What to do with existing tenants in new purchase?

Question

Hello,

I am in the process of learning about real estate investing and being a landlord. I have identified a 10 unit complex that could be remodeled and rented out for a higher price. This would be necessary in order to make the place cashflow for me in the neighborhood. My question is, how do I deal with the existing tenants? I would need to remodel all 10 units and the exterior of the building so it is likely I would not be able to have tenants for that period. And after the remodel, it is likely the rent will be higher than they are willing to pay. I am fully prepared to find new tenants, but what is the process for turning tenants over like this? Do I just wait for existing leases to finish and then raise the rent or do I just refuse to renew their leases? Is there a process that the buyer and seller of the property can work through in regards to the existing tenants? Thank you in advance for the help.

Christopher Costa

Jack P. · Answer

You have a few options.  First, understand that you must honor the existing leases until they expire.  However, if both parties agree, you could have the option of buying the tenant out of their lease.  Otherwise, the tenant has the right to stay put for the term of the lease.

If I were in your situation, here's what I would do:

-Prioritize the units that I want to rehab, and tenants I want to replace.  I would let the lease expire on those units, and give the tenants the requisite notice to vacate (usually 60 days) at the end of their lease.

-Let natural turnover occur in the other units.

-As the units become vacant, either through not renewing the lease, or the tenant leaving on their own accord, I would rehab the units one at a time.

-Do the exterior work with the tenants in place, but potentially offer them a discount on their rent for that period if you want to keep those tenants.  If you want them gone, then don't worry about the discount.  I've replaced roofs, AC units, and other moderate repairs on the exterior of the building with existing tenants.  Generally speaking, they're slightly annoyed with the construction, but appreciate the fresh new look even more.

The above allows you to continue to collect rent through the rehab process.  Most likely on a 10-unit, you're going to have a small-scale general contractor do the work, and they wouldn't be able to do more than one unit at a time.  So vacating the whole building before work began would just mean a preventable loss in income.  Unless you're doing a "to the bones" rehab on the whole building, then it isn't necessary to have an empty complex.

Remember that generally speaking, you're going to profit more by leaving the existing tenants in place for as long as possible.  The difference in rent you make from the rehab will take several years to recoup your investment.  That's why I subscribe to the philosophy of not creating artificial vacancy, and will ride a tenant in a distressed unit for as long as possible, because as soon as they leave, I'll have to spend $10-20k to get the unit in rentable condition again.

Andrew B. · Answer

Great post that covers everything. Only thing I may add, when leases come up for renewal, you can offer a new lease at market rate on any unit you intend to rehab. If they stay, you get market and save your rehab cost for later. If they leave, you planned on rehabbing anyway. of course, this assumes you are only rehabbing cosmetic items.

Christopher Costa · Answer

@Jack P. This is very helpful. I planned to talk to a few HVAC specialists, but you've given me a lot more to think about in regards to that. Thank you very much. I will try to work with companies to guarantee all 10 units over the course of the individual remodels. I appreciate all the help.

Jack P. · Answer

You probably want to talk to an HVAC specialist to explore your options, but since each unit and HVAC will be independent, it shouldn't matter whether you do them all at once, or independently...at least for the duct work.  It should be 10 individual units, not a central system for the whole building.  If it's centralized throughout the building, you'll be on the hood for the cooling bill...something I'd steer clear of.  Get bids and proposals from several HVAC firms...you may be surprised at what they come up with.

The HVAC guys will have a setup cost, and may offer you a discount if you do multiple units at the same time.  However, if you're working with a specific vendor, you can probably explain the situation and work in an arranged deal where you guarantee them all 10 units in exchange for the bulk price.

That being said, I'd really do my homework regarding the cost/benefit analysis on installing central air on every unit, especially with regard to comps in the area.  I also recommend exploring options such as mini-split/ductless a/c.

Christopher Costa · Answer

@Jack P. and @Ned Carey

Thank you both for the responses. I appreciate the input. I understand I have to uphold and honor existing leases. My plan was similar to what you both proposed and to let existing leases go to term and then not renew. The building is distressed and old but in a very profitable and highly valued area of my city. With the $10-20k/unit, as you mentioned, I could likely triple or more the appraised value of the complex. My other problem I see is that one of the biggest renovations would be putting in central heating and air. Currently all units have window AC units. I imagine, and correct me if Im wrong, that adding air ducts and HVAC to all units would be easier all together. Some walls would likely need to come down or opened up to put it in. This is the largest single expense for the renovation, likely costing more than a single unit renovation. I also could see a problem with attracting tenants if the whole place isn't brought up to the standard of the rest of the neighborhood. I suppose if I could do cosmetic repairs to the exterior and fix up specific units, I could get past this though. Thank you for your responses. They were very helpful.

Christopher Costa

Ned Carey · Answer

@Christopher Costa Jack gave you a great answer. I will re-emphasize you must honor any existing leases, unless you and the tenant can agree otherwise.

Many investors have underestimated the cost of carrying a building while doing what you want to do. Often the income goes down while you upgrade the tenants and property.

@Jack P. wrote

While this is a legitimate philosophy, it does not take into account the increase in value of the asset due to renovating and raising rents. It is a common strategy to renovate, raise rents, then refinance due to the greater value of the property.

What to do with existing tenants in new purchase?

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