This is my story about how I bought a 12-unit apartment building with money raised from private individuals.
This deal closed against all odds and then nearly bankrupted me.
Don’t make the same mistakes I did and learn how to raise money to buy your first apartment building.
Finding the Property
One day in March 2011 an email came in from real estate investor friend (we’ll call him “Frank”) who learned of a 12-unit apartment building in NE Washington DC. Even though I get the vast majority of deals through my brokers, every once in a while there’s an exception 🙂
My investor friend positioned the deal as a rehab flip (i.e. buying it, fixing it up, and selling it for a profit), which is what I also do occasionally.
Another investor he knew (“Richard”) had it under contract. The seller was asking $500,000. Frank had a marketing agreement in place with Richard that if he referred a buyer, he would be paid a marketing fee (nice, huh?).
I ran the sample rent roll he sent me through my deal analyzer software and quickly realized that there might be an opportunity. The deal itself worked OK, but my gut was telling me that $500 for a 1-bedroom, even in NE WashingtonDC, seemed low. I confirmed this with some quick rent comps on rentometer.com. I then asked Frank for an introduction to Richard, who was looking to assign the contract to an ultimate buyer (maybe me?) for a fee.
After speaking with Richard, I still liked the deal, but there were issues with the building (there always are, aren’t there?) It had been listed at $650,000 and had been on the market for over a year. Even though buildings like this are selling for around $900,000, the rents are so under market that buyers couldn’t justify a higher price.
The seller was a widow who was slowly selling her deceased husband’s assets, including this building. She was motivated, but not super-motivated. My sense was that the purchase price would be at fair market value based on the financials on the building, but that this might be a value-play opportunity. I felt that if the rents could be increased from $500 per unit to $750, we could add significant value over time.
I decided to proceed, and we agreed on these terms:
- Purchase price $450,000 (plus the marketing fee payable to Richard and Frank)
- $4,000 down payment
- 20 day contingency for feasibility study
- Seller has 7 days to submit documents, and I have 7 days to review
- We have a 45-day appraisal & financing contingency
The seller signed the purchase contract and addendum – we were ratified. My heart was pounding! My first apartment building!
The Long Road to Closing
My exhilaration was quickly tempered after the closing attorney asked me a few questions like, “Have the tenants waived their TOPA rights, or have they expired?” and “Can you provide me with current rent registration form?”
I knew the building was under rent control, but I wasn’t aware of the details. Every year, the owner has to register the current rents with the city. The last time the current owner did this was 2005, so there was a compliance issue that needed to be resolved.
In addition, selling a building in D.C. is more challenging than many other parts of the country because of its Tenant Opportunity to Purchase Act (TOPA). This gives the building’s tenants the right to organize and to purchase the building. This rarely happens, but it complicates and oftentimes delays or even prevents a sale.
It turns out the tenants had decided to exercise their rights to purchase the building, and the seller was working with them on this process, which can take 6-9 months to play out.
I realized that these two issues would take longer than the 20 day contingency period we had put in the original contract. So I fixed this by having the seller sign another addendum that reset the due diligence period until these issues were taken care.
At this point, I was in a holding pattern. I checked with the listing agent once per week to get an update. It took seven weeks to satisfy those two contingencies.
I was a bit surprised that the TOPA matter was addressed so quickly. I learned later that she agreed to pay the tenants an agreeable amount at closing if they would waive their rights to purchase their building vs. letting the rights expire. Wow.
Now that these two issues were taken care of, I had to spring into action and start my due diligence. I only had 20 days to move forward or cancel the contract.
I wrote the owner a letter requesting all kinds of documents. She took a long while to respond, and then the documents I got were incomplete. Not a problem! My 20 days wouldn’t start until I got all documents from her.
Eventually I got the documents I felt I needed, including her bank statements. I wanted to verify that she’s actually depositing the rents she claimed she was getting. It turns out she was only collecting half of the rents!
This was completely unacceptable! The value of the property is based on the income of the building, and her income suddenly was only half of what was advertised.
I told the listing agent that we could not proceed with the contract as it was, and I gave him three options:
- We terminate the contract;
- We add a contingency to give the seller time to collect 100% of the rents for three consecutive months; or
- She could guarantee the rents for a year.
The seller insisted that the tenants would all pay. As far as I was concerned, this deal was dead. Too bad because I had spent countless hours on this deal already.
Three weeks later, the agent called me back and said the seller was going to guarantee the rents. Really? OK, that would work.
We revived the deal with yet another addendum that spelled out the terms of this rent guarantee: whenever I don’t collect rent from one of her tenants, I could collect the difference from the escrow account.
All contingencies were satisfied (except for the financing contingency), and we agreed to close within 45 days.
This deal came back from the dead, and now we were moving forward again!
My lender’s appraisal and their property inspections were fine and we were scheduled to close in 14 days, pending final underwriting review. This is normally a formality, but in this case, the bank’s loan committee inexplicably decided they didn’t want to do the loan. The lame explanation was that the loan committee changed their mind about the location and were no longer comfortable with proceeding.
Really? 14 days before closing?
This is where my previous networking with loan brokers came in handy. I called up another broker I had spoken to about this deal. Initially, the term sheet from the lender he was representing was not quite as attractive. However, they jumped at the deal and said they would close within five weeks.
I explained the situation to the listing agent and exercised my option to extend for an extra 30 days by paying an additional deposit.
The new lender took care of business and we closed four weeks later.
Five months after we were under contract.
How I used Private Money to Finance the Purchase
From the very start, I wanted to use money from private individuals to purchase this building. I want to give you some background on how this was possible.
For several years, I have been renovating houses, fixing them up and reselling them for a profit. I raised the money with a $25,000 minimum from friends and family and paid them 12% to 15% simple interest, guaranteed by the house. The title companies took care of the promissory note and recording the deed, and it was simple to do.
People like and trust real estate, the returns were good and the perceived risk was low. It was surprisingly easy to get friends and family to invest for these reasons.
As I was eyeing commercial real estate, I polled my existing investors to see which ones were interested in buy and hold commercial real estate and if they could refer me to anyone who they thought might be interested.
I quickly assembled a small group of individuals who were interested. Since I didn’t have a deal at the time, I created an investor package of a fictitious building. Everything about the building was accurate (photos, location, financials, etc), except the purchase price – I adjusted that to achieve the returns I wanted for my investors. In other words, I approached potential investors with a deal package that looked like the real thing.
I said, “I don’t have a deal right now, but when I do, it’ll look substantially like this” and then I’d show them the package.
By the time I got this property under contract, I had already primed my investors. When I sent out the deal overview for this property, my investors responded quickly.
I needed $250,000 in cash for the 25% down payment, closing costs, and repairs.
I try to structure the deal so that the investors achieve a 10% – 15% average annual return over the life of the investment. To achieve this return based on my financial projections for cash flow, loan amortization and resale, I could do a 50/50 split with the investors to achieve a 15% average annual return.
I then paid myself an acquisition fee of several thousand dollars at closing. Based on the number of hours this deal took, none of my investors had an objection.
All of this was disclosed in a Private Placement Memorandum and LLC Operating Agreement that was drafted by an SEC attorney. This is expensive, but it’s worth it. It not only protects you but also spells out to the investors the terms of the deal, how profits are split, how decisions are made, and what the potential risks are.
I felt mighty proud of myself for closing this deal, even against all odds. But the fun was only just beginning.
The First Year – A Nightmare
This is the story of “Paul”, one of our tenants, and how he nearly bankrupted us.
Paul is a good guy, I suppose his heart was in the right place. He wanted to make sure everybody, including me and the District of Columbia was doing their job.
He repeatedly sued me for alleged housing code violations. I was in court every six weeks. This was his way of communicating with us, and we responded by addressing every issue we reasonably could.
In the first six months of this, my property manager and attorney were handling all of these cases. I thought this was the way you do things.
Until I got his $3,500 bill after three months of activity!
I realized that if this went on for a year or longer, the legal fees alone would exhaust our capital reserves.
I had an urgent meeting with the attorney and asked him about the sustainability of this plan. He then admitted that for most of these hearings, I did not need legal representation but could represent the LLC myself.
Really? Now you tell me? Well … I guess I never asked either.
I quickly replaced the attorney with one who billed promptly and provided fixed-cost pricing for most eviction-related issues.
I also started going to court myself.
Not a very pleasant experience, but I started getting used to it. We were systematically working through the issues.
In addition to making the court system work, Paul also contacted other governmental compliance agencies, such as the DCRA, which issues construction permits and enforces violations. He would call them daily, reporting construction activities. An inspector would promptly inspect the property and find something awry that needed to be written up.
Because of the high visibility of this building within the agency, the DCRA was enforcing the letter of the law, which in D.C. requires you to have a permit for EVERYTHING you touch with a hammer or screw driver. These permits are expensive, and they can only be pulled by licensed contractors (in other words, I could not do it myself). Due partly to my own ignorance related to “how to do things right” in the city and the heightened level of enforcement, I had to pay thousands of dollars in permits and fines.
Then Paul called the EPA regarding alleged lead paint violations, and of course, an inspector arrived the next day, asking for a lead paint inspection from a licensed professional. Two thousand dollars later, we knew we were lead free in all of the units. But there was lead paint on the railings in the hallways.
You can either be “lead safe” or “lead-free”. To be lead safe, each time a tenant moves in, you have to certify that the unit is lead safe and you have to disclose any lead paint that is known to be in the building. This costs about $250 per unit.
We decided instead to become “lead-free”, which required that we cover the railings with drywall. Our 3rd party lead paint inspector then came back and certified the building as lead free. Another several thousand dollars later, I now have a lead-free building.
A Life Lesson in the Middle of the Storm
As these events unfolded, I grew more and more anxious. My primary concern was running out of money. If we ran out of money, I would have to go back to the investors, tell them that their capital reserve money that was slated for renovations was exhausted, and that they needed to put in more money. Failing that, I would lose the building in bankruptcy and never raise money again.
Not the best start to my commercial real estate investing career.
With each certified letter containing violations or a summons to appear in court, my despair grew. I had trouble sleeping, I was tense. A paralyzing fear was starting to overwhelm me.
In situations like these, my wife is a rock. She can always put things in perspective and offer support that can lift me up. She has tremendous faith. She reminded me that God loves me no matter what happens, that God is good, and that He only wants good things for me. Maybe, she suggested, I’m going through this for a reason. Maybe I am supposed to learn something.
I thought about this for several days and asked myself the question, “what am I supposed to learn?” After much reflection, I felt that my lesson was to be at peace no matter the circumstance. And I slowly started to believe it.
However, it took about a week to set in. But when it did, the sense of peace I felt was inexplicable yet tangible. My body relaxed, and I was able to sleep again – despite the fact that I was scheduled next week for yet another hearing at the Superior Court in WashingtonDC.
A Sudden Change of Heart
At this hearing an odd thing happened.
Because we had been in court so often, the judge wanted to meet in a less formal setting to work through the issues. In attendance were myself, my property manager, the judge, and Paul.
As I sat there silently while the other three discussed the outstanding violations, Paul turned to me and said, “I’d like to talk to Mr. Blank a bit” and then he leaned over the table to extend his hand. As I took his hand, I stammered something like, “OK, that would be great”. The judge and my property manager excused themselves, and suddenly I was alone with Paul.
Some time ago, I made several attempts to communicate with Paul. Once through a 3rd party, and the other time myself. Both attempts went no where.
I was shocked at what was happening.
I don’t exactly remember what we talked about those in the next 5 minutes. I just remember that we agreed to grab a cup of coffee afterwards.
We called the judge back in, and she asked him how he’d like to proceed. He said he would like to dismiss all charges. My property manager looked at me with big eyes as if to say “what did you guys talk about while we were outside?”
As if in a daze, I found myself sitting with Paul, sipping on a coffee in the court house café downstairs and engrossed in a conversation as if we were long lost friends.
He was sharing about his life, and so was I – more, probably, than our common sense should have allowed given our adversarial history.
At one point he turned to me and said, “you don’t have to worry about me any more.” We exchanged contact information and agreed to stay in touch.
He withdrew all outstanding complaints and stopped calling the agencies.
I am open to the possibility of miracles. The miracle of child birth, the mystery of human consciousness, or a series of coincidences. Miracles happen all around us, if we’re open to seeing them.
This development with Paul was so inexplicable that perhaps it was some kind of miracle, too. I also concluded that perhaps the circumstance changed because I had learned the lesson I was supposed to have learned. If you master a lesson, will a situation always improve? No, probably not. But I think I was rewarded in this case with a sudden change of heart that I could not take any credit for.
The Long Road to Stability
A year had gone by since we bought the building, and it had been a roller coaster ride – but not one of those fun ones, one of those terrifying ones you want to get out but can’t.
I had spent thousands of dollars more than expected. My business plan was out the window – I had missed my annual projections by a mile. I felt my credibility with my investors was shot. However, they have been very patient with me, for which I am grateful. The key to investor relations is communication, especially when things aren’t going right. This goes a long way with maintaining their trust.
I have learned a valuable life lesson, which is to be at peace regardless of the circumstance. It is a lesson that I am still working on.
And … I have the most compliant building in the District of Columbia.
Two years after closing, we are 100% occupied and collecting all of the rent most of the time. We have been able to raise the rents in several of the units. We have the cash flow to quickly respond to repairs and make some cosmetic improvements. And we have a good relationship with our tenants.
For me, the key to achieving success as an entrepreneur is a mix of ambition, guts, persistence, discipline, and faith. This property required a strong dose of all of these.