We often hear about the success stories and deals closed. However, those that have been in the business long enough know it is not always smooth sailing. It is through those experiences (or as one of my mentors calls them seminars) that one learns the most.
There is a lot that goes into a deal – finding the deal, locking in the contract, choosing the optimal financing structure, selecting the right third-party partners (property manager, broker, insurance broker, accountant, attorney, contractor, etc.), managing the asset, and of course doing the upfront diligence.
Below I wanted to share my experience from a past deal and hope you find at least one valuable takeaway as you embark on your real estate journey.
Property: 3B/2B/1G duplex, with both units, rented month to month at $1,350/mo each (which was on the lower end of the market).
What I liked: (i) Location (nice B+ suburban area, close to the Villages and Orlando, 65%-35% own to rent ratio providing for multiple exit options; that particular pocket also had low crime and no registered sex offenders), (ii) Product type (3B/2B duplex with a garage, which is rare to find and is ideal for both a small family or a single professional with or without roommates; most duplexes on the market have no garage at all and are 1B/1B, 2B/1B, or 2B/2B), (iii) Age (2006, i.e. less than 20 yrs old), and (iv) Upside potential – opportunity to bring rents closer to market post-close and forced appreciation by performing minor refresh with some deferred maintenance expected due to age (roof, HVAC, heater).
Challenges: There were a few red flags that ultimately caused me to walk away from the property.
Among other items, one of my diligence items requested written reps and warranties from the seller regarding bad debt and past dues, side agreements with the tenants, and tenant-executed estoppels. The seller provided a response via e-mail affirming no bad debt/past dues. Rent roll and copy of deposit proofs were outstanding.
The leases revealed that one of the units was rented at $1,100 (vs. the advertised $1,350). (red flag #1)
My agent inquired about visiting the property (after signing the contract) and was told that if he wanted to see the units, he would need to wait for four days as tenants require a 48-hour notice. It was not ideal but we agreed. When he arrived on Monday, he was not let into the second unit (red flag #2). Visual observation was otherwise positive – the one unit he could see, seemed in ok condition, with no obvious damage or other major structural issues, the area was up and coming C+ next to a B neighborhood, and a park and school were within walking distance.
Soon after, after some probing re the lower $1,100 lease unit (the unit which my agent was not allowed to see), the seller’s agent noted that the unit’s tenant is Section 8 and that a new one year lease for $1,350/mo was just executed as “the seller thought that would be better for me”. The updated lease and housing authority documents were provided to us. In reviewing the documents, it turned out that the housing authority documents were executed a month prior (i.e. not “just executed” as the seller had represented). I was not happy, as not only would this lock me in a lease at the lowest end of the market for an entire year, but also (and most importantly), it should have been disclosed upfront (vs. affirming
no side or other agreements with tenant were present) (red flag #3). The seller’s agent verbally represented to my agent they had a good relationship with the tenant and if I did not like the 1yr lease, they could move the tenant to another property of theirs without a problem. We decided to request that in writing.
And so I proceeded with the inspection. Unfortunately, the inspection revealed that the other unit was in a much worse condition and would also need smoke remediation (the tenant was a smoker and had two other individuals living in the unit, which was a violation of the lease, and the landlord had done nothing about it). When we consulted with a third-party contractor and built-in some cushion for unexpected cost overruns, estimated repairs came down to $40K (vs. the original estimate of $25K).
I presented a counteroffer asking for: (i) follow up on the outstanding written reps noted above, (ii) written affirmation from the seller that they can deliver a vacant unit at close (as they had verbally represented), and (iii) $40K off the asking price.
All of a sudden the seller came back noting the recently executed lease was “deemed invalid” and that the tenant is now on a month-to-month lease and can vacate the property upon a 30-day written notice. There was no mention of them moving the tenant to another property anymore. However, all this contradicted with the housing authority documents executed a month back, which appeared valid (red flag #4). They also agreed to reduce the price by only $10K.
Conclusion: Ultimately I walked away from the deal, given the lack of transparency and red flags that the inconsistent statements from the seller raised for me. Whether or not that was the case, it left me thinking they are trying to hide something. The larger-than-expected rehab was also a concern (though if the tenant and lack of transparency issue were not there and if the seller had agreed to reduce the purchase price by $20K out of the $40K requested, I would have accepted). While I do not have familiarity with managing Section 8 tenants, in reading the lease (assuming it was valid) and contrary to the seller’s statement, I did not see a provision where the tenant could be moved to a different property or asked to leave the property. Moving the tenant would likely also require Section 8 concurrence and other admin processes. I was not willing to further discover what that would entail and how much more it would cost.
My sunk costs included the inspection (which is not a small sum to me) and a small impact on my credit score (as I had started the loan process and naturally my lender had to run a credit check). Nevertheless, I thought it’d be better to walk away before it is too late and before I incur other diligence costs or even worse – a problematic tenant with a property that requires a lot more deferred maintenance than initially anticipated (and possible Section 8 code violations).
It was beneficial that I worked with a full-service property manager, who also acted as my RE broker for the deal. They were just as vested in making sure the property, tenant, and numbers work as they’d be managing it for me.
- Upfront diligence. Inquire about the tenants upfront, even before submitting a contract. Sellers may not disclose anything regardless but you lose nothing by asking.
- Be disciplined about (i) receiving the requested written affirmations in an acceptable format (vs. e-mail) and within the deadlines set – I do not know if that would have resulted in a different outcome for this particular deal if the seller’s intention was to hide information anyway; however, I’d think that having people put that in a different legally enforceable format would carry more weight, (ii) being provided with access to ALL units – we would have discovered the smoke issue, the additional tenants occupying the property, and the larger than expected rehab needs earlier, and (iii) taking the full diligence period available (vs. providing a shorter window to be competitive) – this created a lot of pressure as the seller was stalling and only after we ultimately submitted a counteroffer a day before our diligence expired, they responded.
- Insurance takeaways. I also learned that insurance premiums for older properties in FL can be steep or barely available. My estimate of $75/unit/mo was quite close to the $80/unit/mo that my insurance broker quoted. However, they found only one insurance company (B++ rated) willing to insure the property and noted that would require a detailed inspection (leaving me anxious that they may drop coverage post-close if for any reason my property does not pass inspection). I thought initially that the higher monthly premium was due to the older roof (15 years). However, the broker noted that replacing the roof would not reduce my premium at all and that a driving factor for the quote was the overall property age. As a reference, the cost for a new construction property is $40-50/mo with insurance provided by an A-rated carrier.
- Choose a good team you can trust. In my particular case, my agent/property manager had my back. The inspector I used was very detailed and was able to respond quickly (due to my relationship with my PM). My agent also had connections with a reliable contractor who was able to provide estimates on short notice. This helped me avoid more issues down the road.
- Stay the course. Only time and going through the actual deal would tell what would have transpired. However, the red flags caused me to put the character of the seller into question and to walk away from the deal even though the numbers, location, and product type all had initially checked out on paper. Being disciplined about my criteria and following deadlines helped me get away with the sunk cost of the inspection report only. Had I not done the inspection (waiving appraisal and inspection contingencies is not uncommon in this hot market), I would have been in for a bad surprise.
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Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.