The burden of structural pest control

This article highlights the Federal Housing Administration’s (FHA’s) shift from requiring automatic structural pest control (SPC) reporting and clearance to discretionary compliance by the lender, suggesting sellers (and seller’s agents) always disclose knowledge of wood destroying insects present on a property listed for sale.

Buyer’s agents: it’s your call

When a home constructed using wood components goes on the market, a price-deflating battle over the structural pest control (SPC) report and clearance between buyer and seller commences. For buyers hoping to use Federal Housing Administration (FHA)-insured financing to fund their purchase price, lender requirements regarding a property’s condition can make or break the approval.

In 2011, 40% of California home sales involved FHA financing. Thus, accurately interpreting when an SPC report must be ordered in a sales transaction involving FHA-insured financing is a critical process affecting a significant portion of California homebuyers.

So what are the rules?

Since 2005 the FHA has not required automatic SPC inspections, reports and clearances for every home sale involving an FHA-insured mortgage. In an effort to further U.S. homeownership, the requirements for obtaining maximum purchase-assist financing insured by the FHA now require an inspection only if:

• it is customary for home sales in the area;
• an active infestation is observed on the property;
• it is mandated by state or local law; or
• it is called for by the lender. [ML 05-48]

Three sets of players exist in this seller-induced battle over an SPC report and clearance on an FHA-insured loan. The first team includes the lender who has FHA-authorized discretion to decide if a termite report and clearance is necessary, and the appraiser who conducts the property inspection upon which the lender relies.

For FHA-insured loans, appraisers must indicate on their appraisal form if they observe any evidence of termite infestation, decay or suspicious damage in the house or in other structures on the property. It is then up to the lender to use the appraiser’s information to determine whether an SPC report and clearance must be delivered up prior to funding and closing.

The second team consists of the seller who swears neither hide nor hair of anything resembling a termite infestation exists on his property, and the seller’s agent who is mandated by state law to inspect the structure for observable defects including termite activity. Sellers typically want to sell their home “as is” and let the buyer determine the condition of the property.  Sellers instinctively don’t want disclosures to inhibit prospective buyers from first making an offer and getting involved in the property.

Unionized seller’s agents inculcated with industry-wide seller bias typically allow sellers to control this conversation at the listing stage. As a result, seller’s agents take a pass on obtaining authority to order out an SPC report and see what clearance work must be done.

Seller’s agents often deliberately shift the uncertainty of a risk of loss to the buyer― the hazardous practice of asymmetry, not transparency.  Economically, the uncertainty decreases the value of the property in the eyes of a buyer which in turn drives down the price the seller can command for the property.

The third and most important team is the buyer and the buyer’s agent. Buyers are blind to all that crawls beneath the surface of their dream home. They expect the agents involved in their transaction to take all necessary steps to ensure the home is in the condition “as disclosed” by the seller and the seller’s agent at the time the purchase offer is accepted.

Thus, by breach of the duty owed the general public by seller’s agents, the burden of requiring an SPC report and clearance of any infestations or termite damage is implicitly placed by default on the buyer’s agent.

The seller’s agent has a limited but certain general duty owed to all prospective buyers to advise about known SPC conditions (and any others) which might adversely affect the value of the listed property. On the other hand, it is the buyer’s agent who has the specific duty to care for and protect the best interests of his buyer when purchasing a home.

The duty a buyer’s agent owes to his buyer includes:

• counseling about the availability of investigations and reports on the basic conditions of the property; and
• advice about whether the reports are necessary to reduce or eliminate unacceptable risks of loss.

An investigation by an SPC-licensed individual is one such report a buyer may need, but taking on that responsibility reduces the worth of the property in question.

These fiduciary responsibilities leave the buyer’s agent with two paramount considerations. First, he must determine whether an SPC report and clearance are customarily obtained in home sales transactions in the community surrounding the property. If so, they must be delivered to the lender since they are “customary to the area.” Buyer’s agents must then discern whether the lender will comply with FHA regulations and require the report (and a clearance).

Secondly and most importantly, the buyer’s agent needs to protect his buyer’s expectation that the home is structurally sound and conditions on or about the property will not later interfere with those expectations. The possible presence of termites strikes this bell which cannot be un-rung.

If either consideration suggests a report would be prudent, a contingency provision must be included in the purchase offer prepared by the buyer’s agent calling for the seller to deliver up an SPC report and clearance of any reported deficiencies. [See first tuesday Form 150 §11.1(a)]

California knows termites

In California, termites are extremely common. Southern California has one of the three highest densities of termite infestation in the United States. They dwell in massive quantities near urban areas closest to the coast. Homes located near the Pacific Ocean acquire the most moisture and maintain a stable temperature, creating the ideal breeding ground for wood-consuming insects.

The structural wooden components of a home are usually Douglas fir, Hemlock or Spruce. Of the three, Douglas fir is the most resistant to termites. Homes built using less-resistant wood will be more susceptible to an infestation.

Most homes statewide are at risk of termite invasion because of California’s proximity to the ocean. The existence (or uncertainty of the existence) of termites adversely affects the price a buyer will pay for a property. Termites and the conditions that allow them to thrive must be eliminated to preserve the structure of any property with wood components.

For these reasons, a seller seeking the highest and most premium price for his property discloses property conditions before the buyer sets the price in a purchase agreement offer.

Bifurcated pest control handling by way of a belated inclusion through an addendum to a purchase agreement supplied by the real estate trade union typically causes seller’s agents to arrogantly rebuff the offer, or counter and request the SPC company prepare two separate reports:

• Section I items, listing items with visible evidence of active infestations, infections or conditions that have resulted in or from infestation or infection; and
• Section II items, listing conditions deemed likely to lead to infestation or infection but where no visible evidence of infestation or infection now exists.

Sellers who agree to order a report in escrow for Section I items typically leave the clearance and Section II items as an uncertain risk about the property’s worth that the buyer is asked to bear. This means the buyer may end up paying more for the property than the price agreed if a clearance and the Section II report identifies work to be performed to correct the property for the new ownership.

However, sellers who obtain an SPC report and clear any conditions eliminate one more risk the buyer must consider when setting the price to be paid. If SPC conditions are no longer an uncertainty, the buyer is more willing to pay that premium price.

The dangers of delayed disclosure

Up-front disclosure about a property’s condition before accepting offers is the transparency a seller provides in a sale to avoid personal liability for withholding material facts known to him or his agent. Failure to disclose known or readily knowable conditions affecting value prior to accepting an offer from a buyer is conduct called deceit.

Delayed, in-escrow disclosures of property defects (i.e. the presence of unwanted destructive critters) affect the value of the property at the price a buyer agreed to pay for it.  As a result, the belated disclosures impose liability on the home seller and his listing agent for the cost of restoring the property to the conditions “as disclosed” at the time the offer was accepted.  “As disclosed” includes silence on those insidious known and knowable adverse conditions.

Untimely disclosures most often constitute misrepresentation (read: fraudulent failure to disclose prior to acceptance) no matter the wording in the purchase and escrow agreements about those “as is” or “take it or leave it” provisions used to give the impression the buyer has no remedy but to close or cancel.

The SPC report is not automatically required in every California real estate transaction. However, seller’s agents acting in the best interest of their sellers will be able to obtain a premium price for a property and avoid later offsets by mitigating exposure to the risk of claims made by the buyer before and after closing.

A seller’s agent will urge the seller to authorize them to immediately order an SPC inspection and report upon taking the listing, and then a clearance after review of that report. Termite infestations have the potential to cause hundreds if not thousands of dollars in structural damage― a claim the seller and the seller’s broker do not want from a buyer. [Health and Safety Code §17920.3; California Civil Code §1102]

As a matter of good practice, a buyer’s agent preparing a purchase agreement simply includes as a condition of closing that the seller deliver up an SPC report and clearance ― whether or not an FHA-insured loan is involved. A seller’s agent who chooses not to recommend his seller make an SPC report available to interested buyers as part of his marketing package risks a buyer offering a lower price or worse, walking away from the listing in favor of a listed home around the corner with an SPC report and clearance. [See first tuesday Form 150 §11.1(a)]

The existence of a clean report enhances the quality of the property in the eyes of buyers and their agents. Such transparency in the real estate market is part of the consumer protection paradigm emerging in the post-recession housing market controlled by buyers, not sellers. The mantle of demand has shifted, and will not move again to sellers and their agents for decades in most suburban areas.  [For more information regarding the new market paradigm, see the May 2010 first tuesday article, Looking through the window toward recovery: a real estate paradigm shift – Part I and Part II.]

Who is responsible?

In boom times, sellers often have their way with seller’s agents since the demand for property is greater than the available homes in multiple listing service (MLS) inventory. They can demand top dollar, wait to disclose property defects until just prior to closing and then refuse to correct those deficiencies since buyers fear they will never being able to buy again (when prices are reported to be rising).

In the eventual bust times― such as our current long-term economic climate― buyers are at the top of the food chain; sellers and their listing agents somewhere down the line. Since sellers are desperate to attract a buyer, full transparency at the marketing stage for a listing is critical to success. Agents need to quickly get used to this market condition.

Early disclosures are most advantageous for the seller since pre-contract disclosures avoid in-escrow demands to repair defects or reduce the price for reasons of misrepresented property conditions.  By disclosing all when a prospective buyer is first exposed to the property, before he sets the price he offers in the purchase agreement, closings occur without surprises and offsets. [For more information regarding up-front disclosure, see the November 2010 first tuesday article, Holmes v. Summer: dilatory disclosures and the damage done.]

In a transparent real estate market, the SPC report or clearance (for properties in locations where termites exist) is part of the marketing package given to any prospective buyer who seeks more information on the property ― a cost to be incurred earlier rather than later in exchange for the buyer’s payment of a risk-free premium price.