Buying from Mom and Pop Sellers

One of the easiest ways to improve net operating income (NOI) of a multifamily asset is to operate a property at peak efficiency. This entails keeping expenses low, and income high. When looking to buy a property many purchasers will look for properties that are falling short of these two goals, either by running the property inefficiently, or charging below market rents. In this Wren Davis chronicle we will walk our readers through an acquisition from a seller who was a “mom and pop” owner that was not operating an asset at peak efficiency. We’ll give details on the raw numbers of the large upside we were able to realize through professional management, the difficulties we faced during the underwriting period to fully understand the income and expenses, and the steps we took to mitigate these obstacles.

On one of our recent acquisitions we had the ability to work directly with a seller who was looking to sell their asset after twenty years of ownership. This was a true “mom and pop” seller, and for those readers who haven’t heard of this before, it is exactly what it sounds like. The sellers were an elderly couple who had self managed the property since they bought the place, who were looking to sell the asset and move onto retirement. While there are a lot of investors out there who do self manage their properties with great success, from the beginning of the underwriting we saw that this property had expenses that were grossly higher than the average for the area. Additionally, it became clear from initial conversations that accounting and other key metrics that we would need to evaluate the property were not available.

Many investors may automatically turn away from pursuing an acquisition like this, but at Wren Davis Capital we saw an opportunity. So long as we were able to accurately underwrite the property, we could see there was great upside potential. The key was to determine the cause of the gross expenses, and put together a plan of how to fix the problem. In the case of the mom and pop property we quickly began to see that management was playing a key role in almost every single one of these issues.

By the Numbers

Here is a snap shot of the numbers of the property as a percentage of total income for the year:

• Vacancy: 8%

• Bad Debt (economic vacancy): 10%

• Maintenance: 22%

• Capital Expenditures: 43%

Breaking these numbers down, vacancy of 8% was not that far off the average for the area of 5%. However, when taking into account bad debt, which was primarily tenants not paying rent, we see that vacancy and economic vacancy were totaling 18%, which was extremely high for the area. We found our selves asking the questions- Why was this property operating such a high vacancy? Was the property in bad shape? Was it in an area people did not want to live? For each of these questions this was not the case, so we had to keep looking for the cause. An important part of the due diligence process is getting the whole story of the property. As we looked deeper into it we realized that the owners were self managing, and lived three hours away from the property! They conducted all the property tours to prospective tenants themselves and interviewed every applicant. Their physical distance from the property greatly limited their ability to turn units when a vacancy arrived, and at one point we learned they had gone three months without visiting the property.

Maintenance expenses of 22% were also very high for the property compared to the surrounding area, even with the property being an older vintage. As we combed through receipts and bank accounts we began to see a pattern appear. One contractor repeatedly was receiving all the business for repairs at the property. It was clear from the work being carried out that this contractor was over billing for services, and that the owner was not collecting multiple quotes for work. In one instance, their contractor had charged over $250 to change one light bulb!

Moving to Capital Expenditures, it was relatively straight forward to determine that many of these expenses were a result of the owner getting the property ready for sale. The difficulty remained determining how much remaining capital expenses the property would operate at moving forward in light of deferred maintenance. Through physical due diligence and inspection we were able to determine what major systems would need to be replaced in the next five to ten year timeframe, and budget accordingly moving forward. Additionally, we determined that many of the maintenance and capital expenditures would be addressed through interior and exterior renovations that were factored into the business plan.

Other Obstacles

While this may not be a factor in all transitions with “mom and pop” owners, one of the biggest difficulties we ran into was during financial due diligence due to poor record keeping. The seller had failed to maintain adequate records to include monthly rent collection and maintenance expenses. Compounding this issue was the fact that the seller’s business account for the property was commingled with personal funds and expenses. Rent rolls, those that did exist, were hand kept documents that included months missing at a time.

A lot of time was spent focused on resolving these financial inconsistencies in record keeping. The primary focus was to ensure that the rents that were claimed to be collected, were actually collected, and that large maintenance expenses could be accounted for. This entailed conducting spot checks of numerous units throughout the year, having the seller go to the bank to verify deposit checks, as well as reaching out to vendors to acquire statements for work completed. The latter part of this due diligence assisted in determining the scope of deferred maintenance and capital expenses by providing an idea of what work was being completed, and what work was not.

Another issue encountered were leases, which were not up to standard, and in some cases included illegal provisions for the state that we were purchasing in. For this in order to ensure these liability issues did not transfer over to Wren Davis as new owners, lease transition was made a priority once the sale was complete.

Lessons Learned

In each acquisition there are lessons to be learned. While many investors may have passed over this purchase following the initial review of the numbers, putting time and effort into understanding the why can lead to large realized returns. The key is to focus on the numbers and get the full story. In our case, understanding that many of the expense and income issues were attributed to the lack of professional management gave us full confidence that these numbers would be able to be brought within standard for the area with a diligent management team. Additionally, the low NOI allowed us to purchase the property at a price that will allow for great upside. Finally although the lack of record keeping certainly brought difficulties, through working with the seller we were able to verify and uncover the actual expenses and income with a high degree of confidence.

Employing professional management has allowed us to realize great upside on this property, and without rental increases due to below market rents, and value add renovations, we have been able to operate the property at 78% lower expenses than before.