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The Moment I Turned Pro

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.

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2 Comments
  • Curtis Smith
    Posted at 14:05h, 08 May Reply

    >>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.

    Hi Johnathan, you didn’t mention but it sounds like you over paid, making for low cap rate, low cash on cash making for a too close for safety DSCR. Where dropping below 90% ran into serious problems.

    Might a root cause for problems be paying too much, forcing the model to have to run perfect to avoid problems?

    Atlanta is very hot in MF space. Simple rent increase sales are non existent at the listed level. Too many investors chasing deals. Properties are selling at 6% cap. I wonder if those deals will last through bumps in the road? Through the first rate re-set?

    For a new person to the commercial space. My view is to not get into MF unless an elderly seller pops into your view and has not yet listed. Ok then. Warren Buffet has a view here: buy whats hated and sell whats loved. MF is too loved IMHO. I’ve gone after a hatted asset class. In your area/ REIA. Mention a list of asset types to a room full of investors. The one that gets the most coughs might be a low competition deal type to learn to master. 🙂

    • The Mortar
      Posted at 10:13h, 09 May Reply

      Curtis, I love your advice about unappreciated asset classes. Sounds like a good way to go about identifying them.

      I don’t think we bought at too low a cap rate, since it was over 8% for a stabilized property on actual financials. The real problem was twofold — the low quality of the existing tenants and an inexperienced property manager who was not up to marketing a property aggressively when the bad tenant quality led to a cascade of evictions. The evictions led to a second twofold problem — obviously the lack of revenue, but also the spike in costs from turns and from taking over utility payments from tenants on vacant apartments. There was no reason for occupancy to fall that low, given that market occupancy was in the mid- to high-90s and supply in the B/C space is constrained.

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