Sunday, January 1, 2012

The Great Apartment Turnaround Play

Almost 6 years ago I purchased a triplex and became a first time landlord. The building was in a great area of town and I thought I had stumbled on a fantastic deal. Here were some of the reasons why I bought it:

1) It was cash flow positive after all expenses. I took into account everything and even received a year’s worth of gas and water bills from the previous owner to be sure (hydro was paid by the tenants).
2) The building had all long term tenants. I figured that I wouldn’t need to worry about renting the place every year since the newest tenant had been there 5 years and the most senior tenant had a good 16 years history in the place.
3) Although the apartments looked a bit run down, the building was located in a great part of town.
4) I bought the triplex for less than the appraised value for property tax purposes.

Out of all these reasons, I would still consider most to be great reasons for owning the property. Since the place was cash flow positive I was never out of pocket and over time cash flow only increased on my investment. Since I bought the place for much less than the appraised value, I had no problems financing it, and as a bonus I was able to get my taxes reduced (the property was reappraised based on its current condition and my purchase price). Although the building was a bit run down, it was surrounded by many nicer, owner occupied homes in a great area. There was potential to attract better tenants and increase rents with some work when a place became vacant.

You might have noticed that I skipped over point #2. What I originally thought was a great reason for buying may have been one of the reasons why the previous owner was selling.

Challenges and Mistakes That I Made

What I didn’t factor in as a new real estate investor was that long term tenants can come with their own set of issues. My tenants had a history with previous landlords (undisclosed to me) where it was acceptable to pay the rent sometime during the month instead of promptly on the first. There were no leases or rental agreements, but I did have a statement signed by each of the tenants acknowledging that rent was due the first of each month. Being new and not wanting to rock the boat right away, I told my existing tenants that I would accept rents by the 15th of each month after which time I would have to proceed with the eviction process. The 15th became the new 1st of the month, and I found each and every tenant would push the envelope on my newly imposed deadline date. Another quirk I found with long term tenants is that they tend to become territorial. Since they have been there much longer than the new landlord (and even the previous landlord) they tend to see your property as THEIR property. That doesn’t mean that they will take care of it any better, but if you are trying the change things (no more derelict cars in the driveway for example) each change comes with a bit of a struggle. I am not saying that you can’t remedy these types of issues with existing tenants; all I am saying is that one way or another you are going to have to deal with them.

If I had to do it over again, I would opt for vacant possession if I could get it so that I can set my own rents, pick my own tenants, and write up my own lease agreements. In my case that is not what happened since as a brand new (and somewhat na├»ve) landlord the thought of 3 vacant apartments and a new mortgage concerned me. Because of my inexperience, I ended up running the property pretty much using the same landlord style as the former owner. This approach meant frequently late rent payments after numerous collection calls and in-person visits. One difference between me and the former owner was maintenance as he was milking the property and did minimal upkeep. Although I don’t agree with this approach, I soon had a better understanding of why he operated that way. Rents were well below market, and rent controls limited my ability to increase funds to pay for significant upgrades. If I wanted to maintain a positive cash flow, the key was to maintain what needed to be done and leave what did not. I did splurge a bit by installing new windows and insulation, but this renovation cut my heating bill in half. I also did what I could with some improvements (like a new bathroom), figuring that if I improved the property tenants would appreciate what I had done and make more of an effort to be better tenants (e.g. pay their rent on time). What I failed to understand was that long-term tenants and below market rents were the root of my problem. Improving the property was not going to magically transform my residents into model occupants, and this became evident when improvements I made quickly degenerated to levels almost as bad as they were before I started. As a result, I stopped doing expensive renovations unless they were necessary or I thought they would save time and money over the long run.

One of my first big challenges came after my first apartment vacated. Initially I thought I had a great opportunity to improve the property, raise the rent to a market level, and start turning the property around. What I found out was that I had a tough time attracting new, desirable tenants. I cleaned up the vacated apartment with some new drywall, paint and a brand new bathroom. It looked decent on the inside, but my other residents turned off a lot of prospects. It was an uphill battle, but I even managed to get my one tenant to part with the junked car sitting in the driveway (city bylaws fine landlords, not tenants). When I did find someone, my long term tenants would invariably gang up on whoever moved in and plague me with telephone calls about how noisy and disrespectful they were. It always struck me as interesting since I checked out references in each case and previous landlords (not just current ones) had always given my new tenants a decent recommendation. One day when I was working on the flower beds my most senior tenant confided in me that she heard the tenant upstairs trashing the place. When I knocked on the door my new tenant let me in for an inspection and the place was spotless! After going through a few new tenants I finally rented the apartment to a couple that my wife and I knew personally. I warned them that it might be rough in the beginning, but by now I had every intention of turning the property around as soon as possible.

I finally came to the conclusion that if you have a rundown property and you want to improve it a key step is getting rid of your existing tenants. First, with your existing tenants you will have difficulty raising your rents enough to pay for all of the improvements you need to make (thank you rent control). Secondly, even if you could raise the rents and did make the improvements, do you think that the tenants who neglected your place before would all of a sudden become model occupants? The big question is on the best way to vacate your apartments. Lucky for me, I was given a gift when the tenant in my second unit gave me notice (2 down, 1 to go).

The Turnaround

I didn’t waste any time lining up a contractor because the apartment was a total gut job. Even the interior framing was redone (and yes there were structural issues to address). The renovation process was a real education for me. I did get a couple of quotes on the job from contractors I had used before, and I ended up going with the same contractor who refreshed my upstairs apartment. We got the city permits ahead of time and he was able to start work the day after my tenant moved out.

I didn’t want to waste any time getting the apartment rented, so I placed some advertisements with the explanation that the apartment would be all new construction on the inside. I showed the place a few times before my existing tenant moved out to give prospects a sense of the space with explanations on future improvements. Admittedly, the place looked like a dump when I showed it and I soon discovered that most people either didn’t share my vision or they had some doubts about whether I could deliver. The general reaction was that people would turn up their noses and beat it out of there as soon as time permitted. Two short months later when construction was completed I had prospects fighting over the place! The end result was a brand new apartment that everyone loved and it ended up renting for 33% more that I was getting before.

Finally I set my sights on the last remaining apartment. In spite of ongoing complaints (my newest tenants were apparently horrible and loud as well) my last long term tenant didn’t seem to be moving. She “threatened” to move and she threatened me with lawyers. I encouraged her to move and even waved the 2 months notice if she found a new place to live. It wasn’t working. After concluding that she probably could not afford to move I finally made her a deal. I could have used consistent late payment as grounds for eviction, but I was not keen on the pain of going through the Landlord Tenant Board. It was unpredictable and it was going to cost me time and money. Instead, I decided to offer my tenant a free month’s rent to help her relocate. She negotiated me up to 2 months free rent with the argument that she was going to need the money to move all her stuff out. I figured that although you could consider me a bit of a pushover, it was a win-win deal. My tenant leaves willingly and I have a signed vacate notice that ensures she cannot claim the unit back. In Ontario, if you make a tenant move out to complete major renovations potentially they have the option to move back in (but that’s a whole other issue). Additionally, there was a better chance that I would have less stuff to get rid of after she left. Plus I had a definitive date and could line up the contractor to plan for my brand new apartment.

The last time I tried to rent an apartment under renovation people did not seem very receptive because they could not envision the final product. I had even lowered the rent a little bit in an effort to avoid a month or two of vacancy after it was finished. This time I tried a different approach. I had taken pictures of the completed one bedroom so I posted an advertisement including these pictures. In the ad I explained that although the apartment shown was a different layout and a 1 bedroom, this 2 bedroom unit would be completed in 2 months and would be finished with the same general style and quality as the first one. I had a flood of responses. How many were serious? I will never know. Not wanting to waste my time like I did the first time around, my intention was to hold off on showing the apartment until it was closer to completion. However, I did get a couple of people who were very insistent on seeing the place ahead of time as they were planning their move for the approximate month I expected to have the unit ready. I reluctantly agreed to these appointments as the apartment had been gutted but didn’t even have the walls framed in yet. I explained the best I could what the intended layout was going to be along with all the extras that were being done (soundproofing, high end dishwasher, laundry hookup, etc.).The second person who saw the apartment filled out an application and gave me a deposit on the spot. The apartment rented for 68% more than I was getting from my previous tenant!

If you have been a landlord for a while you know that you will have your ups and downs. My hope is that by improving the quality of my property and the tenants at the same time there will be more ups then there are downs. Even if the level of headaches was the same as before (which I doubt), at least now I am cash flowing more as compensation for any Tylenol I may need to take.
Here are my revised rules for buying a property:

1) It is cash flow positive after all expenses using the current rents.

This is the “golden” rule. Take into account everything and get the last year’s worth of any bills you will be assuming from the previous owner to be sure. On days when you are feeling abused, you don’t want to be paying for the privilege.

2) The apartments and/or building could benefit from cosmetic repairs and may be a bit run down; however, the building is located in a great area.

Ideally this is the building the neighbors all hate. Get a home inspection so you can get a better idea of how much money you will need to sink into the property to bring it up to par. Don’t worry; the neighbors are going to love you once you are done!

3) Make sure that you do not overpay. Build in some cushion for vacancies and unexpected expenses. Get some quotes on what it will cost you to make repairs and factor these amounts into your purchase price.

Don’t ever let the seller make the repairs unless you want to risk a poor quality job. I made this mistake once and it cost me even more to redo the original job plus fix the resulting water damage (but that is another story).

4) Assuming that the building is a bit run down with below market rents and long term tenants – get rid of them. If you can get vacant possession that’s great; if not, find a legal way to encourage them to move.

Fixing up apartments and keeping your existing slum tenants in them is like filling a bucket with a gaping hole in it; your apartments will be right back where you started in no time. If you are in a rent control environment like Ontario (Canada) this rule is especially critical. Make sure that you can actually increase your cash flow enough (increase rents) after spending all that time and money. Additionally, make sure that you are not forced to offer the apartment back to your existing tenant at a ridiculous rent once renovations are completed.

I just want to finish off with a conversation I had at the hardware store the other day. I was looking for a high quality toilet to put into my renovated apartment because I do not want the hassle that comes with a toilet that does not flush as well as it should or easily plugs. The employee told me how so many landlords just want to put the cheapest of everything in their apartments because “the tenants will just destroy it anyway.” I like to think that I have a more positive view on human nature. The quality of your apartment will determine the quality of the tenants you attract. Just as a poor quality tenant (in point #4) will wreck a good apartment, a poor quality apartment will attract just this type of tenant. By improving your property and your tenants you will improve your cash flow and reduce your headaches associated with being a landlord.

The only remaining point to be successful; don’t just read about it – you need to DO IT!