04 March 2011

HIGH RISK INVESTING IS NOT FOR AMATEURS

This blog post is taken from the book
HIGH RISK INVESTING IS NOT FOR AMATEURS
DUE DIIGENCE TIPS TO SAFEGUARD YOUR INVESTMENTS
by HELEN M. HAMILTON


“You want to learn from experience, but you want to learn from other people’s experience if you can.”
Warren Buffett
In writing about my mistakes, my purpose is that I will spare you, the reader, from making similar mistakes. Before touching on basic investment planning and information in subsequent blog chapters here is a story of one of my costly experiences followed by tips you can use to prevent similar missteps. A number of other stories in following blog chapters cover a wide range of other types of my costly investment errors each followed by tips to help you to gain more and lose less.
THE DOWNFALL OF TRUSTING
My greatest weakness as an investor is that I trust people. When they say something or show me an investment plan, I trust that they are telling me the truth. I trust that when they say it is a good investment, they mean it. If they mount a great presentation I trust what it says. If they say they are experts I believe them. Oh boy did my trust get me into trouble!  I trusted so much that I did little checking into either the presenter’s background or the deal. I saw only the dollars I would make. I was a high risk investor.
HOW NOT TO BUY REAL ESTATE
We attempt to buy a million dollars of property with $70,000 down
BUYING A MILLION DOLLARS WORTH OF PROPERTY
“Rich people focus on opportunities. Poor people focus on obstacles.”
T. Harv Eker
Being a novice at purchasing a package of real estate with low money down provided an intense learning curve. We were so inexperienced! There is a saying “buyers are liars” but vendors can also be liars, I found out to my sorrow.
Amusingly, however, the situation also won my lady friend and me trophies from Raymond Aaron, a real estate guru and coach, for being the “Players of the Year.” He told envious meeting attendees that we had bought a million dollars worth of property for $70,000 down. None of them knew that the deal had already collapsed.
My friend, (I’ll call her Ann to protect her privacy), and I enrolled in Raymond Aaron’s Monthly Mentor course. We thought it was going to teach us how to buy real estate, but its focus was goal setting.  However, encouraged by networking with others members we connected with Paul a member of the Real Estate Investment Network (R.E.I.N). Paul (not his real name) told us he had a lead on 7 pieces of property worth at least a million dollars that could be purchased with only $70,000.00 down. He was looking for partners with money. We knew nothing about Paul but he seemed self assured and sounded experienced.

STARTING THE JOINT VENTURE
“Often in the real world, it’s not the smart that get ahead
but the bold.”
Robert T .Kiyosaki
Meeting Paul and his friend in a coffee shop we decided to form a joint venture to purchase these properties. We knew nothing about Paul’s background but he sounded knowledgeable. Paul would be the real estate finding partner, his friend the carpenter to make repairs and Ann and I would provide funds. We would all be equal partners.
Tailoring a R.E.I.N joint venture agreement to suit our circumstances, Paul took it to a real estate lawyer. The lawyer recommended that we incorporate a company to hold the properties instead of writing a joint venture agreement. 
With the vendor’s addresses in hand we drove around to see the exteriors of the properties that Paul introduced us to. They were a 10 suiter building, two side by side duplexes, a condominium apartment, a half duplex and two houses, one with a basement suite.
The vendor met us and first showed us through the newly painted vacant main floor suite of a nice looking well located up/down house. He said it had already been rented for $850 a month plus utilities.  The basement suite was currently rented for $450.00 to a lady with several cats. The vendor said she had been given a rent increase to $500.00.  It turned out that this house was the nicest of the whole batch.  It certainly whetted our interest.
SIGNING THE PURCHASE AGREEMENT
We signed a conditional purchase agreement in December for $993,000.00 including vendor take back mortgages on most houses totaling $189,920.00. We wrote in conditions of mortgage assumptions, inspections and verification of rents. The vendor provided information about mortgage balances and payments on the properties saying that all mortgages were assumable.  Our lawyer advised in writing that legal fees for this deal would be $5,000.00 plus $2,200.00 of disbursements.
Setting possession for February 1st, we began inspecting interiors. Taking on the financial partner role, I made spread sheets; constantly updating income projections, I had also anticipated repair expense, and estimates of our likely return.
Information provided on the ten suite building indicated a 9.9% cap rate if rents were increased by $25.00 per unit. The numbers looked like we would have good positive cash flow of about $14,000.00 a year after allowing for normal repairs, a 5% vacancy and several small rent increases. We were excited!
Pretty soon it became apparent that Paul’s carpenter friend was not contributing.
We dropped him out leaving three of us to complete our company incorporation. For our protection Ann and I held 51% of the voting shares between us since we were the only ones with anything to lose. We each placed $40,000.00 in the corporate bank account for the $70,000.00 down payment, plus legal and other expenses. Neither of us had additional funds that we could easily contribute.
INSPECTIONS DISCLOSE PROBLEMS
Then problems reined down on us. Initial inspections of the older apartment building disclosed many needed repairs: carpets to replace; painting to do; and suspect boiler leaks.
Regardless of attempts to persuade him otherwise the second mortgage lender on the building would not let us assume his mortgage. He would have to be paid out. That meant refinancing.
REFINANCING IS EXPENSIVE
We made an application to a trust company, the current lender, requesting a new mortgage to include $30,000.00 or more for required repairs. Following their inspector’s on site review they required us to obtain a number of reports before they would render their lending decision. They requested a value appraisal, engineer’s reports on roof and boiler systems, and an insurance appraisal. We would also be required to pay to the trust company a 0.5% fee based on mortgage value for their review. We grudgingly accepted, ordering the reports, but expenses were now beginning to badly erode our reduced reserve fund.
 While our purchase price for that building was $300,000.00 the appraisal came back at only $285,000.00. So we negotiated an amendment with the vendor to reduce our contract price by $15,000.00.
My next inspection disclosed several problem tenants that were living in the two run down side by side duplexes. Renovations needed were; paint, replacement of damaged flooring and rotted fences. Several appliance and roof replacements also loomed on the horizon. The vendor said that rent increases had been given out. Up to $750.00 a month each from the $650.00 the tenants told me they were presently paying.
Then we discovered that the vendor did not even have title to the duplexes! He was not even the owner!  His father was. The vendor assured us that his father had agreed to sell.
When the trust company’s mortgage approval was finally received on the 10 suiter, we negotiated a $5,000.00 discount for cash payout of the second mortgage. That would provide us extra funds to offset our rising costs.  However the trust company’s mortgage approval letter added further inspection requirements. These were to be obtained from Emergency Response Department, Building Inspection, utility provider, and an Environmental Law Centre search. It appeared our small payout gain would also be eaten up. Our hearts fell when we discovered we would have to update the fire system to install wired-in heat detectors in every suite. We were relieved when we were able to make a deal with the vendor to cover this expense.
A number of apartment suites and one house was still un-inspected. Looking at that older house on the outside it had water stains on its soffits and stucco walls that to me looked problematic. The stains could be indicating roof and interior damage caused by ice damming, and the potential for mould to start inside the walls.
Time was moving on but our initial requests for information, rent verifications and full building proforma had still not been provided.
Since I was about to embark on a preplanned five week trip to India in early January, Ann and Paul took over. Our lawyers had not received information or adjustments from the vendor’s lawyer so they advised Paul and Ann to extend possession date.  It was extended to March 1st.
NO RENT VERIFICATIONS
On my return in mid February I found out that Paul had cursorily inspected the other properties, without making repair lists. To my horror I learned he had also signed off all conditions without ever having received rent verifications or an actual expense proforma!
Nor had the vendor’s lawyer prepared any of the adjustments yet! Backing out of the deal at this point would mean deposit forfeiture but it was beginning to look like the necessary repairs could bankrupt us in the process.
Telling Raymond Aaron at a meeting in February about our purchase I asked about not having received rent verifications. He replied
  “There is no reason a vendor would not provide this information unless he has something to hide.” 
Now I was doubly concerned.
ENDLESS DELAYS - ERODING CASH FLOW
“Wealth measures how much money your money is making and therefore, your financial survivability.”
Robert T .Kiyosaki
On March 1st we finally received a very simple building proforma.  It did not include caretaking or grounds keeping at all, and indicated different revenue and expense than we had been told. I was very upset.  The other partners were relying on my numbers but with all the extra costs added there was no longer any cash flow left in my projections. It was becoming very dicey. Paul “poo pooed” my concerns saying it was still such a great deal. Of course he had nothing to lose; only Ann and I were at risk.
Our lawyer seemed to be sending out a number of uninitiated letters to us which we asked him to cease. We felt he was just trying to make himself more money. Days passed. Still no information from the vendor’s lawyer, so possession was moved once again first to a date in April and then to May 1st.
In desperation our lawyer’s staff began to prepare the time consuming adjustments with information I submitted. May 1st passed by, and still no verifications were forthcoming. Finally our lawyers arranged a face to face meeting in mid May to see if the deal could be saved.
In a heightened state of anxiety Ann and I went to the lawyer’s office. Facing the vendor and his lawyer across the board room table we finally learned the truth. The vendor had to disclose that there were actually a number of vacancies, including the unrented main floor of the first house we were shown five months before.  Then the vendor sheepishly admitted that rent increases had not been given to any tenants after all. We were thoroughly annoyed to have been deliberately cheated. Perhaps the vendor had seen us as easy marks for his cheating scheme. Our spirits deflated. Any last possibility to make the sale work disappeared at that table. 
The vendor’s failure to provide information requested in the purchase agreement gave us the opportunity to walk away from the sale without forfeiture of our deposit. Our lawyer suggested that a law suit for damages would be expensive so that idea was dropped.
We learned later that the vendor’s lawyer was notorious for his practice of pushing adjustment preparation onto a purchaser’s lawyer to save his client money.
We were shocked to be presented with a bill for $11,357.00 in legal fees. They included charges for unnecessary correspondence work we had earlier chided our lawyer about. We finally settled the total bill for $8,000.00 with the senior partner.
Three months after our settlement was paid we were surprised to receive a letter from our lawyer. It said that two other legal bills were still outstanding for mortgage transfer work by other lawyers. No way were we going to pay the lawyer any more money. In light of our total settlement we refused payment and our lawyer ultimately had to settle with the other firms. 
AVOIDING ANOTHER FIASCO
After this sale collapsed Paul found another property to purchase. An old three story combined commercial and apartment building in a strip mall style. We looked at it from the outside and completed another conditional offer.
My inspection of this building again yielded expensive potential problems. An unfinished part of the basement with cracked concrete and soil floors showed signs of past water problems. The two floors of suites above the offices were in need of painting, carpets and some renovation but were livable and occupied. The parking lot at the rear of the building was in need of patching.
We discovered that the commercial area tenant was a government department whose five year lease was about to expire. Being the only commercial tenant their possible move out could leave both the main and basement levels vacant, a loss of over 60% of the revenue.  That was likely the vendor’s motivation to sell.
We didn’t need any further inspections to tell us to drop it and wisely walked away from this money pit “opportunity” also, with no loss of money. 
CUTTING THE CORD
“You can’t make  a good deal with a bad person.”
Warren Buffett
We then asked Paul to give up his interest in our corporation to which he agreed. His ideas of good deals certainly did not mesh with ours. In the meantime we had learned more about him. We realized he was too greedy and entrepreneurial with no regard for details or follow up. We had been naïve innocents caught up by our inexperience.
Ann and I paid dearly for these lessons.  Our out of pocket expenses were close to $13,000.00.
EXPENSIVE LESSONS LEARNED
  1. When taking on a partner do thorough due diligence into the person’s background and references before agreeing to anything.  Do not presume the person is an expert.
  2. Talk to a lawyer to determine and set up the method by which you will become partners.
  3. Obtain titles to all properties before or as soon as you make your conditional offer.
  4. Verify with the lenders on title all amounts due and whether all mortgages or second mortgages may be assumable.
  5. Do not trust a vendor’s verbal rent statements.  Get proof. 
  6. Request copies and review actual rental lease agreements for length and terms.
  7. Obtain written, signed verifications of rents and utilities from each tenant. When tenant signed verification of rents are not forthcoming in a reasonable time the vendor may have something to hide.
  8. Prepare a spreadsheet to list anticipated expenses and revenue, updating it as new information becomes available.
  9. Obtain an insurance quotation to build the numbers into your spreadsheet.
  10. Limit exposure to expensive lawyer’s fees by doing as much ground work as you can.
  11.  Do you have enough contingency funds to proceed? Costs could be considerably greater than you expect.
  12. Conduct thorough inspections with written repair lists and obtain repair quotations to eliminate surprises prior to being committed to the purchase. Hire an inspection firm to review the property if you have any doubts at all.
13.    Watch for any signs of water problems. Telltale signs of roof ice damming are stains on the siding below the overhanging soffit. Ice damming occurs when freeze thaw cycles gradually build up ice along the roof eaves. The ice expands up the roof pushing under the shingles. The roof eaves are normally protected with a starter course of plastic or tar paper on older homes that does not extend very far up the roof from the edge. When the weather turns warm enough the ice begins to melt and water drips through the soffits and often into the house interior. Moist materials like drywall ceilings and wood framed walls are perfect hosts for the growth of mould. Water in the basement that has seeped in will leave mineral evidence along the joint between floor and wall or along the pathways of flow.
14.    Placing a new mortgage on an old building can be expensive and time consuming. There may be requests for required appraisals, environmental assessment, fire, boiler, roof and other inspections, mortgage placement fees, legal fees, etc. Plus there is the likelihood of having to meet current building and fire codes.
  1. Verify through inspections whether older properties require expensive repairs.
  2. Obtain thorough background and credit checks of tenants with signed lease agreements or you may inherit potential problems trying to collect the rent.
  3. Make certain that condition reports were prepared with the tenants when they moved in. You will need these for damage verification when tenants move out or you will have to pay yourself for any damage restoration expense.
  4. Get assistance from a mentor if tackling something unfamiliar.
  5. In addition when you make a purchase offer:
  • Be sure you list all of your conditions and terms to be provided by the vendor in your offer to purchase.
  • Allow yourself more time than you think may be necessary to obtain the required information or to remove the conditions when buying a commercial property. 
  • If financing is to be obtained allow sufficient time to obtain mortgage approval. A commercial property or an apartment building will require considerably more time to remortgage than a residential purchase. It may take several months time because of the required inspections and reports.
  • Let your lawyer review your agreement before it is presented to the vendor or make one of your conditions a legal review.
  1. Don’t be afraid to challenge your lawyer’s fees if necessary.

AND LASTLY IF A DEAL SOUNDS TOO GOOD TO BE TRUE, IT LIKELY IS!
Helen M. Hamilton
Copyright 2009