Archive for the ‘Due Diligence’ Category
I was trying to buy a small office building in East Hollywood.
Because it was a former gas station, we were concerned it was contaminated.
I spent an enormous amount of time trying to structure a deal that would put the risk on the owner, not me.
Eventually, it became clear I couldn’t do it in a way that made sense and allowed me to get the financing I wanted.
One of my competitors jumped in and took the risk on the environmental.
The property came up clean. He’s closing next week.
“When you’re buying a rent controlled building,” I said to the buyer during an inspection yesterday, “the tenants are at least as important as the physical condition of the building.”
This is kind of counter-intuitive, right? After all, tenants come and go, but you plan to own the building for a long time.
But, under rent control, tenants don’t necessarily come and go. Instead, they often stay for long periods of time. And, if you’ve inherited them, you probably also inherited the terrible leases they are operating under. Here are some examples of terrible legacy tenancies I’ve run across recently:
- One tenant in a 9 unit complex has in his lease that he can pay rent on the 15th, not the 1st like everyone else, so we have to make two trips, every month, to that one building to get the rents;
- Many leases contain an attorney’s fees clause saying that, if the tenant doesn’t pay and the landlord evicts and wins, tenant has to pay landlord’s legal expenses. Sounds good, right? Except that judges in CA have interpreted those clauses as bi-directional, meaning that, if the landlord sues for eviction and loses, landlord has to pay tenant’s legal bills. Tenant advocacy lawyers love that one, because they opt for a jury trial and you’re potentially stuck paying them tens of thousands of dollars if you lose;
- No security deposits. If you have a tenant with no security deposit who doesn’t care about his credit / eviction record, the tenant has zero incentive not to stiff you on the rent/destroy the place. What’s the worst that happens? He sticks around rent free for 2-3 months and then moves out when the sheriff arrives;
- A landlord who intentionally scratched out the pet provisions in his lease, and thereby allowed a tenant to move in four extremely aggressive pitbulls;
- Resident managers working with no employment agreements and without leases, leaving the landlord open to failure-to-pay minimum wage litigation and (possibly) a tenant in an apartment at zero or close to zero rent.
There are a million more of these kind of problems. All are avoidable / manageable with the right leases and the right tenant screening process. (In fact, I’ve never had to evict a tenant from one of our renovated buildings… knock on wood!). But, if you buy something with old leases / badly screened tenants, watch out.
What does this mean for buyers?
- Value those new tenancies more highly. If the leases are good and the tenants are screened and have security deposits, you will definitely have an easier time managing the property; and
- You need to carefully review the leases during the diligence process. If you (or your broker) know what to look for, you can mitigate some of the problems. But you definitely can’t if you don’t know what you’re looking for.
Right now, one of the biggest problems I see across multiple deals is the total lack of understanding of LA rent control among bank underwriters.
Underwriters are the guys (and gals) who review the property and the borrower to help the bank decide whether- and how much- to loan on a given deal.
Because they see a lot of rent rolls, they tend to think they know the rents in different areas. But, without understanding how rent control works, seeing a rent roll can actually lead you far astray.
For example: Say you, the underwriter, look at five rent control deals in Silver Lake in a row. All contain one bedroom apartments with legacy tenants paying between $600-1250. You think you’re now an expert on Silver Lake rents. You probably think that the right range for market rents for 1/1s in Silver Lake is $1000-1250.
You’re totally wrong. Market rent for a decently renovated unit in Silver Lake is easily $1500 and probably more like $1600. But you, the underwriter, don’t know that, because you’ve seen a bunch of rent rolls with rent-controlled tenants paying less.
So, then, when I bring you a building with a few vacancies and I tell you the rent for those units will be $1500-1600, you think I’m bullshitting you. But I’m not. You just don’t know what you don’t know.
When I buy apartment buildings (or help other people buy them) I am ruthlessly focused on the cashflow they generate in year one.
I don’t factor in rents increasing, nor do I factor in price increases stemming from rent increases. I want to know what the cashflow is RIGHT NOW.
Many buyers to factor in rent increases and price increases. They look at a 4% cap, factor in some rent increases, and assume they can exit at a 4% cap in five years. Here’s the math: Let’s say year one rents are $250k and net operating income (NOI) is $162,500. You buy the building for $162,500 / .04 = $4,062,000.
These buyers then assume 3% / year rent increases. In year five, they assume rents will be $281,000 and NOI will be $183,000. If you 4% cap that NOI, you get $183,000 / 0.04 = $4,572,000. So you’ve collected a bunch of cash and your building is worth $500k more than when you bought it. Sounds great, right?
Ah, but what happens if interest rates on multifamily assets increase from their current historical lows? Say they go from 4% (where they are now) to 6%. That probably means cap rates are going to go from 4% up to at least 6%, maybe more.
If you 6% cap the $183,000 NOI in year five, you get a building valuation of $3,050,000. In other words, you vaporized $1,000,000 in asset value, even accounting for the 3% annual rent increases.
It’s important to understand that the above is totally irrelevant as long as you’re happy with the in-place cashflow and have no need to sell quickly. In that situation, you just hold the building for longer and collect the rents until some combination of rent increases and cap rate compression eventually takes your building value back up over par.
But if you’re investing with someone who is slinging a “we’ll buy and hold for five years and then get out” strategy right now, I advise you to give all the tires a good kicking.
Almost forgot to post, which would have broken my streak!
We’re in the process of selling a 16 unit building we rehabbed over the past few years. The buyer brought along an inspection company we’ve never seen before.
After watching them work for an hour or so, without planning it, both Jon and I separately asked the buyer where he found these guys, because we both thought they were pretty good. A little nitpicky, if you ask me, but pretty good.
We usually use La Rocca for inspections on deals that need it (some don’t, because we’re planning to gut anyway). But I’m thinking of adding these new guys to the rotation. There’s such a paucity of talented people in this business that, when you find one, you need to grab him or her for your team.
Am doing an inspection today on a building where the owners’ disclosures indicated that they previously had a mold problem. They also gave mold disclosures to some tenants.
So we’re bringing a mold inspector to the inspection. Here’s how they work (I didn’t know this until yesterday):
- You pay an inspection fee (they quoted $750 or something but quickly offered a “discounted” rate of $450)
- Then, you pay $90 / sample for them to take samples and send them to a lab to be tested
- They have a three sample minimum
- You get the sample results back in 48 hours
The concept is that the lab results give you a sense for whether the mold in the building is your garden-variety “moisture issue”, which can usually be cured by fixing whatever’s leaking and then swapping out the affected drywall / tiles, or whether it’s something more serious.
My general feeling is that these mold inspections are an unnecessary cost. But we’d feel kind of stupid, if, having seen the disclosure, we went ahead and bought the building without checking and then found ourselves with a major problem.
When you inspect the foundation of an older apartment building in LA, probably 7 out of 10 times, your foundation inspector is going to tell you that the foundation isn’t bolted and that you should bolt it after you buy it. Should you?
To answer the question, you first need to understand how these older foundations work. Imagine a low, concrete wall running around the perimeter of the building. Then, imagine imagine a strip of wood lying flat atop the wall (this is called the mud sill), with other pieces of wood rising straight up from the flat ones every 16″. The wood I’ve described is the framing that comprises the building.
Here’s a picture from a building I recently inspected:
You can see that there’s nothing holding the flat wood (called the mud sill) on top of the the concrete wall besides gravity. This is the case for most older buildings.
Can you imagine what can happen to a building with a foundation like this in an earthquake? If there’s enough shaking in the right direction, the framing (the wood) can jump right off the concrete wall. That’s potentially disastrous, because the framing will be stressed in all kinds of ways its not designed to be stressed and the structure will rupture.
Foundation bolting is pretty much exactly what it sounds like: A licensed foundation contractor comes in and bolts steel plates to both the concrete and the framing, keeping them from separating. If you go for cripple wall reinforcement, then the contractor also connects plywood to the vertical lumber rising out of the mud sill to stop it from moving side-to-side in an earthquake.
So, should you pay to have your foundation bolted and reinforced? Well, an earthquake is pretty much the only thing that can totally screw up an investment in an apartment building, because you’re almost definitely not going to have earthquake insurance (because it’s too expensive). And foundation reinforcement is reasonably cheap (probably $10-15k, depending on the size of the building).
So, here’s my advice (and remember, I’m not an engineer or contractor or anything, just someone who has had to make this decision about 15 times recently):
- Always bolt 2+ story buildings (it’s a lot harder to fix these if the framing jumps off the foundation AND people are much more likely to be hurt if it does)
- Err on the side of bolting single story buildings unless the cost of doing so causes you not to be able to do the deal, in which case do the deal and worry about the bolting later
Have seen this on two buildings recently, so figured I’d share.
On modern buildings, all of the electrical meters are grouped together on one big panel, called a “combo” panel. It’s usually in the front of the property near where the electric wire drops from the nearest utility pole to provide power.
Back in the 1920s, when a lot of buildings in Silver Lake / Echo Park were built, the City allowed you to install meters directly inside the units, usually next to the subpanel where the fuses were. Here’s a pic:
Those 1920s electrical systems used cloth wiring which has by now far exceeded its intended useful life. However, the Department of Building and Safety considers the original systems grandfathered in as long as you don’t touch them.
The problem is that the cloth wiring is really not safe. And, there is generally not enough power in those systems for modern tenants with their plasmas, computers, industrial-strength curling irons, etc. So, a lot of building owners want to re-wire. But they don’t want to pay for a new combo panel (one which centralizes all the meters in one place), the purchase and installation of which can run into the low five figures, depending on the number of units served and the distance between the new panel and the units themselves.
What these owners do instead is re-wire without permits. They leave the meter in place but swap out the sub-panels with glass fuses for modern panels with breakers. This allows them to add circuits and, therefore, power for the tenants. And it arguably makes the building safer, because they swap out the deteriorated cloth wiring for new, plastic-insulated wiring.
The problem, from the buyer’s perspective, is the Housing Department’s Systematic Code Enforcement Program, which sends LAHD inspectors into all apartments in the city every 2-3 years. While the inspectors definitely vary in terms of their knowledge of building codes (remember, these are Housing Department inspectors, not Building and Safety inspectors), even the inexperienced ones can spot the new sub-panel underneath the old meter placement and know, without a shadow of a doubt, that the re-wiring was done without permits.
If you get written up by one of these SCEP inspectors, you will end up having to re-wire your entire building and bring it up to code, at a cost of approximately $2-4k / unit, depending on the quality of the un-permitted work (how much of it your electrician can salvage). That’s real money. So the question is: “Who should cover the cost of this – buyer or seller?”
Sellers never want to give you credit for this scenario. Their perspective is that the wiring has been upgraded. They’ve already spent the money to improve the building. Why should they have to, in effect, pay again by giving you a credit (price reduction). Instead, they want you to take the risk with the SCEP inspector. After all, they’ve probably had a SCEP inspection or two since they did the work, and they weren’t busted.
As a buyer, you want to push back on this, because you’re planning to own the building for a long time and the likelihood is that you may eventually get caught. The expected value to you is a 100% chance of getting caught multiplied by the cost of re-wiring the building: 100% x $2-4k per unit is $2-4k per unit.
Will you win the argument? As always, that comes down to who wants to do the deal less.
We walked from away from a deal yesterday and it still hurts.
This building looked like a winner for us: Huge units, high ceilings, incredibly cheap price, tenants who we thought we could buy out.
But there wasn’t any parking and the neighborhood was improving but not great.
There’s an art to evaluating these kinds of deals. You test all of your assumptions about costs and (eventual) rents. Maybe you spend more, make the units nicer and get higher rents. Maybe you try to save on the renovation, understanding this will cost you on the rents. But you have to do all of this model-flexing without pushing your assumptions beyond the realm of reality.
In this case, the fact that there wasn’t parking meant that, in our opinion, there was a cap to the rents we could charge, no matter how creative we got in making the units amazing. And, since our diligence uncovered a lot of problems with the building systems, there was no way to just cheap out and go for a low cost / low rent scenario.
There are deals out there, but it’s not like they come along every five minutes. So it hurts to let one go. But we deal in risk and reward, and you have to make sure that there’s enough upside in these things to make it worth the potential downsides. In this case, we had to let it go.
There’s a postscript here: Our biggest investors heartily congratulated us for our decision. We haven’t worked with them for very long, and I think it gave them comfort to know that we walk when things don’t make sense. Good to get further confirmation they’re the kind of people we want to work with.
The due diligence period, also called the contingency period, is the buyer’s chance to learn everything he can about the building before making a decision about whether to buy it. If you don’t ask your questions during the diligence period, and something comes up later, it will be too late to back out.
Remember: You’re buying a small business (often with a lot of debt!). Would you buy a dry cleaner or florist without asking a ton of questions about how the business works? If you did, you would be an idiot. What makes real estate any different?
So, what kinds of questions should you ask? To give you a sense for the level of detail I think you should go into, I’ve pasted a list of questions I sent to a listing broker yesterday on behalf of a buyer with whom I’m working. (It’s worth noting that the buyer is very savvy and contributed some of these questions).
Sample diligence questions:
1. The following is a list of units together with the number of occupants allowed per the lease. Please let us know if you are aware of any unit having more occupants than allowed under the lease:
Unit 1 – 2 occupants
Unit 2 – 2 occupants
Unit 3 – (no lease)
Unit 4 – 1 adult occupant, 2 children
Unit 5 – 4 occupants
Unit 6 – (no lease)
2. The leases for the following units do not allow pets: Units 1, 4, 5, A. Unit 2 allows a cat but no other pets. Have you made verbal or written agreements with the tenants in any of those units to keep any pets?
3. Please provide a list of occupied units for which you have raised the rent during the last 12 months.
4. Do you have a written or verbal agreement with Unit #A that they can have 2 parking spaces? Do you have a written or a verbal agreement with Unit #A that they can have storage? Where is the storage?
5. Do you have a written or verbal agreement Unit #B that they can have 2 parking spaces? Do you have a written or a verbal agreement with Unit #B that they can have storage? Where is the storage?
6. Do you currently bill any tenants for water, sewer or trash? If so, which units and how do you calculate the charges?
7. The tenant in Unit B was originally paying $550 and is now paying $1095. This does not appear consistent with the city-mandated annual rent increases (we would not expect to see a round number, since increases are typically for 3% / year). Did you make a special agreement with the tenant to get the rent to that level? Is this agreement documented in writing?
8. The tenant in Unit A was originally paying $1300 and is now paying $1450. This does not appear consistent with the city-mandated annual rent increases (we would not expect to see a round number, since increases are typically for 3% / year). Did you make a special agreement with the tenant to get the rent to that level? Is this agreement documented in writing?
9. Did you install AC in any units? If not, did you agree to allow the tenants to install AC? Was this agreement written or verbal?
P.S. If your broker isn’t going into this level of detail on your deal, get a new broker.