My Biggest Mistake in Real Estate Investing
Early in our real estate investing business the window of opportunity to cash flow in California real estate was quickly sealing shut. We didn’t realize how fast the window was closing. There seemed to be so much inventory; investors believed there was time to cherry pick deals. Around late 2012 and early 2013 buying a home in California looked attractive. Workers that survived layoffs during the recession felt comfortable that their jobs and companies had stabilized. Businesses were hiring again. People felt confident enough to apply for home loans. Listings in good areas were getting multiple offers and crowds were showing up at open-house weekends. Inventory was going down as retail buyers and investors fought to buy properties.
It was during this time that we had the opportunity to buy a 13 unit apartment complex in the city of San Bernardino. It was our second commercial deal and we felt moving forward the focus would be strictly commercial multifamily deals. The company was on a growth run and several deals in the beginning gave our investors and us great returns. We had momentum and were riding a confidence wave. We felt assured and thought we had neighborhood familiarity. We previously owned property in neighborhoods north and south of this location. This property turned out to be the classic “worst property on the block”. The issue was we didn’t expect or plan for this scenario. The experience brought us back to earth. We realized the gaps in our due-diligence and management. This experience caused us to change the way we perform both these activities ever since.
We had a 30 day due-diligence period with the sellers that was excruciating. Financial documents from the seller were sloppy, and hand written. We were informed to bend our expectations for documents because sellers are not savvy investors and became disinterested with managing the property. It was obvious they were not professional real estate investors and likely beginners with no experience managing multifamily properties. There were few willing buyers because their financials were confusing and difficult to understand. It required us to reference our experience running properties in close proximity and continuously ask questions. The numbers on the lease contracts were consistent with the income statements provided. Luckily my loan broker kept pressuring their agent to provide clean financials or it jeopardized the loan and the deal falling out of escrow. Finally after 3 weeks into the due-diligence period, the seller provides financials that look like they were done on QuickBooks. I got upset because I felt these documents were purposely withheld from me. It’s the last week of the due-diligence period. This information should have been distributed within the first week after the earnest money deposit.
Knowing the opportunity for a deal was fleeting; we stayed flexible and accommodated the sellers however possible to help get the deal done. We found out later that the co-agent representing the seller was a partner in the property and was helping to manage the property. She did a poor job. After leasing to unqualified tenants and failing to collect rents and evict them, it was now a distressed and mismanaged mess needing to be repositioned. We routinely asked about rent collections coming to the close date. The agent representing the seller communicated rents received were in-line with the income statement provided and that it was cash flowing. We got the financing from Chase bank and closed the deal.
After closing we introduced ourselves as the new owners and discovered a majority of tenants didn’t pay their rent. The feeling in the air was that new ownership was changing things. Their time was limited. It was a serious problem and we needed rent to come in fast. We aggressively demanded rents and immediately started evictions on non-paying tenants. What stalled us were tenants paying portions of rent. It delays filing of eviction paperwork that eventually needs to get filed. We were in a tough spot because income was low. We accepted any little bit of money to maintain operations and control spending money on attorney fees.
Virtually every unit was turned, except the lady with section 8 voucher. If we knew during the due-diligence period that rent collections were this low by confirming the income statements with deposits on bank statements, we could have renegotiated a credit for pending eviction costs or reduction in price. It may have jeopardized the loan but at least we would have clarity on the situation. We misjudged the seller’s nature and realized they and their agent had been dishonest in their representations of the operations. It showed us that you can’t expect sellers to run good accounting processes and represent honest financial documents. It was blatant mismanagement and misrepresentation.
We still got a great deal that required a lot more time and work to make money. Luckily the market was in a sellers cycle causing values to go up. Looking back this was the prefect property for our team. We discovered how to operate a “diamond in the rough” and what was necessary to protect our diamond. Our team became battle-hardened and overcame the roughest parts of San Bernardino. Once we realized our tenants were the problem and repositioned the property; the transformation caused the neighborhood to improve. At times we struggled with cash flow. We used significant amounts of rehab reserves for unexpected security improvements and unit turn-overs. Fortunately our reserves helped construct a perimeter fence to control who gets access to our property. Later we relied on lines-of-credit to keep the operations running. We eventually sold the property before the loan term. We paid off debts and got a nice profit. All the challenges experienced on this deal helped us improve our due-diligence activities and cash flow management.
Don’t make the same mistakes we made. Avoid these mistakes by doing the following:
- Request financial documents are provided in a timely manner (within 5-7 days). Add language in your contract specifying any delays in receiving documents by the seller will cause the due-diligence period to be extended.
- Verify seller’s financial statements by requesting bank statements. Compare the deposits in the bank statements with monthly rents on the income statement. They may not be exact to the penny but they should be close. Any major discrepancies could mean rents are not being collected.
This experience lead me on a personal mission to be the best at performing due-diligence as I possibly can. I vowed never to let this happen again. With every new transaction I learn more and I’m always asking questions of all parties involved including the seller(s) and my own due-diligence team. Don’t expect sellers to always be honest. Realize that some sellers do not have good accounting and bookkeeping practices, especially on smaller properties. Always verify financial documents and especially rent deposits from the seller(s).