In this article I want to share with you the biggest mistake I almost made when buying an apartment building.
Had I made this mistake I most surely would have lost the building in foreclosure within several months. And despite all of my education, training, and reading, this is something none of the experts warned me about.
After getting this building under contract and it was time to do due diligence, I requested a bunch of documentation from the seller: utility bills, invoices, service contracts, leases, rent roll, tax returns, etc.
Her documentation was woefully incomplete, but I did have the rent roll and a copy of the leases. The building currently had a 15% vacancy but I was told that this was a temporary condition and that it’s normally completely filled. OK, whatever … I had still underwritten the deal with 15% vacancy.
It then occurred to me that I should try to verify the rents she was collecting. What could be worse than a bunch of tenants not paying their rent, right? I asked for a copy of her tax return for the building that shows actual income. She didn’t have it or didn’t want to give it to me.
I then asked for bank statements that show the rental deposits. After about a week, the broker faxed over bank statements, but they looked like personal bank statements. I had no clue what deposits were from rents, so I asked her to highlight the ones which were.
This, of course, took another week. When I got the highlights back and I added up the deposits for the last 6 months, it looked like she was actually only collecting 50% of the rent.
What?!? So HALF the Building is Delinquent? Are You Kidding?
So let me get this straight: after I close, not only will I collect only half the rent but I’ll then need to spend thousands of dollars in legal fees to evict these tenants, then spend another several thousand dollars to turn the units over.
I asked the seller about this and she said that these were tough times for the tenants, but they’re good tenants and they’ll pay, they just fell behind the last few months.
For me, the building was now only worth HALF of what I had it under contract for. I proposed three options to the seller:
- Drop the contract price by half;
- Add a contingency to give her time to collect at least 90% of the rent for a period of 3 months in a row and I have the right to review any new tenants she brings in; or
- She guarantees me a year’s worth of rents from any of her tenants that didn’t pay.
None of these options worked for her (as expected), and so we terminated the contract. Three weeks later, the broker contacted me and said that she wanted to pursue option 3.
So she paid a large amount of money into an escrow account that was administered by an escrow agent, and every time one of her tenants didn’t pay rent, I would get the difference from this escrow account. This allowed me to stabilize the property over the next 12 months.
One lesson, of course, is to be creative in coming up with solutions that work for both you and the seller. But the most important lesson is to always verify the actual rental income that is being collected.
It’s so interesting as I review new deals that the delinquency factor is rarely listed on a broker’s marketing package. They’ll have vacancies, of course, and maybe concessions and loss to lease. But very rarely do I see the line item called “bad debt”. That’s a fancy phrase for “uncollected rent”. Very often, this number can be significant.
- Ask for the delinquency number up front and make sure you add some amount of bad debt to your underwriting; and then, most importantly,
- Verify the actual rental deposits during due diligence.
Otherwise, you might get a very unpleasant surprise once you own the building.
What are some big mistakes you made (or almost make)?
Be sure to leave your comments below!