Why you get the rents buttoned-up BEFORE listing a property

Recently, I closed on a deal where the seller inflated the rents in the marketing materials. It was an unpleasant experience for everyone involved, including the buyer, seller, agents and tenants. Here’s what happened:

One of the tenants had applied to the landlord for permission to move a new occupant into his unit. Per LA rent control, the landlord can increase the rent by 10% for each new occupant who is not a minor dependent of the existing tenant. One important caveat is that the landlord must issue the tenant a notice of increased rent within 60 days of “actually or constructively” learning about the new occupant. Obviously, this creates some wiggle room for the tenant, who can claim that the landlord knew but didn’t issue the notice in time.

The seller did not accept the tenant’s application officially, but he did market the property with the rent for that unit increased by 10% (which worked out to roughly $200 per month). The listing agent didn’t know the rules; otherwise, he would have insisted that this problem be buttoned up BEFORE putting the property on the market.

Not knowing anything about this, we offered roughly 10x annual rents to buy the property and we agreed to a deal at 11x. Then we began our due diligence process, which included looking at all the leases and estoppels for each of the tenants. (This is where I beat the dead horse: ALWAYS REVIEW THE ESTOPPELS!!)

Can you see what the problem was? At 11x annual rents (the contract price), that $200 / month accounted for $26,400 worth of the value! If we bought based on the higher number and then the tenant turned around and claimed that the 60 days had elapsed and that the rent increase was void, there would be a good chance that LAHD would side with the tenant and the $26,400 would evaporate.

So, not wanting to take that chance, I requested that the seller get a signed document from the tenant agreeing to the rent increase. Obviously, the tenant didn’t want to sign it.

We were willing to walk from the deal over this, so we told the seller to get the doc signed, reduce the price by $26,400, or sell the property to someone else.

The tenant therefore had the seller over a barrel. And he used the opportunity to extort the seller for a check equal to two years worth of increased rent, or $4,800 ($200 x 24 months). The seller paid the tenant because it was better to do that than to reduce the price by $26,400 or have the deal fall apart. In my opinion, the tenant let the seller off lightly; he had a lot more leverage than he realized and could have exploited it more ruthlessly.

In the end, it all worked out. But this was another reminder of the importance of diligence and experience when it comes to apartment building transactions.