. When an investor needs to liquidate, rental houses are
easier to sell than other kinds of income properties. Also, the owner
can easily manage a single-family home. Two-to-four unit
residential properties have similar advantages. The investor can
also choose to live in one of the units of a duplex, triplex, or fourplex. This will make it easier for the investor to manage the
property.
Qualities to Consider: It is simpler to buy a rental property than
to buy a home. It is more a business decision than an emotional
one. When purchasing a family home, the buyer looks for a house
that suits the familys lifestyle and satisfies personal needs. A rental
house, on the other hand, just has to meet a few requirements. The
house should be in good condition, its location in a good
neighborhood, the square footage large enough to satisfy the
average tenant, the design conventional so that the average tenant
does not feel put off by it.
The location of the rental property should be appealing to the
potential tenant. The renters of the rental property are usually blue
collar workers, single people, career-pursuing individuals, elderly
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citizens, and young families. The neighborhood should be accessible

to employment centers, transportation, shopping and schools. A
rental property will be more appealing if its location is near a
college, hospital, or shopping center.
The structural elements of the property should be in good shape to
attract qualified tenants and also to avoid expensive upkeep and
repairs. The foundation of the property is very important, there
should not be any signs of cracks, breaks, shifts, or bulges.
Examining the heating, wiring, and plumbing systems is necessary.
The house should be well-insulated, so that the electricity and gas
bills will not be too high.
After the investor finds a satisfactory property meeting these
standards, she will start managing the property, probably by
employing a professional property manager.
Property Management: To take care of a large property, a real
estate investor may employ a professional property manager. The
duties of this manager would ideally include: maintaining the
property, doing repair work, periodic inspection of the property,
collecting rents, handling the issues of the tenants, showing vacant
units to potential renters, and acting as a liaison between the
tenants and the owner. According to law, it is mandatory for a
residential property with more than 15 units have a resident
manager (a manager living on the premises).
A property manager is generally paid a flat fee or a commission. The
commission may be based on a percentage of gross receipts, of new
leases, or of the rent received over the lease term.
Indirect Real Estate Investment: With this form of investment,
the investor does not buy the property himself, but rather directs
his funds into a real estate investment syndicate. Interest is
purchased in the syndicate by the investor, and this investment
capital is used to buy and develop the property. A syndicate may be
in the form of a partnership, a joint venture, a corporation, a trust,
or a limited liability company. The syndicate may qualify for a
special tax treatment by meeting the IRS guidelines for a real
estate investment trust, or REIT.

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The investors also buy mortgage-backed securities, issued by one

of the secondary market agencies like Fannie Mae, or by a private
entity. A private entity issuing mortgage-backed securities is
sometimes organized as a real estate mortgage investment
conduit (REMIC) to be able to qualify for tax benefits.
An investor can arrange mortgage loans to make it possible for
others to buy a property. But these private lenders should be
careful not to create a conflict regarding the legal requirements
concerning usury, advertising consumer credit and so on.
According to the nature and level of his activities, a private lender
may need to obtain a real estate license, as a requirement of
California law. Even for the buying and selling of mortgage loans, a
license may be required. This license will be either the one for a real
estate agent or as a securities dealer, and may also be subject to
securities laws.

Chapter Summary
Real estate agents should not convey the impression of being
an expert in residential construction.
Building codes help maintain a level of uniformity in
construction.
The simplest home to construct and maintain is the one-story
ranch home. But it requires more land in terms of living space,
than a two-story or split-level home.
The drawings of the vertical and horizontal cross-sections of a
building are called the plans. They indicate the placement of
foundations, floors, walls, roofs, doors, windows, fixtures, and
wiring. The text that accompanies the plans is called the
specifications.
The wood frame building is the most common type of home
construction.

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 The purpose of a wall is to: (a) provide structural support, and

(b) separate the interior space for creating individual rooms.
An investment is that asset which generates a return: a profit.
Real estate investments include tax benefits such as reducing
the amount of taxes owed with deductions for depreciation,
mortgage interest, and operating expenses; and, deferring
payment of taxes with tax-free exchanges and installment
sales.
A private entity issuing mortgage-backed securities is
sometimes organized as a real estate mortgage investment
conduit (REMIC) to be able to qualify for tax benefits.

Chapter Quiz
1. In building construction, the _______________ assure(s) uniform
standards of construction quality.

a. Planning commission
b. Zoning ordinances
c. Building codes
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d. None of the above

2. The location of a house on its site is called its:

a. Orientation
b. Floor plan
c. Architecture
d. View

3. A well-designed home will have:

a. Bedrooms near the living area.
b. The kitchen near the garage.
c. A single bathroom for every three bedrooms
d. No closets in the bedrooms, for space saving.

4. In a poor floor plan____________

a. A door will lead directly from the kitchen to the garage.
b. The bedrooms are positioned away from the kitchen and
family room.
c. The front door leads directly into the living room.
d. A separate dining area is exactly next to the kitchen.

5. The vertical supports in a wood frame house are called:

a. Studs
b. Beams
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c. Plates
d. Joists
6. Which one of the below is an advantage of renting over owning
a home?
a. Mobility
b. Appreciation
c. Security and stability
d. Federal tax deduction

7. _______________homes have visually attractive designs and

make effective use of hilly terrains.
a. California ranch
b. Spanish
c. Split-level
d. Modern

8. Which of the following is made using reinforced concrete?

a. Framing
b. Exterior sheathing and siding
c. Foundation
d. Interior sheathing
9. One of a series of parallel framing members used to support
floor and ceiling loads is called a _________.
a. Joist
b. Rafter
c. Jamb
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d. Sheathing
10. What is the mix of investments owned by an individual or a
company called?
a. Leverage
b. Yield
c. Portfolio
d. Equity

11. The R-value is a rating that measures:

a. Insulation
b. Energy efficiency
c. How well heat is resisted through insulation
d. Heating capacity of any appliance
12. Which of the following is an advantage of owning over renting?
a. Less financial commitment required.
b. Greater mobility to a person.
c. Fewer responsibilities.
d. Appreciation of property.

13. Ownership investments are sometimes called ____________

a. Portfolio
b. Leverage
c. Equities
d. Yield
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14. Real Estate investors take advantage of ________, which means

using borrowed money to invest in an asset.
a. Leverage
b. Appreciation
c. Cash flow
d. Yield

15. A disadvantage of investing in real estate is:

a. Uniformly low returns
b. Lack of liquidity
c. The use of leverage to increase returns
d. A constantly increasing supply may decrease values

CHAPTER 16
Real Estate License Law in California
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CHAPTER OVERVIEW
The real estate industry in California is strictly regulated. The Real
Estate Law governs licensing requirements and the other
responsibilities of real estate agents. In this chapter we shall learn
when a real estate license is required, who is qualified to get a real
estate license, licensing and renewal procedures, disciplinary
actions against licensees, rules regarding trust funds, and other
requirements of the Real Estate Law. We shall also learn how
antitrust laws affect the real estate business.

ADMINSTRATION OF THE REAL ESTATE LAW

The Business and Professions Codes sections 10000 to 10580
contain the Real Estate Law of California. It is also known as the
license law. This law regulates the real estate profession and
protects the public from incompetent, immoral, or fraudulent real
estate agents.
The Bureau of Real Estate (BRE) -- a division of the California
Department of Consumer Affairs -- administers the Real Estate
Law. The Real Estate Commissioner, the chief officer of the BRE,
enforces the law.
The Real Estate Commissioner implements and enforces the
provisions of the Real Estate Law in such a way as to provide
optimum protection to the members of the public dealing with real
estate licensees. To achieve this goal the Commissioner is given
broad powers.
The power to adopt, amend, or revoke regulations so as to enforce
the Real Estate Law lies with the Commissioner. These regulations
are enforceable and effective under law. The regulations of the
commissioner are available in sections 2705 to 3109 of Title 10 in
the California Code of Regulations.
The following authorities are also available to the Commissioner:
- To investigate non-licensees who are believed to be performing
activities for which a license is necessary,

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- To screen and qualify applicants for a license,

- To investigate complaints against licensees, and
- To regulate some characteristics of the sale of subdivisions,
franchises, and real property securities.
The Commissioner may:
- Suspend, revoke, or deny a license or prevent a sale in a
subdivision after holding formal hearings regarding issues that
involve a licensee, a license application, or a sub-divider,
- Take actions against trust funds violations, and
- Take actions for restrictions and claims for compensations on
behalf of the people injured by licensees violating the Real
Estate Law.
The state attorney general advises the Real Estate Commissioner on
legal matters. Violators of the Real Estate Law are prosecuted by
the county district attorney.
The governor appoints the Real Estate Commissioner. To be eligible
for selection as Commissioner, a person should be an active real
estate broker for at least five years in California. Alternatively, he
must have related experience connected with real estate activity in
California for five out of the previous ten years. The Commissioner
and BRE employees are not allowed to participate in professional
real estate activities, nor can they have an interest in any real
estate firm.
REAL ESTATE LICENSEES
Generally, to regulate an industry or a profession, it is required that
its members be licensed. The state can try to confirm a licensed
persons competence, and control his professional activities by
implementing education, tests, and recordkeeping, and also by
enforcing basic standards for carrying out the business.
Requirement of a License

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According to the Real Estate Law, anyone who acts, advertises, or

seems to act as a real estate broker or a real estate salesperson
should have a real estate license.
Definition of a Real Estate Broker: A person who does or
negotiates to do some acts on behalf of someone else, in exchange
for compensation or expecting a compensation, is called a real
estate broker. The acts include:
1. Sales, purchases, and exchanges of real property or a
business opportunity (discussed further in the chapter).
2. Leasing or collecting rents from real property or a business
opportunity; or buying, selling, or exchanging leases on real
property or a business opportunity.
3. Advertising and listings: Seeking prospective sellers, buyers,
or tenants, or listing real property or a business opportunity
for sale or lease.
4. Government lands: Obtaining or filing an application for
purchasing or the leasing of state or federal governmentowned lands.
5. Advance fees are charged or collected to promote the sale or
lease of real property or a business opportunity. This is done
by either advertising, or listing it, or by procuring financing, or
in any other way.
6. Mortgage loan brokerage: Lobbying borrowers or lenders for
(or negotiating) loans secured by liens on real estate or
business opportunities, or collecting payments, or giving out
other services in connection with such loans.
7. Selling, buying, or exchanging loans or securities: as well
as land contracts, or promissory notes that are secured by
liens on real property or business opportunities, and carrying
out services for contracts or notes-holders.
MLO Endorsement: With regards to residential mortgage loans, by
the end of 2010, real estate brokers were not allowed to engage in
the activities listed in point number 6., above, unless the
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Department of Real Estate adds a special mortgage loan originator

endorsement to their real estate license. To obtain a MLO
endorsement, the real estate broker will have to be licensed through
the Nationwide Mortgage Licensing System and Registry (As
explained in chapter 10).
Also, a real estate broker will not be permitted to take compensation
from a lender or a mortgage loan originator in a transaction that
involves a residential mortgage loan if the broker does not have an
MLO endorsement. The restriction will even apply if the broker
himself offers just real estate brokerage services (those activities
that are listed in points 1., 2., and 3., above).
For these MLO rules purposes, a residential mortgage loan is a loan
primarily for personal, family, or household use, secured by a
property with up to four units.
Making/Selling Loan as a Principal: As previously discussed, the
definition of a broker usually applies to acts that are performed on
behalf of someone else. However, the broker definition also covers
some acts that are performed on behalf of oneself, particularly
covering acting as a principal in the business of making or selling
loans secured by real property. If a person is engaged in the
following activities within one calendar year, then he is considered
to be active and in the business.
Purchases for resale, sells, or exchanges eight or more land
contracts or promissory notes that are secured by real
property, or
Makes eight or more loans secured by one-to-four unit
residential property with his personal funds.
Definition of Salesperson: A person hired by a broker to perform
one or more of the acts listed in the broker definition given above, is
called a real estate salesperson. A salespersons license allows real
estate activities only if he is controlled and supervised by a broker.
A salesperson is not permitted to act directly for a principal in a real
estate transaction.
Also, a salesperson is only allowed to receive compensation from his
own broker (his employer). The clients and co-operating brokers
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need not pay the salesperson directly. They must pay the
salespersons broker, who will then pay the salesperson.
By the end of 2010, an MLO endorsement was required for
salespersons as well as the brokers who are involved in residential
mortgage loan brokerage activities.
Associate Brokers: are licensed brokers who chooses to work for
another broker rather than operating his own brokerage. A broker
who does this is called an associate broker or a brokersalesperson and he is essentially under the same limitations as a
salesperson. The associate brokers and salespersons working for a
particular broker are also called the brokers affiliated licensees.
Business Entities: A corporation can be issued a real estate
license. Under this corporate brokerage license, at least one
corporate officer needs to be appointed to perform the duties of a
broker. This officer should also have his individual real estate
brokers license, and he can only perform as a broker with regards
to corporate brokerage.
Although there is no partnership license, partners may perform
acts that require a brokers license, but every partner should be
licensed as a real estate broker.
Unlicensed Activities Penalties: The penalty for performing acts
that require a license without having a license is a fine of up to
$20,000 and/or six months imprisonment for an individual, and for
a corporation the fine may be up to $60,000.
Note it is unlawful for a broker to employ or compensate someone
who is unlicensed for performing acts that require a real estate
license. There is disciplinary action for brokers who do this and his
license may be suspended or revoked.

NON-REQUIREMENT OF A LICENSE
There are some exemptions from the real estate licensing
requirements. The exemptions could cover those who are acting on
behalf of themselves, or those controlled by another agency (for
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example, security brokers), and those who perform acts in which

expertise is not required.
All the below mentioned are exempt from the real estate licensing
requirements:
1. Those acting on behalf of themselves regarding their own
property.
2. A corporate officer acting on a corporations behalf, or a
general partner acting on a partnerships behalf, regarding
property owned, leased, or to be purchased or leased by the
corporation or partnership.
3. A person acting under a valid power of attorney from the
owner of the property.
4. An attorney providing legal services to a client.
5. A person acting under law, for example a receiver in
bankruptcy or a trustee.
6. A trustee who is under a deed of trust.
7. Concerning mortgage loan activities, an employee or
representative of a financial institution, insurance company,
pension fund, federally-approved housing counseling service,
or cemetery authority; a licensed finance lender; or a licensed
residential mortgage lender or servicer.
8. Regarding activities connected to business opportunities,
mortgage loans, or real property securities, a licensed
securities broker-dealer.
9. A person who performs only clerical functions, without
discussing prices, terms, and condition of property.
10. A hotel, motel, or trailer park manager (or his employees).
11. An apartment manager, who manages the apartment complex
in which he resides (or his employees).
12. A property management companys employee who is
supervised by a real estate licensee working for the company.
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13. Representatives of a film location who negotiate for the use of

property for the purpose of photography.
Unlicensed Real Estate Assistants: Real estate assistants are
sometimes hired by the real estate brokers and salespersons to help
them with their work. If the assistants duties are within the
exemptions for a person performing clerical works (point 9 on the
above mentioned list), then a real estate license is not necessary for
a real estate assistant.
Guidelines have been issued by the Department of Real Estate (it is
available on the BRE website) stating what duties unlicensed real
estate assistants are permitted to perform. Normally, they are
allowed to provide factual information about a property to
prospective buyers, but they cannot show the property or discuss
the terms of a possible sale. Unlicensed real estate assistants are
allowed to prepare documents and advertisements which have to be
reviewed and approved by the licensee for whom they work under.
Unlicensed Property Management Assistants: perform clerical
functions and are also allowed to show property to prospective
tenants, provide information about rental rents and lease
provisions, handle rental applications, accept security deposits, and
collect rents, all under the supervision of a licensee. A broker may
convey responsibility for the supervision of a property management
assistant to a salesperson who has a minimum of two years of fulltime experience as a real estate licensee.

LICENSE QUALIFICATIONS
In order to obtain a real estate license in California, applicants need
to possess several qualifications. These requirements, particularly
the education requirement, are imposed to ensure at least a
minimum level of competence for all real estate professionals.
Salespersons Qualifications: To
salesperson, an applicant should:

procure

license

as

1. Be a minimum of 18-years old,

401

2. Be honest and truthful,

3. Pass the licensing examination,
4. Apply on the form prescribed,
5. Pay the license fee,
6. Be fingerprinted,
7. Provide his social security number to the BRE,
8. Submit the legal presence proof, a document that shows that
she is in the United States legally, and
9. Complete nine semester units of education which includes
Real Estate Principles, Real Estate Practice, and an elective
chosen from the following list: Legal Aspects of Real Estate,
Real Estate Appraisal, Real Estate Financing, Real Estate
Economics, General Accounting, Business Law, Escrow,
Property Management, Real Estate Office Administration,
Mortgage Loan Brokering and Lending, Common Interest
Developments, or Computer Applications in Real Estate.
Brokers Qualifications: To obtain a brokers license, an applicant
should:
1. Be a minimum of 18-years old,
2. Have a minimum of two years of full-time experience as a real
estate licensee within the past five years,
3. Be honest and truthful,
4. Pass the licensing examination,
5. Apply on the form prescribed,
6. Pay the license fee,
7. Be fingerprinted,
8. Give his social security number to the BRE,
9. Submit the legal presence proof, a document that shows that
she is in the United States legally), and
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10. Complete 24 semester units, i.e. eight courses of education,

which include :
a. Five required courses: Real Estate Practice, Real Estate
Appraisal, Legal Aspects of Real Estate, Real Estate
Financing, and either Real Estate Economics or Accounting,
and
b. Three other courses chosen from the following list:
Advanced Legal Aspects of Real Estate, Advanced Appraisal,
Advanced Financing, Real Estate Principles, Property
Management, Escrow, Business Law, Real Estate Office
Administration, Mortgage Loan Brokering and Lending,
common Interest Developments, or Computer Applications
in Real Estate.
An applicant applying for a brokers license, taking both Real Estate
Economics and Accounting has to complete only two, and not three
additional elective courses.
If the applicant has either the equivalent of two years of general real
estate experience, or has a degree from a four-year college or
university in a course of study that has a real estate specialization,
then the experience requirement (as mentioned in point 1 above)
may be waived. To obtain a waiver, the applicant has to submit a
written petition to the BRE.

LICENSE APPLCIATION AND TERM

Within one year of the date of passing the exam (not the date they
receive the notice that they passed), the license applicant should
apply for their licenses. Brokers and salespersons licenses have to
be renewed every four years. A mortgage loan originator
endorsement for a real estate license has to be renewed every year
and the endorsement expires on December 31st each year.
License Renewals: The licenses are renewed at the completion of
the continuing education requirement (as explained below), by
applying to the BRE, and paying the necessary fees. The renewal
application should be date stamped before midnight of the
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expiration date to prevent the license from expiring. The renewal

application cannot be filed until 90 days or less before the
expiration date.
Resident aliens without permanent status need to submit their
proof of legal presence in the U.S. to the BRE each time they renew
their license.
Late Renewal: It may be possible to renew the license that has
expired within the previous two years without retaking the licensing
examination. The licensee has to file a renewal application and pay
a late renewal fee. All license rights will be lost if the license is not
renewed within two years of the grace period. To be licensed again,
the former licensee should meet all the requirements for an original
license application, which also includes passing the licensing exam
again.
Continuing Education: A real estate license can only be renewed if
the licensee fulfills the requirement of continuing education. The
renewal application must contain a special form that confirms
attendance of the applicant at the required courses.
Generally a salesperson or a broker renewing his license should
have completed a total of 45 hours of continuing education courses
during the previous four years. (Note: for salespersons who were
licensed before October 1, 2007, there is an exception: their first
renewal only requires 15 hours of continuing education, i.e. five
three-hour courses covering the compulsory subjects -- Ethics,
Agency, Trust Fund Handling, Fair Housing, and Risk
Management.)
The specific course requirements are subject to whether it is the
licensees first renewal or a subsequent renewal.
Initial Renewal: For a first-time license renewal after it was issued,
the 45 hours of continuing education should comprise:
1. Five individual three-hour courses (15 hours in all) on the
following compulsory subjects: Ethics, Agency, Trust Fund
Handling, Fair Housing, and Risk Management, and

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2. A minimum of 18 hours of courses selected as consumer

protection courses.
The balance of the required hours may be for consumer service
courses (these courses cover business skills that allow licensees to
serve clients professionally), or additional consumer protection
courses may be taken by the licensee.
Subsequent Renewals: A subsequent renewal (after the initial
renewal) also calls for 45 hours of continuing education within the
previous four years. The course requirements are a little different
from the initial renewal. The specific source requirements for
subsequent renewals changed as of July 1, 2011.
The 45 hours continuing education courses now (after July 1, 2011)
must include:
1. Either 12 hours of separate courses of Ethics, Agency, Trust
Fund Handling, and Fair Housing, or a six-hour survey course
covering the just mentioned four courses,
2. A three-hour course in risk management, and
3. A minimum of 18 hours of consumer protection courses.
Just as with an initial renewal, the remaining hours may be in
consumer service sources or additional consumer protection
courses.
In subsequent renewals that were effective on or after July 1, 2011,
points 1. and 2. on the list above were replaced with a single eighthour survey course that covered all five compulsory subjects, i.e.
Ethics, Agency, Trust Fund Handling, Fair Housing, and Risk
Management. Therefore, a licensee needed to take the eight-hour
survey course and a minimum of 18 hours of consumer protection
courses, with the balance of hours in consumer service courses or
additional consumer protection courses.
70/30 Continuing Education Exemption: Licensees who are 70years old or older are not required to complete the continuing
education requirement, if they have been a real estate licensee of
repute for at least 30 years in California. (The period during which a
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license might have been expired does not count in the 30 year
period.) The proof of qualification of this exemption will have to be
submitted to the BRE by the licensee.
Continuing Education for MLO Endorsement: For renewing the
yearly real estate licensees mortgage loan originator endorsement,
the licensee should complete a minimum of eight hours of
continuing education each year. These eight hours should have at
least three hours on federal laws, two hours on ethics issues i.e.;
fraud, consumer protection, and fair lending, and two hours on
lending standards for non-traditional or subprime mortgage loans.

MISCELLANEOUS LICENSE PROVISIONS

Brokerage Offices: A real estate licensee in California is required to
have a place of business located in the state. He may have more
than one branch office and each office must have a separate
license. The branch office could be added or cancelled by filing a
form with the BRE.
License Location: A broker should hold the licenses of all of his
affiliated licensees. All the licenses including the brokers license
should be kept securely at the main office of the broker.
Termination of Affiliation: If a salesperson resigns or is
discharged by his broker, the broker must return the license
certificate of the salesperson within three business days. The
termination notification must be sent to the Commissioner by the
broker by submitting a form to the BRE within ten days.
Salespersons License Transfer: When a salesperson transfers
affiliation from one broker to another, the Commission must be
notified of this transfer as well. The new broker should submit a
notification form to the BRE within five days after the salesperson
starts work.
Before the salesperson gives his license certificate to the new
broker, he must cross out the name and address of his former
broker and add the name and address of the new brokers main

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office on the back of the certificate. The salesperson should also put
the date and his initials along with the changes made.
Discharge for Disciplinary Cause: If a salesperson is discharged
on account of bad conduct, his broker needs to file a certified
written statement of facts with the Commissioner. If he fails to do
so, the brokers license could be suspended or revoked.
Termination of Brokers License: The licenses of all the brokers
salespersons are automatically cancelled, if the brokers license is
suspended or revoked. The salespersons licenses may be
transferred to other brokers.
Upon expiration of the brokers license, the licenses of his
salespersons are at once placed on non-working status. These may
be reactivated once the broker renews his own license.
Changes in Address: The licensees have to maintain current
addresses on file with the BRE. A broker is required to provide a
mailing address, the address of his principal place of business, and
the branch office addresses, if any. A salesperson is required to
provide a mailing address and the address of his brokers principal
place of business.
Any changes in the brokers location or address of his main or
branch office should be conveyed in writing to the DRE within one
business day. All the licensees who are affected by the change need
to correct their license certificates by crossing out the old address
and writing the new one on the back, and also dating and initialing
the changes.
Fictitious Names: A real estate broker is allowed to procure a
license under a fictitious name if it is not:
Misleading or would signify false advertising,
Implying a partnership or corporation that is non-existent,
Involving the name of a real estate salesperson,
Violating certain legislative provisions, or

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 The name that was previously used by a licensee whose

license was revoked.
There are other restrictions regarding fictitious business names,
such as the word escrow should not be included in the name, and
the name should not signify that the broker is providing escrow
services.
A fictitious business name statement needs to be filed with the
clerk of the county where the business is located. Also, the
statement should be published in a county newspaper at least once
a week for a period of four weeks. An affidavit, confirming that the
publication requirement has been completed, is required to be
submitted to the county clerk. (Note: An affidavit is a written
statement sworn before a notary public.)The statement expires five
years after its initial filing.
Child Support Delinquency: The California Department of Child
Support Services (DCSS) maintains a list of people who have not
followed court orders concerning child support payments.
Individuals whose names appear on this list cannot be issued a fullterm real estate license by the BRE, or have their license renewed.
The BRE instead will issue a 150-day license and inform the
applicant that a full-term license will be issued only after the
applicant gets a release from the DCSS during the 150-day period.
Now, if the current licensees name still appears on the DCSS list
and is not removed within 150-day period, the BRE might suspend
his license; until the delinquency is cleared, the suspension
remains effective.

SPECIAL ACTIVITIES
Prepaid Rental Listing Services: Prospective tenants are provided
with listings of residential property available for rent by the prepaid
rental listing service. Tenants have to pay a fee before or at the time
when the listing service provides the listings. The listing service
does not negotiate leases or rental agreements.

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Licensed real estate brokers do sometimes operate a prepaid rental

listing service. An additional license or a special permit is not
required. However, other individuals or companies do require a
prepaid rental listing service license from the BRE.
Mineral, Oil and Gas Transactions: In previous years, the
Department of Real Estate would issue special mineral, oil, and gas
(MOG) licenses. A MOG license holder could act as an agent in
transactions involving mineral, oil, or gas rights even without a real
estate license. Although some MOG licenses are still effective, new
ones have not been issued since 1994. A real estate license has
been required since then.
Real Property Securities: A real estate purchase or project may be
financed by forming an investment syndicate like a limited
partnership (discussed in chapter 2). Investors providing capital for
an investment in real estate but not actively involved in the
management of the property or developing it have their interests
considered as real property securities. Generally, an individual who
is involved in issuing or selling real property securities or soliciting
investors need to be licensed as a real estate broker or as a
securities broker-dealer. (Note: The California Department of
Corporations regulates securities and issues securities licenses.)
Out-of-State Subdivisions: The lots located in a subdivision in
another state may be sold or offered for sale in California only if the
subdivision is registered with the Department of Real Estate.
A real estate broker licensed in California and physically present in
California may engage in out-of-state property transactions. A
California broker is allowed to split commissions with an out-ofstate broker.

BUSINESS OPPORTUNITIES
The sale or lease of a business is a business opportunity; this
includes inventory, fixtures, lease assignments, and goodwill.
Generally, a real estate license is required for listing a business
opportunity or representing the buyer of a business opportunity,
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even if real property is not involved. If the sale involves shares of

stock in a corporation, then the agent may need a securities license.
A franchise agreement is a common type of business agreement,
where the purchaser (franchisee) buys the right to sell goods under
a brand name and marketing system provided by the franchisor for
a franchise fee. A franchise may be sold by a real estate licensee, a
securities licensee, or any person registered for that reason with the
California Corporations Commissioner.
Business opportunity transactions usually involve the transfer of
personal property (like furniture and gears used in business), and
the seller gives the buyer a bill of sale. The bill of sale must have the
names of the transferor and the transferee, the business location,
and the description of the personal property (with trade fixtures,
equipment and the trade name).
If the sale involves real property, then two purchase agreements
may be used, one for real property and one for personal property.
Often there are separate escrows for the real property and the
personal property. The seller will obviously give the buyer a deed
and a bill of sale.
Sales Tax: Sales tax is applicable for the transfer of personal
property in a business opportunity transaction. Just like a normal
purchase at a store, the buyer generally pays the sales tax to the
seller, and the seller in turn pays the Board of Equalization.
In case a business being sold is a wholesale or retail business, there
is another sales tax issue. The buyer needs to get a Certificate of
Clearance from the State Board of Equalization that will certify that
all sales tax owed by the seller on previous wholesale or retail
transactions has been paid. Alternatively, the buyer may have
successors liability for the unpaid sales tax of the seller which will
have to be paid off. The buyer also has to acquire a sellers permit
from the Board of Equalization.
Bulk Sales: The Uniform Commercial Code imposes some
requirements on bulk sales with which the business opportunity
buyer must comply. A bulk sale is not a sale that is part of the
regular course of the sellers business; rather, it consists of more
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than half of the sellers inventory. A buyer interested in a bulk sale

has to give notice to the sellers creditors by recording a notice of
the transaction with the county recorder, sending a notice to the
county tax collector by registered or certified mail, and also
publishing a notice in the local newspaper. Failure to meet these
requirements may lead to the buyer being liable to the sellers
creditors.
Liquor License Transfer: Transfer of an alcoholic beverage license
(liquor license) may be included in the sale of a business
opportunity. Liquor sales are strictly controlled and the state law
limits the number of licenses that are issued in a given county
depending on its population. A general rule states that a current
liquor license may be transferred from person to person or from
premises to premises, on condition of approval from the
Department of Alcoholic Beverage Control (ABC). To obtain an
approval, the seller and the buyer should submit an application to
ABC and publish a notice regarding the application on the
premises. The ABC investigates the buyer and the proposed location
and then approves or disapproves the transfer.
The rules that govern the issuance and transfer of liquor licenses
are different depending on the type of establishment, type of license,
and other aspects. For example, the law usually prohibits the
issuance of a license to a private club established just a year
earlier. Also, when a liquor license is transferred, a limit is set on
how much the seller can charge the buyer for the license, subject to
the type of license and when it was issued. For instance, if a
particular type of license is transferred within five years of its
issuance, then the seller is not permitted to charge the buyer more
than the original fee paid to acquire the license.
DISCIPLINARY ACTIONS
Laws have to be enforced in order to be effective. The Real Estate
Commissioner is authorized to investigate and discipline licensees if
they violate the Real Estate Law or the regulations of the
Commissioner.
Disciplinary Procedures

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The Commissioner must investigate the actions of a licensee when a

written complaint has been lodged. Even if a formal complaint is
not made, the Commissioner may investigate a licensee on his own
volition. The investigation generally comprises obtaining statements
from witnesses and the licensee, checking records (public records,
bank records, and title company records, etc.) and the
Commissioner may call for an informal meeting of everyone
involved.
Accusation and Hearing: A written statement of the charges
against the licensee is called an accusation. An accusation has to
be filed within three years of the alleged unlawful act. However,
when the acts or omissions with which the licensee is charged
pertain to fraud, misrepresentation or a false promise, charges can
also be brought within one year after the date of discovery.
Regardless, an accusation needs to be filed no later than 10 years
from the date it the alleged improper act occurred.
The accusation is served on the licensee and a date is fixed for an
administrative hearing. An administrative law judge considers the
case. An explanation of his rights is also given to the licensee.
The licensee may appear at the hearing without an attorney.
Testimony is taken under oath and a record of the proceedings is
made. On the basis of the hearing, the administrative law judge
submits a proposed decision to the Commissioner. The
Commissioner may accept or reject that proposed decision. A formal
decision is rendered by the Commissioner and, if the decision is
adverse, the licensee can petition for reconsideration. The licensee
also has the right to appeal the formal decision to superior court.
Possible Penalties: If the charges against the licensee are
substantiated by the evidence at the hearing, his license may be
revoked or suspended. A suspension is for a specified number of
days while a revocation can last indefinitely if the license is not
reinstated; the licensee can apply for a reinstatement after a year.
In the public interest, it can be decided that a license should not be
suspended and instead a monetary penalty may be levied by the
Commissioner. The fine cannot be more than $250 per day, while
the maximum amount cannot exceed $10,000.
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Imposing a fine or other disciplinary penalty by the Commissioner

does not protect a licensee from criminal prosecution or from
liability in a civil suit. This criminal or civil liability shall not be
considered double jeopardy.
Debarment: The Commissioner can bar the licensee from any
position of employment, management, or control for a maximum of
36 months under the following conditions:
- When a licensee has purposely or carelessly violated the Real
Estate Law or the Commissioners regulations,
- Has caused material damage to the public, or
- Has been convicted of a crime or held liable in a civil action for
conduct involving dishonesty, or is related to the qualifications
or duties of a real estate licensee.
A debarred licensee cannot act as a real estate broker or
salesperson, cannot be involved in real estate-related business
activities on the premises of a brokerage, and cannot participate in
real estate-related business activities of a financial institution, a
lender, an escrow company, or a title company.
Restricted Licenses: To replace a revoked or suspended license,
the Commissioner may issue a restricted license. The restricted
license is effectively a probationary license. Its term may be limited,
the license may be restricted to certain types of activities, and it
may require affiliation with a particular broker or the filing of a
surety bond, or other limitations can be imposed.
Desist and Refrain Orders: The Commissioner may issue a desist
and refrain order by asking a licensee who is involved in activities
that violate the Real Estate Law to stop the violation. The licensee
has to stop immediately, but he has the right to request a hearing
on this matter.
Suspension without a Hearing: A license can be suspended
without a hearing if a license has been procured through fraud,
misrepresentation, deceit, or material misstatements of facts. The
Commissioner has the power to do this within 90 days after the

413

license is issued and the suspension is effective only until a hearing

is held and a formal ruling made by the Commissioner.
Grounds for Disciplinary Action
The grounds for disciplinary actions, comprising suspension,
revoking, or denying a license, are stated in the Real Estate Law.
The main list can be found in Sections 10176 and 10177 of the
Business and Professions code. Although licensing and license
renewal requirements try to set the licensees minimum level of
competence, this list of acts or omissions actually determine the
standards for the licensees everyday behavior.
The following actions and conduct could lead to disciplinary
proceedings:
1. Making a significant misrepresentation purposely or
carelessly making a false statement of fact, or failing to
disclose a material fact to a principal.
2. Making a false promise that leads someone to do or not do
something.
3. Acting
on
a
continued
or
deliberate
misrepresentation or false assurances.

course

of

4. Working as a dual agent without the consent of all the parties

involved.
5. Co-mingling ones own money/property with money/property
received or holding on behalf of a client or customer (trust
funds).
6. Not putting a definite termination date in an exclusive listing
agreement.
7. Getting an undisclosed amount of compensation on a
transaction (a secret profit).
8. If a listing agreement includes an option to purchase the listed
property, use of the option without revealing to the principal in
writing the amount of profit to be made and obtaining the
principals consent in writing.
414

9. Acting in any way (whether or not it is specifically prohibited

by statute) that amounts to fraud or dishonest dealing.
10. Getting a written agreement from the purchaser to buy a
business opportunity property and to pay commission, before
obtaining the property owners written authorization (a listing
agreement).
11. Not disbursing funds in accordance with a mortgage loan
commitment when the broker represents that the broker is
either being a lender or a mortgage broker.
12. Purposely delaying the closing of a mortgage loan simply to
increase the borrowers interest rate or other charges.
13. With regards to the residential short sale debt forgiveness
sale, creating an incorrect opinion of the propertys value so as
to manipulate the lender into rejecting the proposed sale, or to
get a listing or other financial or business advantage.
14. Not complying with the law where it is required to provide a
real property transfer disclosure statement in some
transactions.
15. Procuring or renewing a license by fraud, misrepresentation,
or deception.
16. Being sentenced to, or pleading guilty, or no contest to a felony
charge, or a crime that is essentially related to the
qualifications, functions, or duties of a real estate licensee.
17. False advertising, such as a material false statement about
property offered for sale, or a misrepresentation of the
credentials of the licensee.
18. Intentionally disregarding or violating the Real Estate Law or
the Commissioners regulations.
19. Intentionally using the term Realtor or any trade name of a
real estate organization that one is not actually a member of.

415

20. A denied, revoked, or suspended real estate license in another

state for actions that would be grounds for denial, revocation,
or suspension of a real estate license ffin California.
21. Negligence or incompetence in performing duties that require a
real estate license.
22. Not exercising proper supervision over the salespersons
activities in his capacity as a broker.
23. Being a government employee, gaining access to private
records, and unlawfully disclosing confidential details.
24. Violating the restricted license terms.
25. Using blockbusting tactics; seeking business on the basis of
statements regarding race, color, sex, religion, ancestry,
marital status, or national origin.
26. Violation of the Franchise Investment Law, the Corporate
Securities Law, or regulations of the Commissioner of
Corporations.
27. Violation of the laws that govern the sale of real property
securities.
28. If one has a direct or indirect ownership interest in the
property and the person fails to disclose the extent and nature
of the interest at the time of selling the property.
29. Violation of the provision of RESPA (refer to chapter 10), TILA,
or HOEPA (refer to chapter 12), or any regulations
implementing those federal laws.
30. If a final judgment has been made against a person in a civil
suit for fraud, misrepresentation, or deception in regards to a
real estate transaction.
31. Being a broker, not notifying the Commissioner in writing of
the discharge of a salesperson on the basis of his violation of
the Real Estate Law or the Commissioners regulations.
32. Fraudulent application for the registration of a mobile home,
not being able to provide for the delivery of a properly
416

endorsed certificate of ownership of a mobile home from the

seller to the buyer, or involving in a sale or disposal of a stolen
mobile home.
33. Not indicating in an advertisement of being a real estate
broker, or not including his license number in a purchase
agreement or in solicitation materials like business cards and
advertising flyers.
34. Being a broker, not notifying the buyer and the seller, in
writing, of the selling price of the property within a month
after the closing of the sale, unless a closing statement is
issued by the escrow.
35. Compensating or employing an unlicensed person for an act
for which a license is necessary.
36. Not providing a copy of a contract to a party who has signed it.
37. Getting compensation in exchange for referring a customer to
any of the following types of companies; escrow, pest control,
home warranty, or title insurer.
38. Taking responsibility for arranging financing for a transaction
in which the person is already acting as a real estate agent, or
vice versa, and not disclosing the dual role in writing to the
concerned parties within 24 hours.
Also, Section 10087 of the Business and Professions Code has given
authority to the Commissioner to suspend a licensee or debar him
any position of employment, management, or control for up to 36
months in the following cases:
- If the licensee knew or should have known that he was
violating the Real Estate Law or the Commissioners
regulations, or has caused material damage to the public, or
- If the licensee was convicted of or pleaded no contest to a
crime, or was held liable in a civil action or administrative
proceeding, if the matter involved dishonesty, fraud,
deception, or any other offense practically related to the
qualifications, functions, or duties of a real estate licensee.
417

EXAMPLES OF UNLAWFUL CONDUCT

The Reference Book of the Department of Real Estate provides
examples of unlawful conduct that would lead to grounds for
disciplinary action. It is in two parts: unlawful conduct in sale,
lease, and exchange transactions, and unlawful conduct in loan
transactions. The entire list is reprinted, below:
Example of unlawful conduct in sale, lease, or exchange: in a
sale, lease, or exchange transaction, the following conducts may
result in license discipline under Sections 10176 and 10177 of
the Business and Professions Code:
1. Intentionally making a significant misrepresentation of the
likely value of real property to:
a) The owner, for the purpose of either securing a listing or
for acquiring an interest in the property for the licensees
own account.
b) A prospective buyer, for the purpose of tempting the
buyer to make an offer to purchase the real property.
2. Representing to an owner of real property when seeking a
listing that the licensee has acquired a bona fide written
offer to purchase the property, unless at the time of the
representation the licensee has possession of a bona fide
written offer to purchase.
3. Stating or implying to an owner of real property during
listing negotiations that the licensee is precluded by law, by
regulation, or by the rules of any organization, other than
the broker firm seeking the listing, from charging less than
the commission or fee quoted to the owner by the licensee.
4. Knowingly making substantial misrepresentations regarding
the licensees relationship with an individual broker,
corporate broker, or franchised brokerage company or that
entitys/persons responsibility for the licensees activities.

418

5. Knowingly underestimating the probable closing costs in a

communication to the prospective buyer or seller of the real
property in order to tempt the person to make or accept an
offer to purchase the property.
6. Intentionally making a false or misleading representation to
the seller of real property as to the form, amount and/or
treatment of a deposit toward the purchase of the property
made by an offeror.
7. Intentionally making a false or misleading representation to
a seller of real property, who has agreed to finance all or
part of a purchase price by carrying back a loan, about a
buyers ability to repay the loan in accordance with its
terms and conditions.
8. Making an addition to or modification of the terms of an
instrument previously signed or initialed by a party to a
transaction without the knowledge and consent of the party.
9. Making a representation as a principal or agent to a
prospective purchaser of a promissory note secured by real
property about the market value of the securing property
without a reasonable basis for believing the truth and
accuracy of the representation.
10. Knowingly making a false or misleading representation or
representing, without a reasonable basis for believing its
truth, the nature and/or condition of the interior or exterior
features of a property when soliciting an offer.
11. Knowingly making a false or misleading representation or
representing, without a reasonable basis for believing its
truth, the size of a parcel, square footage of improvements
or the location of the boundary lines of real property being
offered for sale, lease, or exchange.
12. Knowingly making a false or misleading representation or
representing to a prospective buyer or lessee of real
property, without a reasonable basis to believe its truth,
that the property can be used for certain purposes with the
419

intent of inducing the prospective buyer or lessee to acquire

an interest in the real property.
13. When acting in the capacity of an agent in a transaction for
the sale, lease, or exchange of real property, failing to
disclose to a prospective purchaser or lessee facts known to
the licensee materially affecting the value or desirability of
the property, when the licensee has reason to believe that
such facts are not known to nor readily observable by a
prospective purchaser or lessee.
14. Willfully failing, when acting as a listing agent, to present or
cause to be presented to the owner of the property any
written offer to purchase received prior to the closing of a
sale, unless expressly instructed by the owner not to
present such an offer, or unless the offer is patently
frivolous.
15. When acting as the listing agent, presenting competing
written offers to purchase real property to the owner in
such a manner as to induce the owner to accept the offer
which will provide the greatest compensation to the listing
broker without regard to the benefits, advantages and/or
disadvantages to the owner.
16. Failing to explain to the parties or prospective parties to a
real estate transaction for whom the licensee is acting as an
agent the meaning and probable significance of a
contingency in an offer or contract that the licensee knows
or reasonably believes may affect the vacating of the
property by the seller or its occupancy by the buyer.
17. Failing to disclose to the seller of real property in a
transaction in which the licensee is an agent for the seller
the nature and extent of any direct or indirect interest that
the licensee expects to acquire as a result of the sale. The
licensee should disclose to the seller: prospective purchase
of the property by a person related to the licensee by blood
or marriage; purchase by an entity in which the licensee
has an ownership interest; or purchase by another person
with whom the licensee occupies a special relationship
420

where there is a reasonable probability that the licensee

could be indirectly acquiring an interest in the property.
18. Failing to disclose to the buyer of real property in a
transaction in which the licensee is an agent for the buyer
the nature and extent of a licensees direct or indirect
ownership interest in such real property: e.g., the direct or
indirect ownership interest in the property by a person
related to the licensee by blood or marriage; by an entity in
which the licensee has an ownership interest; or by any
other person with whom the licensee has a special
relationship.
19. Failing to disclose to the principal for whom the licensee is
acting as an agent any significant interest the licensee has
in a particular entity when the licensee recommends the
use of the services or products of such an entity.

Examples of Unlawful Conduct Loan Transactions: When

requesting, negotiating, or arranging a loan that is secured by real
property or the sale of a promissory note that is secured by real
property, the following conducts may result in license discipline:
1. Knowingly misrepresenting to a prospective borrower of a loan
to be secured by real property or to an assignor/endorser of a
promissory note secured by real property that there is an
existing lender willing to make the loan or that there is a
purchaser for the note, for the purpose of inducing the
borrower or assignor/endorser to utilize the services of the
licensee.
2. Knowingly making a false or misleading representation to a
prospective lender or purchaser of a loan secured directly or
collaterally by real property about a borrowers ability to repay
the loan in accordance with its terms and conditions.
3. Failing to disclose to a prospective lender or note purchaser
information about the prospective borrowers identity,
occupation, employment, income, and credit data as
represented to the broker by the prospective borrower.
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4. Failing to disclose information known to the broker relative to

the ability of the borrower to meet his or her potential or
existing contractual obligations under the note or contract,
including information known about the borrowers payment
history on an existing note, whether the note is in default or
the borrower in bankruptcy.
5. Knowingly underestimating the probable closing costs in a
communication to a prospective borrower or lender of a loan to
be secured by a lien on real property for the purpose of
inducing the borrower or lender to enter into the loan
transaction.
6. When soliciting a prospective lender to make a loan to be
secured by real property, falsely representing or representing
without a reasonable basis to believe its truth, the priority of
the security, as a lien against the real property securing the
loan, i.e., a first, second, or third deed of trust.
7. Knowingly misrepresenting in any transaction that a specific
service is free when the licensee knows or has a reasonable
basis to know that its covered by a fee to be charged as part of
the transaction.
8. Knowingly making a false or misleading representation to a
lender or assignee/endorsee of a lender of a loan secured
directly or collaterally by a lien on real property about the
amount and treatment of loan payments, including loan
payoffs, and the failure to account to the lender or the
assignee/endorsee of a lender as to the disposition of such
payments.
9. When acting as a licensee in a transaction for the purpose of
obtaining a loan, and in receipt of an advance fee from the
borrower for this purpose, failing to account to the borrower
for the disposition of the advance fee.
10. Knowingly making a false or misleading representation about
the terms and conditions of a loan to be secured by a lien on
real property when soliciting a borrower or negotiating the
loan.
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11. Knowingly making a false or misleading representation or

representing, without a reasonable basis for believing its truth,
when soliciting a lender or negotiating a loan to be secured by
a lien on real property, about the market value of the securing
real property, the nature and/or condition of the interior or
exterior features of the securing real property, its size or the
square footage of any improvements on the securing real
property.
Thus, there are many grounds for disciplinary action in California.
The above provisions are the steps taken by the state authorities to
avoid corrupt and illegal actions by real estate licensees. However,
the suspension of a real estate license after wrongdoings by the
licensee does not help someone who has lost money due to the
unlawful actions. Even if the injured party takes the licensee to
court, the licensee may not have money or assets for repayment, so
a judgment would be worthless. In case like these the state has
provided for an additional method of reimbursing, through the Real
Estate Fund.

THE REAL ESTATE FUND

The state treasury collects all license fees and credits it to the Real
Estate Fund. A portion of the money from this fund is disbursed to
other accounts. About 8% of the money is credited to the
Education and Research Account for the advancement of real
estate education and research projects. About 12% of the money
from the Real Estate Fund goes to the Recovery Account. Note
that the monetary penalties that are collected by the Commissioner
also go into the Recovery Account. This Recovery Account
compensates the parties that are injured by real estate licensees.
After a civil judgment or arbitration award is made in favor of an
injured
party,
against
a
licensees
intent
of
fraud,
misrepresentation, or deceit, or conversion of trust funds, the
injured party has to apply to the Recovery Account for payment of
the judgment. The injured party is required to prove that the
licensee has no funds or assets to be seized for the payment of the
judgment.
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Amounts up to $50,000 for losses in a single transaction and up to

$250,000 for losses incurred through the actions of one licensee are
paid by the Recovery Account. Payment is made from the Recovery
Account on behalf of the licensee; his license is suspended
automatically as of the payment date. The license can only be
reinstated when the amount given out from the Recovery Account is
fully paid (including interest) by the licensee. Even if the licensee is
bankrupted, he will not be excused from this obligation.

TRUST FUNDS
Mishandling of trust funds is the most common cause of
disciplinary action among real estate professionals. Some of the
reason behind this is confusion regarding the functions and use of
trust funds. California law is precise about the handling of trust
funds and it is essential for the licensees to be well-acquainted with
these rules. Sometimes an unintentional blunder can cause not
only a violation of the Real Estate Law, but even in a breach of the
agency duties owed by the licensee towards his clients or customers
(refer to chapter 8).
Trust Funds Definition
Learning to recognize trust funds is the first important step to
handling these kinds of financial instruments correctly. In simple
terms, trust funds are money or any other valuables that a licensee
is holding on behalf of another person. A trust fund may be in the
form of cash, a check, a promissory note, or any other item of
personal property. The licensee is simply holding the money or
property on someones behalf (normally a client or customer) while
a real estate transaction is being processed. As per the Reference
Book of the BRE, the definition of trust funds is:
Money or other things of value that are received by a broker or
salesperson on behalf of a principal or any other person, and which
are held for the benefit of others in the performance of any acts for
which a real estate license is required.
The good faith deposit that a buyer conveys to the broker along with
his offer to purchase a listed property is the most common example
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of a trust fund. The broker holds the buyers deposit in trust so

that the seller may decide whether to accept the buyers offer.
The rent that a broker providing property management services
collects from tenants and holds for some time before providing it to
the client is another example of a trust fund.
Similarly advance fees are also trust funds. These are fees that a
client may give to the broker in advance, in lieu of anticipated costs
like advertising expenses connected with a listing or as
compensation for services that the broker will provide in the near
future. (Advance fees are discussed in detail towards the end of this
section.)
There are other types of funds kept in a brokers possession such as
general operating funds, earned real estate commissions, or rent
from the real estate of the broker himself which are not trust funds
since the broker is not holding them on behalf of someone else.
Handling Trust Funds
The trust funds that a broker accepts from the clients or customers
should be deposited in:
1. A neutral escrow account,
2. The principals hands, or
3. A trust account in a bank or other recognized depository
maintained by the broker.
Depending on the circumstances and the instructions of the broker,
any one of these options may be used. However, the trust funds
should be deposited within three days of the receipt of the funds. In
case the funds are deposited into an escrow account or into the
hands of the principal then the transfer should be noted in the
trust funds records kept by the broker.
Trust funds given to a salesperson rather than the broker must be
handed over to the broker immediately and, if directed by the
broker, to one of the three places mentioned above.

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The only exception to these rules occurs when a broker receives a

good faith deposit check from a buyer; the broker may choose not to
cash the check before the buyers offer is accepted, if:
1. The check is not negotiable by the licensee, or the buyer has
given instructions in writing that the check is not to be
deposited or cashed till the time that the offer is accepted, and
2. The seller is informed before or when the offer is made that the
check is being held.
On acceptance of the offer, the broker can keep holding the undeposited check provided he receives written authorization from the
seller to do so.
Trust funds must be kept in their trust accounts until further
instructions from the owner. It is easy to identify the owner of the
trust fund, but the ownership of the trust funds may change with
the progression of the real estate transaction. For instance, the
ownership of a good faith deposit could alter depending on whether
the buyers offer is accepted. Before acceptance, the funds belong to
the buyer and have to be maintained as instructed by him.
However, once the offer is accepted, the ownership is less certain;
therefore the funds are to be handled as mentioned below:
A check that is held uncashed by the broker prior to
acceptance of the offer can be continue as uncashed only
when authorized by the seller in writing.
If both parties agree in writing, then the check can be given to
the seller.
The deposit money cannot be refunded unless an express
written permission is provided by the seller.
In a situation when the transaction does not materialize after the
good faith money has been deposited into the escrow account or a
brokers trust account and there is a dispute over who is entitled to
receive the money, the escrow agent or broker holding the funds in
trust should file an interpleader action. This action will take the
case to court and the court will decide the rightful owner of the
funds.
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Trust Accounts
Avoiding commingling is the foremost reason for maintaining a
separate account for trust funds. (Commingling is the mixing of
trust funds with personal funds.) A broker must always keep the
trust funds separate from his general account. Similarly he must
also refrain from putting his own funds in a trust account.
Commingling is different from conversion. Conversion is the actual
misappropriation of the funds of a party for the brokers own
purposes. Conversion may be considered as theft under the
California penal code. Wrongfully removing a piece of real property
or personal property, or defrauding another person of money, labor,
or real or personal property is all considered as theft.
Borrowing trust funds by the broker is disallowed due to the
prohibition against commingling. If, in fact, the trust funds were
placed in the brokers general account then a judgment creditor
might seize those funds along with the brokers funds. Due to the
commingling rule, the trust funds are protected from any legal
actions that might be taken against the broker.
Shortages or Overages: The total amount of funds in the trust
account should at all times equal the brokers cumulative trust
fund liability. Comparing the trust fund balance to the sum of
individual transactions is called reconciliation. On reconciliation,
the trust account balance should equal the total of the balances
due to individual clients and customers.
There will be a trust fund shortage if the trust account balance is
less than the total liability. This type of shortage is a violation of the
Real Estate Commissioners regulations. If the trust account
balance is more than the total liability there is a trust fund
overage. As non-trust funds cannot be commingled with trust
funds, this will also be considered as a violation of the regulations.
A broker must always confirm that a check deposited into the trust
account has cleared before he disburses any funds against the
check. If funds are disbursed before the clearance of the check, or if
the check is returned for insufficient funds, a trust fund shortage
will occur.
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Exceptions to Commingling Rule: The two exceptions to the rule

against commingling are:
1. The service charges on the trust account must be paid by the
broker out of his general account. For this purpose the broker
can have a maximum of $200 of personal funds in a trust
account. A better option, though, would be to have the bank
deduct the trust account service fees directly from the general
account of the broker.
2. At times, a broker is entitled to deduct his commission from
the trust funds. If this is the case, then the broker must
promptly transfer the commission out of the trust account into
his general account. If the commission cannot be transferred
immediately into the general account, then it may stay in the
trust account only for a maximum of 25 days.
It is better for the broker to not pay any personal obligations out of
the trust account, even if the payments are a draw against the
commission of the broker. The earned commission should be
transferred to the brokers general account before using it for the
payment of personal obligations.
Account Requirements: A trust account should be opened in a
recognized financial institution in California in the name of the
broker, since the brokers license carries his name. This account
should be specially designated as a trust account and the broker as
the trustee. There is no requirement of an advance written notice by
the financial institution for withdrawals from the account.
Although the trust account usually cannot be an interest-bearing
account, there is an exception allowing it. If the trust funds owner
requests, the broker can deposit the funds in a separate interestbearing account. However, the broker must disclose how the
interest is calculated, who pays the service charges, and how the
interest is to be paid. The broker does not receive any of the interest
or benefit from it, either directly or indirectly.
Withdrawals: The signature of the broker -- or in the case of a
corporation licensed as a broker, the signature of the appointed
broker-officer -- is normally required for withdrawals from a trust
428

account. A broker nay even authorize the below mentioned

individuals to withdraw trust funds:
1. A salesperson or a broker-employed associate broker, or
2. Any unlicensed employee who is covered by a fiduciary bond
equal to the total amount held in trust.
Even if the broker authorizes others to withdraw trust funds, she
cannot assign responsibility for the funds. The broker will be held
responsible for any violation of the trust funds even if it was caused
by the negligence or carelessness of the employee.

Trust Fund Records

Proper records should be kept for all trust funds, as well as trust
fund checks that are held uncashed, trust funds deposited directly
to the escrow, and trust funds released to the owner. Orderly kept
trust funds records allow the broker to prepare accurate
accountings for the clients, to calculate the amounts owed to clients
at any given time, and to identify an imbalance in the trust account.
The trust account records should be reconciled by the broker on a
monthly basis.
The broker can choose from the two types of accounting systems to
keep track of trust funds; a simple columnar system or an
alternative system that complies with general accounting practices.
Whichever method is used, the accounting system should definitely
show the following:
1. All trust fund receipts and disbursements in chronological
order with all relevant details,
2. The balance of each trust account on the basis of all recorded
transactions,
3. All receipts and disbursements relating to each client or
customers account in chronological order, and
4. Every beneficiarys
transactions.

balance

on

the

basis

of

recorded

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Columnar System: A broker opting for the columnar recordkeeping system must keep three types of records:
1. A record of all received and disbursed trust funds: A record
that lists all trust funds deposited to and disbursed from the
trust accounts. Following information needs to be included:
a) Funds received date,
b) Received from whom,
c) The amount received,
d) The date of deposit,
e) For disbursements: the party to whom the funds were
paid,
f) The paid out amount,
g) The check number and date, and
h) The daily balance of the bank account.
2. A record for every client/customer or transaction: The
following information needs to be included:
a) The date of the deposit,
b) Deposited amount,
c) The name of the payee or the payer,
d) For the funds paid out, the check number, date, and
amount, and
e) The daily balance of the individual account.
3. A record of trust funds that are received and not deposited
into the trust account: This information needs to be
included:
a) The funds received date,
b) The form of the payment,

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c) The amount received,

d) A description of any property received in lieu of funds,
e) Where the funds were forwarded to, and
f) The date of deposition.
General Accounting Practices System: The other option besides a
columnar system is the general accounting practices system. In this
system there should be a journal, a cash ledger, and beneficiary
records for every trust account.
1. Journal: A journal is an everyday chronological record of trust
fund receipts and disbursements that shows:
a) All trust funds transactions in chronological order,
b) Sufficient information to identify the transaction (for e.g.
date, amount received, name of payee, etc.), and
c) The total receipts and total disbursements at least on a
monthly basis.
2. Cash Ledger: This shows the increases and decreases in the
trust account and the resulting account balance, normally in
summary form.
3. Beneficiary Ledger: A beneficiary ledger needs to be
maintained for each client or customer, or for each transaction
or series of transactions. The details of all receipts and
disbursements relating to the individual account, and the
resulting account balance are shown in chronological order.

All trust fund records are bound to be inspected by the

Commissioner. The broker is required to keep the copies of all trust
records (even cancelled checks) for every transaction for three years.
The three-year period starts on the date the transaction closes, or if
the transaction does not close, then on the date of the listing.

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ADVANCE FEES
As explained earlier, an advance fee is the money collected by a real
estate broker from a client in advance to pay for the expenses he
expects to incur on behalf of the client, or as advance compensation
for services to be provided later. Advance fees are also handled in
compliance with the trust funds rules that have been discussed
thus far. Advance fees should not be commingled with the funds of
the broker, and should be deposited into the trust account of the
broker within three days after receiving it.
Before advance fees in connection with any services are collected, a
broker should provide all of the materials intended to be used in
advertising or promoting those services to the Department of Real
Estate for approval, along with the advance fee agreement he is
entering into with his clients. The DRE reviews the materials to
confirm it includes a full description of the services to be provided;
states the total amount of the advance fee and when they need to be
paid; mentions a termination date for the agreement; does not
contain deceptive guarantees; and are not otherwise misleading.
The advance fees deposited in a brokers trust account cannot be
withdrawn until they are expended for the clients benefit or until
five days after an accounting has been sent to the client. This
accounting may either be a quarterly accounting or a final
accounting after the agency has ended.

DOCUMENTATION REQUIREMENTS
According to the Department of Real Estate, the brokers must keep
all of the documents connected with a real estate transaction. The
documents include:
Listings and buyer agency agreements,
Purchase agreements,
Rent collection receipts,
Bank deposit slips,
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 Canceled checks,
Supporting documents for checks (e.g., invoices, receipts, or
escrow statements),
Agency disclosure statements,
Transfer disclosure statements, and
Property management agreements.
The above mentioned documents should be kept for at least three
years. The three-year period begins with the closing date (in case
the transaction does not close then the date of listing), and should
be available for inspection by the Commissioner. If required, the
records may be audited.
The below-mentioned documents have to be kept for four years
instead of three:
Real property security statements, and
Disclosure statements given to non-institutional lenders or
deed of trust purchasers.
Document Copies: Whenever a document is prepared for signature
by the licensee, a copy of the document must be conveyed to the
person signing it once signed. It is made mandatory by the Real
Estate Law for contractual documents (which includes listing
agreements,
buyer
representation
agreements,
purchase
agreements, property management agreements, all contract
addenda, and any later amendments), while other laws require it for
disclosure statements, settlement statements, and many other
documents.
Brokers Review of Documents
Brokers are supposed to supervise their salespersons; if they dont,
it is grounds for disciplinary action. Reviewing the documents
prepared by the salesperson that might have a material effect on
the rights or obligations of a party to a transaction is also part of
the brokers supervisory responsibilities.

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Broker-Salesperson Agreement
When a broker hires a real estate salesperson, he should document
this relationship in a written agreement. This agreement should be
filed and kept at the brokers office. The agreement has to be
retained for three years after the termination of the relationship.

ADVERTISING REGULATIONS
It is necessary for real estate licensee to be aware of the laws that
regulate the advertising that pertains to real estate as well as the
general advertising rules, such as the prohibition against false
advertising. The violation of state laws against false advertising also
counts as a violation of the Real Estate Law.
Licensee Designation in Advertising
The advertisements that are published or distributed by a real
estate licensee must carry a licensee designation, and any signs
that the advertiser is a license holder. An advertisement that does
fulfill this requirement is sometimes called a blind ad. The use of
single words like broker, agent, or Realtor are sufficient. Even
abbreviations like bro or agt can be used.
This rule typically applies to advertising regarding any matter for
which a real estate license is necessary. An exception to the
classified ads for rental properties is if the ad provides the phone
number or address of the rental property, then the licensee
designation is not required.
First Contact Solicitation Materials
A licensee is required to include his license identification number in
any solicitation materials that are going to be the initial point of
contact with potential clients or customers. Initial contact
solicitation materials consist of business cards, stationery,
advertising fliers, and other materials that are designed to solicit
the formation of a professional relationship with a consumer. It is
specifically stated in the law that identification numbers are not

434

necessary on For Sale signs or in ads appearing in print or

electronic media.
Initial contact solicitation materials used by a real estate licensee
holding a mortgage loan originator endorsement have to include the
identification number issued by the Nationwide Mortgage Licensing
System and Registry, along with the real estate license number.
Internet Advertising
Brokers advertising or providing information about real estate
services on the internet are supposed to comply with a rule which
is concerned with contacting specific customers. There should be a
system in place to monitor that only a real estate licensee (or a
person exempt from the licensing requirement) replies to inquiries
from customers or contacts customers.
Advertising Loans and Notes
Additional regulations are imposed in California on a licensees
advertisements for loans secured by real property. An ad of this
nature must be pre-approved by the Department of Real Estate
before publication. Obviously, any misleading or deceptive ad will
not be allowed.
Ads for loans shall only use phrases such as guaranteed if they
also explain how the loan is secure. The ads shall not imply that a
loan can or will be approved over the phone, nor imply that any
government agency has endorsed the licensees business activities,
nor imply that loans are available on more favorable terms than
those normally available in the community, unless the advertiser
can show that those terms would be available without undisclosed
restrictions or conditions.
The same type of regulation applies to ads regarding the resale of
promissory notes. For example, an advertisement cannot guarantee
a yield on a note other than the interest rate specified in the note
unless it also includes the discount amount, too. (The difference
between the outstanding note balance and the sales price of the
note is the discount.)
Inducements
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At times, a gift, rebate, or a prize is offered as an inducement,

usually regarding attendance at a sales presentation or for
purchasing property. Inducements are always prohibited as part of
loan transactions. If obtaining a gift is a necessity for attendance at
a sales presentation, it must be disclosed in the advertisement or
solicitation. If there are any other conditions for receiving gifts or
prizes, they must all be disclosed.
Remember, if an inducement (which is a material fact) is given to
one of the parties in a transaction, it has to be disclosed to all
parties involved in the transaction.
Do Not Call Registry
Licensees soliciting business through making cold calls to
strangers need to comply with the Federal Trade Commissions
telemarketing rules. It is illegal to make calls to a person whose
name appears on the National Do Not Call Registry, so licensees
should check the registry before making the calls.

ANTITRUST LAWS AND REAL ESTATE LICENSEES

Apart from the Real Estate Law, federal and state antitrust laws
also impose certain restrictions on a real estate agents conduct
towards clients, customers, and other agents.
The antitrust laws were established with the idea that free
enterprise is an integral part of a democratic society, and that
competition is healthy for both the economy and society as a whole.
Antitrust law disallows any agreement that might create an
unreasonable restraint of trade. Any act that prevents an entity
from doing business in a certain area or with certain people is a
restraint of trade. When two or more business entities become
party to a common scheme that has the effect of a restraint of trade,
it is termed a conspiracy.
The history of antitrust laws in the U.S. is a long one. The first of
the federal laws, the Sherman Antitrust Act, was passed in 1890.
The Cartwright Law, which is the main antitrust law of California,
was enacted in 1907. Such laws in the past were associated
436

primarily with big steel mills, oil companies, and telephone services,
but in 1950 antitrust laws were also made applicable to the real
estate industry. In a groundbreaking case, the Supreme Court held
that mandatory fee schedules, established and implemented by a
real estate board, violated the Sherman Act. This was the United
States v. National Association of Real Estate Boards case.
A real estate agent violating the antitrust laws may face both civil
and criminal actions. A violator of the Sherman Act may be fined up
to one million dollars and/or sentenced to ten years imprisonment.
A corporation can be fined up to $100 million dollars.
Prohibited Practices and Activities
The below-mentioned business
prohibited by antitrust laws:

practices

and

activities

are

Price fixing,
Group boycotts,
Tie-in arrangements, and
Market allocation.
Price Fixing: Price fixing is defined as the cooperative setting of
prices or price ranges by competing firms. To avoid the emergence
of price fixing, real estate agents from different agencies should
refrain from discussing their commission rates. (The discussion
between competing salespersons/brokers could violate the law.
However, a broker can discuss rates with his own affiliated agents,
and agents who work for the same broker can discuss rates
amongst themselves.)
There is an exception to this general prohibition -- competing
brokers who are part of a cooperative sale are allowed to discuss a
commission split, the division of the commission between the listing
broker and the selling broker.
Even an informal pronouncement about a brokers plan on
increasing his commission rates could lead to antitrust issues.

437

Brokers should know that they can be charged with fixing

commissions even if they dont actually consult with each other.
Just a casual mention of his intention to raise commission rates by
one of the brokers could trigger an antitrust action.
Also, publications that indicate a fixing of prices are prohibited. Any
multiple listing service or real estate association that publishes
going or recommended rates for commissions could face an
antitrust lawsuit.
Group Boycotts: An agreement between two or more business
competitors (as in real estate brokers from different firms) to stop
another competitor from fair participation in business activities is
called a group boycott.
If a real estate broker finds that another broker is unethical and
dishonest, he may choose not to do any business with him. But he
is not supposed to encourage other brokers to do the same.
Tie-in Arrangements: A tie-in arrangement is also called a tying
arrangement. It is an arrangement to sell one product, on the
condition that the buyer must also purchase a different (or tied)
product.
For instance, if a builder wants to buy a lot from a subdivision
developer but the developer is only willing to sell it on the condition
that the builder enter into a list-back agreement. It means that the
builder has to sign a contract promising that after he builds a
house on the lot, he will list the improved property with the
developer.
In that example, the tie-in arrangement asked for is illegal. The listback agreement is not necessarily illegal. It is only illegal if it is a
required condition of the sale, thereby creating a tie-in
arrangement. If two parties mutually agree on a list-back agreement
there is no violation of antitrust laws.
Market Allocation: This is another type of business practice that
violates antitrust laws. In this one, competitors divide up a market.
It is illegal when competing businesses agree not to sell certain
products or services in specified areas, or to certain customers in
specified areas.
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Just as in a group boycott, only collective action/agreement

constitutes illegal market allocation. It is acceptable for an
individual business to limit its market area for services it provides
or to limit its business to certain types of customers. Therefore, if
John, a real estate agent, decides to specialize in luxury homes or if
Peter, another agent, decides to specialize in budget homes, it does
not amount to a antitrust violation. However, it does constitute a
violation if John and Peter enter into an agreement to allocate an
areas luxury market to John and its budget market to Peter.
Avoiding Antitrust Violations
To avoid antitrust violations the brokers must:
Always fix their fees and other listing policies independently,
without discussion with competing firms,
Not use listing forms that have preprinted commission rates,
Never imply to the client that the commission rate is fixed or
non-negotiable, or refer to a competitors commission policies
when discussing commission rates,
Not discuss their business plans with competitors,
Never inform clients or competitors that they should not do
business with a competing firms because of doubts about its
competence or integrity, and
Train their affiliated licensees to be aware of and avoid actions
that may violate antitrust laws.

Chapter Summary
The Real Estate Law comprises the licensing requirements and
the responsibilities of real estate agents.

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 The Business and Professions Codes sections 10000 to 10580

contain the Real Estate Law of California. It is also known as
the license law.
According to the Real Estate Law, anyone who acts, advertises,
or seems to act as a real estate broker or a real estate
salesperson should have a real estate license.
A franchise agreement is a common type of business
agreement, where the purchaser (franchisee) buys the right to
sell goods under a brand name and marketing system
provided by the franchisor for a franchise fee.
A bulk sale is not a sale that is part of the regular course of
the sellers business; rather it consists of more than half of the
sellers inventory.
The Real Estate Commissioner is authorized to investigate and
discipline licensees if they violate the Real Estate Law or the
regulations of the Commissioner.
The Reference Book of the Department of Real Estate provides
examples of unlawful conduct that would lead to grounds for
disciplinary action.
The first federal antitrust laws, the Sherman Antitrust Act,
was passed in 1890. The Cartwright Law, which is the main
antitrust law of California, was passed in 1907.

Chapter Quiz
440

1. Before a real estate license is renewed, completion of _____

hours of approved courses within four-year period is
necessary.
a. 25
b. 45
c. 65
d. 85

2. The full term of a real estate license is:

a. One year
b. Two years
c. Three years
d. Four years

3. If a real estate licensee does NOT renew his license before its
expiration, then the licensee:
a. Must cease all real estate activities.
b. May complete transactions in progress.
c. Is allowed to complete transactions that are almost
finished.
d. May act under authority of another agents license for a
period not more than 60 days.

4. A real estate business under a partnership can have more

than one office location, if:
a. There is at least one partner at each location.
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b. All partners are real estate licensees.

c. There is a designated office for the broker.
d. A broker partner acquires an additional license for each
location.

5. The Department of Real Estate regards a salespersons

relationship with a broker as being the brokers:
a. Employee
b. Independent contractor
c. General partner
d. Limited partner

6. A non-licensee places an advertisement for real estate services

without listing a real estate license number. This individual
could be liable for prosecution by the:
a. Local law enforcement agencies
b. Office of the Attorney General
c. Local district attorney
d. Department of Real Estate

7. Commingling is:
a. Paying a commission to an unlicensed person
b. Mixing personal funds with trust funds
c. The same as embezzlement
d. Any dishonest act related to trust funds

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8. The Recovery Account pays a maximum of _________ per

transaction.
a. $50,000
b. $75,000
c. $100,000
d. $150,000

9. If a broker-employer discharges a salesperson for violating a

provision of the Real Estate Law, the broker:
a. Must call the Commissioner immediately
b. Must notify the Real Estate Commissioner within three
days of the termination of the salesperson
c. Need not inform the Commissioner at all
d. Should notify the Commissioner immediately by mailing
a certified written statement of the facts

10.

A blind ad does not disclose the:

a. Name of the seller
b. Name of the broker
c. Price of the property
d. Address of the property

11.
A broker regularly puts the earnest money deposits in his
personal account for overnight safekeeping. This practice by
the broker is:
a. Acceptable
b. Mandated
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c. Prohibited
d. Discouraged

12.
The written agreement documenting when a broker hires
a salesperson must be retained by the broker for at least
_______ after their relationship terminates.
a. Three months
b. One year
c. Three years
d. There is no requirement to retain the agreement.

13.
A broker may keep an earned commission in a trust
account for not more than _______days.
a. Seven days.
b. 25 days.
c. 45 days.
d. 60 days.

14.

A brokers trust account records:

a. Can be kept by a columnar method.
b. Can be kept by the principal.
c. Must be kept in a safe deposit box at a financial
institution in California.
d. Should be discarded one year after the transaction
closes.

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15.
The commission rate that a listing broker charges on a
sale is determined by:
a. The buyer and the seller.
b. The seller and the broker.
c. The multiple listing services.
d. The Real Estate Commissioner

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CHAPTER 17
Real Estate Math
CHAPTER OVERVIEW
Real estate agents regularly use math for calculating their
commissions, to calculate the square footage of homes they are
listing or selling, to prorate closing costs, and so on. Although
electronic calculators make these calculations easier, it is necessary
to understand the basics of the math involved. In this chapter we
shall study step-by-step solutions of math problems that are an
important part of real estate business.

SOLVING MATH PROBLEMS

Employing a simplified approach, mastering these four steps can
help solve most common math problems.
1. Read the question:

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Thoroughly reading and understand the question is the most

important step. To solve any math problem successfully, it is most
important to know what one is looking for. Once it is known what to
find out, it can be decided which formula to use.
2. Write down the formula:
The correct formula for the problem that needs to be solved should
be written down. For instance the formula to fin Area = Length x
Width (abbr. is A = L x W). This chapter contains formulas for every
type of problem.
3. Substitute:
The relevant numbers need to be substituted from the problem into
the formula. Math problems usually contain unwanted information,
therefore it is very important to read the question and know what
exactly one is looking for. The formula helps in differentiating
between the relevant and irrelevant information given in the
problem.
There might be some math problems where it is only necessary to
substitute numbers into the formula without further steps, while in
some problems more steps are needed. For instance, converting
fractions to decimals may be required.
4. Calculate:
After inserting the numbers into the formula, the calculation can be
performed to find the unknown component of the formula that was
not given in the problem. The basic form of most of the formulas is
A = L x W. Two of the three numbers will be given in the problem
and one has to divide or multiply to find out the third number. That
third number is the solution of the problem.
Whether multiplying or dividing is required will be determined by
that unknown component in the formula. For instance, the formula
A = L x W may be further converted into two other formulas. The
three formulas are similar to each other but have been expressed in
different forms as per the element needed to be found.

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 If the quantity A (i.e. the Area) is unknown, then the formula

used will be: A = L x W. The number L is multiplied by W. The
product of L multiplied by W is A.
If the quantity L (i.e. the Length) is unknown, then the formula
used will be: L = A W. The number A is divided by W. The
quotient of A divided by W is L.
If the quantity W (i.e. the Width) is unknown, then the formula
used will be: W = A L. The number A is divided by L. The
quotient of A divided by L is W.
Consequently, there may be three different ways of using the
formula A = L x W, depending on which quantity is unknown. In the
below examples, lets assume that the area of a rectangle is 1000
square feet, the length is 50 feet, and the width is 20 feet.

A=LxW

L=AW

W=AL

A = 50 x 20

L = 1000sq.ft. 20

50 x 20 = 800sq.ft.

1000sq.ft. 20 = 50

W = 1000sq.ft. 50
1000sq.ft. 50 = 20

Once the numbers given in the problem have been substituted into
the formula, it might be difficult to decide whether to multiply or
divide. Compare the equation to a similar calculation of 2 x 3 = 6,
and it becomes easier to do the math. If the unknown component of
the equation is in the same position as the 6 in 2 x 3 = 6, then it is
necessary to multiply the other two given numbers in order to find
the unknown.
Similarly, if the unknown component is in the position of 2 or 3,
then divide. The number given in the position of 6 will have to be
divided by the other given number to find the unknown.

? x 3 = 6 becomes 6 3 = 2

2 x ? = 6 becomes 6 2 = 3
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Now, we shall apply the four-step approach to an example. Assume

that a room is 10 feet wide and 20 feet long. How many square feet
is the room?
1. Read the question: In this problem we have to find the square
footage or area of the rectangular room. Here we will have to
use the area formula for a rectangle.
2. Write down the formula: Area = Length x Width
3. Substitute: The numbers given in the problem should be
substituted into the formula. In our example the length of the
rectangle measures 20 feet and the width measures 10 feet.
Therefore, A = 20 x 10.
4. Calculate: By multiplying the length with the width we will get
the answer: 20 x 10 = 200 sq. ft. Thus, the area of the room is
200 square feet.
Suppose that the information given in the problem about the same
room is changed. The area is given as 200 square feet and the width
is 10 feet. What is the length of the room? We will again follow the
four-step approach.
1. Read the question: We need to find the length or width. So we
will apply the area formula again.
2. Write down the formula: Area = Length x Width
3. Substitute: The numbers given in the problem should be
substituted into the formula: 200 = L x 10.
4. Calculate: Since the length of the rectangle is unknown, the
key area formula gets converted into a division problem to
arrive at the length of the rectangle: 200 sq ft. 10 = 20. The
quotient of 200 divided by 10 is 20. Hence, the length of the
room is 20.

DECIMAL PROBLEMS
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For doing a calculation, it is easier to work with decimal numbers

rather than fractions or percentages. So, if a problem contains
fractions or percentages, convert them into decimal numbers before
solving the problem.
Converting Fractions: To convert a fraction into decimal number,
divide the top number of the fraction (the numerator) by the bottom
number of the fraction (the denominator).
Example: To convert into a decimal, divide 1 (number on top) by
2 (the bottom number): 1 2 = .50.
Example: To convert into a decimal, divide 3 (number on top) by
4 (the bottom number): 3 4 = .75.
It will be useful to remember the decimal equivalents of the most
common fractions:
= .25
= .50
= .75
Converting Percentages: To solve a problem having a percentage
in it, first convert the percentage into a decimal number, and then
convert the decimal answer back into percentage form.
For converting a percentage into a decimal number, just remove the
percentage sign and move the decimal point two places to the left.
You may have to add a zero.
Example:
95% becomes .95
8% becomes .08
45.5% becomes .455
To convert a decimal into a percentage, simply do the opposite of
the above example. Move the decimal point two places to the right
and add a percentage sign.
Example:
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.20 becomes 20%

.05 becomes 05%
.075 becomes 07.5%
The conversion of a percentage to a decimal number can be done by
using the percent key on a calculator. In almost all calculators, just
key in the digits and press the percent key, the calculator will
display the percent in decimal form.
Decimal Calculations: Calculators handle decimal numbers just as
they do whole numbers. You just need to enter the numbers with
the decimal point correctly into the calculator and the result is
displayed. However, to work out the calculation without the
calculator, the following rules should be applied:
For adding or subtracting decimals, put the numbers in a column
with their decimal points in place.
Example: To add 4.50, 14.75, 1.560, 1,547.3, 820, and 2.2, arrange
the numbers in a column with the decimal points lined up as given
below and add them up together.
4.50
14.75
1.563
1547.3
820.0
+
2.2
2,390.313
For multiplying decimal numbers, do the multiplication just as it is
normally done (dont bother about the decimal point) and then just
put the decimal point into the answer in the correct place.
Remember, the answer must have as many decimal places
(meaning, numbers to the right of the decimal point) as the total
number of decimal places in the numbers that were multiplied.
Thus, you must count the decimal places in the numbers that are
being multiplied and put the decimal point accordingly to the left in
the answer.
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Example: When 31.4 is multiplied by 19.3, there are a total of two

decimal places in the two numbers.
31.4
X 19.3
606.02
There will be cases where one or more zeros may have to be
included in the answer to get the correct number of decimal places.
Example: When .2 is multiplied by .3, the total number of decimal
places is two.
.2
X .3
.08
Thus, a zero is added in the answer so that the decimal point can
be moved two places to the left.
To divide a decimal number, the decimal point in the denominator
(the number that is being divided by the other number) should be
moved all the way to the right. Then the decimal point in the
numerator (the number being divided) is to be moved the same
number of places to the right. Remember, it might be required to
add one or more zeros to the numerator so that the decimal point
may be moved the correct number of places.
Example: Lets divide 32.165 by 2.5. First, move the decimal point
in 2.5 all the way to the right (here, it is only one place). Next, move
the decimal point in 32.165 the same number of places to the right.
Thus, 32.165 2.5 will become 321.65 25
We will now divide 321.65 25 = 12.866
When using a calculator, these steps are not required. Just key in
the numbers correctly and the calculator will give you the correct
answer with decimal points in correct place.

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AREA PROBLEMS
A real estate agent regularly needs to calculate the area of a lot, a
building, or a room. Area is generally stated in square feet or square
yards. The shape of the lot should determine to which formula to
use for calculating the area. It could be a square, a rectangle, a
triangle, or a shape that is a combination of these shapes.
Squares and Rectangles
We already learned the formula for finding the area of a square or a
rectangle is A = L x W.
Example: If one wall of a rectangular room measures 15 feet and
the other wall measures 12 feet, how many square feet of carpet will
be required to cover the full floor?
1. Read the question: You have been asked to find out the square
footage of the rectangular room.
2. Write down the formula: A = L x W
3. Substitute: A = 15 x 12
4. Calculate: As the quantity of A is to be found, multiply L times
W for the answer. 15 x 12 = 180sq.ft. Thus, 180 square feet of
carpet will be required to cover the floor.
Lets take the problem a step further. If a carpet is chosen to be
purchased and it costs $15 per square yard, what would be the cost
of carpeting the room?
Read the question: First, you have been asked to find out how
many square feet are there in a square yard, and next how many
square yards make up 180 square feet. We have to know that a
square yard is a square measuring one yard on each side and there
are three feet in a yard.
Write down the formula: A = L x W
Substitute: A = 3 x 3
Calculate: As the quantity of A is to be found, multiply L times W
for the answer. 3 x 3 = 9 sq. ft.
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Thus, there are 9 square feet in a square yard. Now you will have to
divide 180 by 9 to find out how many square yards there are in 180
square feet. 180 9 = 20sq. yd.
Now, the number of square yards (20) should be multiplied by the
cost per square yard ($15). 20 x $15 = $300 will be the cost to
carpet the full room.
Triangles
The formula for finding the area of a triangle is:
Height
x Base
___________
Area

or

Area = Base x Height

Example: If building lots in a particular neighborhood are on sale

for approx. $10 per square feet, about how much should be the
price of the lot as depicted below:

Street
70 ft.

100 ft.

Street

1. Write down the formula: A = Base x Height

2. Substitute: Area = 50 ( of 100) x 70
3. Calculate: 50 x 70 = 3,500 sq. ft.
The sequence of multiplication does not matter. You can multiply
100 times 70 and then divide it in half. Alternatively, you can divide
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100 by 2 and then multiply the result by 70. You can even divide 70
by 2 and then multiply the result by 100. Any way it is done the
answer will be the same.
A

Step (1) 100 x 70 = 7,000

100 2 = 50

Step (2)

50 x 70

7,000 2

Answer = 3,500 sq. ft.

= 3,500 sq. ft.

C
70 2 = 35
35 x 100
= 3,500 sq. ft.

The lot is 3,500 sq. ft. If the lots in that neighborhood are selling for
about $10 per square foot, then this lot would be priced at $35,000.
3,500 sq. ft.
X $10 per sq. ft.
$35,000 Selling price
Odd Shapes
The best way to find out the area of an odd-shaped lot is to divide it
up into squares, rectangles and triangles. Then add up the results
to get the area of the odd-shaped lot.
Example: If the lot depicted below is rented on a 50-year lease for
$5 per square foot per year on a monthly rental payment basis,
what would be the monthly rental of such a lot?

Street
80 ft.

Street

40 ft
50 ft

125 ft.

60ft

Street

180 ft.

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First, the lot has to be divided into rectangles and triangles.

80 ft.
40 ft.
125 ft.

100 ft.

50 ft.
60 ft.

50 ft.

Next, find the area of each of the above triangle, and two rectangles.
The height of the triangle is determined by adding the borders of the
small rectangle and the big rectangle seen in the above figure.
First, get the area of the triangle.
1. Write down the formula: A = Base x Height
2. Substitute: A = 25 (1/2 of 50) x 100
3. Calculate: 25 x 100 = 2500 sq. ft.
Then, get the area of the large rectangle.
1. Write down the formula: A = Length x Width
2. Substitute: A = 100 x 80
3. Calculate: 100 x 80 = 8,000 sq. ft.
Now, calculate the area of the small rectangle.
1. Write down the formula: A = Length x Width
2. Substitute: A = 100 x 80
3. Calculate: 60 x 50 = 3,000 sq. ft.
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Last, add the three areas together to find the area of the whole lot.
2,500 + 8,000 + 3,000 = 13,500 (Total Square feet area of the entire
lot.)
The entire lot is 13,500 sq. ft. and at $5 per square foot per year,
the yearly rent will be $67,500.
13,500 Square feet
X $5 Rent per square foot
67,500 Amount of rent per year
The monthly rental payment will be one-twelfth of the yearly rent
i.e. $67,500 12 = $5625. So the monthly rental payment of the
odd-shaped lot will be $5625.

VOLUME PROBLEMS
To calculate the volume of a three-dimensional space: volume is
normally stated in cubic feet or cubic yards. The formula for
calculating volume = Length x Width x Height, or V = L x W x H. the
formula is same as the formula for Area with an additional element,
the height (H) of the space to be measured.
Example: A storage unit floor measures 11 feet and 6 inches by 16
feet and its ceiling is 13 feet. Find the volume of the unit in square
yards.
1. Write down the formula: V = L x W x H
2. Substitute: V = 16 x 11.5 x 13
3. Calculate:
Step 1

16 x 11.5 = 184 sq.ft.

Step 2

184 sq. ft. x 13 = 2392 cubic ft.

4. Convert the cubic feet into cubic yards: As we already know, a

square yard measures 3 ft x 3 ft (or 9 sq. ft.). A cubic yard measures
3 ft. x 3 ft. x 3 ft. (of 27 cubic ft.) To find the volume in cubic yards,
divide the volume of the storage area in cubic feet by 27, i.e. 2392
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27 = 88.592 cubic yards. Thus, the volume of the storage space is

88.592 cubic yards.

PERCENTAGE PROBLEMS
Percentages are involved in many math problems in the real estate
business. There are problems regarding brokerage commissions,
interest on mortgage loans, property appreciation or depreciation,
and capitalization.
Solving Percentage Problems
When solving percentage problems, one has to generally convert the
percentage into a decimal number, calculate, and convert the
answer back into percentage form. As we know by now, a
percentage is converted into a decimal number by removing the
percentage sign and moving the decimal point two places to the left.
In case the percentage is a single digit number, such as 5%, then a
zero will have to be added, and it becomes .05. If a decimal number
is to be converted into a percentage, the above steps have to be
reversed: move the decimal point two places to the right and add
the percent sign.
Remember, in a math problem whenever something is expressed as
a percentage of another number, it means that you must multiply
that other number by the percentage. For example, if you have to
find 45% of $15,000:
Step 1:

45% becomes .45

Step 2:

$15,000 x .45 = $6,750

In simple words, in percentage problems you have to find a part of a

whole. The whole is always the larger figure, just as a propertys
sale price. The part is a smaller figure, just as a brokers
commission. The formula may be stated as: A percentage of the
whole equals the part. As an equation, it can be written as: Part =
Whole x Percentage.
Example: According to the terms of an agreement, a broker is to get
a commission of 5% of the sales price of a particular property that
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is eventually sold for $ 220,000. How much commission will the

broker receive?
1. Write down the formula: P = W x %
2. Substitute: Change the percentage (5%) into decimal number (.05)
first. P = $220,000 x .05
3. Calculate:

$220,000 Sales price

X
.05 Commission rate
$11,000 Brokers Commission

The brokers commission will be $11,000.

You may come across some percentage problems where the part will
be given and you will have to calculate the whole or the percentage.
For problems as those, you are supposed to rearrange the
percentage formula into a division problem. When the whole is
unknown, divide the part by the percentage:
Whole = Part Percentage.
When the percentage is unknown, divide the part by the whole:
Percentage = Part Whole.
In either case the value of the part is divided by either the whole (to
find the percentage) or by the percentage (to find the whole).

COMMISSION PROBLEMS
Just as in the above example, almost all commission problems can
be solved with the general percentage formula:
Part = Whole x Percentage
The percentage is the commission rate, while the whole is the
amount on which the commission is based. In most of the problems
the whole will be the sales price of a property. The part is the
amount of the commission.
Example: A property is listed for sale with an agreement to pay the
broker a commission of 6% of the sale price. The broker decides to
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pay 60% of the commission to his salesman. Now, if the property

sells for $480,000, how much commission will the salesman earn?
1. Write down the formula: P = W x %
2. Substitute: Change the percentage (6%) to a decimal number
(.06): P = $480,000 x .06
3. Calculate: Since the part is the unknown quantity, the
percentage is multiplied by the whole.
$480,000 Sales price
X .06 Commission rate
$28,800 Total Commission
The total commission is $28,800 out of which 60% of the total
commission will be passed on to the salesman. Here again the
percentage formula needs to be applied to determine the amount of
the salesmans share.
1. Write down the formula: P = W x %
2. Substitute: Convert the percentage (60%) to decimal number
(.60): P = $28,800 x .60.
3. Calculate:

$28,800 Total Commission

X .60 Salesmans percentage
$17,280 Salesmans share

Another commission problem is explained in the example, below.

Example: Based on a propertys sales price, a listing agreement
provided for a two-tiered commission. The commission would be 8%
of the first $100,000 and for any amount over $100,000 the
commission would be 5%. Now, if the commission was $10,500,
what was the sales price of the property?
1. Read the question: The commission rates and the commission
amount are given. If asked to find the sales price, first, find out the
amount of commission that is attributable to the first $100,000 of
the sales price.
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2. Write down the formula: P = W x %

3. Substitute: Convert the percentage to decimal number. P =
$100,000 x .08.
4. Calculate: $100,000 x .08 = $8000
Thus, based on the first $100,000 of the sales price, the
commission is $8000. Now, subtract this amount from the rest of
the commission amount given.
$10,500 Total commission
- $8,000 Commission from first $100,000
$2,500 Commission for over $100,000 sales price
We now know that $2,500, out of the total commission is
attributable to the part of sales price in the excess of $100,000.
With this information and the second-tier commission rate (5% of
the amount over $100,000) we can find out the total sales price.
1. Write down the formula: P = W x %
2. Substitute: Convert the percentage to decimal number. $2,500 =
W x .05.
3. Calculate: Since the whole is an unknown quantity, the basic
formula will convert into a division problem. The part divided by the
percentage equals the whole: $2,500 .05 = 50,000
Thus, the part of the sales price in excess of $100,000 is $50,000.
So, the total sales price of the property is $100,000 plus $50,000,
$150,000.

LOAN PROBLEMS
Interest problems and principal balance problems are two kinds of
loan problems. These are also solved using the general percentage
formula: Part = Whole x Percentage. In loan problems, the part is the
amount of interest, the whole is the loan amount or principal
balance, and the percentage will be the interest rate.

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Example: Mr. Brown procures a loan for $6000 and agrees to pay at
an interest rate of 6%. How much interest will he be paying?
1. Write down the formula: P = W x %
2. Substitute: P = $6000 x .06
3. Calculate:

$6000 Loan Amount

X .06 Interest rate
$360 Interest Amount

Thus, Mr. Brown will be paying $360 in interest.

Interest Rates: Interest rates are stated as annual rates, a certain
percentage each year, although some problems may deal with
monthly, quarterly, or half-yearly interest payments instead of the
annual amount. In such a problem, multiply the payment amount
stated in the problem to obtain the annual amount before
substituting the numbers in the formula.
Example: If $600 in interest is paid on a $7,500 interest-only loan
in six months. What would be the annual rate of interest?
1. Read the question: $600 is accrued in only six months. The
annual interest amount will double of $600; $1200.
2. Write the formula: P = W x %
3. Substitute: Remember, for P use the annual figure, $1200.
$1200 = $7,500 x Percentage
4. Calculate: Re-arrange the formula to isolate the unknown (the
percentage in this case). The part will be divided by the whole to get
the percentage.
$1,200 7,500 = .16.
Convert the decimal back into a percentage. Thus, .16 will become
16%.
The annual interest rate will be 16%.

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Principal Balance: In some loan problems you may be asked to

determine a loans current principal balance at a particular point in
the loan term.
Example: Monthly payments of a home loan are $550, including
principal and 8% interest and $45.50 per month for tax and
insurance reserves. If $25.75 of the June 1 payment was applied to
the principal, what will be the outstanding principal balance during
the month of May?
Note that mortgage interest is paid in arrears, so the June payment
includes the interest that accrued during May.
1. Write down the formula: P = W x %. Again, the part is the
amount of interest, the whole is the loan balance, and the
percentage is the interest rate.
2. Substitute: First, find the interest portion of the payment by
subtracting the reserves and the principal portion.
$550.00 Total June Payment
45.50 Reserves
25.75 Principal
$478.75 Interest portion of the payment
The next step is to multiply the interest portion by 12 to arrive at
the annual interest amount: $478.75 x 12 = $5745.
Now substitute the annual interest amount and rate with the
formula: $5745 = W x .08.
3. Calculate: You must first rearrange the formula to isolate the
unknown component (W). This becomes a division problem: $5745
.08 = 71812.50
Thus, $71,812.50 was the outstanding principal balance for May.

PROFIT OR LOSS PROBLEMS

In profit or loss problems you will be asked to compare the cost or
value of a particular property at an earlier point in time with its cost
or value later. These problems can be solved using the percentage
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formula, but with a slight variation; instead of Part = Whole x

Percentage, the formula will be: Now = Then x Percentage.
In the formula, the value or cost of the property at an earlier time is
stated as Then. The value or cost of the property at a later time is
stated as Now. The percentage is 100%, plus the percentage of
profit or minus the percentage of loss.
The reason behind this calculation is to state the value of the
property after a profit or loss (Now) as a percentage of the propertys
value before the profit or loss (Then). In case there is no profit or
loss, the Now value will be exactly 100% of the Then value, as the
value had not changed. If there is a profit, the Now value will be
more than 100% of the Then value, as the value has increased. In
event of a loss, the Now value will be less than 100% of the Then
value.
Example: Maggie bought a house about four years ago for $375,000
and sold it last month for 25% more than she paid. How much did
she sell the house for?
1. Write down the formula: Now = Then x %
2. Substitute: For figuring out the percentage, you have to add the
percentage of profit to (or deduct the percentage of loss from) 100%.
In this example there is a profit, therefore add 5% to 100% and
convert it to decimal number. Thus 125% becomes 1.25: Now =
$375,000 x 1.25.
3. Calculate: $375,000 x 1.25 = $468,750
Maggie sold the house for $468,750.
Example: Gary recently sold his house for $765,000. He had
purchased the same house two years earlier for $900,000. Calculate
his percentage of loss.
1. Write down the formula: Now = Then x %
2. Substitute: $765,000 = $900,000 x %

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3. Calculate: Since the percentage is an unknown quantity, the

formula will have to be rearranged to isolate the percentage:
$765,000 $900,000 = 0.85 or 85%
Thus, the Now value is 85% of the Then value. Subtract 85% from
100% to find the percentage of loss: 100% - 80% = 15%
Garys loss on the sale of his house is 15%.
A last variation of this type of problem is given, below.
Example: Keith sold his apartment for $425,000, 22% more than
what he paid five years ago for the same apartment. What was the
original price he paid for the property five years ago?
1. Write down the formula: Now = Then x %
2. Substitute: $425,000 = Then x 122%
3. Calculate: In this problem, the unknown quantity is the original
price that Keith paid for the apartment, so isolate the Then part of
the problem: $425,000 1.22 = 348360.65.
Keith had paid $348,360 for the apartment five years ago.
Appreciation or depreciation that has accrued at an annual rate
over a specified number of years is also involved in some profit and
loss problems. These type of problems are solved using the Then
and Now formula (one year at a time).
Example: A propertys current value is $240,000 and it has
depreciated 3% per year for the past four years. What was the value
of the property four years ago?
1. Write down the formula: Now = Then x %
2. Substitute: Since the property is worth 3% less than it was a
year ago, the percentage will be 97% instead of 100%: $240,000 =
Then x .97.
3. Calculate: First rearrange the formula to isolate the unknown
Then: $240,000 .97 = 247422.68

465

The propertys value one year ago was $247,422.68. Now apply the
same formula to $247,422.68 to get the value of the property two
years earlier. Repeat the process two more times to arrive at the
value of the property four years previously.
247422.68 .97 = 255074.92
255074.92 .97 = 262963.83
262963.83 .97 = 271096.73
Thus, the value of the property four ago was $271,096.73.

CAPITALIZATION PROBLEMS
With these kind of problems, the capitalization approach to value is
utilized. This method of real estate appraisal was discussed in
chapter 11.
The capitalization formula is another variation of the percentage
formula. Instead of Part = Whole x Percentage, the formula is stated
as: Income = Value x Capitalization Rate.
Here the value would be the investment propertys value or the
purchase price that the investor is willing to pay for the property to
get a specified rate of return. This rate of return is the capitalization
rate, the return that the investor is looking to gain on the
investment. Depending on various factors the desired rate of return
would vary. A higher desired rate of return would mean a higher
capitalization rate and a lower value for the property.
Note that the income in the capitalization formula is the yearly net
income produced by the investment property.
Example: Annual net income of an investment property is $22,000.
An investor is expecting a 12% rate of return, what should he pay
for the property?
1. Write down the formula: I = V x %
2. Substitute: $22,000 = V x .12

466

3. Calculate: First, rearrange the formula to isolate the V

unknown quantity): $22,000 .12 = 183,333.34

(the

Thus, the investor will have to pay about $183,333 for the property.
Example: Using a 7% capitalization rate, if the value of a property is
900,000, then what is its value using a capitalization rate of 9%?
First, you will have to apply the capitalization formula to arrive at
the propertys annual net income.
1. Write down the formula: I = V x %
2. Substitute: I = 900,000 x .07
$900,000 Value
X .07 Capitalization rate
$63,000 Annual net income
We have the annual net income as $63,000. We have to now
substitute this figure into the formula to find the value at a 9% rate
of capitalization.
3. Calculate:

4. Substitute: $63,000 = V x .09

5. Calculate: Isolate the unknown quantity V by rearranging the
formula: $63,000 .09 = 700,000.
Thus, the value of the property using a 9% capitalization is worth
$700,000. This proves that a higher capitalization rate applied to
the same net income will reduce the value of the property.
In some of the problems, bad debt or vacancy factor, and operating
expenses will have to be compulsorily deducted for the gross income
in order to arrive at the net income.
Example: An apartment building has ten units with seven of them
rented out for $780 per month and the remaining units rented for
$830 per month. Allow 5% for vacancies and uncollected rent.
Operating expenses are inclusive of annual property taxes of
$7,000, monthly utilities of $1,800, and maintenance expenses of
about $12,400 per year. The outstanding mortgage balance of the
owner is $235,000 at 7% interest, with monthly payments of $2000.
467

If the investor desires a 6.5% rate of return, what is the propertys

offering price?
1. Write down the formula: I = V x %
2. Substitute: Since the income referred to in the capitalization
formula is annual net income, it is necessary to calculate that
annual income before substituting. First, the annual gross income
will be calculated:
$780 x 12 months = $9360/year x 7 units = $65,520
$830 x 12 months = $9960/year x 3 units = $29,880
$95,400
Thus the gross income is $95,400 per year.
Next, you will calculate the bad debt/vacancy factor and deduct it
from the gross income to arrive at the effective gross income. The
bad debt/vacancy factor is 5% of the gross income.
$95,400 Gross Income
X .05 Bad debt/Vacancy factor percentage
$4,770 Bad debts and vacancies
Thus, the expected loss from vacancies and uncollected rents will
be $4,770 per year.
$95,400 Gross Income
- $4,770 Bad debts and vacancies
$90,630 Effective gross income
The operating expenses need to be deducted from the effective gross
income to figure out the net income. Note that we are trying to find
the annual net income; therefore, all the expenses should be
annualized. The operating expenses will be as given, below:
$7,000 Property taxes
$21,600 Utilities (@ $1,800 monthly)
+$12,400 Maintenance
$41,000 Annual operating expenses
As just shown, the annual operating expenses will be $41,000.
Note: Mortgage payments will not count as operating expenses (refer

468

to chapter 11). On subtracting the operating expenses from the

effective gross income, find the annual net income.
$90,630 Effective gross income
- $41,000 Annual operating expenses
$49,630 Annual net income
Now, substitute the net income and the capitalization rate into the
formula I = V x %:
$49,630 = V x .065
3. Calculate: To isolate the unknown quantity V, rearrange the
formula: $49,630 .065 = $763,538.
Thus, the investor will have to pay $763,538 for the property.
Example: Continuing with the above example; if an investor paid
$610,000 for the apartment building, assuming that the propertys
income and operating expenses were the same, find the
capitalization rate applied.
Write down the formula: V x % = I
Substitute: Using the net income from the example above: $49,630
= $610,000 x %
Calculate: After isolating the unknown quantity, the capitalization
rate: $49,630 $610,000 = .0813 or 8.13%
Thus, the capitalization rate used by the investor is approximately
8.1%
Sometimes, the propertys operating expense ratio (O.E.R.) may be
given in a capitalization problem. The percentage of gross income
used to pay the annual operating expenses is the O.E.R. The
remaining amount is the annual net income.
Example: The annual gross income of the property is $350,000, and
the O.E.R. is 72%. For an investor who desires a 12 % return, the
required amount will be:
1. Write down the formula: I = V x %

469

2. Substitute: Using the operating expense ratio, calculate the

annual operating expenses. After that, subtract the operating
expenses from the gross income to get the annual net income.
$350,000 x .72 = $252,000 Annual operating expenses
$350,000 - $252,000 = $98,000 Annual net income
Lets substitute the income and the capitalization rate into the
formula: $98,000 = V x .125
3. Calculate: Isolate the unknown quantity V, by rearranging the
formula: $98,000 .125 = $784,000
Thus, the investor can have the property for $784,000.

TAX ASSESSMENT PROBLEMS

Most tax assessment problems can be solved by using the formula:
Tax = Assessed Value x Tax Rate. The assessed value may have to
be found first, in order to solve the rest of the calculation. Assessed
value is a propertys value for taxation purposes.
Example: According to a tax assessment, the market value of a
property is $324,500. The applicable assessment ratio is 80%. How
much is the annual tax amount if the tax rate is 3%?
1. Multiply: the market value by the assessment ratio to find out
the assessed value of the property: $324,500 x 80% = $259,600.
$259,600 is the assessed value.
2. Substitute: the assessed value and the tax rate into the formula:
Tax = $259,600 x .03
3. Calculate: $259,600 Assessed value
X .03 Tax rate
$7788 Annual taxes
The annual tax owed for this property are $7788.
Some of the problems will not state the tax rate as a percentage of
the assessed value. Rather, it might be expressed as a dollar
amount per hundred or per thousand dollars of assessed value.
470

Example: A property with an assessed value of $225,400 is taxed at

a rate of 2.85 per hundred dollars of assessed value. The annual
tax, then, would be:
1. Divide: $225,400 by 100 to get the number of hundred dollar
increments in the assessed value: $225,400 100 = 2,254 $100
increments.
(A partial $100 increment would be taxed as one $100 increment.)
2. Multiply: the number of $100 increments by the tax rate to be
able to calculate the annual tax amount.
2,254 $100 increments
X $2.85 Tax rate
$6423.90 Annual taxes
The annual tax would be $6423.90.
In some problems, the tax rate may be expressed as a specified
number of mills per dollar of assessed value. A mill is one-tenth of
one cent (.001). Ten mills are equal to one cent, and 100 mills are
equal to 10 cents.
Example: The market value of a property is given as $410,000 and
the assessment ratio is 75%. The tax rate is given as 25 mills per
dollar of assessed value. What would be the annual tax amount?
1. Multiply: the market value by the assessment ratio to determine
the assessed value.
$410,000 Market value
X .75 Assessment ratio
$307,500 Assessed value
2. Multiply: the assessed value by the tax rate to find out the tax
amount. Converted in decimal form 25 mills will become .025.
$307,500 Assessed value
X .025 Tax rate
$7687.50 Annual tax
Thus, the annual tax would be $7687.50
471

SELLERS NET PROBLEMS

In the sellers net problems, the seller wishes to take a specified net
amount from closing, after paying the commission of the broker and
other costs. Then, find out how much the property will have to be
sold for to get the desired net price of the seller.
Example: The seller desires to net $55,000 from the sale of his
property. The mortgage balance which he has to pay off is about
$135,500, the cost of repairs is $1200, and he has $1950 in other
closing costs. The commission of the broker is fixed at 6%. Find out
the minimum sales price that will net the seller his desired amount
of $55,000.
1. Add: the desired net of the seller to the costs of sale, without
adding the commission.
$55,000 Sellers net
135,500 Mortgage balance
1,200 Repairs
+ 1,950 Closing costs
$193,650 Total
$193,650 should be left to the seller once the commission has been
paid, if he is to be able to pay all of the listed expenses and have
$55,000 remaining.
2. Subtract: the commission rate from 100%: 100% - 6% = 94%
3. Divide: the total from the first step by the percentage from the
second step. As the commission rate was fixed at 6% of the sale
amount, the sellers net plus the other costs should equal 94% of
the sales price: $193,650 .94 = $206,010.
The property will have to sell for at least about $206,010 so that the
seller will get his desired net of $55,000.
At first glance, it may seem that the commission rate is being
applied to the closing costs as well as the selling price. But that is
not the case. This becomes apparent by working through the
problem backward; as in a real closing process, the commission is
472

deducted from the selling price, and then the closing costs of the
seller are subtracted from those proceeds.
Start by calculating the cost of the 6% commission.
$206,010 Selling price
X .06 Commission
$12360.60 Commission Amount
Now subtract the commission and other closing costs from the
gross proceeds and findh the sellers net proceeds.
$206,010 Selling price
$12360 Commission Amount
135,500 Mortgage balance
1,200 Repairs
- 1,950 Closing costs
$55,000 Net proceeds

PRORATION PROBLEMS
Allocation of an expense between two or more parties is called
proration. We have studied in chapter 12 that prorations are
needed in real estate closings. Based on the closing date, various
expenses are prorated.
The three main steps of the proration process are:
1. Calculate the per diem (daily) rate of the expense.
2. Fix the number of days for which one person will be
responsible for the expense.
3. Multiply the per diem rate by the number of days to find out
the share of the expense that one party is responsible for:
Share = Rate x Days.

473

To find out the per diem rate of an annual expense, you must divide
the amount of the expense by 365 days (366, in a leap year). Some
problems might instruct you to divide by 360 days, just to simplify
the calculation. Note: A 360-day year is also referred to as a
bankers year rather than a calendar year.
To calculate the per diem rate of a monthly expense when prorating
on the basis of a calendar year, divide the amount of the expense by
the number of days in that specific month. Or else, to make the
calculation easier, base the prorations on a bankers year, which
implies that every month (including February) has 30 days.
You will be given a number of examples in relation to the proration
of various expenses: property taxes, hazard insurance, rent, and
mortgage interest. (In chapter 12, detailed information on these
expenses is provided.)

Property Tax Prorations

Property taxes are an annual expense. At closing, these taxes may
or may not have been paid. If already paid, the buyer will owe the
seller a share of the taxes. If not, then the seller will owe the buyer
a share. In either case, the proration process remains the same.
Example: The date of closing is March 5, and the annual property
taxes, $3,200, have already been paid by the seller. At closing, the
seller should receive a credit for the tax amount covering the period
from March 3 until June 30 (since the tax year begins on July 1st).
That amount will be a debit for the buyer. Calculate the amount the
buyer will owe to the seller for the property taxes, making use of the
360-day year (30 days month) for the calculations.
1. Calculate: the per diem rate for the property taxes, using the
360-day year: $3200 360 = 8.89 per diem.
2. Count: the number of days for which the buyer is responsible,
using the 30-day month.
25 days March 5 through 30
30 days April
474

30 days May
+ 30 days June
115

days

3. Substitute: the rate and number of days into the formula: S = R

x D, then calculate.
115 days
X $8.89 Per diem
$1022.35 Credit to seller
Thus, at closing the buyer will be debited $1,022.35 and the seller
will be credited the same amount for the property taxes from March
5 until the end of the tax year.
In the next example, the taxes have not yet been paid. The sellers
share of the taxes is provided in order to calculate the annual tax
amount.
Example: The seller has not paid any of the annual taxes. The
closing date is October 11. At closing, the seller will owe the buyer
$980.50 for the taxes. Calculate the amount of the annual tax bill.
Use the 365-day year and the correct days of each month in the
calculations. The buyer will be responsible for the taxes starting
from the day of closing.
1. Write down the formula: S = R x D that th
2. Substitute: Add up the number of days for which the seller is
responsible.
31 days July
31 days August
30 days September
+ 10 days October
102 days
Substitute the share of the seller and the number of days into the
formula: $980.50 = R x 102 days.
3. Calculate: To isolate the unknown R, rearrange the formula:
$980.50 102days = 9.62 Per diem.
475

So, the per diem rate is $9.62. Now multiply this amount by 365 to
find the annual tax amount.
365 Days
X $9.62 Per diem
$3511.30 Annual taxes
Thus, the annual taxes are $3511.30

Insurance Prorations
If there is any prepaid insurance coverage extending beyond the
closing date, then a seller will be entitled to obtain a refund from
the hazard insurance company.
Example: A property is being sold and the transaction closing date
is June 15. The owner has already paid an annual hazard
insurance premium of $950. Coverage was provided until the end of
September. How much of the premium will be refunded, if the
insurance company is not charging the seller for the day of the
closing? The basis of this calculation is a 360-day year.
1. Calculate: the per diem rate for the insurance (use 360-day
year): $950 360 Days = 2.64 Per diem.
2. Add: the number of days for which the seller owes a refund (use
30-day months).
15 days June
30 days July
30 days August
+ 30 days September
105

days

3. Substitute: the rate and the number of days into the formula: (S
= R x D) and calculate.
105 Days
X $2.64 Per diem
$277.20 Sellers credit
Thus, the insurance company will refund $277.20 to the seller.
476

Rent Prorations
If a rental property is being sold, the seller will owe the buyer a
prorated share of any rent that was paid in advance.
Example: A ten-unit apartment building that is being sold, with the
closing date being June 15. The rent for 5 of the units is $1,200 per
month and the other 5 units are rented out for $900 per month.
The tenants have all paid the rent for June on time. Calculate the
share of the prepaid rents that the seller owes to the buyer at
closing.
1. Find out the total rent amount owed for June.
$1,200 x 5 = $6,000
$900 x 5 = $4,500
$6,000 + $4,500 = 10,500
2. Calculate the per diem rate for the month of June:
$10,500 30 = $350 per diem
3. Determine: the number of days of rent for which the buyer is
entitled, beginning on the closing date. (June 15 to June 30 is 15
days.)
4. Substitute and calculate.
$350 Per diem
X 15 days
$5250 Prorated rent
The seller will owe $5,250 to the buyer, in prepaid rents at closing.

Mortgage Interest Prorations

In most real estate transactions, two different types of mortgage
interest prorations are necessary. One is for the seller, the other for
the buyer. The seller usually owes a final interest payment on the
loan he is paying off.
477

Example: The remaining balance on a sellers mortgage is $340,500

and the rate of interest is 6%. The closing date is fixed for March 5.
Since mortgage interest is paid in arrears, the mortgage payment
paid by the seller on March 1 will cover the interest accrued during
February. At closing, the seller will owe the lender interest covering
March 1 through the closing date. Calculate the amount of that
interest payment, your base for calculation being a calendar year.
1. First, calculate the annual interest by using the percent formula:
a) Write down the formula: Payment = Loan Balance x Interest
b) Substitute: P = $340,500 x .06
c) Calculate:
$340,500 Loan amount
X .06 Interest rate
$20,430 Annual Interest
2. Find the per diem rate of expense by dividing the annual rate by
365: $20,430 365 days = $55.98 Per diem.
3. Figure the number of days the seller owes interest for. The lender
will charge for the day of closing from the seller. Therefore, the
seller will owe interest for five days, from March 1 through March 5.
4. Last, substitute the numbers into the proration formula, S = R x
D and calculate it.
$55.98 Per diem
X 5 Days
$279.90 Final Interest Payment
Thus, the seller will have to make a final interest payment of
$279.90 at closing.
Even the buyer owes some mortgage interest at closing. This is the
prepaid interest or the interim interest on the new loan of the
buyer. Prepaid interest covers the closing date through the last day
of the month in which the closing takes place.

478

Example: $270,800 is the principal amount of a buyers new loan.

The rate of interest is 7% and the closing date of the transaction is
April 12. On the basis of a 365-day year, calculate the amount of
the prepaid interest that the lender of the buyer will require the
buyer to pay at closing.
1. Calculate the annual amount of interest by using the percentage
formula:
a) Write down the formula: Payment = Loan Balance x Interest Rate
b) Substitute: P = $270,800 x 7%
c) Calculate: $270,800 x .07 = $18956
2. Dividing the annual interest rate by 356 days find the per diem
rate of the expense: $18956 365 = $51.94 Per diem.
3. Find out the number of days the buyer is responsible for. The
buyer pays for the closing date, in prepaid interest prorations.
Thus, there will be 19 days (from April 12 through April 30)
4. Now, we will substitute the per diem day rate and the number of
days into the proration formula, S = R x D and do the calculation.
$51.94 Per diem
X 19 Days
986.86 Prepaid Interest Amount
Thus, the interest rate that the buyer will pay at closing will be
$986.86.

Chapter Summary
Formula to find Area of squares and rectangles: Area = Length
x Width (A = L x W).
Formula to find Area of triangles: Area = Base x Height (A =
B x H).
Formula to find the Volume: Volume = Length x Width x Height
(V = L x W x H).
479

 Formula to find the percentage: Part = Whole x Percentage (P =

W x %).
Formula to find Profit or Loss: Now = Then x %
Formula for Capitalization: Income = Rate x Value (I = V x %)
Formula for Proration: Share = Daily rate x Number of days (S
= R x D)
How to:
a)

Convert fractions to decimals:

Divide the numerator (top number) by the denominator
(bottom number).

b)

Convert percentages to decimals:

Move the decimal point two places to the left and remove the
percent sign.

c)

Convert decimals to percentages:

Move decimal point two places to the right and add a percent
sign.

Chapter Quiz
1. Jerry purchased a property one year ago @ $175,500. The
property rates in his neighborhood are increasing at a rate of
5% annually. Calculate the current market value of his
property.

2. Sally has borrowed $8,500 for one year and she paid $650 in
interest. Calculate her rate of interest.

480

3. Mr. Smith brought a house for $350,000 and sold it later for
$425,000. What is the rate of profit earned by him on this
sale?
4. A rectangle measuring 85 x 45 feet contains how many square
yards?
5. Margaret sold a farm house for $148,000 and made a profit of
18%. How much did she initially pay for the farm house?
6. Patrick owns a 3-acre lot, the front footage of which is 400 ft.
Calculate the depth of Patricks lot.
7. Linda sold her house on August 10. Her existing loan on the
house is $150,000. The interest on the loan is 7%. Francis
took over the loan with interest paid up to July 15. Linda also
owes property taxes of $1250 for the year.
Based on the above information calculate:
A) Prorate interest, and who is credited or debited, and
B) Prorate tax, and who is credited and debited.
8. Chris bought a building for $550,000. The yearly net income
produced by the building is $65,000. Calculate the rate of
return for Chris.
9. A triangular lot has a base of 45 ft. and a height of 55 ft.
Calculate the area of the lot.
10.
Calculate the percentage of the commission, if a property
was sold for $850,600 and the commission paid for it was
$56,500.
11.
Mr. Lee is looking to procure a home mortgage loan on
the property that he is purchasing in Palm Springs. The price
of the property is $960,000 and Mr. Lee will make a 20% down
payment. Mr. Lee has a choice of taking a 30-year loan at an
interest rate of 7% or a 15-year loan at an interest rate of 6%.
Which of the two loans will have a smaller monthly installment
and what will be the amount of that installment?

481

12.
The Jensons have sold their house and are paying off the
mortgage at closing. The remaining principal balance on the
mortgage at closing will be $155,600.50. They have to pay the
interest accrued over the 10-day period between their last
mortgage payment and the closing date. If the annual rate of
interest paid by the Jensons on their mortgage was 9%. What
will be the amount of interest they will have to pay at closing?
(Base your calculation on a 365-day year.)
13.
Gerard has purchased a building for $745,000. This
building will fetch a 8.75% return on his investment. Calculate
the annual net income generated by the building.
14.
Jake, a salesman found a buyer for a property that was
listed with another broker. Jake worked as a buyers agent in
return for a commission to his brokerage firm of 3% of the
sales price. Jakes share on any commission earned would be
60 percent. Now, if the property sold for $500,000, what was
Jakes commission?
15.
Thelma paid $875,000 for a 10-unit apartment building.
The gross income per month is $750 per unit and the annual
expense is $3,500. What will be Thelmas capitalization rate on
her investment?

Chapter Quiz Answer Key

Chapter 1
1.
B
2.
D
3.
C
4.
D
5.
B
6.
A
7.
C

Chapter 2
1.
C
2.
B
3.
A
4.
C
5.
A
6.
D
7.
A

Chapter 3
1.
C
2.
A
3.
B
4.
D
5.
C
6.
D
7.
C

Chapter 4
1.
A
2.
C
3.
A
4.
C
5.
D
6.
A
7.
C
482

8.
9.
10.
11.
12.

D
B
C
D
C

Chapter 5
1.
C
2.
A
3.
D
4.
B
5.
A
6.
D
7.
B
8.
D
9.
B
10. D
11. A
12. B
13. D
14. B
15. B
Chapter 9
1.
B
2.
A
3.
C
4.
D
5.
B
6.
D
7.
A
8.
C

8.
9.
10.
11.
12.
13.
14.
15.

C
B
A
B
C
C
A
C

Chapter 6
1.
B
2.
D
3.
C
4.
D
5.
C
6.
A
7.
B
8.
B
9.
B
10.
A
11.
D
12.
A
13.
C
14.
B
15.
A
Chapter 10
1.
B
2.
B
3.
A
4.
C
5.
A
6.
D
7.
A
8.
A

8.
9.
10.
11.
12.
13.
14.
15.

C
A
D
C
A
B
C
A

Chapter 7
1.
A
2.
D
3.
B
4.
C
5.
D
6.
A
7.
C
8.
A
9.
D
10. B
11. A
12. C
13. C
14. A
15. D
Chapter 11
1.
A
2.
C
3.
B
4.
A.
5.
D
6.
B
7.
A
8.
B

8.
9.
10.
11.
12.
13.
14.
15.

D
A
C
D
A
C
C
B

Chapter 8
1.
C
2.
B
3.
A
4.
A
5.
D
6.
B
7.
A
8.
D
9.
C
10. C
11. D
12. B
13. A
14. A
15. D
Chapter 12
1.
C
2.
B
3.
D
4.
D
5.
B
6.
D
7.
B
8.
B
483

9.
10.
11.
12.
13.
14.
15.

A
A
C
A
C
C
C

9.
10.
11.
12.
13.
14.
15.

C
D
C
A
B
A
A

Chapter 13 Chapter 14
1.
A
1.
C
2.
B
2.
B
3.
C
3.
A
4.
D
4.
C
5.
D
5.
A
6.
A
6.
B
7.
B
7.
B
8.
D
8.
C
9.
A
9.
B
10. C
10. C
11. B
11. B
12. D
12. D
13. A
13. A
14. D
14. C
15. B
15. B

9.
10.
11.
12.
13.
14.
15.

A
B
A
D
A
B
B

Chapter 15
1.
C
2.
A
3.
B
4.
C
5.
A
6.
A
7.
C
8.
C
9.
A
10. C
11. C
12. D
13. C
14. A
15. B

9.
10.
11.
12.
13.
14.
15.

C
A
B
A
D
D
D

Chapter 16
1.
B
2.
D
3.
A
4.
D
5.
A
6.
C
7.
B
8.
A
9.
D
10. B
11. C
12. C
13. B
14. A
15. B

Chapter 17 Math Problem answers:

1. 1.05 x 175,000 = $183,750

2. 650/8,500 = .0765 = 7.65% or (9,150 / 8,500)1/1 = 1.075 =

7.65%

484

3. 425,000 / 350,000 = 1.2143 = 21.43 % simple return (not

annualized)

4. 85 x 45 = 3,825 / 9 = 425

5. $148,000 / 1.18 = $125,425

6. 43,560 x 3 = 130,680 / 400 = 326.70

7. a) $10,500/360 = $28.767/day interest X 26 days = $747.95,

Debit to Linda.
b) $1250/360 = $3.472/day X 41 days = $142.36 Debit to
Linda; and $142.36 Credit to Francis.
8. $65,000 / $550,000 = 11.82%

9. (45 x 55) / 2 = 1,237.5 sq. ft

10. $56,500 / $850,000 = 6.64%

11. Smaller installment: 30-year loan of $768,000, at 7% =

$5,109.
15-year loan of $768,000 loan, at 6%, = $6,480.82
12. 10 / 365 x .09 x $155,600.50 = $383.67

13. $745,000 x .0875 = $65,187.50

485

14. $500,000 x .03 x .6 = $9,000

15. (10 x $750 x 12) - $3,500 / $875,000 = 9.89%

Index
A
Abstract of title 49
acceleration clause 185, 186, 206
accession 43, 51
accretion 47, 54
acquisition cost 87
acre 79, 200, 272, 470
adjustable-rate mortgage 233
(ARM). 233
adjusted gross income 332, 335,
336
adverse possession 43, 45, 46, 49,
51, 64
age-life See age-life method
agency 79, 81, 82, 88, 89, 95, 99,
110, 112, 113, 115, 117, 138, 141,
142, 143, 144, 145, 146, 147, 153,
154, 155, 156, 157, 158, 159, 160,
161, 162, 164, 165, 166, 167, 177,
178, 179, 195, 206, 225, 235, 239,
241, 251, 257, 258, 346, 347, 392,
415, 423, 424, 426
Air rights 15
Alienation 2, 36, 53, 186, 207
Alienation Clause 186
Alquist-Priolo Act 82
ALTA 50, 51
amenities 151, 263, 267, 274, 277,
371
amortization 228, 229, 234, 252

annexation 16
Annual percentage rate 217, 218
Appraisal 5, 227, 256, 258, 261,
278, 292, 305, 317, 394, 395
appraisal license 260
appraisal process 257, 265, 267,
279, 292
appurtenant 13, 14, 20, 62, 70
arbitration 415
assessed value 84, 85, 86, 92, 459,
460, 461
assignment 103, 116, 132, 140,
184
Assignment 102, 103, 107, 132,
184
attachment 16, 20, 21, 56, 58, 60,
68, 69, 70, 115, 139
avulsion 47, 54

B
balloon payment 180, 204, 220,
222, 231, 249, 252
Bankruptcy 45, 55, 197, 198
base lines 18
bequest 28, 41
bilateral contract 94, 114, 299
blanket encumbrance 201
blockbusting 344, 408
boot 329, 338

486

breach of contract 93, 104, 105,

106, 108, 114, 118, 120, 123
broker license 260
bulk sales 402
bundle of rights 14, 21
business opportunity 389, 401, 402,
403, 406

C
California Veterans Farm and Home
Purchase Program 245
capital gains 322
capitalization approach 295, 297,
455
capitalization rate 286, 287, 288,
289, 456, 457, 458, 459, 471
CC&R 31, 66, 67, 71
CC&Rs 31, 66, 151, 352
Certificate of Clearance 402
Certificate of discharge 189
Certificate of Eligibility 243
Certificate of occupancy 76
Certificate of ownership 408
Certificate of qualification 29
Certificate of Reasonable Value
(CRV). 243
Certificate of sale 191
chain of title 48, 49, 55
chattel 25
Civil Rights Act 341, 342, 343, 349,
353, 354, 355, 356, 357, 358
closing 298, 299, 300
closing statement 302, 316, 317,
408
codicil 42
collateral 174, 177, 182, 183, 203,
205, 208, 227, 228
color of title 46
commercial banks 172, 209, 210

commingling 418, 419

commission 219
common areas 31, 77, 131, 149,
151, 152, 333
common interest subdivision 77
common law dedication 43
community property 28, 35, 38, 43,
121
comparables 276, 277, 279, 281,
290
concurrent ownership 23, 26, 27,
31, 32
condemnation 43, 44, 51, 52, 70,
83, 89, 135, 257, 327, 328
conditional use permit 75, 90
condominiums 1, 31
conduit 365, 381, 382
construction loan 188, 200, 312
constructive fraud 98, 107
contingency clauses 121
contract law 3
contract rent 285, 290
Contracts
Elements of a valid contract 114
Elements of a void contract 114
Executed 114
Executory 114
Express 114
implied 114
unenforceable 114
unilateral 114
conventional loans 178, 235, 236,
237, 238, 240
co-operative 32, 77, 149
corner lot 274
corporation 27, 29, 30, 32, 35, 38,
62, 178, 257, 375, 381, 391, 392,
399, 401, 420, 428
Cost Approach 268, 275, 276, 280,
283
487

cost basis 323

counteroffer 97, 107
covenant 353
crawlspace 371
credit history 202, 224, 225, 228,
237, 240, 241
credit unions 209, 211

D
dealer property 326
deed 2
acknowledgement of deed 38
blanket 200
delivery 237
of reconveyance 41
deed of trust 40, 59, 99, 126, 183,
184, 193, 197, 198, 201, 202, 207,
220, 222, 304, 312, 333, 337, 392,
413, 424
default
notice of 86
depreciation 280, 282, 283, 284,
286, 287, 289, 294, 323, 327, 331,
333, 337, 378, 382, 447, 455
devisees 42
discount points 214, 215, 216, 241,
247, 277, 305, 334
Doctrine of Laches 102
Doctrine of Emblements 16, 22
dual agency 147, 160, 161
duplex 325, 380
duress 98

E
easement 2, See appurtenant
easement by deed 63
easement by implication 63

easement by prescription 64
easement in Gross 62
economic rent 285, 290
effective gross income 285, 286,
457, 458
emancipated minor 95
eminent domain 44, 52, 64, 83
encroachments 51, 61
encumbrances 39, 50, 56, 61, 68,
88, 201, 222, 318
equitable title 120, 124, 182, 184
equity loan 203
escheat 43, 44
Escrow 298
escrow account 145, 305, 417,
418
escrow agent 122, 298, 299, 300,
302, 304, 307, 308, 310, 311, 313,
315, 319, 418
escrow arrangement 298
escrow closing 299
escrow fees 220
escrow instructions 299, 300, 302
escrow termination 300
estate for years 25
estate in remainder 25
estate in reversion 25
estoppel 142, 144
eviction 133, 134, 140
exclusive listing 113, 114, 406
exclusive right to sell listing 117
executed contract See Contracts
executor 42, 96
executory contract See Contracts
express contract See Contracts

F
Fair Credit Reporting Act 225
488

fair market value 44, 52, 83, 84,

192, 332, 378
Fannie Mae (FNMA) 177, 178, 179,
206, 223, 224, 235, 237, 240, 254,
255, 258, 312, 381
feasibility 294
Federal Deposit Insurance
Corporation (FDIC) 174, 206
Federal Home Loan Bank System
(FHLB) 174, 205
Federal Housing Administration
(FHA) 174, 238, 262
Federal Reserve Board (the Fed)
172, 216
Federal Reserve System 172
fee estate 128
fee simple 24, 34, 63
absolute 24
defeasible 24
determinable 24
financial instruments 416
fixed interest rate 368
fixed rate loan 252
fixtures 13, 17, 20, 361, 362, 364,
365, 382, 401, 402
flashing 371
floor plan 264, 274, 372, 383
footing 363
foreclosure 4, 44, 45, 55, 57, 58,
133, 135, 168, 190, 192, 194, 195,
196, 197
foreclosure action 58, 190, 193,
207
forfeiture 67, 206
foundation 256, 274, 281, 361,
363, 366, 371, 380
fraud 98
actual 98
constructive 98
freehold estate 24, 33, 34, 128

frontage 272
full cash value 84, 91
functional obsolescence 282

G
general agent 143, 166
gift deed 40
Ginnie Mae (GNMA) 174, 177, 178,
179, 206, 312
graduated 136, 140
graduated payment mortgage 202
grandfather clause 75
grant deed 39, 53
grantee 37, 38, 39, 40, 53
grantor 37, 38, 39, 40, 41, 53, 63,
183
gutter 371

H
highest and best use 256, 263, 264,
267, 271, 289, 291
holographic will 42
homeowners insurance 308, 315
homeowners 266
homestead exemption 33, 70
Homestead Protection 2
Housing Financial Discrimination Act
(Holden Act) 349, 351, 356, 357,
358
hypothecation 182

I
implied warranty of habitability 134
improvements 1, 13, 16
Imputed Knowledge Rule 144

489

Income Approach 268, 275, 276,

283, 285, 287, 288, 289, 291, 297
income property 328, 329, 380
income tax 5, 92
incompetent 95, 97, 101, 145, 154,
387
independent appraisal 258
independent contractor 162
indirect costs 281
inflation 171, 173, 206, 263, 336,
369, 374, 377
inheritance tax 338
inspection 76, 91, 120, 148, 149,
165, 168, 217, 301, 306, 315, 344,
359, 366, 381, 424
installment note 180
installment sales contract 124, 204
institutional lenders 301, 312, 348,
358, 424
insulation 275, 365, 372, 385
interim loan 200
intestate 41, 43, 52
involuntary lien 56, 57

J
joint tenancy 27
joint venture 381
joists 363, 364, 365
judgment 33, 48, 56, 58, 59, 60, 68,
69, 70, 162, 182, 190, 191, 192,
193, 194, 207, 227, 283, 284, 292,
408, 414, 415, 418
judgment lien 56, 59
judicial foreclosure 190, 191, 192,
193, 194

K
kickback 313

L
land contract 126
land use regulations 73, 89
landlord 3
latent defects 148
Lease 3, 128-132
flat lease
gross lease 136, 140
ground lease 136, 140
step-up lease 136
straight lease 136
leasehold 1, 24, 25
legacy 41
legal title 44, 120, 182, 245
lenders 4, 178, 213, 230, 236, 249
Leverage 377, 385, 386
License 6, 76, 124, 156, 260, 387,
389, 395, 398, 399, 403
license application 6, 388, 396
licenses 2
liens 51, 56, 57, 58, 59, 60, 68, 83,
87, 88, 125, 184, 190, 191, 193,
195, 196, 200, 201, 203, 207, 302,
377, 389
life estate 24, 25
like-kind property 328, 329
limited liability company 30
line of credit 203
liquid asset 376, 377
liquidated damages 104, 109
lis pendens 48, 56, 58, 190
490

listing 3, 112, 116, 156, 400

loan fees 200, 217, 236, 301, 315,
367
loan originator 124, 197, 213, 222,
258, 312, 313, 314, 390, 395, 398,
426
loan-to-value 229, 231, 232, 236,
237, 240, 243, 247
lock-in clause 187
Lot and Block 18, 22

M
margin 233
marginal tax rate 321
market allocation 428
Market Data Approach 276, 283
market price 262
marketable title 36, 125
masonry 361
master plan 73
mechanics lien 56, 57, 58, 60, 200,
201
median 12, 19, 235, 239, 242
Mello-Roos Community Facilities Act
87, 151
merger 65, 67
Metes and bounds 17, 18, 22
mineral rights 14, 16, 20
minor 75, 95, 96, 106, 347
misrepresentation 98, 147, 148,
153, 250, 404, 405, 406, 407, 408,
410, 415
MLS 116, 119, 155, 157
Mortgage 4
mortgage broker 180, 212, 213,
222, 246, 248, 250, 251, 407
mortgage companies 11, 209,
211, 212

mortgage insurance 217, 223,

236, 237, 239, 243, 247, 306, 334
mortgage markets 177, 210
mortgagee 50, 59, 183, 189, 207
mortgagor 59, 183, 207
Multiple Listing Service 119, 155,
344, 429
See also MLS

N
National Association of Realtors 156
negative amortization 234
negotiable instrument 181
net lease 136, 140
net listing 115
nonconforming uses 74,75
non-exclusive right to occupy or use
the property 78
non-financial encumbrance 56
non-freehold estates 25
non-payment of rent 133, 134
non-possessory interests 23
non-recognition provision 326
non-requirement of a license 6
notary public 53, 400
notice of cessation 57, 70
notice of default 192, 193, 194, 196
notice of non-responsibility 57, 58,
69
notice of sale 192, 193, 196
novation 102, 103, 107, 108, 132,
139

O
objective value 261
open listing 94, 112, 113, 114, 115
491

ordinary income 334, 335

orientation 274, 383
origination fee 214, 216, 247, 334
ownership in severalty 26, 32

P
panic selling 345
partial payment 60
partial release clause 201
partial satisfaction clause 201
partial tax exemption 86
partition action 45
partnership 29
pension funds 211, 212
percentage lease 136
periodic payments 180, 362
periodic tenancy 26
personal property 1, 13, 14, 16, 17,
20, 27, 42, 183, 184, 199, 224,
258, 306, 402, 416, 418
physical deterioration 282, 283
plottage 273
police power 72, 73, 76, 88, 90
possessory rights 66, 182
power of attorney 38, 392
power of sale provision 192
preapproval 222
prepayment penalty 187, 188, 217,
232, 304, 334
prescription 63, 64, 65
primary mortgage market 255
principal balance 180, 181, 184,
202, 230, 231, 234, 252, 304, 377,
451, 452, 453, 471
principal, interest, taxes, and
insurance 226
PITI 226

Principle of Anticipation 264

Principle of Balance 266
Principle of Change 264
Principle of Competition 266
Principle of Conformity 265
Principle of Contribution 266
Principle of Highest and Best Use
263
Principle of Progression 265
Principle of Regression 266
Principle of Substitution 265
Principle of Supply and Demand
265
Private Mortgage Insurance 236
PMI 236
private restrictions 2
probate 36, 42, 43, 44, 53, 55, 96,
109, 150
procuring cause 113, 138
promissory note 116, 123, 179,
180, 181, 182, 184, 185, 186, 187,
188, 200, 206, 411, 413, 416
property tax lien 56, 60
proration 5, 7, 469
public restrictions 2, 72
puffing 147, 167
punitive damages 342, 347, 351
purchase agreement 120
purchase contract 103
purchase money loan 192, 218, 221
purchase money mortgage 199

Q
quantity survey method 281
quiet title action 45
quitclaim deed 40, 64, 126

492

R
rafters 363, 364
ranch home 361, 382
range lines 19
rate lock-in 215
ratification 141, 142, 165, 166
Real Estate Commissioner 79, 352,
387, 388, 403, 419, 431, 434, 435
Real Estate Investment Trust 31
REIT 31
Real Estate Settlement Procedures
Act 219, 298, 311
Real Property Loan Law 219
real property taxes 46
reconciliation 292, 293, 419
reconveyance deed 41, 189
recording 32, 36, 47, 48, 49, 52, 57,
59, 60, 68, 69, 110, 125, 184, 188,
307, 353, 402, 434
Recovery Account 415, 433
recurring costs 305, 313
redemption period 86, 88, 92, 191,
193, 194
redlining 344, 345, 347, 348
reformation 40
regressive tax 320
Regulation Z 216, 249
Reinstatement 190, 193, 207, 244
reliction 47
Renting 366
replacement cost 280, 281, 282,
283, 284, 328
reproduction cost 280
rescission 103, 104, 197, 218
RESPA 219, 221, 311, 312, 314,
315, 318, 408
return on the investment 286

revocation 97, 107, 153

ridge board 364
Right of Appropriation 15
Right of First Refusal 128
Right of Survivorship 27
riparian doctrine 15, 22
roof 122
R-value 365, 385

S
safety clause 114, 116, 138
sale-leaseback 378
sales tax 402
salesperson 4, 390, 393, 398, 425
sandwich lease 132, 140
savings and loans 175, 210, 211,
251, 301
scarcity 170
secondary market 169, 175, 176,
177, 178, 179, 181, 206, 212, 224,
229, 235, 258, 381
secret profit 406
Section 1031, re property exchanges
328
section and township system 18, 22
security deposit 130, 367
security instruments 183
seller financing 204, 217, 277, 304
separate property 28, 35
setback 74
settlement statement 302, 303, 304,
305, 306, 307, 308, 309, 312, 313,
314, 315, 317, 318
severance 16
sheathing 363, 364, 365, 384
sheriffs deed 41, 191
sill 363
simple interest 180, 205
sole plate 363
493

sole proprietorship 29
special agent 143, 164
special assessment lien 56, 59
special assessments 87
specific data 268, 269, 275, 294
specific lien 56, 58, 59, 69
specific performance 120, 126, 154
Statute of Frauds 37, 99, 100, 108,
114, 117, 120
Statute of Limitations 101, 108, 109
steering 248, 344
step-up lease 136
straight lease 136
straight-line method of depreciation
283, 284
straight-lne method of depreciation
See age-life method
Street Improvement Act of 1911 87
stucco 360, 361
sub-agent 113, 157, 162
subdivision 19, 66, 71, 76, 77, 78,
79, 80, 81, 89, 90, 91, 151, 200,
279, 291, 352, 388, 401, 429
sublease 132, 140
Subordination Clause 188
successors liability 402
surface rights 14, 20
syndicate 379, 381, 401

tenants 17, 23, 25, 28, 30, 32, 35,

131, 134, 236, 285, 289, 309, 335,
344, 345, 350, 379, 380, 381, 389,
393, 400, 416, 466
testate 41
testator 41, 42, 43
time is of essence 104, 106
title 1
title insurance 33, 36, 41, 49, 50,
51, 52, 60, 122, 189, 299, 300,
301, 306, 314, 315, 317
title search 48, 49, 50, 120
tort 144, 152
township lines 19
Transfer Disclosure Statement 149,
168
transfer of ownership 43
trust deed 40, 55
junior trust deed 40
trustee 31, 40
trustees deed 41, 193, 198
trustees sale 191, 192, 193, 194,
197, 207
Truth in Lending Act 4, 172, 209,
216, 218, 249, 251, 313
See TILA 216, 217, 218, 251, 408

T
take-out loan 200
tax basis 338
tax deductions 320, 368, 369
tax-deferred exchange 328
tax-free exchanges 328, 337, 378,
382
tenancy in common 27, 34
tenancy in partnership 28

underwriting 178, 209, 213, 222,

224, 226, 227, 228, 235, 239, 240,
241, 243, 248, 251
underwriting standards 178, 224,
227, 228, 235, 240, 241, 243, 248
undue influence 98
unearned increment 263
494

unenforceable contract 101, 108

Uniform Commercial Code 402
unilateral contract 94, 114, 127
unit-in-place method 281
unlawful detainer 134
useful life 264, 284, 323
usury law 179
utility 261

V
Value
elements of 260
variance 75, 89, 90
verification 292
Veterans Administration 224

void contract 100, 101, 108

voidable contract 101, 108
voluntary lien 56

W
warehousing 212
Warranty deed 41, 53
water rights 14, 15, 20
wear and tear 130, 131, 282, 332
writ of execution 59, 70

Z
zoning ordinances 73, 76, 89, 263

495

Glossary
Abandonment:

Giving up possession or ownership of property by

not using it, generally indicated through some affirmative act, like
removing ones belongings from an apartment.
Abstract of judgment: Document that summarizes the result of a
legal action, which can be filed in any county where the judgment
debtor owns a property.
Abstract of title: Summation of all recorded transfers,
conveyances, legal proceedings, and any other facts relied on as
evidence of title to show ownership continuity and signify any
possible loss to title.
Acceleration clause: Provision in a real estate financing
instrument allowing the lender to declare the full debt due
immediately if the borrower breaches any of the provisions of the
loan agreement. Also referred to as a call provision.
496

Acceptance: a) Agree to the terms of an offer and enter into a

binding contract.
b) Receive delivery of a deed from the grantor.
Accession: The process of manufactured or natural improvement or
addition to property.
Accretion: A steady addition to dry land through the forces of
nature, as when waterborne sediments get deposited on waterfront
property.
Acknowledgment: Formal declaration made before an authorized
person (generally a notary public) by an individual who has
executed a written instrument that it has been done voluntarily.
Acquisition cost: Amount of money required to acquire title to a
property, it includes the purchase price as well as the closing costs,
legal fees, escrow, service charges, title insurance, recording fees
and other such expenses.
Acre: Area of land measuring 160 square rods, 4,840 square yards,
or 43,560 square feet, or a tract of about 208.71 feet square.
Actual age: Number of years since a building was completed; also
called historical or chronological age.
Actual authority: Authority actually given to an agent by the
principal (expressly or by implication).
Actual eviction: Forcing someone physically off real property or
preventing someone from re-entering the property or using legal
action to make someone leave the premises.
ADA: Americans with Disabilities Act.
Addendum: A page containing additional provisions attached to a
purchase agreement or any other contract.

497

Adjacent: Next to, nearby,

necessarily in real contact).

bordering,

or

neighboring

(not

Adjustable-rate mortgage (ARM): Loan in which the interest rate

increases or decreases periodically to reflect changes in the cost of
money.
Adjusted basis: Purchase price of property plus cost of specified
improvements, minus any depreciation deductions taken.
Adjustment period: Time period between when the interest rate or
monthly payment for an adjustable-rate mortgage is changed.
Administrative agency: Government agency administering a
complicated area of law and policy, implementing and enforcing
detailed regulations that have the force of law. For example, the
Department of Real Estate is the administrative agency charged
with regulating the real estate business.
Administrator: Individual appointed by the probate court to
manage and distribute the estate of a deceased person if no
executor is named in the will or there is no will.
Ad valorem: Latin phrase meaning according to value, referring to
taxes assessed on the value of property.
Adverse possession: A way of acquiring title to real property
belonging to someone else by occupying it without permission, and
fulfilling other statutory requirements.
Affidavit: Acknowledged sworn statement in writing made before a
notary public (or any other official authorized to administer an
oath).
Affiliated licensee: A real estate salesperson or associate broker
employed by a broker is known as an affiliated licensee.
Affirm:

(a) To confirm or approve.

498

b) To make a sincere declaration that is not under oath.

After-acquired title: If a title is acquired by a grantor only after a
conveyance to a grantee, the deed to the grantee becomes effective
at the time the grantor actually receives title.
Agency: The association between a principal and the agent of the
principal that is formed by way of a contract, that may be oral or
written, express or implied, by which the agent is employed by the
principal to do certain acts dealing with a third party.
Agency, Apparent: When the impression given to a third party is
that someone who hasnt been approved to represent another is
that persons agent, or are given the idea that an agent has been
approved to perform acts which are actually beyond the capacity of
his authority; also called ostensible agency.
Agency, Dual: An agency relationship where the agent represents
two principals in their dealings with each other.
Agency, Exclusive: Listing agreement that employs a broker as
sole agent for a seller of real property for which the broker is
entitled to compensation if the property is sold via any other broker,
but not if a sale is negotiated by the owner without the services of
an agent.
Agency, Ostensible: (Refer: Agency, Apparent).
Agency Confirmation Statement: Written statement indicating the
representation of a real estate agent of a party. It should be signed
by both the buyer and the seller before they enter into a residential
purchase agreement.
Agency Disclosure Form: Form explaining the duties of a sellers
agent, a buyers agent, and a dual agent, required to be signed by
both the buyer and the seller before they enter into a residential
purchase agreement.

499

Agency law: Body of legal rules governing the relationship between

agent and principal by imposing fiduciary duties on the agent as
well as liability for the actions of the agent on the principal.
Agent: Individual authorized to represent another (known as the
principal) in dealings with third parties.
Agents in production: The elements necessary to generate income
and establish a value in real estate: labor, coordination, capital, and
land.
Age of Majority: Age of a person when he/she becomes legally
competent (usually the age is 18 years).
Agreement: Contract between two or more persons to do or not do
a certain thing, for consideration.
Air rights: The right to unobstructed use and possession of the air
space over a parcel of land. This right may be transferred separately
from the land.
Alienation: The transfer of ownership or an interest in property
from one person to another, in any way.
Alienation, Involuntary: Transfer of an interest in property against
the will of the owner, or without any action by the owner (ensuing
through operation of law, natural processes, or adverse possession).
Alienation, Voluntary: When an interest in property is voluntarily
transferred by the owner to someone else (generally by deed or will).
Alienation clause: A security instrument provision giving the
lender the right to declare the full loan balance due immediately if
the borrower sells or else transfers the security property; also
termed as due-on-sale clause.
All-inclusive Deed of Trust: Refer: Mortgage, Wraparound.

500

Alluvion: Or Alluvium is the increase of soil along the bank of a

body of water by natural forces.
Alquist-Priolo Act: A law in California that requires applications for
development of property in an earthquake fault zone to include a
geologic report.
ALTA: or American Land Title Association is a nationwide
organization of title insurance companies. An extended coverage
title policy is also referred to as an ALTA policy.
Amendment: A supplementary agreement that changes one or
more terms of a contract is called a contract amendment or contract
modification. It needs to be signed by all the parties to the original
contract.
Amenities: The features of a property that adds to the pleasure and
/or convenience of owning it, such as a swimming pool, a beautiful
view, a gym and so on.
Americans with Disabilities Act: Federal law mandating that
public facilities must be accessible to disabled people.
Amortization, Negative: The adding of interest-not-paid to the
principal balance of a loan.
Amortize: To pay off a debt gradually, with installments that
include both principal as well as interest.
Annexation: When personal property is attached to real property,
so that the personal property becomes part of the real property (a
fitting) by law.
Annexation, Actual: Physically attaching personal property to real
property, so that it can be made a part of the real property.
Annexation, Constructive: Associating personal property with
real property so it is treated as a fixture by law, although it is not
501

attached physically. For instance, a heirloom is constructively

annexed to the house.
Annual percentage rate (APR): All the charges paid by the
borrower for the loan (including the interest, origination fee,
discount points, and mortgage insurance costs), expressed as an
annual percentage of the amount borrowed.
Annuity: Sum of money received in a series of payments at regular
intervals (usually annually).
Anticipation, Principle of: The principle in an appraisal which
holds that value is created by the expectation of benefits to be
obtained in the future.
Anticipatory repudiation: Action taken by one party to a contract
to inform the other party, before the time set for performance, that
he does not intend to fulfill the contract.
Anti-deficiency rules: Laws prohibiting a secured lender from
suing the borrower for a deficiency judgment in certain
circumstances.
Apportionment: A division of property or liability into proportionate
parts (may not be equal parts).
Appraisal: An estimate or opinion of the value of a piece of property
as of a specific date.
Appraiser: Person who evaluates the value of the property,
especially a trained and experienced person who has expertise in
this field.
Appraiser, Fee: A self-employed appraiser who is hired to appraise
real estate for a fee, as opposed to an appraiser who works for a
lender, a government agency, or some other entity as a salaried
employee.
Appreciation: An increase in value; the opposite of depreciation.
502

Appropriation: Keeping property or reducing it to a personal

possession, excluding others from it.
Appropriative Rights System: A water rights allocation system, in
which a person wanting to make use of water from a certain body of
water (like a river or lake) is supposed to have a permit. A permit
that is issued earlier has precedence over a newer permit. This is
also called the prior appropriation system.
Appropriative rights: A persons water rights to hold a water
appropriation permit.
Appurtenances: Rights that go along with ownership of a particular
piece of property, such as air rights or mineral rights. These are
generally transferred with the property, but in some cases they may
be sold separately.
Appurtenances, Intangible: Rights concerning ownership of a
piece of property that does not comprise physical objects or
substances. An access easement is a good example of this.
APR: Annual Percentage Rate.
Area: (a) Locale or region.
(b) The size of a surface, normally in square units of measure, as in
square feet or square miles.
ARM: See Mortgage, Adjustable-Rate.
Arms length transaction: Transaction where there is no family
relationship, friendship, or pre-existing business relationship
between the two parties.
Arranger of credit: A real estate licensee or attorney who arranges
a transaction where credit is extended by a seller of residential
property.

503

Artificial person: A legal unit, such as a corporation, treated as an

individual having legal rights and responsibilities by the law; as
distinguished from a normal being, a human. An artificial person is
also called a legal person.
Assemblage: Merging two or more adjoining properties into one
expanse.
Assessment: Property valuation for taxation purposes.
Assessor: Officer responsible for determining the value of the
property for taxation.
Asset: A thing of value owned by a person.
Assets, Capital: Assets that a tax payer holds, other than (a)
Property held for sale to customers, and (b) Depreciable property or
real property used in the taxpayers trade or business. Real property
is a capital asset if it is used for personal use or for profit.
Assets, Liquid: Any assets or cash that can be turned into cash
(liquidated), such as stock in a company.
Assets, Section 1231: Properties used in a trade or business or
held for the production of income (it is referred as Section 1231 in
the federal income tax code).
Assign: Transfer of rights (particularly contract rights) or interests
to another.
Assignee: One to whom rights or interests are assigned.
Assignment: (a) Transferring contract rights from one person to
another.
(b) In case of a lease, the transfer of the entire
leasehold estate by the original tenant to another.

504

Assignment of contract and deed: The instrument through which

a new vendor is substituted for the original vendor in a land
contract.
Assignor: Someone who assigns his rights or interest to another.
Assumption: Action by a buyer to take on personal liability for
paying off the sellers existing mortgage or deed of trust.
Assumption fee: A fee paid to the lender, generally by the buyer,
when a mortgage or deed of trust is assumed.
Attachment: Court-ordered seizure of property belonging to a
defendant in a lawsuit, so it will be available to satisfy a judgment if
the plaintiff wins. An attachment creates a lien in case it is real
property.
Attestation: The act of witnessing the execution of an instrument,
such as a deed or a will.
Attorney General: The principal legal advisor for state government,
including legal advisor to the Department or Real Estate on matters
regarding the Real Estate Law.
Attorney in Fact: Someone who is authorized to represent another
by a power of attorney, not necessarily a lawyer.
Attractive nuisance: A dangerous feature that is appealing to
children, thus posing a potential source of liability for the property
owner.
Auditing: Verifying and examining records, particularly
financial accounts of a business or other organization.

the

Automated underwriting: Refer: Underwriting, automated.

Avulsion: (a) A sudden (not slow) tearing away of land by the action
of water. (b) A sudden shift in a water course.

505

Bad

debt/Vacancy

factor:

percentage

deducted

from

propertys potential gross income to find the effective gross income,

estimating the income that will probably be lost due to vacancies
and non-payment of rents by the tenants.
Balance, Principle of: An appraisal principle which holds that the
maximum value of real estate is achieved when the agents in
production (labor, capital, land, and co-ordination) are in proper
balance.
Balloon payment: A payment on a loan (usually the final payment)
that is substantially larger than the regular installment payments.
Bankruptcy: a) A condition resulting when the liabilities of an
individual, corporation, or firm exceeds assets.
b) A court declaration that an individual, corporation, or firm is
insolvent, resulting in the assets and debts being administered
under bankruptcy laws.
Barter: To exchange or trade one commodity or piece of property for
another without the use of money.
Base Line: Main east-west line in the government survey system
from which township lines are established. Each principal meridian
has one base line associated with it.
Basis: Figure used in calculating the gain on the sale of real estate
for federal income tax purposes; also called the cost basis.
Basis, adjusted: The initial basis of the owner in the property, plus
capital expenditures for improvements and minus any allowable
depreciation deductions.
Basis, initial: The amount of the owners original investment in the
property: the cost of acquiring the property including closing costs
and other expenses along with the purchase price.

506

Bearer: A person in possession of a negotiable instrument.

Bench mark: A surveyors mark at a known point of elevation on a
stationery object, used as a reference point in calculating other
elevations in a surveyed area, most often a metal disk set into
cement or rock.
Beneficiary: (a) One for whom a trust is created and on whose
behalf the trustee administers the trust.
b) The lender in a deed of trust transaction.
c) Someone who is entitled to receive real or personal property
under a will (a legatee or devisee).
Beneficiarys Statement: Document in which a lender confirms
the status of a loan (the interest rate, principal balance, etc.) and
describes any claims that could affect an interested party.
Bequeath: To transfer personal property to someone by will.
Bequest: Personal property (including money) that is transferred by
will.
Betterment: An improvement to real property that is more
extensive than ordinary repair or replacement which increases the
value of the property.
Bilateral contract: Contract under which each party promises
performance.
Bill of sale: A document used to transfer title to personal property
from a seller to a buyer.
Blanket mortgage: Mortgage that include more than one property
parcel as security.
Blind ad: An advertisement placed by a real estate licensee that
does not indicate the ad is from a licensee.
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Block: A group of lots surrounded by streets or unimproved land in

a subdivision.
Blockbusting: Attempting to lure owners to list or sell their homes
by predicting that the members of another race or ethnic group, or
people suffering from some disability, will be moving into the
neighborhood; also called panic selling. It is a violation of the
antidiscrimination laws.
Blue sky laws: Laws regulating the promotion and sale of securities
in order to protect the public from fraud.
Board of Directors: The body responsible for governing a
corporation on behalf of the shareholders.
Bona fide: In good faith; genuine, not fraudulent.
Bond: a) A written obligation, normally interest bearing, to pay a
certain sum at a specified time.
b) Money put up as a surety, protecting against failure to perform,
negligent performance, or fraud.
Bonus: An additional payment, over and above the due payment.
Boot: Something given or received in a tax-free exchange, which is
not like-kind property. For instance, in an exchange of real property
where one party gives another one cash in addition to real property,
the cash is the boot.
Boundary: The perimeter or border of a parcel of land; the dividing
line between two pieces of property.
Branch manager: An associate broker appointed by a firms
primary broker to manage the operations of a branch office.
Breach: Violation of an obligation, duty, or law.
Breach of contract: Failure to perform a contractual obligation.
508

Broker, Associate: Someone who is qualified as a broker and is

affiliated with another broker.
Broker, Cooperating: A broker belonging to a multiple listing
service who helps sell a property listed with another member of the
listing services.
Broker, Designated: A corporate officer or a general partner who is
authorized to act as the broker for a licensed corporation or for a
partnership.
Broker, Fee: A real estate broker who allows the use of his license
to another person to carry on a brokerage, in violation of the license
law.
Broker, Listing: A broker having a listing agreement with a
property seller.
Broker, Real estate: Someone who is licensed to represent
members of the public in real estate transactions in exchange for
compensation.
Brokerage: Business of a real estate broker.
Brokerage fee: Service charges of a real estate broker that is paid
as a commission or as other compensation.
Buffer: Undeveloped area that separates two areas zoned for
incompatible uses.
Building codes: Regulations that set minimum standards for
construction methods and materials.
Building restrictions: These are rules that apply to building size,
type, or placement. They may be public restrictions, such as in a
zoning ordinance or private restrictions, like CC&Rs.

509

Bulk transfer: The sale of all or a substantial part of the

merchandise, equipment, or any other inventory of a business that
is not in the ordinary course of business.
Bulk transfer law: A law that requires a seller who negotiates a
bulk transfer (generally connected with the sale of the business
itself) to furnish the buyer with a list of creditors and a schedule of
the property being sold, and to notify creditors of the impending
transfer.
Bump clause: A provision in a purchase agreement allowing a seller
to keep the property on the market while waiting for a contingency
clause to be fulfilled. In the meantime, if the seller receives another
good offer, he can ask the buyer either to waive the contingency
clause or terminate the contract.
Bundle of rights: The rights inherent in ownership of property,
including the right to use, lease, enjoy, encumber, will, sell, or do
nothing with the property.
Business opportunity: A business that is for sale.
Buy down: Discount points paid to a lender to reduce (buy down)
the interest rates charged to a borrower, especially when a seller
pays discount points to help the buyer (borrower) qualify for
financing.
Buyer representation agreement: A contract in which a
prospective buyer hires a real estate broker to act as his agent for
locating desirable property and negotiating its purchase, or in
negotiating the purchase of a property that the buyer has already
found. This is also called the buyer agency agreement.

California Coastal Act: Law that is designed to protect and control

development along the California coastline.
510

California Fair Housing Law: Law that guarantees equal treatment

for everyone in all business establishments, often referred to as the
Rumford Act.
California Veterans Farm and Home Purchase Program: Statesponsored residential finance program utilized to provide cheap
home and farm loans to veterans, often called the Cal-Vet
program.
Call: A specification that describes a segment of the boundary in a
metes and bounds description; for example, South 20 west 100
feet is a call.
Cancellation clause: Terminating a contract without undoing acts
that have already been performed under the contract.
Cap: A limit on how much a lender may raise an adjustable rate
mortgages interest rate or monthly payment per year, or over the
life of the loan.
Capacity: The legal ability or competency to perform any act, such
as enter a binding contract (contractual capacity) or execute a valid
will (testamentary capacity).
Capital: Money or other forms of wealth available for use in
producing more money.
Capital assets: Assets held by a taxpayer other than property held
for sale to customers in the normal course of the taxpayers
business, It also comprises depreciable property or real property
used in the taxpayers trade or business. Therefore, real property is
a capital asset if owned for personal use or for profit.
Capital expenditures: Money spent on improvements and
alterations that add to the value of the property and/or prolong its
life.

511

Capital gain: Profit achieved from the sale of a capital asset. It is a

long-term capital gain, if the asset was held for more than one year
and it is a short-term capital gain, if the asset was held for one year
or less.
Capital improvement: Any improvement so designed that it
becomes a permanent part of the real property or that will have the
effect of prolonging the propertys life significantly.
Capitalization: A method of appraising real property by converting
the anticipated net income from the property into the present value;
also called the income approach to value.
Capitalization rate: A percentage used in capitalization (Net
Income = Capitalization Rate x Value). It is the rate believed to
represent the proper relationship between the value of the property
and the income it produces; the rate that would be a reasonable
return on an investment of the type in question; or the yield
necessary to attract investment of capital in property like the
subject property. It is also called the cap rate.
Capital loss: A loss that is a result of a sale of a capital asset. It
may either be long-term (held for more than one year) or short-term
(held for one year or less).
Capture, rule of: Legal rule that grants a land owner the right to all
oil and gas produced from wells on his land, even if it migrated
underneath from land that belongs to someone else.
CAR: California Association of Realtors.
Carryback loan: Refer: Mortgage, Purchase Money.
Carryover clause: Refer: Safety clause.
Cash flow: The residual income after deducting all operating
expenses and debt service from the gross income.

512

Cash on cash: The ratio between cash received in the first year and
cash initially invested.
CC&Rs: A declaration of covenants, conditions, and restrictions
that is generally recorded by a developer to place restrictions on all
lots within a new subdivision.
CEQA: California Environmental Quality Act.
CERCLA: Comprehensive Environmental Response, Compensation,
and Liability Act.
Certificate of Discharge: Document given by the mortgagor to the
mortgagee when the mortgage debt has been paid in full,
acknowledging that the debt has been paid and the mortgage is no
longer a lien against the property; also called a satisfaction of
mortgage or mortgage release.
Certificate of Eligibility: Document issued by the Department of
Veterans Affairs regarding the veterans eligibility for a VAguaranteed loan.
Certificate of Occupancy: Document issued by a local government
agency (such as the building department) verifying that a newlyconstructed building is in compliance with all codes and may be
occupied.
Certificate of Reasonable Value (CRV): Based on an appraisers
estimate of the value of a property, it is mandatory for a VAguaranteed home loan to be authorized; the amount of the loan can
not be more than the CRV.
Certificate of Sale: Document given to the purchaser at a mortgage
foreclosure sale, instead of a deed which is replaced with a sheriffs
deed only after the redemption period expires.
Chain of Title: Record
pertaining to a property.

of

encumbrances

and

conveyances

513

Change, Principle of: An appraisal principle holding that it is the

future, not the past, which is of primary importance in estimating a
propertys value.
Charter: A written instrument granting a power or a right of
franchise.
Chattel: An article of personal property.
Chattel mortgage: Using personal property as security for a debt.
Chattel real: Personal property closely associated with real
property. A lease is a good example.
Civil Rights Act of 1866: Federal law guaranteeing all citizens the
right to purchase, lease, sell, convey, and inherit property,
regardless of race and color.
Civil Rights Act of 1964: Federal law that disallows
discrimination on the basis of race, color, national origin, or religion
in programs for which the government provides financial
assistance.
Client: Someone who employs a broker, lawyer, appraiser, or any
other professionals. A real estate broker may have clients who is
either is a seller, a buyer, a landlord, or a tenant.
Closing: The last stage of a real estate transaction when the seller
receives the purchase money and the buyer receives the deed with
the title transferred to him. It may also be called a settlement.
Closing costs: Expenses incurred while transferring real estate in
addition to the purchase price.
Closing date: Date on which all the terms of a purchase agreement
have to be met, or else the contract is terminated.
Closing statement: Accounting of funds from a real estate
purchase, furnished to both seller and buyer.
514

Cloud on title: A claim, encumbrance, or apparent defect that

makes the title to a property unmarketable.
Code of ethics: Set of rules of accepted standards of conduct,
reflecting principles of fairness and morality.
Codicil: An addition to, or a revision of a will.
Collateral: Anything of value used as security for a debt or
obligation.
Collusion: Agreement between two or more persons to defraud
another.
Color of title: Appears to be of good title, but in fact, is not.
Commercial bank: Type of financial institution that has
traditionally emphasized commercial lending (loans to businesses),
and also makes residential mortgage loans.
Commercial paper: Negotiable instruments, such as promissory
notes, sold to meet the short-term capital requirements of a
business.
Commercial property: Property that is zoned and used for
business purposes, such as restaurants, office buildings. Set apart
from residential, industrial, and agricultural property.
Commingled funds: Funds received from different sources that are
deposited in one account and thus lose their separate character.
Commingling: Illegally mixing trust funds held on behalf of a client
with personal funds.
Commission: a) Compensation received by a broker for services
provided in connection with a real estate transaction (normally a
percentage of the sales price).
b) Group of people gathered for a purpose or a function (generally a
governmental body, as in a planning commission).
515

Commitment: A lenders promise to make a loan, in real estate

finance; loan may be firm or conditional. (A conditional loan is
based on fulfillment of certain conditions, such as a satisfactory
credit report on the borrower.
Common elements: Land and improvements in a condominium,
planned unit development, or other housing development that are
owned and used collectively by all the residents, as in parking lots,
hallways, and recreational facilities provided for common use.
Common elements, limited: There are features outside of dwelling
units in condominiums and other developments that are reserved
for the use of owners of a particular unit. For example, assigned
parking lots, these are also called limited common areas.
Common law: Long-established rules of law based on early English
Law, it usually prevails unless overruled by statutory law.
Community property: In California as well as other community
property states, property jointly owned by a married couple, as
distinguished from each spouses separate property; usually, any
property acquired through the labor or skill of either spouse during
marriage.
Co-mortgagor:
Family
member
(generally)
who
accepts
responsibilities for the repayment of a mortgage loan, along with the
primary borrower, to help the borrower qualify for the loan.
Comparable: In appraisal, a property that is similar to the subject
property and which has been sold recently. The sales prices of
comparables provide data for estimating the value of the subject
property using the sales comparison approach.
Comparitive Market Analysis: Estimate of property value for
appraisals based on indicators from the sale of comparable
properties.

516

Competent: (a) Having a sound mind for the purpose of entering

into a contract or executing a legal instrument (mentally
competent).
(b) Having a sound mind and also having reached the
age of majority (legally competent).
Competition, Principle of: Appraisal principle which holds that
profits tend to encourage competition, and excess profits tend to
result in disastrous competition.
Compliance inspection: For the benefit of a lender, a building
inspection done to determine if the building codes, specifications, or
conditions established after a prior inspection have been met,
before funding a loan.
Comprehensive Environmental Response, Compensation, and
Liability Act: A federal law governing liability for environmental
cleanup costs.
Condemnation: (a) Taking private property for public use via the
governments power of eminent domain.
(b) A declaration that a structure is not fit for
occupancy and must be closed or demolished.
Condemnation appraisal: An estimate of the value of condemned
property to find out the just compensation to be paid to the owner.
Condition: (a) A provision in a contract that makes the parties
rights and obligations depend on the occurrence (or nonoccurrence)
of a particular event; also called a contingency clause.
(b) A provision in a deed that makes title-conveying
subject to compliance with a particular restriction.
Conditional use permit: Authorization for a land use that would
otherwise not be allowed by zoning ordinances.
517

Condominium: A subdivision that provides an exclusive ownership

(fee) interest in the airspace of a particular portion of real property,
and an interest in common in a section of that property.
Confirmation of sale: Court approval of a sale of property by an
executor, administrator, or guardian.
Conflict of interest: Situation in which an action that would
promote the interests of the agent is in conflict with an action that
would promote the interests of the principal. In such a situation the
agent must inform the principal and offer to retreat.
Conforming loan: Home mortgage loan in which the borrower and
real estate conform to Fannie Mae and Freddie Mac guidelines, with
a lower interest rate than a non-conforming loan.
Conformity, principle of: This principle holds that property values
are boosted when buildings are similar in design, construction, and
age.
Conservation: (a) Preservation of structures or neighborhoods in a
healthy condition.
(b) Preservation or limited use of natural resources
for long-term benefits.
Consideration: Something of value provided to induce entering into
a contract; money, personal services, love. Without consideration, a
contract is not legally binding.
Construction lien: Refer: Lien, Mechanics.
Consumer Price Index: An index that tracks changes in the cost of
goods and services for a typical consumer.

Contiguous: Adjacent, abutting, or in close proximity.

Contingency clause: See: Condition.
518

Contract: A written or oral agreement to do or not do specified

things, in return for consideration.
Contract, Bilateral: A contract by which each party is bound to a
promise to perform.
Contract, Executed: A contract whose contractual obligations have
been completely performed by all parties.
Contract, Executory: A contract in which one or both the parties
have not yet completed their contractual obligations.
Contract, Express: A contract that has been worded, either spoken
or written.
Contract, Implied: A contract that has been worded, but is implied
by the actions of the parties.
Contract, Land: A contract for the sale of real property in which
the buyer (the vendee) pays in installments. The buyer obtains
possession of the property immediately while the seller (the vendor)
retains legal title until the full price of the property has been paid. It
is also called the conditional sales contract, installment sales
contract, real estate contract, or contract for deed.
Contract, Oral: A spoken agreement that has not been written
down, also called a parol contract.
Contract, Unenforceable: An agreement that a court of law refuses
to enforce.
Contract, Unilateral: A contract that is accepted by performance.
The offerer promises to perform his side of the bargain if the other
party performs, but the other party has not made the same
promise.
Contract, Valid: A binding, legally enforceable contract.

519

Contract, Void: An agreement that is not an enforceable contract,

as there is an absence of a required element (like consideration) or
there is a defect of any kind.
Contract, Voidable: A contract that any of the parties involved may
negate without liability, due to lack of capacity or a negative factor
such as fraud or duress.
Contract of deed: Refer: Contract, land.
Contract of adhesion: A one-sided contract that is unfair to one of
the parties.
Contract of sale: See: Purchase agreement.
Contractual capacity: The legal capacity to enter into a binding
contract. A mentally competent person who has attained the age of
majority is a person with contractual capacity.
Contribution, Principle of: An appraisal principle which holds that
the value of real property is at its best when the improvements
produce the highest return proportionate with their cost the
investment.
Conventional loan: Mortgage loan not guaranteed by governmental
agency, such as the Veterans Administration.
Conversion: a) Misappropriating property or funds belonging to
another (for example, converting trust funds to ones own use).
b) The process where an apartment complex is
changed to a condominium or cooperative.
Conveyance: Transfer of title of real property from one person to
another through a written document (usually a deed).
Cooperating agent: A member of a multiple listing service who
finds a buyer for property listed for sale by another broker.

520

Cooperative: Building owned by a corporation, in which the

residents are the shareholders. Each shareholder receives a
proprietary lease for an individual unit along with the right to use
the common areas.
Cooperative sale: A transaction in which the listing agent and the
selling agent work together but for different brokers.
Corporation: Legal entity that acts via its board of directors and
officers, usually without liability on the part of the person or
persons owning it.
Correction lines: Guide meridians running every 24 miles east and
west of a meridian, and standard parallels running every 24 miles
north and south of a base line, used to correct inaccuracies in the
rectangular survey system of land description caused by the earths
curvature.
Cost approach to value: One of the three key methods of appraisal.
An estimate of the subject propertys value is determined by
estimating the cost of replacing the improvements, and deducting
the estimated accrued depreciation from it while adding the
estimated market value of the land.
Cost basis: See Basis.
Cost recovery deductions: See: Depreciation deductions..
Counteroffer: Reacting to a contract offer by changing some of the
terms of the original offer as a substitute offer.
Covenant: An agreement or a promise to perform or not perform
certain acts (generally imposed by deeds). See: CC&Rs.
Covenant, Restrictive: A promise to do or not do acts concerning
real property, particularly a promise that concerns land. Most often
it is an owners promise to not use the property in a certain
manner.
521

Covenant against encumbrances: A promise (in a deed) that the

property is not weighed down by any encumbrances other than
those disclosed in the deed.
Covenant of quiet enjoyment: A promise to not disturb a buyers
or tenants possession by the previous owner, landlord, or anyone
else that makes a lawful claim against the property.
Covenant of right to convey: A promise (in a deed) that the
grantor has the legal ability to make a valid conveyance.
Covenant of Seisin: A promise (in a deed) by the grantor that he
actually owns the interest being conveyed to the grantee.
Covenant of warranty: A promise (in a deed) that the grantor will
defend the title of the grantee against claims superior to the
grantors that exist when the conveyance is made.
CPM: A Certified Property Manager has satisfied the requirements
set forth by the Institute of Real Estate Management of the National
Association of Realtors
Credit arranger: A mediator between prospective borrowers and
lenders negotiating loans, such as a mortgage broker.
Credit bidding: When the lender obtains a property by bidding the
amount the borrower owes in a foreclosure sale.
Credit union: Financial institution that may serve only members of
a certain group (as in a labor union or a professional association)
and has traditionally emphasized consumer loans.
Cul-de-sac: A dead-end street with a semi-circular turnaround at
its end.

Damage deposit: See Security deposit.

Damages: a) Losses suffered by a person due to a breach of
contract or a tort.
522

b) An amount of money the defendant is ordered to pay to the

claimant in a lawsuit.
Damages, Actual: See: Damages, compensatory.
Damages, Compensatory: Damages that are awarded to a claimant
as compensation for injuries (personal injuries, property damages,
or financial losses) caused by the acts of the defendant; also called
actual damages.
Damages, Liquidated: Sum agreed upon by the parties in advance,
while the contract is being made, to serve as full compensation in
case a breach of contract occurs.
Damages, Punitive: An award added to actual damages (in a civil
lawsuit), as a punishment to the defendant for contemptible or
malicious conduct and to discourage others from doing such acts.
Dealer: Someone whose business is to buy and sell real estate.
Dealer property: Property that is held for selling rather than for
long-term investment. An example of this would be a developers
inventory of subdivision lots.
Debit: A charge or debt owed to another.
Debtor: Someone who owes money to another.
Decedent: A dead person.
Declaration of abandonment: An owner-recorded document that
voluntarily releases a property from homestead protection.
Declaration of homestead: A recorded document that creates
homestead protection for a property that would otherwise not
receive it.
Declaration of restrictions: See: CC&Rs.
Decrement: Means a decrease in value, the opposite of increment.
523

Dedication: Land that is given by its owner for public use and
accepted (for that particular use) by the appropriate representative
of the government.
Deduction: Amount on which income tax is not required to be paid.
Deed: Correctly executed and delivered written instrument that
conveys title to real property (from the grantor to the grantee).
Deed, Administrators: Deed that an administrator of an estate
uses to convey a deceased persons property to his heirs.
Deed, General warranty: Deed by which the title is warranted by
the grantor against defects that may have surfaced before or after
his tenure of ownership; also called a warranty deed.
Deed, Gift: Deed in which there is no support of valuable
consideration, most frequently listing love and affection as the
consideration.
Deed, Grant: The most commonly-used type of deed in California, it
uses the word grant in its words of conveyance and holds certain
implied warranties that the property is not encumbered and has not
been deeded to someone else.
Deed, Quitclaim: Deed conveying any interest in the property that
a grantor may have at the time of executing the deed, without
warranties.
Deed, Tax: A deed that a buyer of a property obtains at a tax
foreclosure sale.
Deed, Trustees: A deed that a buyer of a property receives at a
trustees sale.
Deed in lieu of foreclosure: A deed given to the lender by the
borrower (who has defaulted) to avoid foreclosure proceedings by
the lender.
524

Deed of reconveyance: Once the debt has been repaid the security
property is released from the lien that is created by a deed of trust.
The instrument used is called the deed of reconveyance.
Deed of trust: To secure the repayment of a debt, an instrument is
used that creates a voluntary lien on real property. This lien
includes a power of sale clause that allows non-judicial foreclosure.
The parties to this deed are the grantor (borrower), the beneficiary
(lender) and the trustee (neutral third party).
Deed restrictions: Provisions in a deed that set restrictions on the
use of property. It may either be covenants or conditions.
Default: When one of the parties to a contract fails to fulfill one or
more of the obligations or duties as enforced by the contract.
Defeasance clause: There is a clause in a mortgage, deed of trust,
or lease which provides for the cancellation of a certain right if a
particular event occurs.
Deferred maintenance: Curable depreciations that ensue due to
maintenance or repairs that were postponed and thus caused
physical deterioration.
Deficiency judgment: Determination by the court that the
borrower owes more money when the security for a loan does not
completely satisfy a debt default.
Delivery: When a deed is legally transferred from the grantor to the
grantee, thus transferring title.
Demand: One of the four elements of value (other three being
scarcity, utility, and transferability). It is a desire to own along with
the ability to afford.
Demise: a) Conveying an interest in real property via the terms of a
lease.

525

b) Transferring an estate or interest in property to someone for a

long time period, for life, or at will.
Department of Housing and Urban Development: (HUD) Federal
agency responsible for public housing programs, FHA-insured home
mortgage loans, and enforcing the Federal Fair Housing Act. The
FHA and Ginnie Mae both are a part of HUD.
Department of Real Estate: (BRE) The Real Estate Law of
California is administered by the BRE, as well as the licensing of
real estate brokers and salesperson.
Depreciable property: In regards to the federal income tax codes, a
property that is qualified for depreciation deductions as it might
wear out and may have to be replaced.
Depreciation: a) A loss in value as a result of physical
deterioration, functional obsolescence, or external obsolescence.
b) Allocating the cost of an asset over a period of time for the
purpose of income tax deductions.
Descent: When a property is transferred through intestate
succession rather than by will. Receiving property by intestate
succession is said to be received by descent (not by devise or
bequest).
Developer: Someone who subdivides land or improves land to
obtain a beneficial use.
Devise: Transferring title to property by will. See Bequest.
Devisee: Person who receives title to real property by way of a will.
Devisor: Testator by whom real property is devised by way of his
will.
Disaffirm: To request a court to terminate a contract that is
voidable.
526

Disbursements: Money spent out or paid out.

Disclaimer: Denying legal responsibility.
Discount points: Percentage of the principal amount of a loan that
is collected by the lender or withheld from the loan amount when
the loan is originated. This is done to increase the lenders revenue
on the loan.
Discount rate: Interest rate which is charged when a member bank
borrows money from the Federal Reserve Bank.
Discrimination: Unequal treatment given to people on the basis of
their race, religion, sex, national origin, age, or some other trait.
Disintegration: Period of decline in a propertys life cycle, when the
propertys current economic usefulness is ending and constant
maintenance becomes inevitable.
Dispossess: Forcing someone out of possession of real property by
using legal procedures, as it is done in an eviction.
Down payment: Portion of the purchase price of a property that is
paid in cash by the buyer, generally the difference between the
purchase price and the financed amount.
Downzoning: Rezoning a land for limiting its use.
Drainage: Natural or artificial method of removing surface or subsurface water from an area.
Duress: When someone enters into an agreement as a result of
threats of physical violence or mental harassment.
Dwelling: A place of living, a house or a home.
Earnest money: Deposit made
demonstrating her good faith.

by

real

estate

buyer

527

Easement: Right given to another person or entity to trespass upon

property that is not owned by that person or entity.
Easement, Access: An easement that allows the holder of the
easement to reach (and leave) his property (which is the dominant
tenement) by passing through the servient tenement; also called an
easement for ingress and egress.
Easement, Appurtenant: An appurtenant easement is a right to
use an adjoining property. The one benefitting from the easement is
the dominant tenement.
Easement by express grant: Easement that is voluntarily created
in a deed, will, or other written instrument.
Easement by express reservation: When an easement is created
in a deed by which the property is divided by the landowner, the
servient tenement is transferred while the dominant tenement is
retained.
Easement by implication: Easement that is created by law so as to
provide access to a landlocked parcel of land.
Easement by necessity: Such an easement is most commonly
implied in favor of grantees that do not have any access to their
land except over the land owned by the grantor.
Easement in gross: Easement benefitting a person rather than a
piece of land. There is a dominant tenant, without a dominant
tenement.
Economic life: Time period when an improved property yields a
return on investment apart from the rent due to the land itself; also
called the useful life.
Economic obsolescence: Loss of value due to factors stemming
from beyond the property.

528

Effective age: Age of a structure as its condition indicates and the

remainder of its usefulness (as opposed to its actual age). Effective
age of a building may be increased if maintained well.
Ejectment: Legal action through which possession of real property
is recovered from someone who has illegally taken possession of it;
also called an eviction.
Emblements, Doctrine of: Law allowing an agricultural tenant to
enter the land for harvesting the crops even after the lease period
ends.
Eminent domain: Right of the government to take title to real
property for public use by condemnation. The property owner
receives just compensation for property.
Encroachment: Unlawful intrusion onto neighborhood property,
often due to a mistake regarding boundary location.
Encumber: Placing a lien or encumbrance against the title to a
property.
Encumbrance: Non-possessory interest in real property, such as a
mortgage (loan), a lien (voluntary or involuntary), an easement, or a
restrictive covenant that limits the title.
Entitlement: In terms of a VA loan, it is the amount of the
borrowers guaranty.
EPA: Environmental Protection Agency.
Equal Credit Opportunity Act: Federal law prohibiting lenders
from discriminating against loan applicants on the basis of race,
color, religion, national origin, sex, marital status, or age, or that
the applicants income is generated from public assistance.
Equitable remedy: Judgment granted by a civil lawsuit to a
complainant that is not an award of money/damages which could
be an injunction, rescission, or a specific performance.
529

Equitable right of redemption: Real estate owners right to take

back property after default but before foreclosure, by paying all
debt, costs and interest.
Equity: Difference between the current market value of the property
and the liens against the property.
Erosion: Process where the surface of the land wears away by the
actions of water or wind.
Escalation clause: Provision in a lease agreement that allows an
increase in payments on the basis of an increase in an index, such
as the consumer price index.
Escheat: Reverting of a property to the state in case there are no
capable heirs found.
Escrow: Agreement that a neutral third party will hold something of
value (money or a deed) until the provisions of a transaction or a
contract may be carried out.
Escrow agent: Neutral third party entrusted by a seller and
purchaser to hold a something of value pending the fulfillment of
conditions needed to close a transaction.
Escrow instructions: Directions that a party to a transaction gives
to an escrow agent specifying the terms under which the escrow is
to be conducted.
Estate: Interest held by the property owners, it may be a freehold or
a leasehold property.
Estate at sufferance: Unlawful occupation of a property by a
tenant after their lease has terminated.
Estate at will: Occupancy of real estate by a tenant for an
indefinite period, which either party can terminated at will

530

Estate of inheritance: Estate that may be passed on to the heirs of

the holder, as in a fee simple.
Estate for years: Interest in real property that permits possession
for certain, set time period.
Estoppel: Legal principle that restricts a party from negating or
asserting a certain fact owing to that party's previous actions or
statements.
Estoppel certificate: Document that prevents a person who signs
it from later asserting facts different from mentioned in the
document; also called an estoppel letter.
Et ux: Abbreviation for the Latin phrase et uxor which means
and wife.
Eviction: Dispossession through the process of law.
Eviction, Actual: Forcing someone physically from a property or
preventing them from re-entering the real property or using lawful
procedure to make someone leave the premises.
Eviction, Constructive: Act of the landlord that interferes with the
tenants quiet enjoyment of the property to such an extent that the
tenant is forced to move out.
Excess land: Part of a parcel of land that does not add to the value
of the property.
Exclusive agency listing: Employment contract providing one
broker the right to sell property for a definite period, while also
enabling owner to sell it without having to pay commission.
Exculpatory clause: Provision in a mortgage relieving the borrower
of personal liability on the loan (for certain defaults or problems) if
the borrower voluntarily surrenders the property to the lender.

531

Execute: a) Signing an instrument and taking other steps that may

be necessary for validation.
b) To perform or complete.
Executor: Person named in a will to carry out the provisions of the
will; also called a personal representative.
Executed contract: Contract for which all terms and conditions
have been completed, making it legally enforceable.
Executor: Person selected in a will to carry out its provisions.
Exemption: Provision by which a law or a rule is not applicable to a
certain group or person.
Expenses, fixed: Recurring property expenses such as real estate
taxes or hazard insurance.
Expenses, maintenance: Cost of cleaning, supplies, utilities,
tenant services, and other administrative costs for properties that
produce income.
Express: Spoken or written words.

Fair

Employment and Housing Act: Civil rights law in California

prohibiting all housing discrimination on the basis of race, color,

religion, sex, marital status, national origin, sexual orientation,
familial status, source of income, or disability; also called the
Rumford Act.
Fair Housing Act: Also called Title VIII of the Civil Rights Act of
1968, federal law that makes discrimination illegal on the basis of
race, color, religion, sex, marital status, national origin, sexual
orientation, and familial status, source of income, or disability for
the purpose of sale or rental of residential property (or just land
that may be used for constructing a residential building).
532

Federal Deposit Insurance Corporation (FDIC): Federal agency

that insures accounts in savings and loans and commercial banks,
bolstering confidence in the banking system.
Federal Home Loan Bank System (FHLB): Twelve regional
wholesale banks that loan funds to FHLB members to bolster local
community lenders.
Federal Home Loan Mortgage Corporation (FHLMC) (Freddie
Mac): Federally-sponsored agency that buys mortgages on the
secondary market, bundles and sells them to investors.
Federal Housing Administration (FHA): Federal agency that
insures lenders for the repayment of real estate loans.
Federal National Mortgage Association (FNMA) (Fannie Mae):
Federally-sponsored agency that buys and sells residential
mortgages, thereby enhancing liquidity in the mortgage market.
Federal Reserve (the Fed): Government body that regulates
commercial banks and implements monetary policy in order to
stabilize the national economy.
Federal Reserve System: Consisting of the twelve Federal Reserve
Banks, which make loans to member banks.
Federal Trade Commission (FTC): Federal agency with the
responsibility for investigating and terminating unfair and
misleading business practices; in charge of enforcing the Truth in
Lending Act.
Fee: See: Fee Simple.
Fee simple: Recognized this as the highest form of estate
ownership in real estate. Duration of this ownership is unlimited
and can be conveyed in a will to the owner's heirs.
Fee simple absolute: A form of freehold ownership, not subject to
termination.
533

Fee simple defeasible: A form of fee simple estate subject to

termination in case of a condition not being fulfilled or there is an
occurrence of a specified event; also called a qualified fee.
Fee simple subject to a condition subsequent: Form of estate
ownership that can only be terminated by legal action in case a
condition is not fulfilled; also called a conditional fee.
Fidelity bond: Bond that covers any losses that occur due to an
employees dishonesty.
Fiduciary relationship: Relationship of trust and loyalty in which
one party owes a high level of good faith and loyalty to someone
else. For example, an agent is in a fiduciary relationship with his
principal.
Financial statement: Summation of facts that show the financial
condition of an individual (or a business), including a detailed list of
assets and liabilities.
Finders fee: A referral fee paid to someone who directs a buyer or
a seller to a real estate agent.
First lien position: Mortgage or a deed of trust that has a higher
lien priority than any other mortgage or deed of trust against the
property.
Fiscal year: Twelve-month period that is used as a business year
for accounting, tax, and other financial activities, in contrast to a
calendar year.
Fixed disbursement plan: Financing arrangement in a
construction project where loan proceeds are to be disbursed in a
series of preset installments at different phases of the construction.
Fixture: Personal property that is permanently attached to land or
improvements so that it becomes a part of the real property.

534

Floor area ratio: Zoning requirement controlling the ratio between

a buildings floor space and the percentage of the lot occupied.
Foreclosure: Sale of real property by mortgagee, trustee, or other
lien-holder when a borrower defaults.
Foreclosure, Judicial: (a) Sale of property as ordered by the court.
b) Lawsuit that is filed by a mortgagee or deed of trust beneficiary to
foreclose on the security property of a defaulting borrower.
Foreclosure, Nonjudicial: Trustees foreclosure under the power of
sale clause in a deed of trust.
Foreign Investment in Real Property Tax Act (FIRPTA): Federal
law which requires a real estate seller to withhold funds from a
buyer who is neither a U.S. citizen nor a resident alien.
Forfeiture: Failure to perform a duty or condition leading to a loss
of rights or something else of value.
Franchise: Government-granted right or privilege for conducting a
particular business, or a private business-granted right for the use
of its trade name for conducting a particular business.
Fraud: Premeditated or careless misrepresentation or cover-up of a
material fact, on which someone is relying upon causing him to
suffer loss or harm.
Fraud, Actual: Premeditated deceit or misrepresentation to cheat or
defraud someone.
Fraud, Constructive:
fraudulent intent.

Misrepresentation

made

without

any

Freehold: Estate in land where ownership is for an indefinite length

of time, such as a fee simple or a life estate.
Frontage: Distance between the two side boundaries at the front of
the lot.
535

Front foot: Property that is measured by the front linear foot on its
street line, each front foot extending the depth of the lot.
Front money: Money needed to initiate a project, including
expenses such as attorneys fee, loan charges, feasibility studies,
and a down payment.
Fructus industriales: Plants such as crops that are cultivated by
people.
Fructus naturales: Plant growth that grow naturally, such as trees,
plants, and shrubbery.
Fugitive substance: Substance that is not stationary in nature
such as natural gas, oil, and water.
Functional obsolescence: Loss of value from causes within the
property, excluding any due to physical deterioration.

Garnishment:

Legal procedure through which a creditor acquires

access to the funds or personal property of a debtor previously

under the control of a third party.
General plan: Long-term, comprehensive plan for development of a
community implemented through zoning and other laws; also called
a comprehensive plan or master plan.
Gift funds: Money given by a relative (or a third party) of a buyer
who himself does not have enough cash to close a transaction.
Good faith deposit: Deposit provided by a prospective buyer to the
seller as evidence of his good intention of closing the transaction;
also called an earnest money deposit.
Goodwill: Intangible asset of a business it acquires from having a
good reputation with the public. Goodwill is generally as indication
of the future return business.
536

Government National Mortgage Association (GNMA) (Ginie Mae):

One of the three main secondary market agencies, this federal
agency is part of the Department of Housing and Urban
Development.
Government-sponsored
Enterprise:
GSEs
are
private
corporations chartered and managed by the federal government.
Secondary market agencies Fannie Mae and Freddie Mac are the
most important GSEs in the real estate industry.
Government Survey System: System of grids made up of range
and township lines dividing the land into townships, which are
further subdivided into sections. Identification of a particular
property is done through its location within a particular section,
township, and range; called the Rectangular Survey System.
Grant: To transfer or convey an interest in real property through a
written instrument.
Grantee: Person receiving a grant of real property.
Granting clause: Words in a deed that points out the grantors
granting clause.
Grantor: Person conveying an interest in real property.
Gross Income Multiplier: Figure multiplied by the gross income of
a rental property to calculate an estimate of the propertys value;
also called the gross rent multiplier.
Gross Income Multiplier Method: Way of appraising residential
property by reference to its rental value; also called gross rent
multiplier method.
Guardian: Person appointed by a court to manage the affairs of a
minor or an incompetent person.

537

Guide Meridians: Lines running north-south (parallel to the

principal meridian) at 24-mile intervals, in the Government Survey
System.

Habendum

clause: Clause included after the granting clause in

many deeds, it begins to have and to hold and describes the type
of estate the grantee will hold.
Habitability, implied warranty of: Warranty implied by law in
every residential lease that states that the property is fit for
habitation.
Heir: One who is entitled to inherit the property of another under
the laws of intestate succession.
Heirs and assigns: Phrase used in legal documents to take into
account all successors to a persons interest in property. Assigns
are successors who acquire title in some manner other than
inheritance, as in deed.
Hereditament: Real or personal property that can be inherited.
Hereditament, Corporeal: Real or personal tangible property that
can be inherited; a property with physical substance such as a car
or a house.
Hereditament, Incorporeal: Real or personal property that is
intangible and can be inherited, for example an easement
appurtenant or accounts receivable.
Highest and Best Use: Legal and physically possible use of a
property that, at the time it is appraised, is most likely to generate
the greatest return over a particular time period.
Holden Act: See Housing Financial Discrimination Act.

538

Holder in Due Course: One who has taken a note, check or similar
asset prior to it being overdue, in good faith and for value, and with
no knowledge that it had previously been dishonored.
Holdover tenant: Tenant who keeps possession of leased property
after the lease term has expired.
Home Equity Line of Credit (HELOC): Credit account secured by
equity in the borrowers home, enabling him to borrow up to a
specified credit limit.
Home Equity Loan: Loan secured by a second mortgage on a
principal residence, usually used for a non-housing purpose.
Homeowners Association: Non-profit organization comprising
homeowners from a particular subdivision, responsible for enforcing
their CC&Rs and managing other community affairs.
Homestead: Dwelling occupied by the owner along with any
appurtenant outbuildings and land.
Homestead Law: State law providing limited protection
homestead properties against judgment creditors claims.

to

HUD: See Department of Housing and Urban Development.

Hypothecate: Using real property as collateral for a debt without
having to give up possession of it.

Implied

agency: Understood from actions or circumstances

without expressing in words that an agency relationship exists.

Impounds: Borrowers funds collected and kept in a reserve
account by the lender.
Improvements: Additions to land property that are man-made.

539

Imputed knowledge: Legal doctrine stating that a principal is

considered to have notice of information that the agent has, even if
the agent never told the principal.
Inadvertent dual agency: Occurs when a real estate agent while
representing one party to a transaction, unintentionally becomes
the agent of the other party -- a dual agent -- by leading the other
party to believe he is acting as their agent.
Inchoate: Unfinished or incomplete, a task begun but not
completed.
Inchoate instruments: Documents not fully executed,
documents that should be, but have not been, recorded.

or

Income, Disposable: Income that remains after the payment of

taxes.
Income, Effective gross: Measure of a rental propertys capacity
to generate income calculated by subtracting a bad debt/vacancy
factor from the economic rent-potential gross income.
Income, Gross: total income of a property before making any
deductions such as bad debts, vacancies, operating expenses, etc.
Income, Net: It is the income that is capitalized to estimate the
value of a property. It is calculated by subtracting the operating
expenses (i.e. fixed expenses, maintenance expenses, and reserves
for replacement) of the property from the effective gross income.
Income, Potential gross: Economic rent of the property, the
income the property would earn if it were available for lease in the
current market.
Income approach to value: One of the three main methods of
appraisal in which an estimate of the property value is based on the
net income it produces; also called the capitalization method or the
investors method of appraisal.
540

Income property: Property which generates rent or other income

for the owner, referred to as property held for the production of
income in the income tax code.
Income ratio: Criteria used for qualifying a buyer for a loan, to find
if their income is sufficient. The buyers debt and proposed housing
expenses should not be over a specified percentage of his income.
Incompetent: Person who cannot manage their own affairs, due to
reason of insanity, or lack of mental capacity; business matters
relating an incompetent should be overseen by a guardian.
Incorporeal rights: Rights in real property where
possession is not involved, as in an easement.

physical

Increment: An increase in value, the opposite of which is

decrement.
Independent contractor: Contractor who is self-employed and
whose method of work is not controlled by another.
Index: Changes in the cost of money indicated in a published
statistical report, which can be used to make adjustments in such
areas as wages, rental figures, and loan interest rates.
Inflation: Decrease in moneys purchasing power, measured by the
Consumer Price Index; real estate is considered a hedge against
inflation because it generally holds its value.
Injunction: Court order or writ designed to stop a party to a
lawsuit from committing an act that is seen as unjust or inequitable
in regard to the rights of another party.
Installments: Portion of a debt paid in successive period, usually to
reduce a mortgage.
Installment sales contract: Real estate purchase structured to be
paid in installments with title retained by seller until all payments
are made; also called contract of sale and land contract.
541

Instrument: Written document formulated to set the rights and

liabilities of the parties; examples are a will, lease, or promissory
note.
Interest: Money charged by bank or other lending institution for
the use of money. Also, a partial degree of ownership.
Interest rate: Percentage of an amount of money that is the cost of
using it, usually expressed as a monthly or yearly percentage.
Interpleader: Proceeding started by a third party to find the rights
of other claimants to a property or in a transaction.
Inter vivos trust: Trust created during a persons lifetime.
Intestate: One who dies leavning no will or a will that is incomplete
or not transacted correctly; property then is conveyed to heirs at
law or next of kin.
Investment property: Property acquired for its capacity to produce
income or anticipated resale value, such as office buildings or
undeveloped land.
Involuntary lien: Lien applied against a property without the
owners agreement, such as unpaid taxes.
Irrevocable: Incapable of being reversed or revoked; unalterable.

Joint tenancy: Ownership of a property interest by two or more

parties, each of whom has an undivided interest with the right of
survivorship (sharing equally in the interest of a deceased joint
tenant with the surviving tenants).
Joint venture: Agreement to invest in a single property or business
by two or more parties.
Judgment: A court ruling directing that one party is indebted to
another one and setting the amount of indebtedness.
542

Judgment creditor: Party who has received a judgment from the

court for money owed to her.
Judgment debtor: Party whom a judgment has been directed
against for money owed.
Judgment lien: Claim upon the property of a debtor as the result of
a judgment, enabling the judgment creditor to have the property
sold for payment to satisfy the judgment.
Junior mortgage: Mortgagee whose claims on a property will be
addressed only after previous mortgages have been settled.

Laches: Negligence or delay in putting forward ones rights.

Land: Earths surface area that is solid, and not composed of water.
Land contract: Installment agreement for the purchase of real
estate in which the buyer may use and occupy the land, without the
passage of deed or title until all or a portion of the selling price is
conveyed.
Landlord: Person, the lessor, who rents property to another person,
the lessee.
Landmark: A stationary object that serves a boundary or reference
point for a land parcel.
Late charge: Amount assessed by a lender against a borrower who
misses making an installment payment when due.
Lateral support: Support which the ground of an adjoining
property provides to a neighbors land.
Lease: Contract agreement in which an owner of real property, in
exchange for the consideration of rent, passes the rights of
543

possession to the property to another party for a specified time

period.
Leasehold estate: Tenants ownership interest in the property that
is leased to her.
Leasehold improvements: Fixtures attached to real estate that are
installed by the tenant and which can be moved by him after the
leases expiration if their removal does not damage the property.
Legal description: Legally proper identification of realty by one of
three agreed-upon methods: the government rectangular survey,
metes and bounds, lot and block number.
Lessee: Person to whom property is rented under a lease; a tenant.
Lessor: Person who rents property to another person; a landlord.
Leverage: Using borrowed funds to raise purchasing power and
enhance profitability of an investment.
License: Having the right granted by the state of California to work
as a real estate broker or salesperson.
Licensee: Person who hold a real estate license, which conveys the
privilege to accept compensation for helping with a real estate
transaction.
Lien: Encumbrance against property rendering it security for the
payment of a debt, mortgage or other money judgment.
Life estate: Freehold land interest that terminate upon the death of
the owner or another designated person.
Life tenant: Individual who is permitted to possess property for her
lifetime or during the lifetime of another specified person.

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Limited partnership: Business organization in which at least one

partner is passive, with liability limited to the sum invested, and
one partner whose liability extends beyond his amount invested.
Liquidated damages: Amount designated in a contract that one
party will owe the other party in case of a breach of contract.
Lis pendens: Recorded notice that the rights to the possession of
real property is the subject of litigation, thus impacting disposition
of its title.
Listing: Employment contract in writing between an agent and
principal authorizing the agent to conduct services for the principal
regarding the principals property. Also, a record of the property for
sale by the broker authorized by the owner to sell it.
Loan-to-value ratio (LTV): Ratio calculated by dividing the
mortgage principal by the property value.
Lock-in: Agreement to maintain a certain rate or price for a
specified time period.
Lot and block number: Method of land description that relies on
the placement of recorded plats.

MAI: Professional membership in the Appraisal Institute.

Margin: Figure added to an index in order to adjust an interest rate
on an adjustable-rate mortgage.
Marginal property: Realty that generates barely enough income to
cover the cost of using it
Marketable title: See insurable title. Title that a court will assess
as being free enough from defect so it will enforce its acceptance by
buyer.

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Market Data Approach: See Sales Comparison Approach. One of

the three methods of appraisal, it compares recently-sold properties
to the property being appraised.
Market price: Actual price paid for a property in a transaction.
Market value: Highest price a willing buyer will pay for a property
and the lowest a willing seller will accept, assuming no undue,
outside pressures.
Material fact: Fact that is significant in regard to a particular
transaction, without which it can be assumed a contract would not
be agreed upon.
Mechanics lien: Lien created by law against real property as
security for payment for the labor and materials used for the
improvement of the property.
Mello-Roos Community Facilities Act: Enacted in 1982, it
authorizes the creation of community facilities, issuing bonds, and
levying taxes to finance specified public services.
Meridian: North-south line used in government rectangular survey.
Metes and bounds: Land description method that relies on land
boundary lines, utilizing those lines with their terminal points and
angles.
Mineral rights: Authorization to amass income from the sale of gas,
oil and other resources underground.
Misrepresentation: Untrue or misleading statement, whether
unintentional or on purpose. Misrepresentation of a material fact,
the injured individual may sue for damages or revoke any
agreement affected by the false assertion.
Monument: Fixed object and point specified by surveyors to
establish land locations, such as boulders or unusual trees.

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Mortgage: Written instrument that establishes a lien on real estate

as security for payment of a designated debt.
Mortgage banker: Person who originates, finances, sells, closes,
and services mortgage loans, which are generally insured or
guaranteed by a private mortgage insurer or government agency.
Mortgage broker: Places loans with investors for a fee, but does not
service them.
Mortgage commitment: Agreement between a borrower and a
lender to set up a loan at a later date, dependent on the conditions
specified in the agreement.
Mortgagee: Someone who receives a mortgage from a mortgagor to
secure a loan or performance of a duty; also called a lender or a
creditor.
Mortgage loan disclosure statement: Statement on a form
approved by the Real Estate Commissioner that discloses to a
potential borrower the terms and conditions of a mortgage loan,
required by law to be proffered by mortgage brokers before the
borrower is bound by the loan terms.
Mortgagor: Person who provides a mortgage on property to a
mortgagee to secure a loan or the mortgagees performance of a
duty.
Multiple listing: Arrangement between real estate brokers to cooperate by providing information to each other regarding listings
and to split commissions between the listing and selling brokers.

National Association of Realtors (NAR): Organization which

promotes professionalism in real estate business.

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Negative amortization: Increase in a loans outstanding balance

due to periodic debt service payments not covering the total amount
of interest attached to the loan.
Net income: Actual earnings remaining after deducting all
expenses from gross income.
Net lease: In addition to rent, tenant pays charges against the
property, such as taxes, insurance and maintenance.
Net Listing: In a sale, brokers commission payment is anything
over and above an agreed-upon net price to the seller.
Net operating income: The income from realty or a business after
deducting operating expenses but before deducting tax payments
on and interest and principal payments.
Non-conforming loan: Mortgage loan that does not meet the
criteria for being funded by Fannie Mae or Freddie Mac.
Note: Written instrument acknowledging a debt and promises to
pay.
Notice, Actual: Implied or express factual knowledge
Notice, Constructive: Fact which should have been discovered due
to ones actual notice and/or inquiries that a reasonably prudent
person would be expected to make
Notice, Legal: Notice required by law to be given
Notice to quit: Notice provided to a tenant to vacate property
Novation: Substitution of a revised agreement for a previous one
upon the agreement of all parties.
Null and void: Without any legal validity.

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Obsolescence: Decline in value to a reduction in desirability and

usefulness of a structure because its design and construction
become obsolete or decline due to a structure becoming outmoded,
not in keeping with current needs.
Offer to purchase: Proposal to a property owner by a potential
purchaser to acquire the property under previously-stated terms.
Open-end mortgage: Mortgage including a clause under which the
mortgagor may obtain additional funds from the mortgagee after
some loan payments have been made.
Open listing: Listing provided to a number of brokers without a
duty to compensate any besides the particular broker who first
secures a buyer ready, willing and able to accept the listings terms
or obtains the sellers acceptance of a different offer.
Open mortgage: Mortgage that has matured or whose payments
are late, so that it is open to being foreclosed upon.
Operating expenses: Funds used to maintain property, such as
insurance and repairs, but excluding depreciation or finance costs.
Operating lease: Lease that a lessee subleases to another party
who is the actual user of the property.
Option: Right without the obligation, to lease or purchase a
property upon specified terms during a specified period.
Optionee: One who receives or acquires an option.
Optionor: One who gives or sells an option.
Oral contract: An agreement not in writing, usually unenforceable.
Overall capitalization rate: Rate calculated by dividing net
operating income by the propertys purchase cost.

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Ostensible authority: Authority that a reasonable third person

believes an agent was given, due to the principals acts or
omissions.

Package mortgage:

Mortgage created in which the principal loan

amount is raised to include improvements and movable items such
as appliances, along with real estate.
Paramount title: Title which takes priority over any others.
Partition: Dividing real property between its owners in undivided
shares.
Partnership: Agreement between two or more parties to enter into a
business venture, with each partner sharing in the partnerships
profits as well as being liable for its debts.

Party wall: Constructed on the dividing line between two properties

with different ownership, a wall that that either party has the right
to use.
Patent: Title conveyed to government land.
Percentage lease: Property lease with the rental amount based on
a percentage of sales made on the premises, with a set minimum
amount; usually used by retailers.
Periodic estate: Lease based on a specified calendar amount of
days, like month to month or year to year; also known as a periodic
tenancy.
Personal property: All property that is not realty; also known as
personalty.
Physical depreciation: Decline in value stemming from age, wear
and tear, and the elements.

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Planned Unit Development (PUD): Zoning or land-use plan for

large tracts that includes intensive development of common and
private areas, designed as one integrated unit.
Plottage: Increasing the value of a plot of land that has been
assembled from smaller plots under a single ownership.
Points: Fees provided to lenders to attract a mortgage loan. One
point equals one percent of the principal loan amount, which lowers
the funding amount advanced by the lender, effectively raising the
interest rate.
Police power: Governmental right to pass laws and enforce them
to achieve health, order, public safety and general welfare for the
public.
Power of attorney: Instrument through which a principal confers
authority to a person to act as their agent.
Premises: Land and buildings, an estate.
Prepayment clause: Mortgage clause conveying the privilege to a
borrower to pay her entire debt prior to its maturity; in some cases,
a penalty is assessed against the borrower for exercising this right.
Principal: a) Employer of a broker or agent
b) Amount of money from the mortgage or other loan, apart from
the interest due on it.
c) One of the main parties in a real estate deal
Private mortgage insurance (PMI): Mortgage guarantee insurance
that protects conventional lenders in case of default, with premiums
paid by the borrower.
Probate: To prove the validity of a will of a deceased person.
Procuring cause: Legal term for the cause resulting in the
objective of a real estate broker or agent procuring a ready, willing

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and able realty purchaser, used to determine who is entitled to a

commission.
Promissory note: Borrowers signed promise to repay the loan to a
specific person under specific terms.
Property: Rights that a party has to use and possess land or
chattel to the exclusion of anyone else.
Proprietorship: Business ownership, including the management of
real estate, by a person, as opposed to a corporation or partnership.
Proration: Allocation between seller and purchaser of proportional
shares of a debt that has been paid, or due to be paid, regarding a
realty sale, such as property taxes and insurance.
Purchase capital: Funds used to purchase realty, from whatever
source.
Purchase money mortgage: Mortgage provided by a buyer
(grantee) to a seller (grantor) in partial payment of a real estate
purchase price.

Quiet enjoyment:

Right of an owner or tenant to the use of a

property without any interference to their possession.

Quiet title: Court action to remove a defect or cloud on an owners

legal right to a piece of realty.
Quitclaim deed: Conveyance establishing only the grantors
interest in real estate, with no ownership warranties.

Range lines: Used in the government rectangular survey method of

land description as lines parallel to the principal meridian,
demarcating the land into 6-mile strips called ranges.
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Ratification: Approval of an action done on someones behalf

without prior authorization.
Real estate: Land and all permanent attachments to it.
Real Estate Advisory Commission: Ten-member board that makes
recommendations to the Real Estate Commissioner on pertinent
issues.
Real Estate Commissioner: Appointed by the governor as head of
the California Bureau of Real Estate (BRE), in charge of appointing
the Real Estate Advisory Commission and administering the Real
Estate Law.
Real estate investment trust (REIT): Mutual fund authorized by
law to be immune from corporate taxes if most of its profits are
distributed to individual investors who are taxed.
Real property: All the rights inherent in ownership to use real
estate.
Realtor: Real estate professional who follows the code of ethics
pursuant to their membership in the National Association of
Realtors.
Recapture clause: Contract clause allowing party granting an
interest or right in real estate to re-take it under specific conditions.
Recording: Act of entering documents regarding title to real estate
in the public record.
Recourse: Authority of a lender to assert a claim to funds from a
borrower in default, besides the property pledged as collateral.
Redlining: Unlawful policy of a lender denying to make loans in
certain areas with high minority populations due to alleged overall
lending risks there without considering the creditworthiness of each
applicant.
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Release clause: Mortgage clause that provides property owner with

the right to pay off part of their indebtedness, releasing a specified
portion of the property from the mortgage.
Reliction: Gradual lowering of a water level, uncovering more dry
land.
Remainder: Estate that goes into effect after a prior estate, usually
a life estate, is terminated.
Remainderman: Party who receives possession of a property upon
the death of a life tenant.
Rent: Compensation paid for the use of realty.
Replacement cost: In appraisals, the cost of construction to
replace or serve the same function as a similar, previous building.
Reprdouction cost: In appraisals, the cost of construction of a
replica of a property as of a certain date.
Recission: Terminating a contract and restoring the parties to the
identical positions they occupied before entering into the contact,
permitted when the contract was induced by fraud, duress,
misrepresentation or mistake.
Restriction: Limitation enplaced on property use, as included in
the deed or other instrument in the chain of title.
Reversion: Lessors right to take possession of leased property
upon the end of a lease.
Reversionary interest: Future interest held by a person in
property upon the termination of the preceding estate.
Revocation: Recalling power of authority previously conveyed, such
as an agency.

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Right of survivorship: Right of a surviving joint tenant to take the

interest of a deceased joint owner.
Right of way: Easement right to use to specific path for access or
passage, as well as the subdivision areas allocated to government
use for streets and other types of public access.
Riparian rights: Rights regarding water use on, under or adjacent
to a persons land, providing reasonable use of such water.
Rumford Act: See Fair Housing Law.
Sale-and-leaseback: Seller retains occupancy to land by leasing it
back simultaneously with its sale, generally for a long term lease.
Sales comparison approach: In appraisals, estimating value
through analysis of comparable properties recent sales prices.
Salesperson: One licensed to perform any act authorized by the
states Real Estate Law, if employed by a broker also licensed.\
Salvage value: Anticipated value an asset will be worth at the
conclusion of its useful life.
Sandwich lease: Leasehold which has been sublet by a lessee to
another party, so the former becomes a lessor.
Satisfaction piece: Written instrument for the recordation and
acknowledgement of a mortgage loans last payment.
Section of land: Square mile in the government rectangular survey
description of land.
Security instrument: Realty interest permitting the property to be
sold if the obligation for which the security interest was created is
defaulted upon.
Seizin: Possession of real estate by one who purportedly owns a
valid salable interest.
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Separate property: As distinguished from community property,

property owned by a spouse prior to marriage; acquired by gift or
bequest; or, by proceeds from other separate property.
Setback: Area from the the curb or other set line of demarcation
within which no construction can take place.
Special assessment: Property is assessed a certain amount to pay
for public improvements which will benefit the property.
Special warranty deed: Deed under which the grantor warrants
the title provided to the grantee only against defects that arose
during grantors ownership, not from any that might stem from
conditions existing before that time.
Specific performance: Court action directing a party to fulfill
contract terms which he has refused to perform these obligations.
Statute of Frauds: State law holding that certain contracts be in
writing and signed to be enforceable, unless the terms of a contract
can be performed within one year.
Straight-line depreciation: Method of depreciation which uses
equal yearly reductions to estimate propertys book value.
Subagent: One who receives the powers of an agent not from a
principal, but from another agent whom the principal has
authorized to do so.
Subdivided Lands Law: Regulating the sale of subdivided land in
California, this law mandates the subdivision meet state standards
and that the Real Estate Commissioner publish a Subdivisions
Public Report provided to potential purchasers.
Subdivision: Land tract divided into plots appropriate for the
construction of homes, as per the states Subdivided Lands Law.

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Subject to mortgage: Method to take title to mortgaged realty

without being personally liable for payment of amount due on the
promissory note. If the new buyer fails to make payments going
forward, the most he will lose is his equity in the property.
Sublease: Lease from a lessee to a different lessee, who becomes
the sublessee or subtenant.
Subordination clause: Instrument allowing a mortgage recorded at
a subsequent date to take precedence over an earlier mortgage.
Surety: One who guarantees anothers performance; a guarantor.
Surrender: Leases cancellation before its termination by consent of
both the lessor and lessee.
Survey: Procedure under which a parcel of land is measured and
its area calculated.

Tax: Charge assessed against individuals, corporations and

organizations to fund government.
Tax-free exchange: Trade of one property for another that is
excluded from tax liability on any profit when the trade occurs.
Tax sale: Property being sold after a period of unpaid taxes.
Tenancy at sufferance: Tenancy created when a lawful tenant
retains possession of a property after the lease terminates.
Tenancy at will: License to possess realty and tenements for an
indefinite period, at the owners will.
Tenancy by the entireties: Estate that exists just between
spouses, with each having equal right of possession and with right
of survivorship.

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Tenancy in common: Ownership of real property by two or more

persons, with each having an undivided interest but without the
right of survivorship.
Tenant: Person given possession of real property belonging to
someone else for a fixed term or at will.
Termites: Insects that feed on wood causing great damage.
Testament: A will.
Testamentary trust: Trust established by will which only comes
into effect after testator dies.
Testate: The making of a valid will.
Time of the essence: A contract condition requiring that all
references to specified dates regarding performance be followed
exactly.
Title: Establishes that a land owner has lawful possession of a
property, having all the elements of ownership.
Title insurance: Insurance policy providing protection from losses
caused by possible defects in the title.
Title search: Public records inquiry to ascertain any issues of
ownership and encumbrance regarding realty.
Topography: Surface of the land; may be hilly, flat, rocky.
Tort: Wrongful act which is not criminal in nature but gives rise to
a civil action with the committer of the tort (tort-feasor) potentially
liable for civil damages.
Township: Six-mile square tract located between two range lines
and two township lines established by government rectangular
survey.

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Trade fixtures: Articles annexed to rental structures by a

commercial tenant in the course of operating their business,
removable by the tenant.
Trust deed: Conveyance of realty to a neutral third party (trustee)
which that person holds for another partys benefit.
Trustor: Party who gives property to a trustee to be held on a
beneficiarys behalf, so that the trustor becomes the owner of real
estate and the lender is the beneficiary.

Unearned increment: A rise in real estate value due to no effort by

the owner, usually due to population growth.
Unit in place method: Projecting the cost of building a structure
based on estimating the price of its individual components, such as
the foundation, floors, walls and cost of labor.
Unity: Four unities are needed to establish a joint tenancy: interest,
possession, time and title. Thus, joint tenants are required to have
equal interests created by a conveyance, the identical undivided
possession, and the same use during the same time.
Unruh Act: State law requiring real estate borrowers be provided
with explicit notices of default on a mortgage to safeguard
homeowners from losing their residence due to default on a retail
installment purchase.
Urban property: City, closely-settled realty.
Usury: Interest rate impermissibly set higher than allowed by law.
Utility: One of the elements of value, the capability to provide
gratification, inciting the wish to possess a property.

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Valid: Having legally sufficient force, enforceable by a court.

Value: What something is worth to a particular party.
Variable expenses: Operating costs for a property that rise upon
occupancy.
Vendee: Buyer, a purchaser.
Vendees lien: Lien applied to property according to a contract of
sale, to secure buyers deposit.
Vendor: Seller
Vicarious liability: Someone being responsible for the actions of
someone else.
Void: With no force of law or effect
Voidable: Something that can be voided, but action must be
directed to void it.
Voluntary alienation: Term designating a sale or gift made with
free will.

Warranty:

Promise or guaranty included in a contract.

Warranty deed: Instrument that includes a covenant declaring the

grantor will protect the grantee from claims on title.
Will: Directions for the disposition of ones property after death.
Without recourse: Phrase employed in endorsement of a note or
bill indicating that the holder cannot expect payment from the
debtor personally if non-payment occurs.

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Zoning: Governmental authority designating an area for a

particular use.

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