Managing Rental Properties

You’ve finally closed your first deal. What do you do now? Yeah, I didn’t know either. And it nearly caused me to blow my first deal. Then I got serious.   I went pro. On Top of the World During due diligence on my first deal, I decided not to hire the seller’s onsite property manager (PM) after closing. The property started operations with our management company’s transition team. The regional manager (RM) was to hire a new PM. Hiring a PM took months. Numerous candidates turned down the position before one finally accepted. Her background was in affordable housing, not market-rate property like ours. It didn’t sound quite right to me, but the RM believed she could learn the PM role quickly. Anyway, who was I to say? I was a newbie. I still felt like an amateur. The RM was the professional. I deferred to her judgment. Operations started off very well. By the end of the Second Quarter, the property was fully occupied and outperforming our financial projections. I sent a nice fat dividend check to the investor. He had just invested in our second deal, too. I felt on top of the world. Whoops!  Not So Fast . . . Almost immediately, though, things started going wrong. Occupancy started trending down in the weekly reports. We were experiencing very high rent delinquency rates and had to evict several tenants. I brought it up with the RM on our weekly property calls. Each week, she assured me that everything was under control.  I kept my mouth shut. But by early fall occupancy dropped to about 90 percent, and operating profits fell. Eviction expenses and apartment turn costs were rising. We would miss the Third Quarter distribution. And, then, black mold was found in a vacant unit. Then another. Then a third. All three units had to be gutted to the studs. The RM kept assuring me everything was under control, we’d start seeing improvement soon. I deferred to her. I said nothing. The property was in free-fall. The PM and RM were not doing their jobs. The professionals were failing, and I did not know what to do. I felt paralyzed. Turning Pro When occupancy fell below 90 percent, something in me snapped. I realized, for the first time, that the hard work started when we closed the deal. I was an asset manager now. Someone had invested more than $1,000,000 of his family’s money in this deal. I owed him a duty to fix things. I had to take action fast, even though I was not really sure what to do. I made a decision. I would stop assuming the RM and PM knew more than me. I would stop deferring to their judgment.   I would take charge. I would captain the ship. That moment, I turned pro. I emailed the management company’s top executives. The company was managing our second property, too, and was in the middle of due diligence on our third and fourth deals. We had been discussing a long-term relationship as we built our portfolio. I told them that they would straighten out the first property right away, or I would terminate all their management contracts. That email got action, fast. The CEO and other executives flew in to meet with me. The PM returned to her old job in affordable housing before she could be fired, and the RM took direct control over the property. The company assigned one of its best asset managers to oversee the RM, and he drafted a recovery plan for the property. After a few months, a new executive manager took over our entire portfolio, replacing the RM. Taking Stock and Facing Facts We also made sure to get to the bottom of what happened, to avoid making the same mistakes ever again. We dug in and discovered that: The PM was used to filling vacancies from a waiting list. She could not adjust to a market-rate property that required constant marketing to maintain occupancy. She did not check vacant units for problems. She was unaware until it was too late that moisture issues had caused mold in three vacant units. She set qualifications too low in the tenant evaluation software, causing her to rent to unqualified tenants who fell behind on rent and had to be evicted. She entered invoices into the accounting software improperly. The property looked more profitable than it was, because expenses were not being booked. The PM said the property lacked operating cash to turn vacant units to be re-rented. But she never told her superiors. We could have advanced money from corporate to help, but were never informed of the problem. The RM was not paying attention to any of these matters. Nor were her superiors. And I faced up to the fact that, as the sponsor and asset manager, I was ultimately responsible for the situation. And I made some rookie mistakes too: Ignoring my gut and deferring to the RM’s assurances that everything was fine. I should have spoken to the management company’s executives the moment I felt that what the RM was telling me was inconsistent with the numbers I was seeing. Distributing too much cash too soon, depriving the property of operating funds, because I wanted to look good to the investor. I should have distributed only what was needed to meet the preferred return and waited for the property to stabilize. After we brought in the new management team and implemented the recovery plan, the property’s position improved dramatically. And our other three properties, which were already performing well, benefitted too. But significant damage had been done at the first property: The property fell behind on payables to vendors. Vendors did not want to work at the property. We had to fund accounts payable from corporate, and it took months to catch up and restore the property’s credit with vendors. The property fell below the lender’s required debt-service coverage ratio, and the bank took control of the property’s bank accounts for two calendar quarters. Most important, the investor did not receive distributions for more than a year. There were negative consequences for our company, too: We, as the sponsor, could not participate in any profits until the investor’s preferred return deficit was made up. We waived our asset management fee until distributions resumed. Our contract did not require it, and the investor did not ask us to do it, but it was the right thing to do. As a result, we received no compensation from the property that required more time and effort and caused more stress and sleepless nights than any other we own. Lessons Learned So, what can a new investor take away from this experience? Once you close, you are in charge of the deal. If things are not going right, it’s your responsibility to fix it. Strong property-level staff is vital to the success of your business. If you see any signs of incompetence, you must address it immediately. Require your management company to hire property-level staff with direct experience with your property type. Different property types require different skills. Hiring a manager without the right skill set could destroy your business. The situation at a property can unravel very quickly. It can take years to restore the property to its full potential. You must take swift action at the first sign of trouble. Don’t be afraid to speak up. If your gut tells you something is wrong, it’s your responsibility to demand that the management company fix the problem. The problems with this property caused me to lose many a night’s sleep. But, taking a long view, I’m grateful this situation arose early in my career. It taught me how to be an asset manager. This property forced me to become a pro at what I do....

Landlords get starry-eyed when rents are going up. Rising rents signify strong apartment demand and can bring in higher revenues. How could they possibly ruin your bottom line? It all depends on how you’re implementing rent increases. When vacancy results from normal turnover – the tenant takes a faraway job or experiences a life change like marriage, etc. – you should certainly charge the next tenant whatever the market will bear. But what about an existing tenant who wants to renew the lease? That question is harder. You want to keep pace with the market, and you need to offset rising expenses. But increasing the rents too aggressively might cause a tenant to move out. If the tenant is a headache, this might be a good thing. And even if the tenant is a good one, if the current rent is far enough below market, then you might benefit from renting to someone new. But the current rent must be very far below market to justify losing a good tenant. Otherwise, the new rents won’t recoup the costs of vacancy for a very long time. Vacancy Costs You More Than Just Lost Rental Income How does this work in practice? When a tenant leaves, you incur several costs. Obviously, there’s lost rent. Then add in “turn” costs; incidental costs, like utilities reverting to the landlord; and unanticipated costs that can arise when apartments are uninhabited. For example, imagine your tenant pays $700 in rent – 5{c8cadb6b157e97ed0bdc6df9c01b7d60fb42806e70d6a9acb324c508125f4e61} below the market rate of $735. Assume it takes 30 days to turn and re-rent an apartment, a soft turn (painting, carpet cleaning, and light repairs) costs $400 a unit, and utilities cost $25 a month. In this scenario, if the tenant moves out, you lose $1,125 from your bottom line. At $35/month in increased rents, it would take 32 months – nearly 3 years – to make up the loss! Even if the original rent was 10{c8cadb6b157e97ed0bdc6df9c01b7d60fb42806e70d6a9acb324c508125f4e61} ($70) below market, the gap wouldn’t fill for 16 months. Then imagine it’s a harder turn, where you must replace the carpet for $1000 rather than clean it for $100. Your total cost is now $2,205, which would take you a shocking six years to make up if the rents were only 5{c8cadb6b157e97ed0bdc6df9c01b7d60fb42806e70d6a9acb324c508125f4e61} below market! Now multiply this across several units in your property, and you can see why rising rents can destroy your bottom line if you’re not careful. Bad Things Can Happen in Uninhabited Apartments And these costs are not the only ones that can result from vacancies. Bad things can happen when no tenant is present to report problems to management. In cold weather, pipes can freeze and cause flooding. In hot weather, unnoticed leaks can cause mold outbreaks, which can quickly overtake an apartment. Remediation costs can wipe out a whole year’s rent, not even counting rent lost during renovations. The lesson is to be judicious when raising rents. Work hard to retain good tenants. Raising rents only 2.5{c8cadb6b157e97ed0bdc6df9c01b7d60fb42806e70d6a9acb324c508125f4e61} to keep one in place will add $210 in annual revenue versus $1,125 in vacancy costs, a difference of $1,335 to your bottom line. It could even make sense to renew the lease at the original rent, if the alternative is the tenant moving out. Normal turnover and natural vacancy are facts of life in the apartment rental business. Good operators budget adequately for these costs. But good operators also know that the key to maximizing profits is minimizing unnecessary turnover and its associated costs....