LOS ANGELES—While lenders are generally familiar with condemnation of real property collateral by governmental agencies, they may be less familiar with the ability of a governmental agency to interrupt the income stream from their real property collateral. Lenders who have borrowers that fail to maintain the multifamily rental units they own in habitable condition may find that their collateral (the rents) are diverted into an account controlled by the City of Los Angeles if one or more units are placed into the Real Estate Escrow Program (REAP).

REAP is administered by the City of Los Angeles Housing Department (LAHD) and applies to all dwelling units in the City of Los Angeles. "REAP works in conjunction with other enforcement programs to combat substandard housing in Los Angeles and to encourage landlords to comply with the housing code." Sylvia Landfield Trust v. City of Los Angeles, 729 F.3d 1189, 1193 (9^th Cir. 2013).

The City places properties into REAP when the landlord fails to correct health, safety, or habitability violations on rented, residential property. In addition to a reduction in rental income, once a property is accepted into REAP, the landlord's operating expenses will increase due to repairs which will be mandated under the REAP program.

What about selling the rental units to simply get rid of the problem, or refinancing the building to fund the necessary repairs? Once the units are in REAP, the City of Los Angeles will record a Notice of REAP against the rental property in the real estate records of Los Angeles County, which may impede the sale or refinancing of the property.

The constitutionality of REAP was challenged last year. In Sylvia Landfield Trust, the United States Court of Appeals for the Ninth Circuit affirmed the District Court's dismissal of a complaint brought by four landlords challenging the constitutionality of REAP. The Court of Appeals held, among other things, that: (1) REAP was rationally related to the legitimate governmental interests of repairing and preventing substandard housing; (2) REAP did not violate plaintiffs' substantive due process rights; and (3) that the placement of plaintiffs' properties into REAP did not shock the conscience. See Sylvia Landfield Trust at 1196.

GETTING INTO REAP

"REAP deems a residential unit 'untenantable' if it lacks sufficient waterproofing, weather protection, plumbing, gas facilities, water supply, heating facilities, or electrical lighting …. REAP also mandates that the building and grounds be free of 'debris, filth, rubbish, garbage, rodents and vermin …. Buildings must have garbage receptacles, and landlords must maintain floors, stairways, and railings in good repair." Sylvia Landfield Trust at 1194. Residential rental properties that fail to meet these minimum standards may be involuntarily placed into REAP.

Any Enforcement Agency (i.e., any governmental agency that inspects rental units for compliance with health or safety laws, such as the Department of Health Services) or tenant may refer a rental property or unit to the LAHD for acceptance into REAP if:

1. the building (or unit) is the subject of one or more orders or notices to comply, correct or abate a condition or violation issued by an Enforcement Agency;

2. the period in which to comply with the order has expired without compliance; and

3. the violation affects the health or safety of the occupants, is subject to the Rent Stabilization Ordinance or the violation results in a deprivation of housing services.

When the LAHD receives a referral, it will verify that the period for correcting the violation(s) has expired and will check for any other outstanding orders against the property. The determination will be mailed to the landlord, but the failure of the landlord to receive the notice does not invalidate any subsequent proceedings.

Once a property is accepted into REAP, the owner will be notified of the amount of rent reduction, the date the escrow account will be established, the $50 per month per unit administrative fee and whether or not the building will be referred for periodic inspections at the owner's expense. The LAHD will mail a notice to the tenants and advise the tenants that they have the choice of paying (reduced) rent into the REAP account or continuing to pay rent to the landlord.

If the violations are such that more than one unit in a building is likely to impacted, all of the affected units can be placed into REAP (and thus subject to a rent reduction).

Rent reductions are determined according to the severity of the problem and any prior history of placement of other properties owned by the same landlord into REAP. The rent reduction applicable to any unit is determined by adding up all of the percentage reductions in each of the 15 categories of violations, subject to a cap of 50% reduction in monthly rent. However, the 50% cap can be exceeded where the landlord owns other properties that were in REAP for more than 12 months and in more extreme cases, the rent reduction may increase to 100%.

APPEALING THE REAP DETERMINATION

Once the property is placed into REAP, the landlord has 15 calendar days from the date the notice described above is mailed to submit a written appeal and request a hearing before the General Manager of the LAHD. If no appeal is filed, the property is automatically placed into REAP. Any appeal must be made on the from prescribed by the LAHD and while the appeal is pending, the placement of the property into REAP will be stayed.

The General Manager will serve a notice of the hearing date on the landlord and the affected tenants at least 7 days prior to the hearing. If the appeal is made timely and meets the LAHD's requirements, the General Manager will set a hearing date within 30 days of the LAHD's receipt of a request for a hearing. Landlords, tenants and any Enforcement Agency may attend the hearing and present evidence. A landlord may present evidence that a rent reduction is not appropriate because the substandard conditions and violations were caused by the tenants. The burden of proof is on the landlord. The hearing officer must issue a written decision within 10 working days of the date of the hearing, and may affirm, modify or reverse the determination by the LAHD.

APPEALING THE APPEAL

The landlord, any tenant or the Enforcement Agency may appeal the determination by the General Manager to the Appeals Board within 10 calendar days after receipt of the General Manager's determination. The appeal must state which portions of the determination are being appealed and the basis for the appeal. Enforcement of the parts of the determination being appealed are stayed pending the outcome of the appeal. Another hearing is scheduled and the owner, tenants and the Enforcement Agency are given 5 days' notice of the hearing date. The Appeals Board is charged with reviewing any alleged errors or law or abuse of discretion and no new evidence will be entertained unless newly discovered. The Appeals Board will make a decision within 15 days of the hearing.

WHAT TO EXPECT WHILE IN REAP

Within 5 working days after a final decision (i.e., all appeals have been exhausted) that a building or units have been accepted into REAP, the LAHD will open an escrow account.

The LAHD will record a notice with the Los Angeles County Recorder's Office stating that the property has been placed into REAP. This notice will be reflected in any preliminary title search conducted against the property and will cloud title.

The landlord will receive a monthly accounting of the rents paid by the tenants, as well as any permissible deductions from the account, such as the $50/month per unit administrative fee.

A Case Manager from the LAHD will be assigned and the landlord can anticipate that the scope of any inspections will go beyond the specific violation(s) that triggered placement of the building into the REAP program. Landlords with buildings in REAP can also expect multiple inspections at their expense. The $50 per month per unit administrative fee will continue to accrue as long as the unit in question is occupied.

While a property is in REAP, a landlord, tenant, Enforcement Agency or a creditor may apply to the General Manager for a release of funds from the REAP account. A withdrawal of escrowed funds may be approved (after a hearing) for the following reasons:

a. to pay for essential services, such as utilities, trash and managerial services;

b. to correct deficiencies in the condition of the property;

c. to the extent legally permissible, by a tenant to repair conditions that affect the tenant's health and safety;

d. to a tenant who has or will relocate;

e. to a tenant who has incurred expenses due to the unit being uninhabitable;

f. in response to a court order; and/or,

g. to satisfy a judgment under L.A. Municipal Code Section 162.09.C.

Funds in the REAP account may be released on shortened notice or without a hearing if necessary to address an imminent threat to the building's occupants, or to prevent the termination of utilities.

GETTING OUT OF REAP

Once all of the violations that triggered the placement into REAP (and any subsequent orders) have been cured, the landlord, the affected tenant or the Enforcement Agency may notify the LAHD that compliance with all orders has been achieved. The landlord may also apply to have the rent reductions lifted on units that are in compliance, even though other units in the same building are still in violation. Any assertions that all violations have been resolved will have to be supported by appropriate inspections, and the LAHD may impose conditions, such has requiring the landlord to prepay the cost of 2 annual property inspections. If the LAHD determines that the landlord has satisfied all outstanding orders and has paid all charges owing for LADWP services, the LAHD may recommend the termination of the REAP account to the Los Angeles City Council. If the REAP account is terminated by resolution of the City Council, any funds in the account are first used to pay administrative fees and penalties, and then any remaining amounts to the landlord. The landlord will be responsible for any negative balance in the escrow account. While the timeframes for the appeal process are quite specific, it is unclear how long the City Council could take to terminate the escrow account.

LOVELY PARTING GIFTS

When the REAP account is closed, things should go back to normal, right? Not so, as the landlord stays in the "penalty box" for an additional year. Until a unit is removed from REAP, and for one year thereafter, the landlord may not increase the rent for the current (or any subsequent) tenant. During this same one year period, if a landlord wants to evict a tenant for reasons other than nonpayment of rent, the burden is on the landlord to demonstrate that the eviction is not retaliatory in nature.

WHAT'S A LENDER TO DO?

Regular physical inspections of the rental units to make sure that the property is being properly maintained according to code would be the best way to avoid the horrors of REAP, but this is not a practical solution.

When a lender discovers that the multifamily building that is the collateral for its loan has been placed into REAP, the first step would be to meet with the borrower to determine how he/she/it plans to address the deficiencies and how the corrections will be funded. If the borrower is cooperative and amenable to fixing the problems, the lender should monitor the remediation and inspection process to make sure that the landlord is working diligently to cure the violations.

If the borrower is uncooperative or for any reason cannot make the necessary repairs, one possible solution would be to file a motion with the court seeking the appointment of a receiver over the property with the power to make the necessary corrections and negotiate with LAHD to get the property out of REAP. Under Section 564(b)(9) of the California Code of Civil Procedure, a receiver may be appointed where necessary to preserve the property or rights of any party. If appointed, the receiver would be tasked with making sure that the appropriate repairs have been made and guiding the building out of REAP. However, in order to utilize this option, the lender will need to first file suit against the landlord-borrower. Most well-drafted deeds of trust include provisions: (a) requiring the borrower to maintain the property in tenantable condition, including performing all repairs, replacements, and maintenance necessary to preserve its value; (b) requiring the landlord to comply with laws applicable to the use and occupancy of the property; (c) take action to protect and preserve the property. Accordingly, the fact that a building has been placed in REAP may itself be sufficient grounds for obtaining a receiver. While receivers are expensive, this may be the best way to resolve REAP issues while minimizing the risks to the lender.

Carol A. Robertson, Senior Counsel, Frandzel Robins Bloom & Csato. The views expressed in this column are the author's own.