Multifamily Death Spiral

Written July 31st, 2012 by

The creation of a distressed property is a frequent topic of discussion among new investors.  What is wrong with these properties, and why did sellers allow them to get into such terrible condition?

As discussed in prior blogs, distressed properties create an amazing opportunity to make money.  Similarly to foreclosed homes - these properties can be purchased at a  deep discount.  Once the deferred maintenance is addressed and the operations are stabilized, the improved property can be sold at multiples of the original purchase price!

BUT, HOW DO THESE PROPERTIES BECOME DISTRESSED?

INGREDIENTS

In reality, it is often a series of events that leads to a distressed property, including such mistakes as:

  • Poor resident maintenance support - this is the number one reason tenants leave properties.  Poor owner/operators mistakenly believe that if they ignore maintenance requests, they can cut back on nuisance requests from residents.  Unfortunately, this can drive residents away, thereby increasing turn-over and thus creating much higher costs.  In addition, it can create a poor reputation, making leasing difficult as well, which may ultimately result in a lower rent vs. competitor properties.
  • Unqualified tenants - it is tempting to lower qualification standards to help increase occupancy on a property.  This appears to be a short-term gain, as at least the unit isn't empty.  Unfortunately, this theory doesn't hold up, as these residents often don't pay.  The costs to evict them, as well as to make-ready the unit for the next tenant, will often result in a net loss.  In addition, unqualified tenants often attract a criminal element to the property, which can make the property less desirable and create an even worse price differential with competitor properties.
  • Poor property condition - properties require routine maintenance to stay in proper working condition.  Owner's who choose not to spend the money necessary (or who may not have sufficient cash flow available to cover the costs) slowly allow the property condition to deteriorate.  This results in a less desirable property (results in lower rent vs. competition) as well as increased liability for larger costs in the future.
  • Missing sense of community - residents want more than just a place to sleep -- they want to be a part of a community.  Apartment communities that recognize this can reduce turn-over, leading to lower make-ready expenses.  Residents in these communities also become an advocate for the community, helping to bring in friends and family, thereby increasing occupancy.  Building a sense of community doesn't require tremendous money or staff - it can be as simple as barbecues, bingo nights, or setting up local sports leagues.  Activities like these go a long way to achieving the peak performance from the property.
  • Uncontrolled expenses - distressed properties frequently have very high expenses.  This can be due to a lack of discipline in working vendors to get the lowest quotes (e.g. insurance, electricity).  Tax rates may be high due to operators not working with tax protestors to get the lowest possible valuation.  Repairs and maintenance costs may be high due to deteriorating property conditions (due to a lack of proper property maintenance) requiring constant repairs.  Payroll costs may be high due to inappropriate size of staff and/or compensation that is not consistent with the rest of the market.

COMBINATION LEADS TO DISASTER

While each of the above mistakes can cause problems, they typically combine and interact in a way that can lead the property into a death spiral.  An example of how this could occur is:

  1. Owner tries to cut costs to save on maintenance of the property
  2. Property conditions start to deteriorate, leading to a worse condition vs. competitor properties
  3. Occupancy and rents starts to drop (going to competitor properties instead)
  4. Owner becomes nervous and starts dropping qualification standards to increase occupancy
  5. Tenants may have criminal history, thereby attracting crime to the property
  6. Crime and lower property conditions make leasing difficult, so rents are dropped
  7. Unqualified tenants don't pay, combined with lower rent and lower occupancy, resulting in even lower income
  8. Owner cuts back even further on maintenance to save costs
  9. And the process continues until eventually the property is losing money, and the owner defaults on the mortgage.  

The property is now in poor condition, with low occupancy, and unqualified tenants.  It is now a prime candidate to PURCHASE AT A DISCOUNT!  Once turned around, this property can generate a TREMENDOUS CAPITAL GAIN.

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