When good deals gone bad, turn out to be the best case scenario
“It ain’t so much the things that people don’t know that makes trouble in this world, as it is the things that people know that ain’t so.” — Mark Twain.
I am always amazed with what people do under the pressure of different situations and circumstances. Never really what you might expect as far as common sense goes, but in their own mind – it makes perfect sense to them at the time.
As a property manager, I have the fiduciary responsibility to be a trustworthy steward for our clients. This goes both for our landlord clients, and, our residential tenants. I run somewhere between the gamut of helping families find homes they can afford making sure they don’t go broke paying rent, to helping some of our newer landlord clients stay within the boundaries of compliance to keep them from ending up in a housing law suit. Sometimes, getting both sides of the equation to sit at the same table to see eye-to-eye can be a challenge to say the least.
On one hand, we may need to have the painful conversation with a rental prospect candidate to gently explain to them why they do not qualify based upon their income for the property they want to rent. On the flip side, we have all too many conversations with new landlords with the best of intentions that may want to do something that just goes against the grain of what is allowed by building and sanitary code. Then, somewhere in the middle of the discussion, lies the voice of reason and compromise to foster a win-win-win situation for all parties.
It’s not easy, but it’s totally worth it!
What’s The Big Deal?
Whether you are a seasoned Real Estate professional with scores of closings under your belt, or just venturing into the world of passive Real Estate income investing for the first time – we all have had to pull the trigger on that first deal. I empathize with first-time Real Estate investors and what they are going through on their first purchase of income producing property. The emotional rollercoaster of “what if?” scenarios stops so many would be investors dead in their tracks with the investor-ending dear in the headlights gaze of analysis paralysis.
Pulling the trigger on that first deal can be a killer to a future of financial freedom a new investor has been longing for and has always dreamed of. But getting to the closing table, for some beginning investors is not only “their first deal”, but all of those looming unknowns is a tremendously “BIG DEAL!”
If you have not closed your first investment property yet, I am sure you can relate to the long list of questions and concerns you are having even trying to figure out of the property you have invested so much of your time is even worth buying at all. No one wants to put in that much time and effort and walk away empty-handed. So many times, I have heard it said but investors savvier than I, “Sometimes the best deal you do is the one you walk away from”.
For the rest of the investors who have just inked the deed to their first deal yesterday, or even if it was decades ago – we all know what the first-time property investor is going through. We all enter the Dojo wearing a white belt starting from ground zero trying to figure out how to even throw a punch. I truly believe that one acquires a black belt by rolling up your sleeves, getting down to business, and getting your hands dirty doing the deal. There is no book, video, or podcast you can use to learn how to ride a bike. It takes planning, determination, and action. You need to figure out how to balance, steer, and navigate all while pedaling your butt off. You absolutely need to know when to stop and hit the brakes. Yes, it is a lot of work, but to get from point “A” to point “B” it is totally worth it.
All of this leads to a story of a first time investor who found our property management company on Google, liked our reviews, and decided to give us a “spin around the block”. A typical sales call starts with a conversation. Usually about the property, or the client’s investing strategy and goals. We have a Landlord Media Kit we send over to answer most of the questions they may have up front. This saves both us and them a lot of time by reading what we have already produced. We can always tell more about the client by the questions they ask when we first speak. Most new landlords will ask “How much do your services cost?”, instead of “How much are your services going to save me?”.
We received a call from a new client a few weeks ago. For our discussion, let’s call him “Jim”. Jim was interested in a 3-Unit Property in our market and he called to see what we might be able to do for him as a new investor. We talked about the property. We talked about his retirement goals, what were his plans as an investor, and decided to meet at the property during an open house the following day.
That “Really Good Idea” was a “Really Bad Idea”
We met at the 3-Unit Property and started to walk through the beautifully staged units. I always like to start at the top and work my way down for an inspection. No particular reason for that. I just like to be on the ground level when I am finished. And for some reason, I always spend a lot more time in the basement immersed in the infrastructure of the building. To me, the nuts and bolts are what gets sexy and those details you find will really give you a better idea of how the building is put together.
We started on the top floor and observed all of the usual things you might expect in a 100+ year old New England “Triple-Decker”. For those of you not from this region there is a huge amount of inventory stock of three-unit properties with one unit stacked on top of another. These usually have balloon architecture structure, which means little to no insulation in the walls so plumbing and electrical can more easily pass from floor to floor. This also creates issues for fire blocking between properties, but let’s save those details for another story. So we did see some attractive upgrades, and some really puzzling renovation decisions.
To the good, we saw mini-splits which are heating and air conditioning units installed throughout the units. But something we saw that was puzzling when we walked through the top unit was that the kitchen had been totally removed from the property? Why did they do that? This would only be an additional cost for the buyer to reinstall a full kitchen including plumbing, electrical, ventilation, cabinets and countertops. Well, we were soon to find out why they pulled out the kitchen on the third floor.
Apparently, before the current owners purchased the building, the property had been vacant for more than 2 years. There is a little known municipality law regarding vacant buildings. If the property remains vacant for a set period of time then any non-conforming issues that may be present will need to be brought up to code BEFORE the municipalities will grant an occupancy permit for the building. Those old issues that once would have been grandfathered in on transfer of deed, lost their variances from being vacant so long. For this property, this was the case.
The biggest issue, believe it or not, was the parking. You need to have at least 2.5 parking spaces for each rental unit. I know, this is crazy, but it restricted the new owner from obtaining an occupancy permit for a 3-unit building. Let’s just say I did not agree with the choices made to have the property “conform” to existing building code. In hindsight, I would have torn up the front yard to make two more parking spaces. The building had four spaces in a two-lane driveway that could park four automobiles. There was also a 2-stall garage at the top of the driveway, but this did not constitute the six parking spaces needed to allow the property to conform. Again, hindsight is 20/20 and the easy answer was to add two parking spaces. There was plenty of room and they would still have ample room in the front yard. Heck, there would even have been less property maintenance with less lawn to mow. But that was not the chosen path.
The couple that bought the 3-unit (just 2 people) decided they would live in all three units. That’s nine bedrooms when they actually only needed one bedroom to live there comfortably. In essence, they ended up living in an 18-room dwelling. Okay, I like having space to breathe, but 18 rooms? Really?!?
Because and Effect
As you may have guessed. Because the property no longer conformed to being a 3-unit rental property, something had to be done so they could gain the proper occupancy permit from town hall so they could start living in the property they had just closed. So instead of taking the path of least resistance (and the highest profitability), they opted to tear out the kitchen from the third floor apartment. Problem solved, right? Well, yes, for the moment. If they had planned on living there “forever” this would have been their happily ever after. Rainbows and unicorns all day long. But that’s not what happened to our couple.
What did they do to the property? Great question! Their “good ideas” consisted of tearing out a functional kitchen, removing plumbing, closing out electrical boxes, and reconfiguring the kitchen layout. While they were at it, they also decided to replace the furnace and do a ton of electrical work to the property as the proud new home owners. Did I forget to mention they never had their contractors pull the required permits for the “upgrades”? Oh yeah, that small detail. Yup, that’s right. The ONLY permit they pulled for the entire property since they owned it was for the property to conform from a 3-unit dwelling to a 2-unit dwelling.
There were no permits pulled for the demolition, tearing out the kitchen, plumbing or electrical work performed on the premises.
So What’s The Big Deal With That?
They owned the building, they lived there, they did the work, or had it done as the homeowner, and switched the “use” of the property from a legal 3-unit property to a legal 2-unit property. So what? Well, the issue is this. They lived there for a period of time and now have decided to sell. But instead of trying to selling the property as a legal conforming 2-unit, they are promoting the sale as a legal 3-unit. Well, like Ernie and Bert used to sing on Sesame Street, “One of these things is not like the other”. They listed the property as a 3-unit, and oh, by the way – you just need to add a new kitchen.
So let’s look at what they did to the property because the non-conforming issues were not allowed to be grandfathered in.
- Took out the kitchen from the third floor unit switching the property use
- Replaced the furnace as the homeowner (no permits and missing fire blocking)
- Upgraded breaker panels connecting Romex to existing Knob and Tube (no permits)
All this was “kind of okay” if the home owner was planning to stay here and ride the mortgage into the sunset. It is still a legal 2-family. It currently conforms to IBC residential code and all would be fine if the property stays in that space. But time and circumstances have changed.
The couple has found the commute of over 15-hours a week for a 40-hour a week job has been a bit too much to get to enjoy life. I can relate. They reached the decision to sell the property to cash out for as much as they can and relocate across state lines to a home closer to their place of employment. Somewhere in the pipeline, they also decided to market the deal as a 3-family rental property investment. And there is the problem.
To bring the property back to a 3-family rental property, there is a lot of spaghetti on the plate to unravel. Here is a list of the challenges for the new buyer to bring the property back to a legal 3-unit.
- Demo and install a new kitchen on the third floor ($10,000 to $18,000)
- Create the needed additional parking spaces ($2,000 to $3,000)
- Address the furnace install without pulling a permit ($1,500 to $3,000)
- Address the breaker panel installs without pulling a permit ($3,500 to $5,000)
- Address new Romex being connected to the existing knob and tube ($3,500 to $5,000)
- Conform the property up to 2018 IBC Commercial Energy Code ($15,000 to $25,000)
- Install a sprinkler system IBC Commercial Code ($15,000 to $40,000)
- The Building Department IS GOING TO PULL OCCUPANCY upon the transfer of deed
Price tag upon sale to conform back to commercial 3 – unit? ($40,510 to $99,000). Ouch, again! So what is the strategy from here? That’s a good one for sure. The average rehab is in the ballpark of $70,000.
So what would you do? Do you go with the accepted offer on the table and suck up the brain damage with the Building Department and eat the renovation to bring the property into 3 – unit code compliance? Do you renegotiate the price down $70,000 and possibly get a construction loan for the purchase to wrap the rehab into the monthly mortgage payments? Well, it depends. Where is your risk tolerance on this type of deal? For my client looking to invest for cash flow in his retirement, this may not be a good first deal.
On Second Thought…
My suggestion to my client was to mitigate his risk to not get into a high risk position. If this deal turns south then he could potentially lose a lot of his investment to a position with very little cash flow, or even worse, an alligator that he is paying out-of-pocket every month just to keep afloat.
Unfortunately, by this time, my client was becoming “emotionally attached” to the property. He really wanted the deal to work so we came up with a plan. We opted to revise our offer based upon the home inspection report to reduce the price $70,000. We anticipate the seller is going to reject the offer. The strategy is to keep the lower offer on the table as a backup offer. We are hedging that the next buyer is going to uncover the same issues that we uncovered and probably walk on the deal. After two or three buyers completing due diligence, and then walking on the deal – we think that our standing back up offer is going to become a lot more attractive over time.
At the time this post was published, the property is still on the market, there have been some full price offers, and the property has yet to close escrow. It cost my client a few hundred dollars for the home inspector, but could have cost him hundreds of thousands of dollars or even worse, their retirement nest egg. We will see how this deal plays out over the next few weeks and months if anyone pulls the trigger. As the saying goes, “Time changes all buyers and sellers”.
Final Thoughts from the Building Inspector
As I was writing this article I ran into the Building Inspector who had given me the details on this property. I was in Housing Court picking up some forms for the new online Summary Process procedure and had a chance to discuss the property with him one more time.
I had outlined what is mentioned above to see if they could have done anything differently instead of the path they took when this couple (the seller) originally bought the property. Mind you they converted the use from a 3-Unit Commercial into a 2-Unit Residential.
After going through the list of what they did, and what now needed to be done, we determined that all they needed to do to stay in compliance as a 3-Unit Commercial was the following.
To stay as a 3-Unit Commercial:
- Install a much more simple sprinkler system ($14,000)
- Create more parking from the front yard of the property ($2,500)
So had they spent the $16,500 on the property when they bought it, it would still be holding its value as a three family property. They would have probably been collecting rents for the past two years, and would now be able to command the selling price they were looking for as a three family property.
Because they had converted the use of the property to a two family, they were seeing a severe reduction in the offering price from my client to compensate for the $70,000 to restore the property back to its conformed use as a three unit property.
If the owner couple had just spent the $16,500 upfront when they bought the property to keep it as a three unit, they would easily have realized a net return on investment of $53,500. That would have been over a 300% return on the dollar for bringing the property back into compliance as a three unit property!
And they would have been collecting rents on 2 units for market rents of $1,300 a door on a 3 bedroom unit. That sums up to another $2,600 a month, that adds up to $31,200 a year. The two year holding time would generated $62,400.
Roll those cash flows into the ROI comes in at $115,900.
Since the writing of this article, our buyer has placed a backup offer with a number that makes sense. The seller has gone with another buyer that (so far) is going to pay a 3-Family price for a 2-Family property – then, deal with the Building Inspector who is going to put a stop order on the occupancy permit as soon as the property closes.
What’s on Your Mind?
Do you have any other ideas on this topic you could share to help our online community?
Please chime in to share a comment or review. All feedback is welcomed!
Belaire Property Management
Regional Property Manager
(978) 448-0669 office
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