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Brandon Bought a “Waldo” Rental Property…. But Should You?

by Ben Leybovich on December 3, 2013 · 34 comments

  
Brandon Bought Waldo

First, I must congratulate my friend Brandon Turner on his latest acquisition of a triplex which he recently discussed in his article “How I Found, Analyzed, and Bought an Ugly Purple Rental Property.”

The numbers he provided looked great.

This definitely seems like a rock-solid deal for Brandon (except for the cash out of pocket), but I do see some elements of this acquisition that give me heartburn…

In fact, I wouldn’t have touched it with 10-foot pole and I caution you against it as well…

I want you to know that I asked and received permission from Brandon to write this article.  I am writing this in the interest of all of you newbies out there, because while experienced operators like Brandon will more-than-likely do very well with this deal, there are structural elements here that represent a great case study of the less obvious things that can potentially be very problematic…

Why Waldo

When we talk about a triplex, what we are really talking about as income investors are 3 units representing 3 revenue streams.  It is important to realize, however, that not all 3-unit properties were created equal.

Did you take the time to view the video as part of Brandon’s post?  I did, and I also read the entire post.  I am not sure if you noticed this, but the video seems to be missing one vital piece of information which is contained in the text – the fact that this building used to be a single-family dwelling and was at some point converted into multi… In the world of triplex buildings, this one is indeed a Waldo; it does not conform!

“Who cares,” you say – “it’s three units and three revenue streams!”

Understand – the original design and functionality of all of the mechanical systems was intended as a SFR and not a multi-family, and while systems have obviously been adapted, we just don’t know how well and proper this was done, which can lead to significant headaches later on.  Let’s look at some of the elements that could cause concern:

Sewer

In the case of centralized municipal sewer system, the main sewer line from the house is connected to the main city line at the street level.  Each connection is what we call a “tap” and its size is designated to accommodate a specific number of units, in this case 1.  In order to add additional units, one would have to either pull permits and pay the fees for additional taps, which can be thousands of dollars in most municipalities, or the new lines could simply be tied into the existing plumbing.

Most people do the latter and the problem with this is that a line which was intended to handle waste from 3 baths, 1 kitchen, and 3 toilets is now handling almost twice that volume.  This may be no big deal, or it may cause some stinky issues.  Not to mention that if the work was done under the cover of night and without pulling appropriate permits, this means the work was never inspected.  As such, Brandon bought a cat in the bag.

Now – even more serious can be a situation with septic sewer, and even though this is not relevant in Brandon’s case, some of you may run across a similar deal but with septic sewer system, so – listen up:

Government regulations regarding septic are stringent and become more so every day.  Every septic system is designated to service so many units and so many people.  If you buy a SFR and decide to convert it to duplex, you may be surprised at needing to replace the entire system – just saying.

And then there’s water and electric, which I’m not going to even touch at this time…

Size and Layout Of Units

There are a couple of issues that jump out at me with this investment relative to size and layout of the units.  Let me begin by accentuating a general concept – in my understanding, successful income investing exists at the intersection of desirability to tenants and desirability to landlord.  Put differently, while we absolutely must ensure that the unit is attractive to prospective tenants so that it rents quickly and stays full with well-qualified renters, we have to temper this with something I call ease of management; no matter how attractive and desirable the unit is to tenants, you will hate your life if this unit is difficult to manage and maintain.

With this in mind, a unit above the garage is just that – a unit above the garage.  The staircase leading to the front door is in a lot of cases on the exterior and susceptible to weather, which creates additional liabilities on the owner.  A unit like that comes with highly diminished desirability to tenants, as it for all intents and purposes precludes single parent with a stroller, retiree suffering from arthritis, or me – there is no way in hell I would ever schlep my behind up like that…

Then there is a basement unit, and I only have to say one thing here – this will not be rented to a single woman due to safety issues.  Therefore, the market for a unit like that is single men.  Depending on the demographics this could work, but…

The Big Unit

Now – this is going to take you out of the proverbial box a little, but stick with me.  Here’s the deal – the nice, big, 3-bath unit is I am sure the sexiest thing Brandon’s future tenants will have ever seen.  Who wouldn’t want that; Jacuzzi and all?  Here’s the issue – the bigger the unit, the more people/larger family it can accommodate legally.  Let me ask you: Do you want 2 adults and 5 kids in your rental unit as it relates to wear and tare?  Do you want to clean out 3 sets of drains, and auger 3 toilets?

No problem, you say; I’ll just place occupancy limits into the lease.  May be, or may be someone decides to sue you for discrimination under the Familial Status protected class of the Fair Housing Act of 1968 – and they would win in this case!  You are going to have a hell of a time trying to prove to the feds that a family of 7 in a 1,000 sq.ft. unit with 3 baths is unsafe or unsanitary for the kids – trust me, they’ll have you…

As you gain experience, you’ll begin to figure out that it is very difficult indeed to control occupancy legally, and that the size and layout of the unit becomes the main tool.  While it is reasonable to decline an application for a 2-bedroom/1-bath from a family of 7, it is not reasonable to decline them in Brandon’s big unit.  So, when Brandon saw the nice, big unit with 3 bathrooms, he got excited; he still is excited.  Me – I see nothing but liabilities in this; wear and tear galore and an inability to effectively limit occupancy.  The last thing you want is HUD investigating you…

Conclusion

We get fixated on the numbers, and we should – numbers are important.

However, real estate is not about the numbers; it’s about people.  All I’ve done here is look at the deal from a perspective of different people involved in the life-cycle of the asset.  I suppose that none of the above is make it or break it, and one could learn to live with all of the above. But, in that we are looking for the cherries, we should try to see more than just the numbers…

Thoughts?

[Note from Brandon, the Editor: I did indeed encourage Ben to publish this post, because he's right: there is more than meets the eye than just the math. The concerns that Ben addressed in this post are very important to understand going into a property.

That said, I also believe that there is no "perfect" property and by waiting for that one perfect rental, you may never purchase anything. Instead, do as I or Ben do ... and continue to educate yourself on these factors. The best way is by speaking with other investors and doing proper due diligence. Ben and I talked about this deal before I bought it, and I talked with numerous other investors about it as well. Yes, there are risks, and those conversations helped to identify them. Then, I factored those into the deal and made a decision based on my risk tolerance.

Yes, the sewer could be a concern (doubtful) and yes, these units will not appeal to everyone so my vacancy rate may be higher than average, and yes- I will be renting to a very large family with lots of kids. However, I will be going into this deal with full acceptance of those concerns and approaching the business and math with them in mind. If you do the same, I see no reason to avoid these properties with a 10-foot pole... just with eyes open and help from the BiggerPockets community!]

Photo Credit: jakedobkin

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{ 34 comments… read them below or add one }

Jan December 3, 2013 at 9:16 am

This has been very informative – both Brandon’s post about his purple house and Ben’s response. There’s always a few sides to every property. Thank you both for sharing your knowledge.

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Ben Leybovich December 3, 2013 at 10:21 am

Thanks so much Jan – both Brandon and I are very glad you found this useful!

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Roy Schauer December 3, 2013 at 9:26 am

Great article Ben, and Brandon!
I like that it shows two sides of the same coin. Depends on your perspective, business model, experience, and risk tolerance. There isn’t a cut and dried “one way to do all” formula. My business partner and I recently addressed this issue because we both have slightly different ways of approaching the real estate industry. Our final decision came down to, what are we really trying to do, what’s our time line, and what methods are the most efficient for getting us to the next stage of our business evolution. Once that was discussed, it made sense how we should proceed at this point until the next growth level. But now we know what direction we are going, how we are going to get there, and what needs to be in place to take the next step on the path.
Thank you both for playing the roles of optimist and pessimist on this deal. It’s good for newer people to see as many angles and perspectives as possible. I ran into a similar property that looked really good as far as numbers went, was a tri-Plex also, the only problem was when digging for info I found it was zoned as a single family residential. Doesn’t mean you can’t do the deal, but it throws a variable in that you need to be aware of when making a final decision.

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Ben Leybovich December 3, 2013 at 10:28 am

Roy – I didn’t go into zoning cause that’s a can of worms. There are people in life who we would chose to go into battle with when shit hits the fan. Brandon is that guy for me – I value his judgment and respect his talents. Besides, he is luckier than all get up – have you seen a pic of his wife Heather? Wow!!! The dude is like a cat who always lands on his feet. I’m sure he’ll do just fine on this, but there is another perspective that needs to be brought out – and that’s mine :)

Thanks so much Roy!

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Trevor December 3, 2013 at 9:59 am

I like renting, “single family unit slabs.” Less foundation problems, less liabilities.

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Ben Leybovich December 3, 2013 at 11:54 am

Slabs are great – I like them as well. SFR – not so much my speed, but to each his own :)

Thanks so much Trevor!

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Jeffrey Hare December 3, 2013 at 10:31 am

Ben – you hit on a key issue – nonconforming use – that goes to the very premise of Brandon’s calculations, namely whether you can legally rent all three units. If not, the math doesn’t work. Moreover, if the electrical, plumbing, and HVAC systems are not up to code or not sufficient to handle the expanded use of the building, there could be an issue of habitability. A landlord may not charge rent for a substandard housing unit, period. Multifamily units are also regulated more strictly than SFR, and in some jurisdictions are subject to annual inspections, special fees, etc. Last, but not least, the awesome muti-unit converted Victorian may turn out to be eligible for listing on the local or state historic inventory, meaning that each and every external modification must be approved by the local historic or landmark preservation board or commission. Unlike Barney, the Big Purple Thing may not give you lots of love in return.

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Ben Leybovich December 3, 2013 at 10:40 am

Bingo – I don’t know if the basement unit is heated by the same system as the main unit. If it is, it perhaps is possible to pass the cost along contractually, but not with subsidized…

There are a lot of angles here indeed. Thanks so much for your commentJeff!

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Brandon Turner December 3, 2013 at 11:28 am

Ben, Ben, Ben…

:) I left most of my response above, but I’ll to the conversation here.

I agree 100% that this is important stuff to consider. That said, I disagree with the idea that someone should not buy this based on your info. Research more: yes. Refuse to buy? Nope! This property is a no-brainer, so I especially think it would be great for a new investor. Are there challenges? Of course, we’re not playing Pokemon here, we’re investing in real estate. We like challenges – and we overcome them. If you run from every challenge and question, you’ll be 90 years old and look back to realize you missed out on life.

So yes, I love this post cause it makes people think… but we both know you are just jealous ;)

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Ben Leybovich December 3, 2013 at 11:53 am

I am jealous – but not of the property :)

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Bill Briscoe December 5, 2013 at 9:31 am

Good stuff Brandon.

Ben brings up a list of important risk factors to consider during due diligence, but I’m sure you considered those and decided the property still made sense. Yes, some of that risk factors may cost extra to mitigate, but IMO, that simply justifies a lower offer price. AND it probably repels other buyers who are irrationally afraid of the unique risks, which presents an opportunity for guys like Brandon who are willing to take on a little extra risk.

Risk and Reward is always a tradeoff. Higher risk investments should demand a higher potential/expected rate of return, and hence a lower offer price, all else equal.

And of course, not all risk factors represent the same level of exposure to all investors. Some are better equipped to deal with various risks than others, because of cash flow, experience, network of contractors, etc.

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Mehran Kamari December 3, 2013 at 12:22 pm

Great post Ben! The more deals I do, the more I realize there are things that lie below the surface of the numbers and what I “think I see upfront”.

Aside from that, seems like you’re always picking on the B-Man! Be mindful about waking up a sleeping giant haha!

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Ben Leybovich December 3, 2013 at 12:25 pm

Brandon is a friend Mehran – I pick on him because he is committed to his vision which stimulates thought in me. Besides, he knows I’m right :)

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Paula Pant December 3, 2013 at 12:35 pm

Ben and Brandon, I think you both make excellent points, and I’d recommend both of your articles to people who are interested in buying triplexes.

My first property was a triplex, which was also built as an SFR and later converted. The water/sewer has been fine, and frankly, this property cash-flows so much — and is located in such a prime spot — that even if we had to shell out big bucks replacing/upgrading the system, I’d feel okay about it.

That said, all 3 units in this triplex attract “upper-end” tenants. All the units are spacious, with large windows and lots of charm and appeal. I might feel differently if we had a basement unit.

Anyway … that’s a long-winded way of saying that every property is unique. I wouldn’t outright reject all SFR’s that have been converted into multi-units. Nor would I outright embrace any investment that had appealing numbers. RE investing is sometimes more of an art than a science/formula. :-)

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Ben Leybovich December 3, 2013 at 4:49 pm

For sure Paula – nothing is definitive. I just wanted to point out another way of looking at things. I think the ability to do so is an acquired skill and we should all learn it…

Thanks so much for your comment indeed!

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Tiffany December 3, 2013 at 1:42 pm

Thanks so much Ben & Brandon! It was really helpful to see two different perspectives on the same property. Much of real estate is hyped up and while it’s good to have lofty dreams, you also need to make sure your feet are firmly on the ground and you cover all your bases… I’ve definitely learned that! So, it was really neat just getting it straight and honest with no sugar coating about it. Everyone’s strategy is different which is why what works for Brandon may not work for Ben and that’s OK. Really glad I read this post, and thanks for the transparency Brandon :-)

Tiffany

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Ben Leybovich December 3, 2013 at 4:51 pm

Haha – it’s easy to tell you about how much money you are going to make; it’s less easy to tell you about all the money you will potentially loose. But, someone is got to do it – I’ll take the bullet :)

Thanks very much for reading!

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anthony cecchini December 3, 2013 at 3:54 pm

Both posts were abosultly great. I think these two perspective posts regarding one topic are very informative to the readers. You both are great. Now on a more humorous note, I hope brandon is not setting up a perfect opportunity for a basement creeper to creep on children living upstairs. I bet that would lead to some middle of the night calls haha.

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Ben Leybovich December 3, 2013 at 4:52 pm

Wow Brandon – I didn’t even take Anthony’s scenario into account. This could be interesting :)

Thank you very much Anthony!

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Tom Sylvester December 4, 2013 at 5:20 am

Ben – Thank you so much for this post! Although I agree with Brandon and the pros outweigh the (potential) cons of this deal, the points that you bring up are excellent and anyone new to real estate need to be aware of. I truly hope and believe that you save people money and headaches in the future with this post.

Brandon – If Ben’s post keeps you up at night, you know my number. As you know, I love investing in rrrrrrrural areas and will take that triplex off your hands. :O)

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Ben Leybovich December 4, 2013 at 8:43 am

I don’t think Brandon is letting go of this one so easily lol

Thanks so much Tom!

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Eugene December 4, 2013 at 3:50 pm

Great post and great responses. I’m a newbie here but not necessarily a newbie at investing.
It’s always great to read about the pros and cons but I am siding more with Ben on this one.

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Ben Leybovich December 4, 2013 at 6:06 pm

Thanks Eugene!

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Armaity December 5, 2013 at 7:19 pm

Loved the information packed articles and the different perspectives, and more than anything else the honest and frank exchange …awesome!

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Ben Leybovich December 6, 2013 at 7:08 am

Thanks so much Armaity!

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Chris December 5, 2013 at 7:49 pm

I was enjoying the article until Ben dropped the “Fair Housing Act of 1968.. They’ll get you” line. This is not true, a family can not sue you because you don’t allow 9 people in a 3 bedroom house. I worked for a property management company that owned/managed $100M + in assets and the rule is “2 beating hearts per bedroom.” I believe it’s babies 18 months or young are not considered in that. We enforced it regularly and had the legal paperwork to back it up if anyone ever challenged us, which of course they never did.

Otherwise good article, it’s important to consider the whole picture.

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Ben Leybovich December 6, 2013 at 7:11 am

Hey Chris,

Thanks for reading. I don’t know of the “rule” you mention. Any chance you can share a link? This would be helpful because the regulations are specifically vague…

Thanks much!

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Chris December 6, 2013 at 4:51 pm

Ben, thanks for your reply. I had a discussion with a friend that is the President of the local apartment association and completed a bit of research to confirm my understanding of the laws. Of course I am technically wrong about your scenario (though 7 unrelated college students would have no case) so apologies for speaking too soon. However, below is a quote from the Keating Memorandum of Occupancy Standards:

“Specifically, the Department believes that an occupancy policy of two persons in a bedroom, as a general rule, is reasonable under the Fair Housing Act. The Department of Justice has advised us that this is the general policy it has incorporated in consent decrees and proposed orders, and such a general policy also is consistent with the guidance provided to housing providers in the HUD handbook referenced above. However, the reasonableness of any occupancy policy is rebuttable, and neither the February 21 memorandum nor this memorandum implies that the Department will determine compliance with the Fair Housing Act based solely on the number of people permitted in each bedroom. Indeed, as we stated in the final rule implementing the Fair Housing Amendments Act of 1988, the Department’s position is as follows:

[T]here is nothing in the legislative history which indicates any intent on the part of Congress to provide for the development of a national occupancy code. * * *

On the other hand, there is no basis to conclude that Congress intended that an owner or manager of dwellings would be unable to restrict the number of occupants who could reside in a dwelling. Thus, the Department believes that in appropriate circumstances, owners and managers may develop and implement reasonable occupancy requirements based on factors such as the number and size of sleeping areas or bedrooms and the overall size of the dwelling unit. In this regard, it must be noted that, in connection with a complaint alleging discrimination on the basis of familial status, the Department will carefully examine any such nongovernmental restriction to determine whether it operates unreasonably to limit or exclude families with children.”

Which can be found here: http://fairhousing.com/index.cfm?method=page.display&pagename=HUD_resources_keatingmmo

As you can read, it specifically states that 2 people per room is considered reasonable and there is no intent by congress to restrict managers from having occupancy standards. At the end of the day it’s all about having specific rules and guidelines that everyone must follow and qualify for. Limiting your 3/2 house to a max of 6 people is considered reasonable by HUD, if its good enough for them it’s good enough for me.

Thanks!!

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Ben Leybovich December 6, 2013 at 6:33 pm

Thank you for this info Chris. I guess that the statement you make “…considered reasonable by HUD, if its good enough for them its good enough for me” is where I’d prefer to part way. The law is specifically vague and gives HUD wide range of discretion – I am not specifically comfortable with that and would rather to not have to prove my innocence.

Thanks so much!

Chris December 6, 2013 at 7:01 pm

Understand Ben, everyone has their own risk tolerance. While I’ll never think twice about implementing occupancy restrictions (2 per bedroom), I can understand and respect why some would. Happy investing and keep-up the articles, I enjoy reading your stuff.

Rose December 6, 2013 at 4:52 am

Great articles, great comments.

This all boils down to the proper knowledge to make an educated risk versus reward.decision.

If Brandon knows ALL the risks going into the deal and properly accounts for them and feels comfortable with them, then by all means he should proceed.

In our opinion, the number one cause of investors losing money is because they entered into a transaction without all the facts.

That reason is followed closely by investors not understanding and properly accounting for the facts even when they have them.

There are too many cause & effect factors that will come into play once Brandon assumes control of the property to determine the ultimate merit of this deal – does he advertise it correctly, pick the right tenants, etc. He may succeed where others would fail

For that reason everyone reading these articles should focus on the PROCESS not the results:)

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Ben Leybovich December 6, 2013 at 7:40 am

Right on Rose!

The Cause and Effect is not an easy thing to master. We don’t know what we don’t know…

Thanks so much!

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Chris December 6, 2013 at 4:52 pm

It can also be found on HUD’s website here: http://www.hud.gov/offices/fheo/library/occupancystds.pdf

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Shaun December 16, 2013 at 10:11 am

Good follow up on Brandon’s article.
Valid things to look into and could certainly sour some on the deal.

Overall I am with Brandon that it looks like a pretty solid deal that should make him and his partners some money.

The one concern that I would have is the big discrepancy in unit size. As someone pointed out above the “creepy” factor could come into play.
If you have a family that have 16, 13, and 10 year old girls they are going to at least take pause if there are single guys living in the basement and above the garage (big target audience for both of those units). Conversely a single person might be turned off by the thought of having 3+ little kids running around right over their head or babies crying and all that family stuff.
I’d factor in bigger vacancy rates going in to account for some misalignment of the people looking at adjoining units.

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