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The Biggest Mistake I Almost Made Buying an Apartment Building (And What You Can Learn From It)

by Michael Blank on August 4, 2014 · 18 comments

  
Mistakes to look for in buying apartment buildings.

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.

Related: The Surprising Truth Behind Tenant Turnover

For me, the building was now only worth HALF of what I had it under contract for. I proposed three options to the seller:

  1. Drop the contract price by half;
  2. 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
  3. 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.

Related: 5 Things To Do When Your Tenants Can’t Pay

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.

Lessons Learned:

  1. Ask for the delinquency number up front and make sure you add some amount of bad debt to your underwriting; and then, most importantly,
  2. 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! 

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{ 18 comments… read them below or add one }

Dennis August 4, 2014 at 6:41 am

I can bet that building is a millstone around the sellers neck. I might have tried to take the place over on a master lease at 99% owner financing at closing after the place was straightened out.

The offer of half just blows the entire deal.

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Michael Blank August 4, 2014 at 6:53 am

I don’t think the seller was capable of straightening out the place. I thought I’d throw the idea of an escrow account out there, and it worked. Otherwise I would have been happy to walk!

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Lutonya August 4, 2014 at 7:59 am

Great Article
I’m learning so much!
Thank you Michael. :)

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Michael Blank August 4, 2014 at 8:51 am

My pleasure …!

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Denis C. Monahan August 4, 2014 at 8:08 am

Also consider getting “tenant estoppel letter” from each tenant where the tenant verifies the terms and conditions of their lease – amount of rent, any amount owed, the security deposit or lack thereof, that there are or are not any repair issues, etc. This not only verifies the information but can prevent the tenant from claiming a different position later on. It sounds like a lot of work but it’s better to do the work before you buy than after.

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Michael Blank August 4, 2014 at 8:52 am

I considered that, but the seller did NOT want the tenants to know that she was selling the building. I could have just ignored it and proceeded anyway, or what is your opinion on this?

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Antonio Coleman August 4, 2014 at 11:42 am

Michael I guess this is a lesson learn, but in this business there is no replaces experience. Sometimes we have to go out and fall flate on our face to know how to handle deals in the future.

Thanks for sharing this because you may just saved someone from making a bad deal.

Antonio Coleman “Signing Off”

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Michael Blank August 4, 2014 at 12:21 pm

You can’t avoid mistakes but you can minimize them by educating yourself. But at one point you just gotta “do it”, the best you can, learn from your mistakes, and continually get better.

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Alan Malicse August 4, 2014 at 1:24 pm

Always enjoy your articles Michael! Thank you for posting!

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Rachel August 4, 2014 at 1:48 pm

Great article, definitely haven’t heard this situation thrown around to often but I feel armed and ready to handle it and/or look out for it in the future. So with option #3 it went into escrow out of her own pocket??

Thanks!
Rachel

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Michael Blank August 4, 2014 at 3:41 pm

Yes, her escrow account paid for the delinquency and gave us time to get the tenant out of the building.

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Eric August 4, 2014 at 3:58 pm

That is actually a perfect scenario. A under-managed building. As long as you get the great discount.

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Kimberly H. August 4, 2014 at 5:03 pm

Good to know, thanks for posting! I am surprised the seller had all that money to put into an escrow account!

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Jordan August 5, 2014 at 2:57 pm

This was a great article and It helps you to put things into perspective . Thanks for your insight will defiantly look out for this when purchasing an apartment building.

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Mehran Kamari August 7, 2014 at 10:01 am

Thanks so much for this Michael. Articles like this help people like me avoid nightmares, thus making our journey that much simpler :)

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Michael Blank August 7, 2014 at 11:29 am

Cool, hopefully it’ll come in handy one day -;)

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Raj August 7, 2014 at 2:56 pm

Great Article Due diligence very important to look at all aspects great lesson I will keep that in mind anytime in future of multifamily deal. Thank You so much

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Steve Pohlit August 29, 2014 at 6:11 am

Very valuable Michael because it is an actual case study with summary action steps. Verifying the deposits is very sound advice. If anyone does not do that they are nuts. There is an eviction specialist in my market. The number one thing I learned from him is that if you have a very good lease and follow the procedures exactly, eviction is not difficult or time consuming. If I were buying a rental property with tenants already there, I would use his lease form and have everyone resign their leases as a condition of closing.

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