Avoiding regulatory trouble in the real estate industry should be easy. All one needs to do is play by the rules.
But to play by the rules means you must know the rules. And, perhaps, that’s where the problems begin. Brokers must understand the laws and regulations that govern their operations and the work they do every day. In other words, licensees need to know the law. However, so many brokers fall short of this simple adage and find themselves in hot water.
This has never been truer than in the property management space.
A California example
In California, when you engage in property management activities, you inevitably enter a world of risky compliance. It doesn’t have to be risky, of course, but it is when you don’t know what is expected of you on the regulatory level.
Interestingly enough, while some property management brokers appear to be quite successful in managing properties, dealing with landlords and tenants, and acquiring new business, you would never guess that they are simultaneously failing at everything else that truly matters: fulfilling the regulatory and more technical requirements involved. For this reason, in my opinion, property management is the problem child of real estate. Why is this? Two words, trust funds.
There is no quicker way to garner the attention of the California Department of Real Estate (DRE) then to handle trust funds. While most real estate brokers are not handling trust funds when they engage in real estate activities, the majority of property management brokers are knee-deep in trust funds and trying to understand and navigate DRE’s extensive trust fund handling requirements.
Based upon the DRE disciplinary actions that get filed each month, which you can publicly view on the State Department’s website, it looks like a large number of property management brokers run afoul of the Real Estate Law. Each year, DRE’s statistics in this area are a reminder that property management brokers are notorious violators of trust fund handling requirements.
According to DRE’s public information, their audit section completed 490 audits for the fiscal year 2018-2019, of which 333 involved property management, and 133 of those audits found shortages totaling $6,619,061. Given those numbers, it appears that property management brokers deservedly have a target on their heads. In turn, DRE will continue to seek out and audit those brokers who engage in these activities.
Know the Law and Be Proactive
Is it all doom and gloom? Not at all. Every broker who engages in property management can do the right thing. All licensees have a clean slate before getting into the business and that is the best time to do your homework. Even if you have been in the business awhile, and perhaps have been lucky enough to escape a DRE audit, it’s not too late to invest in your regulatory compliance.
Either way, your ultimate success and hope for longevity in this industry should be a product of the following mantra and actions: know the law, understand what is expected, put it into practice, regularly evaluate your brokerage, and correct any non-compliance. The bonus part of this exercise is where you choose to implement “best practices” and go above and beyond what is required.
As a consultant and former DRE Investigator, I have come across a large spectrum of compliance when it comes to property management. Unfortunately, though, it is very apparent that trust fund handling is a major hurdle for many real estate brokers. And when you factor in broker supervision over the operation, or lack thereof (which is a whole other article), it can quickly become a disaster.
To prevent your brokerage from becoming a DRE problem child, here are a few, fundamental requirements that property management brokers engaged in trust fund handling should be acutely aware of along with my insider tips:
- Trust account set-up: The property management bank account holding trust funds must be designated as a “trust account” in the name of the broker, or in a fictitious name if the broker is the holder of a license bearing such fictitious name, as a trustee at a bank or other financial institution. If you maintain more than one trust account, each account must be set up correctly.
Tip: Even if you are certain that you maintain a trust account, it is never a bad idea to double-check this information. If your bank signature card does not reflect the fact that the account is a trust account, then please check with your bank to ensure that it is, in fact, a designated trust account and obtain written proof.
- Signatories: the sole proprietor broker, or designated officer of a licensed real estate corporation, must be a signatory on the trust account. If the trust account has any other signatories, who may be a real estate salesperson or broker associate affiliated with the broker, or even a non-licensed employee, these individuals must have the written authority of the sole proprietor broker or designated officer to be a signatory on the trust account.
Tip: Surprisingly, I have come across too many brokerages where the designated officer of the licensed corporation was not a signer on the trust account. This is one of the easiest requirements to get right, so please don’t fall short of this one.
A non-licensed employee may be a signer on the trust account as long as the broker has fidelity bond or insurance coverage equal to at least the maximum amount of the trust funds to which the unlicensed employee has access at any time. Brokers who are required to maintain a fidelity bond or insurance coverage should refer to the law for specific requirements regarding deductibles and evidence of financial responsibility
Tip: It should be noted that if the non-licensed individual is not an “employee,” then he or she is not technically allowed to be a signer on the account. Admittedly, I have come across several corporate brokers who had non-licensed “owners” as signers on the trust account. But because these owners were not considered or treated as “employees,” they were not lawful signatories.
- General Ledger/Beneficiary Records: A broker is required to maintain a “control” record of all trust funds received and disbursed (e.g., general ledger for all properties), as well as “separate” records for each beneficiary or transaction, which must be complete, accurate and in a compliant format.
Tip: In my experience, the “format” of records, and the type of information they contain, are common problems for all brokers who handle trust funds. A broker who relies on property management and accounting software would be wise to ask their software company about how their reporting and documents comply with DRE trust account record requirements.
- Trust Funds Received and Deposited: When a broker receives trust funds, said funds must be deposited into the trust account bank within three business days. A broker must retain copies of bank deposit receipts to keep evidence of compliance in this area.
Tip: If you rely on a software company to process online rental payments, take notice of when funds are received and deposited into your trust account, and whether you are in compliance with DRE’s three business days requirement.
- Withdrawal of Property Management Fees/Avoid Commingling: Any property management fees earned by brokers must be withdrawn within 25 days, or else the broker may be charged with commingling. Additionally, a broker is allowed to maintain no more than $200 in the trust account to cover bank service fees and other charges. However, any funds belonging to the broker in excess of $200 in the trust account would also be deemed commingling.
Tip: Make sure to cash your management fee checks each month; otherwise, checks paid to the brokerage which remain outstanding more than twenty-five days may be deemed evidence of commingling.
- Trust Account Reconciliation: A broker must reconcile their trust account(s) on a monthly basis (except in those months when the trust account did not have any activities) and maintain a record of each reconciliation in a complete, accurate and compliant format.
If reconciliation issues or exceptions are found, these items should be addressed right away and not allowed to carry over to the next month. Any shortage in the trust account must be cured and/or corrected immediately, and is a violation of the law that the DRE treats very seriously.
Tip: In my experience, property management brokers are often culprits of trust fund shortages, both small and large. One of the more common reasons for trust fund shortages in this space that I have found is brokers disbursing owners’ monthly distributions before rents have actually been received and/or cleared. This is primarily done to keep landlords happy, albeit it comes with the risk of property management brokers violating the DRE’s laws and regulations.
While there are other DRE trust fund handling requirements and areas which require strict compliance, including but not limited to the charging and handling of fees involving lease applications, credit reports, late rental payments and non-sufficient funds, the above items serve as a basic trust funds handling checklist and starting point to build upon. Honestly, this checklist should be one of many to not only focus on trust fund handling and day-to-day policies and procedures, but be part of a larger system of broker supervision and blueprint for compliance for the entire operation, agents, and activities.
Remember, the message here is simple. Know the law up-front and before the DRE shows up on your doorstep to perform an audit. Even long-time brokers can salvage their potential issues by taking a time-out to ensure they understand the laws that regulate their daily activities and continually cross-check their brokerage with DRE compliance requirements.
Bottom line, as a property management broker, you will likely be audited at some point. The opportunity here is to be proactive and not the problem (child). It is brokers who hold the key to their success and can avoid becoming a disciplinary statistic in the area of property management through compliance education, periodic self-evaluations, and action.
Any opinions, suggestions or recommendations contained in this article are based on Summer Goralik’s experience working for, and knowledge of the laws enforced by, the Department of Real Estate, and must not be considered legal advice. It is recommended that you consult with appropriate legal counsel for further clarification.
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