Recently I bought three apartment buildings from the same owner and, even though I have been doing this for fifteen years, these buildings taught me something new and invaluable. Watch out for the tenants you inherit.
As we progress in our real estate rental investing from single family homes, through duplexes and fourplexes and then into multi-family we tend to focus our diligence on the building itself. We get an inspection done, we plan in our head what renovations we need to do once we own the property and we watch out for the really bad stuff like foundation issues.
However, we usually don’t pay that much attention to the people who already live in the building. We just assume that, while they probably won’t be angels, they probably won’t be devils either. I have talked to a bunch of other investors over the years and I don’t think I am alone in this. We tend to think that the quality of the tenants will match the quality of the building itself. But even then, how bad can it be. The current owner had to manage this property and surely he wouldn’t have wanted to rent to the worst of the worst – right?
I specialize in buying apartment buildings that are mismanaged or physically run down and need some love. I assume that the existing tenants will have issues and that over time I will weed out the bad ones and replace them with better ones as I improve the quality of the building.
These three buildings surprised me though. They were really run down, nothing earth shattering, but the last owner had owned them for 30 years and hadn’t put a penny into them that he didn’t absolutely have to. But, in my mind it was nothing that some paint, new flooring, some new fixtures and time wouldn’t fix. The rents were actually higher than I would have expected given the condition of the buildings which I saw as a bonus.
That should have tipped me off. I found out, after I bought the buildings, that the prior owner had rented to anybody. Got a drug issue? No problem, pay an extra $150 a month and in you go. A drug dealer? Who cares? Buy your way in. Have three cats and two yappy dogs and nobody else will touch you? A little extra on the rent and here are the keys.
Inspections don’t reveal these types of things. Personally walking through each suite (which I always do before I buy all of my buildings) won’t necessarily reveal these issues (mysteriously cats and dogs are usually absent during walk throughs). The existing owner surely won’t disclose what he has been doing so sometimes you just have to find that out the hard way. I bought the building and, literally, within the first two weeks, eight out of 33 tenants moved out due to there being a new sheriff in town.
I did not expect that. That put a serious dent into the projected cash flow. I had been planning on renovating the suites as they became vacant and using a lot of the positive cash flow to subsidize my reno costs. Almost right away revenue was way down and cash out of pocket was way up. Not good.
Two weeks into my ownership the S.W.A.T. team broke into the building and busted down the door of somebody who was a known drug dealer. The next day I went down to the police station and learned that these buildings were the worst in town. I didn’t know this but, just like there are rap sheets on individuals, the police keep a file on buildings too. If you have some concerns about the quality of your tenants before you buy the building, I would recommend going down to the local police station and seeing what they know about your building.
So, word to the wise, pay some attention to the existing tenants at the same time as you are reviewing the building itself before purchase. Before, I always asked for the existing leases but that was typically just to verify the rents were as advertised. Now I will do more checking into the tenants themselves and save myself a bit of grief (or at least go in with my eyes open) next time.
Read more about this in Comparing Real Estate Strategies.