When Wendy Dorchester was fresh out of school as a young leasing manager at Pegasus Residential, her firm had purchased a 400-unit community with a supposed vacancy of 20 apartments. Due diligence was performed during the purchase process, but not at a deep enough level. When the new owner and its associates walked all 400 of the apartment homes, they encountered a surprise.
“It was one of those cases where the occupancy was stated at 95 percent, but once you walked the entire community, that was not what we found,” Dorchester says. “Occupancy was actually 80 percent.”
As her employer dug deeper, Dorchester says it discovered that the previous owner of the community had faked lease signings and there were actually 80 vacant apartments.
“The files were indicating that people were living in the units,” she says. “When we walked the units, no one was in those apartments. We found out the previous owner actually paid the rent on those units to make the property’s value look greater than it was.”
Dorchester remembers what ultimately happened 20-plus years ago with that 400-apartment home community and its doctored leases, and the experience taught her a valuable lesson: When you are repositioning a recently acquired community, there will be unexpected pitfalls.
Dorchester recommends due diligence and walking every unit to eliminate surprises.
Now the Vice President of Talent and Culture at Pegasus Residential, she is not alone in suggesting a comprehensive approach.
“We look at what is in a file and then we walk 100 percent of the apartments,” says Diane Batayeh, CEO of Village Green, who says she has encountered situations where she has been mistakenly presented bad information during due diligence. “We look at the ledgers, the bank accounts and the deposits. If you are doing your checks and balances correctly, you will not get tricked.”
But even if you take these precautions, other things pop up. “I have been involved in more than 50 renovations,” Batayeh says. “There are always hidden things.”
Those hidden things may not be as fraudulent as doctored leases, but they can create headaches for the company assuming control of a community. Even if leases are real, new owners may find unwelcome surprises in the credit quality of the existing residents or the concessions and expiration dates in their leases. Beyond that, they could encounter issues within their onsite teams and, of course, behind the walls of the actual community itself.
If Lynn Owen, COO, TruAmerica, tours an apartment community for sale and sees furniture pushed up against a wall space, closets packed with clothes or hoarding, she usually draws one conclusion about the community.
(And that assumption is not that the community is full of sloppy residents.)
“Inevitably, we find that after closing, those apartments have issues: Things such as plumbing, water intrusion, condensation with organic growth, pest issues, delaminated flooring, missing closet shelving and holes in sheetrock,” she says.
Owen says that today she is not shy about insisting that she get a closer look or asking that those apartments be cleaned so a second inspection can be scheduled.
“The lesson is to inspect every unit and know what we are buying so we can budget and underwrite, accordingly,” Owen says.
While Owen’s experience shows that there are ways to sense problems behind the walls, there is no true way to know for sure what is going on beyond the drywall without the use of an X-ray machine.
“You have to accept the fact that if you buy an older property, there is potentially going to be old infrastructure,” Batayeh says.
A thorough investigation of the community can help apartment buyers understand what they may encounter. “You really need to take a hard look at what you can actually see,” Batayeh says. “That can give you an indication of what to budget for.”
Sometimes that is easier said than done. Owen has encountered situations where historical maintenance request logs were not obtainable from the seller or keys to individual apartments are not available.
“We used to expect all owners to operate their buildings like us or in a standard operating fashion,” she says. “So, if some records were not available, or if keys to apartments during unit walks were missing, red flags did not necessarily arise.”
Now, Owen knows an absence of records can be a huge issue. Batayeh advises buyers to review at least a year’s worth of service requests.
“That will be very telling as to what types of issues exist that you may not be able to see,” she says. “If there is a recurring type of work order, then that is another way to tell that you have a systemic issue.”
A close inspection also helps to pinpoint problems. Looking under the sink can reveal what type of piping is in the community. For instance, galvanized pipe is notorious for pin holes leaks, which over time can lead to major plumbing replacement needs, according to Batayeh.
“If you don’t have the budget to replace aged pipes, you should budget for the assumption that you will have recurring annual costs to repair those pipes,” Batayeh says. “You should always plan for the worst when it comes to plumbing systems.”
Max Sharkansky, Managing Partner at Trion, says preparation is key — from diligent assessments prior to acquisition to budgeting for unexpected costs.
“Conducting research and drawing from previous experience [or consulting with someone who has previous experience] with properties of similar vintage and style can also be highly valuable,” Sharkansky says.
When most apartment owners prepare to sell a community, they want to fill their apartments, certainly with actual paying residents.
Tim Reardon, Director of Revenue Management at Bridge Property Management, says occupancy should be in the 94 percent to 95 percent range at a community before a disposition. “It proves to the buyer that you can keep the community full,” he says.
But to fill apartments before a disposition, some owners may sacrifice credit quality.
“As a buyer, you have to ask yourself how a community is filled to position it for sale,” Batayeh says. “Sometimes, the previous owners will loosen their credit standards to increase occupancy to maximize the NOI and maximize the pricing,”
Unfortunately, it is easy for owners to overlook what is happening with their resident profile during due diligence.
“When you review resident files, you want to look at the applications to see what standards upon which their application was judged,” Batayeh says. “This is a hidden challenge that people don’t always focus on. It is really critical to understand that profile.”
TruAmerica will ask for bank statements so it can uncover delinquency issues at the site that are not clear in the profit and loss statement.
“Without bank statements, we have closed on escrow, taken possession only to find out that prior ownership had allowed residents to pay their rent throughout the month,” says Owen.
When Blackfin made its first purchase, Calvert at Quarterfield Station, a distressed 203-apartment garden-style community in Glen Burnie, Md., it faced similar issues. Lurking beneath the surface was a resident base with serious delinquency issues — some of whom had not paid rent in months. Blackfin needed to bring in a different group of residents, but that is not easy in Maryland because of law.
Blackfin Managing Principal Doug Root learned that it is smart to use a conservative timeline for any repositioning.
“When turning around a property with performance issues and high credit loss because of lowered credit qualifying standards, your occupancy and performance will always take a much harder hit than you think once you begin to tighten up the operations and implement institutional management practices,” Root says.
Like Blackfin, TruAmerica has faced challenges when it brought its institutional policies and procedures to communities with credit and delinquency issues.
“[In this case] we have to educate the residents on what their lease states and how timely rent payments are mandatory or the residents will find themselves in an unpleasant legal position,” Owen says.
Concessions and Expirations
Even if residents are qualified and paying rent, lease expirations and the concessions they are given can cause hidden issues.
“One thing easy to miss on your rent roll is the concessions that may have been offered,” Batayeh says. “If given upfront, they won’t show up on a rent roll. If amortized over the course of the lease, they will. So, it’s important to understand first how they were given and secondly to learn when they burn off.”
Fortunately, there are ways to evaluate concessions during due diligence to help managers avoid these risks.
“My tip is to dig deep in your rent roll to look at gross potential rent versus net rental income and then look at the delta between those two,” Batayeh says. “Understand what the loss to lease is and how much of that is comprised of concessions.”
If operators miss amortized concessions, residents might be paying far below market rate.
“That makes it even more challenging to increase their rents to your post-renovation rent,” Batayeh says. “If not planned for, that can pose problems with higher turnover and vacancies.”
In these situations, Batayeh recommends that operators take great care with renewals, doing things such as meeting with residents well in advance of their lease expiration to discuss the changes planned for the community and gauge their desire and financial ability to remain. It might be necessary to offer these residents a lease renewal rate that may not be as high as the market.
“You have to be strategic and conservative when planning how you are going to renew those residents when they come up,” Batayeh says.
Dorchester finds that during takeover, a lot of lease expirations are not given the attention they should.
“Using our lease-expiration matrix, sometimes we find that too many leases are expiring in one month,” she says. “That creates a big challenge.”
Melissa L. Smith, Chief Administrative Officer for Fogelman Management Group, says it’s a given that some attrition will occur when her firm takes over a community. She says the goal is to keep the current team in place.
“We understand we are disrupting our employees’ lives,” she says. “Onsite staff members are the ones who are disrupted most in a sale.”
Sometimes those new staff members don’t fit the culture of the company making the acquisition or reflect the new direction of the community.
“It is important to assess the current team and to make sure the right team is in place,” Dorchester says. “Obviously, if you find that there are occupancy issues and challenges, it is reasonable to ask about the team’s performance.”
Pegasus makes it a priority to bring the regional manager onsite to get a greater understanding of what is happening with leasing and other important functions. Problems can stem from lack of focus.
“Our No. 1 job is to lease apartments,” Dorchester says. “People get caught up in so many other things that they forget that. We get bogged down in the minutiae and details of running a community instead of focusing on leasing.”
That focus can blur when a renovation is happening onsite, Batayeh says.
“Many times, investors underwriting [a value-add] acquisition assume the status quo with staffing the management office,” says Batayeh. “But when a renovation is occurring, a property manager is pulled to act as pseudo project superintendent and is given responsibilities for quality control and scheduling. Their job as a property manager becomes secondary to their job as a project manager.”
To ensure that her residents are properly taken care of, Batayeh brings someone on board to free the onsite staff to manage the community.
“I recommend to any owner to have someone in place who is dedicated to being that owner’s eyes and ears and making sure things are being properly scheduled and the quality of the renovation work is acceptable,” Batayeh says. “Having a dedicated renovation coordinator representing the owner to interface with the construction contractor is so important. This will allow the property manager and service team to focus on day-to-day site operations. Not staffing appropriately during a renovation project is the one thing that gets missed the most.”
Les Shaver is Senior Content Editor for NAA. He can be reached via email.