Thank you for your patience as I ventured off-course to discuss employment considerations last week. Now, back to the real estate investing series! This blog will cover our third property, which has proven to be quite the challenge. I’ll talk the good, the bad, and the ugly of this deal and share some valuable lessons learned to date.
At least he's fashionable... pretty ugly?
What’s The Deal?
For context, we were several months removed from closing on our last deal, and everything was going great with both properties. Our duplex was rented long-term on one side and well-booked with short-terms on the other side. The quadplex was fully rented, and we had turned over (new tenants) three of four units, with all four having rent increases back up to market. In good standing on both existing properties, I began searching for the next deal. Given the last deal was more straight forward, we had some capacity to take on a more “unique” deal. Enter property #3.
This 5-unit residence was special in many ways – positive and negative. On the positive side, the location is outstanding: just two blocks from the downtown of a tourist city, with great views of the mountains and foothills. The town is essentially a pass carved out of the foothills of the Rockies, and with limited land to build on, properties naturally appreciate with limited supply and consistent demand. Additionally, the property itself offered the opportunity for value-add. The units could be improved to drive higher rents, and empty spots on the lot could be utilized for adding an ADU (accessory dwelling unit).
Now, for the negatives. The property is older, and while in good condition, it lacked some of the modern conveniences and functionality you expect in a residence. While there were two parking spots on the lot, street parking was tricky. Depending on the day and time, it is hard to find a parking spot adjacent to the building. For example, during our inspection, I had to park about two blocks away as it was a Friday during tourist season. The fifth unit was added on in the 1960’s, and was built under the porch (the house is built on a sloped lot). If it sounds small, you’re not wrong: 180 square feet! Finally, the rents were lower than expected, but rent growth would be somewhat limited. As it’s more of a tourist town, most of the employment is service or retail, so keeping occupancy high requires rents to stay at or below market.
Making It Work
This property had been on the market for several months at this point; in fact, I had looked at it several months prior when I found our second property. The seller had dropped the price significantly, as it was overpriced even in a hot market. Since our broker had brought this one to me, I thought it only fair to work with him instead of the seller’s broker (which is traditionally done in multi-unit/commercial deals) - and since it was his listing previously, I figured he would have additional insights on the property that the listing broker wouldn’t be able (or willing) to disclose.
We came in with a very aggressive offer – which the seller accepted! However, we wrote it with 30% cash down and 70% financed elsewhere, and we didn’t get into selling financing. Now that we were under contract at a good price, we went back and asked about seller financing. He was open to the idea... however, he wanted to change the price. After some negotiation, we found a mutually-beneficial deal where we would purchase at the latest list price, put 20% down, and he would finance the remaining 80% over seven years. The first two would be interest only, and the last five would be principal and interest @ 30-year amortization schedule. At seven years, we would have a balloon payment (paying off the remaining balance), where we would either need to refinance through a lender, sell the property, or maybe hit the lottery and pay cash? Regardless, these terms worked out better for both parties – our ROI improved over loan terms we found on the open market (seller offered 6% while market was 7+%). Additionally, the interest-only payments for the first two years is really helpful in getting the property up to speed on rents, renovations, and other considerations when taking on a new property. This certainly came in handy after we closed...
Lessons Learned
Once we closed, we started encountering some issues that needed to be addressed. About a month after closing, our tenants reported some leaking valves in the bathrooms. Given the location, this meant replacing flooring just to access the valves... for a few thousand dollars! Yikes. Adding insult to injury, we had occupancy concerns as well. After not renewing a lease on the second unit with a difficult tenant, we found out a “lease” for the fifth unit under the deck was nothing more than paper. The tenant had moved some items in, but never paid and wasn’t even occupying the unit! Our property manager got the items out and had the tenant evicted, but we now sat at 60% occupancy. While I tend to underwrite conservatively for occupancy (I use 90% vs. a standard 94% for our market), losing out on two rent checks means losing money each month. The interest-only payments helped reduce the blow, but we still weren't profitable overall. We are now two months in, with two vacant units. If you are looking to move to Colorado, let me know: I have a place for you to stay!
So what lessons did we learn on this deal? Well, let’s start with pesky lease situation. While you typically receive rent roll as part of your due diligence, you can also ask for deposit verification where the seller shows proof that the tenants have been paying their rent. While this may not sway you from not buying, it’s good to know so you either negotiate the deal or at least underwrite it most conservatively. Knowing the tenant wasn't playing would have probably led us to keep that difficult tenant. I mean, what's a property manager for if not to deal with those special folks! Secondly, and more broadly, listen to your gut. While under contract, we had some concerns about the property – the roof and steps came up on the inspection report, and we were struggling to get insured as a result. We were ready to walk away from the deal, but the seller offered to pay in full for the roof replacement and steps and our broker was able to work with our insurer to agree to coverage.
This brought us back to the table – and we ended up closing as planned. This gut feeling may have been a precursor for the challenges we would face, and we are certainly not turning a profit today. That said, I don’t regret doing this deal. Is it going as well as our first two properties? Absolutely not. We are still relatively new to investing, and not every deal will be perfect off the bat. Because we have been conservative with our financing and remain mostly unleveraged, we have enough capital on the sidelines to support down months; in fact, our other two properties are easily offsetting any losses on the third. Meanwhile, we continue building equity via appreciation as well as the tax advantages of depreciation. And I'm confident we will get tenants soon and turn a profit in the coming months.
Well folks, that’s all we own to date. We will buy more in the future, but now you know our portfolio – the good, bad and ugly! Until we get another one under our belt, I will continue to write about real estate investing. I have several topics in mind, but if you have a specific question you’d like to ask, please feel free to message me. Have a great week and for my American friends, have a great Thanksgiving!