Takeaways From a Recent Deal Offer

[Vessi Kapoulian]

Herewith I am sharing experience from a recent deal and hope people find at least one valuable take away.

Property: 3B/2B/1G duplex in Eustis, FL (2,452sqft). Listing noted both units are rented month to month at $1,350/mo each, which was on the lower end of the market.

What I liked: (i) Location (nice B+ suburban area, close to the Villages and Orlando, 65%-35% own to rent ratio; that particular pocket had low to no crime and no registered sex offenders vs. other parts of town), (ii) Product type (3B/2B duplex with a garage, which is rare to find and is ideal for both a small family or a single professional with or without roommates; most duplexes on the market have no garage at all and are 1B/1B, 2B/1B, or 2B/2B), (iii) Age (2006, i.e. while it was on the higher end of my age spectrum it was less than 20 yrs old), and (iv) Upside potential - opportunity to bring rents closer to market post close (tenants were on month to month leases) and forced appreciation by performing minor refresh with some deferred maintenance expected due to age (roof, HVAC, heater).

The Numbers:

Asking price of $330K and ultimate contract price of $320K.

Bringing rents up to $1,500/mo and updating (over time) the property ($25K estimated), and assuming 10% vacancy reserve, 5% capex reserve, 7.5% other maintenance expenses, 10% property mgmt. fee, and $1,920 annual insurance premium, resulted in proforma annual NOI of ~$18K or ~$500/mo cash flow after debt service, 1.50x DS, 5% COC, 5% ROI and conservatively assuming no further upside on rent and no equity appreciation - a 20yr payback (or less).

Challenges: There were a few red flags that ultimately caused me to walk away from the property.

One of my diligence items requested (among other items such as the standard copy of leases and rent roll) included written reps and warranties from the seller re bad debt and past dues, side agreements with the tenants, and tenant executed estoppels. Those were due within 3 days of contract execution and my earnest money was due within 5 days. Seller provided response via e-mail affirming no bad debt/past dues and no past dues were present. Rent roll and copy of deposit proofs was outstanding.

The leases revealed that one of the units was rented at $1,100 (vs. the advertised $1,350). (red flag #1)

My agent inquired about visiting the property (after signed contract) and was told that if he wanted to see the units, he would need to wait to Monday (contract was signed on Thursday) as tenants require a 48 hour notice. It was not ideal but we agreed to wait 3 days. When he arrived on Monday, he was not let into the second unit (red flag #2). Visual observation was otherwise positive – the one unit he could see, seemed in ok condition, no obvious damage or other major structural issues, area was up and coming C+ next to a B neighborhood, a park and school were within walking distance.

Soon after, after some probing re the lower $1,100 lease (the unit which my agent was not allowed to enter), the seller’s agent noted that unit’s tenant is Section 8 and that a new one year lease for $1,350/mo was just executed as “the seller thought that would be better for me”. The updated lease and housing authority documents were provided to us. In reviewing the documents, it turned out that the housing authority documents were executed a month prior (i.e. not “just executed” as seller had represented). I was not happy, as not only this would lock me in a lease at the lowest end of the market for an entire year, but also (and most importantly), it should have been disclosed upfront (vs. affirming no side or other agreements with tenant were present) (red flag #3). The seller’s agent verbally represented to my agent they had a good relationship with the tenant and if I did not like the 1yr lease, they could move the tenant to another property of theirs without a problem. We decided to request that in writing.

And so I proceeded with the inspection. Unfortunately the inspection revealed that the other unit (Section 8) was in a much worse condition and would also need smoke remediation (tenant was a smoker and had two other individuals living in the unit, which was a violation of the lease, and the landlord had done nothing about it). When we consulted with a third party contractor and building in some cushion, estimated repairs came down to $40K (vs. the original estimate of $25K).

I presented a counteroffer asking for: (i) follow up the outstanding written reps noted above, (ii) written affirmation from seller that they can deliver a vacant unit at close (as they had verbally represented), and (iii) $40K off the asking price.

All of a sudden the seller came back noting the recently executed lease was “deemed invalid” and that the tenant is now on a month to month lease and can vacate the property upon a 30-day written notice. There was no mention of them moving the tenant to another property any more and all this contradicted with the housing authority documents executed a month back, which appeared valid (red flag #4). They also agreed to reduce the price by only $10K.

Conclusion: Ultimately I walked away from the deal, given the lack of transparency and red flags that the inconsistent statements from the seller raised for me. Whether or not that was the case, it left me thinking they are trying to hide something. The larger than expected rehab was also a concern (though if the tenant and lack of transparency issue was not there and if the seller had agreed to reduce the purchase price by $20K out of the $40K requested, I would have accepted). I also do not have familiarity with managing Section 8 tenants and in reading the lease, assuming it was valid, contrary to the seller’s statement, I did not see a provision where the tenant could be moved to a different property or asked to leave the property. I’d assume Section 8 concurrence would also be required to move the tenant and I’d assume a move would require the housing authority to inspect the property the tenant is moving into, which could take more than 30 days. I was not willing to further discover what that would entail and how much more that would cost.

My sunk costs included: (i) $515 for the inspection (which is not a small sum to me) and (ii) small impact on my credit score (as I had started the loan process and naturally my lender had to run a credit check). Nevertheless, I thought it’d be better to walk away before it is too late and I incur other diligence costs or even worse - a problematic tenant with a property that requires a lot more deferred maintenance than initially anticipated (and possible Section 8 code violations).

Thankfully, my agent and I paid close attention to the due diligence deadlines and were able to cancel the contract within the diligence period and I received my full earnest money back (though it was odd that the title company did not wire the money back and instead mailed a check, which delayed receipt of my money back by a week).

It was beneficial that I work with a full service property manager, who also acted as my RE broker for the deal. They were just as vested in making sure the property, tenant, numbers work as they’d be managing it for me (and down the road selling the property).

Takeaways:

1. Upfront diligence. Inquire about the tenants upfront, even before submitting a contract. Sellers may not disclose anything regardless but you lose nothing by asking.

2. Be disciplined about: (i) receiving the requested written affirmations in an acceptable format (vs. e-mail) – I do not know if that would have resulted in a different outcome for this particular deal, if the seller’s intention was to hide information anyway; however, I’d think that having people put that in a different legally enforceable format would carry more weight, (ii) being provided with access to the full property within 48 hours – we would have discovered the smoke issue, the additional tenants occupying the property, and the larger than expected rehab needs earlier, and (iii) taking the full diligence period available (vs. providing a shorter window to be competitive) – this created a lot of pressure as the seller was stalling and only after we ultimately submitted a counteroffer a day before our diligence expired, they responded.

3. Insurance takeaways. I also learned that insurance premiums for older properties in FL can be steep. My estimate of $75/unit/mo was quite close to the $80/unit/mo that my insurance broker quoted. However, they found only one insurance company (B++ rated) willing to insure the property and noted that would require a detailed inspection (leaving me anxious that they may drop coverage post close if for any reason my property does not pass inspection). I thought initially that the higher monthly premium was due to the older roof (15 years). However, the broker noted that replacing the roof would not reduce my premium at all and that a driving factor for the quote was the overall property age. As a reference I pay $40/mo provided by an A-rated carrier for a new 2021 construction SFR.

4. Choose a good team you can trust. In my particular case, my agent/property manager had my back. The inspector I used was very detailed and was able to respond quickly (due to relationship with my PM). My agent also had connections with a reliable contractor who was able to provide estimates on a sort notice. This helped me avoid more issues down the road.

5. Stay the course. Only time and going through the actual deal could tell what would have transpired. However, in this case, the red flags caused me to put the character of the seller into question and to walk away from the deal even though the numbers, location, and product type all had initially checked out on paper. Being disciplined about my criteria and following deadlines helped me get away with a sunk cost of $515. Had I not done the inspection (waiving appraisal and inspection contingencies is not uncommon in this hot market), I would not have uncovered the other issues.