April 14, 2024

JF3510: Discovering Creative Value-Add Opportunities Through Due Diligence — the Due Diligence Show ft. Jonathan Bombaci



Welcome to the Due Diligence Show, a new Best Ever series featuring deep dives into every aspect of the due diligence process. In this series, our host, Slocomb Reed, will interview expert guests to uncover their stories, tips, and strategies to give you the information you need to master the due diligence process. In this episode, Jonathan Bombaci, founder of Candor Realty, joins Slocomb to discuss his due diligence process, specifically how to discover creative value-add opportunities.

Jonathan Bombaci | Real Estate Background

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Slocomb Reed (02:08.834)
Best ever listeners. Welcome to the best real estate investing advice ever show. I'm Slocomb Reed. And today we are bringing you another episode of our due diligence show. This mini series is all about the due diligence process and commercial real estate investing during your acquisition process, especially focused on multifamily acquisitions. 

Today we have with us Jon Bombaci. He is based in Lowell, Massachusetts. He's the owner of Candor Realty. They're a vertically integrated multifamily investor and operator with both syndication and joint venture ownership structures. Their current portfolio consists of over 550 apartments. John, can you tell us a little bit more about your background and your current portfolio?

Jon (03:15.66)
Sure, yeah, thank you for having me.

So I started off in the insurance industry. I went to college got a good degree Spent ten years in corporate churn before jumping into real estate full-time The first property I bought was actually a three-family house hack when I graduated from college when I was 22 I didn't do real estate for a long time after that But then when push came to shove I kind of found my way back into the industry in 2019 when we ended up going full-time real estate at that time. 

Ever since then kind of focused on building a team focused on bigger deals and with bigger deals comes syndication and new ways to partner in order to take down projects. The more complicated the project, the more important due diligence becomes. It's all a process. There's not much difference between a single family and a hundred-unit apartment complex in terms of what could go wrong, but the cost of something going wrong is magnified by multiples. And so due diligence becomes very important on the larger scale.

Slocomb Reed (04:21.598)
Yeah, of course it does. Hey, quick question. When, when did you graduate college and get your house hack?

Jon (04:28.353)
I graduated college in 2010 and I got my house hack in 2011.

Slocomb Reed (04:33.826)
Gotcha. That makes sense. I, Greg, I'm a little older than you, but I got my house hack in 2013. Man. Was it a good time to buy a house hack for sure.

Jon (04:42.164)
Wish I bought more at that time for sure.

Slocomb Reed (04:44.638)
We, we all do. Right. Um, so the working title of this episode of the due diligence mini series is uncovering value add opportunities through due diligence. I want to start by asking John, what does opportunistic due diligence mean to you? What does that look like?

Jon (05:05.952)
So for us, and actually we say this a lot to our sellers, is when we enter due diligence, we look for reasons to move forward before we start looking for reasons to back out. And I feel like a lot of times in this industry, people are constantly putting things under contract and then starting due diligence looking for problems. Our first time going through due diligence is we're looking for opportunities where we call the city.

We ask them questions to understand what they want to happen with the building. What opportunities they might be if there's a pain point or a problem with the building. So like the first, the first 15, 20 days of our due diligence is really looking at what, what things are, are available to us at this property that this, that might not be available to the seller. Um, and a lot of times because we're, we're buying some of the worst properties in towns, um, just by by transferring title to us, we can solve some of the problems and open up opportunities that weren't available to the prior ownership.

Slocomb Reed (06:13.174)
What are some examples of those kinds of opportunities that have come up in your portfolio?

Jon (06:20.288)
A lot of times it comes down to conversion. So we might look at a building and it's a mixed use building. And the prior owner wasn't able to get permission to convert it into the number of apartments that we can. Because it's a problem for the city, because it's across the street from town hall, because this particular investor is well known for all the bad things they've done, the city won't work with them.

If we can enter due diligence and during due diligence, open up those relations with the city and say, hey, we're buying this building, we're solving this problem. What do you want this building to look like, leading the conversation that way and then asking for the things we need in return tends to be very well received in a lot of the cities we do Dillonson to it and um or do business with a lot of people always ask like is it is it because you know the city going in and the answer is most of the time we don't it's really making that call to town hall and asking we're buying this building, what do you want to happen here?

And you'll be surprised how quickly the planning department or the building department want to sit down and talk to a new owner, want to get you introduced to the mayor or the town manager or the planning board or the economic developing director to say, hey, I've got someone that wants to come into the town and change this parcel that's been driving us nuts. So like, let's take advantage of talking to this person early and kind of convincing them to buy this parcel and helping us fix it.

A lot of times the cities and the towns are looking for partners. If you can enter that relationship as a partner before you have any skin in the game, you'll be surprised how much progress you can make. But if you close on the building and you already inherited the problem, now the city can hold you to a new standard. But if you're going into it with nothing at risk, it's a very equal playing field conversation.

Slocomb Reed (08:23.882)
You, you kind of referenced this already, Jon, but you said you don't typically know the city before you get the property under contract. How much of a factor in your underwriting and in your, uh, your offer process, is it to know that, uh, local and regional, uh, government authorities are going to be agreeable to working with you on something like that.

Jon (08:56.2)
It normally isn't, right? So we assume the property we're buying is the property it will be in the future. But I mean, we look for opportunities to improve that asset. And that conversation with the city is normally an easy slam dunk early on, where we can say, hey, we have this industrial building that's driving the city nuts. We know it's driving the city nuts. We'd love to have a redevelopment play here, but we need some sort of assurance from the city that this is gonna work.

Otherwise, you know, the building's just gonna exist as what it is today. And sometimes those conversations go very well. Sometimes the conversations are just like, nope, sorry, you can't do that. The zoning is different. Like, you know, the neighbors aren't going to allow it. There's nothing the city can help you with. But then the building is just what we thought it was when we bought it. And we find out the building can be a lot more that gives us, um, gives us extra value in that asset that wasn't available to the current owner.

Slocomb Reed (10:02.21)
So effectively you're not talking about a change in the way that deals are underwritten necessarily or the kinds of, uh, the price that you're willing to offer for a property. It's more about adding an additional step to your due diligence process to see if engaging the city about the property and possibly changing its use is going to be of greater benefit and greater financial advantage to you and your investors than the current use which currently pencils based on your pre-offer underwriting.

Jon (10:40.012)
Correct. Yeah. So for example, like we bought a building in a small town called Gardner, Massachusetts, and it was a commercial building. It was retail on the first floor, office space on the second and third floor. We bought it for $1,000, $400,000, $500,000. And the underwriting was based off of it remaining 100% commercial building. It made sense at $500,000 with four commercial tenants on the first floor and office space on the second and third floor. Once we had under contract, we talked to the city, they wanted housing.

And so we were able to get a permit approved to put 18 residential units on the second and third floor. And then we got a new appraisal on it with the bank. And now it's worth the 3.2 million dollars. We're in the process of doing the conversion. It's going to be a two million dollar renovation budget, but we bought it for 500. We're putting two million into it. And we're sitting on a three, two appraisal that is already 18 months old and the rents have gone up quite a bit over the course of the last 18 months. But again, like we purchased it based off of what it was. The conversations with the city opened up a whole different dialogue about what it could be.

Slocomb Reed (11:49.506)
That's definitely an opportunistic approach to due diligence on that's John. That's awesome. What other opportunities have you, what other opportunities do you all target? And what have you, what else have you uncovered during your due diligence processes?

Jon (12:09.39)
Believe it or not, and this is going to be a shock to you, people don't like paying taxes.

So a lot of times we're dealing with some of our older, more seasoned landlords, we find out that there's a lot of income that is potentially off the books, whether that's laundry or parking or something. And we're very quick to dismiss it from our underwriting in terms of buying the asset because they didn't claim it, we can't count it, the bank doesn't recognize it. And then we're very quick to legitimize that money the day we buy the building. And so it, but I'm on 132 unit apartment building we bought like it was literally $5,000 a month in laundry that was missing from the books by recognizing that $5,000 a month or $60,000 a year on a five cap Like that had a pretty big impact on value day one that the current owner was neglecting because they were penny wise, but dollar foolish in that approach, where they were saving the money on the five grand a month, but they were losing the opportunity on the resale because it wasn't legitimate income.

Slocomb Reed (13:22.846)
And again, you go under wrote that deal and it had to work based on your targeted returns without bringing to light those revenue streams, but then added bonus when you were able to actually take credit for that revenue, which increases your tax bill, but also significantly increases the value of the property.

Jon (13:48.424)
And if we're only holding it three to five years, I want three years of legitimate books. So then when I go to turn this thing over, like you can count it in your underwriting, right? And so I think it's all about the strategy. If I was going to buy this thing and hold it for 30 years and die with it in my estate, maybe I would like to avoid taxes as well. But if my goal is to maximize the return for investors in a short period of time, my incentive is to legitimize as much money as possible, as quickly as possible.

Slocomb Reed (14:22.39)
That makes sense. So we have the potential for conversion or working with the local municipality to turn the property into something that the city will find more favorable that will have a significantly higher appraised value. We have uncovering revenue streams that are currently off the books to increase revenue, increase NOI and the value of the property, even though it'll increases your taxes a bit in the meantime, what other big opportunities have you all been able to take advantage of?

Jon (15:05.796)
I mean those are probably like a lot of the ones that we look for especially when we're... So we have the knack of buying properties off of the worst landlords in cities and so we tend to find quite a bit of opportunity there where the city's not letting them do certain things because they have a bad reputation, the tenants are unhappy, you know, pest control needs to be done across the whole portfolio, all the tenants are very miserable because of the current setup of the buildings.

And so a lot of times we look at that as as goodwill when we enter these relationships and we can kind of call the city and say, hey, we're buying this building. What do you know about it? We're new to town. We run a good shop. You can talk to some of the mayors or town managers and other cities in your state in case you want to check up on us. We're going to do our best to clean up the building.

And then normally we get a lot of goodwill out of the city because of that, where, you know, we bought a big portfolio up in Lewiston, living in one of the abandoned buildings. There's a homeless shelter set up in one of our buildings. We did our due diligence. We built a relationship with the city early on, explained to them who we were, what we're going to do. The day of closing, they had six cop cars on the property to help us empty the building, put up plywood, secure it. And that wouldn't have happened if we didn't do the due diligence upfront to build that relationship and get the municipality on board.

And so what might have taken someone else six months to get squatter rights removed from the property and corridors and police on site to fix a problem across the street from the town hall, we were able to resolve within 24 hours of closing because of the way we did our due diligence, because of the way we built that alignment with the municipality before we even owned the building. Does that make sense? Like it's like, it's unforeseen value where it's like because we're able to build goodwill, we're able to ask for favors, but it comes across as us doing a favor for the city as well.

Slocomb Reed (17:15.67)
Yeah, that makes a lot of sense, John. The question it's leaving me with specific to this deal and how long ago was this acquisition?

Jon (17:23.324)
Lewiston was September of last year. So we're just wrapping up that portfolio now, but we've only had it, you know, that was maybe 15 months ago, 16 months ago.

Slocomb Reed (17:39.906)
Gotcha. So almost a year and a half, I'm not going to ask you to remember every single number in detail from that underwriting and due diligence process, John, but, the Lewiston deal, had you not been able to resolve the, these issues that the police came out and helped you with day one, that's a deal that still would have delivered targeted returns without that happening.

Jon (18:09.968)
Of course. Yeah, I mean, it's got to otherwise we wouldn't have entered it, right? Like everything we find during due diligence that makes our life easier. That's a bonus. But like you have to assume that it's going to go the way that you would expect, where it's going to take you 30, 60 days to get a court date. It's going to take you 30, 60 days to get someone on site to help you deal with it. And potentially, you're going to have to be paying to relocate those people in case that they are able to establish quarter rates.

Slocomb Reed (18:41.398)
Yeah, it's interesting. It also makes me very happy that I'm still investing in the Midwest where things like that don't necessarily exist.

John, these are really helpful examples and ideas that I know all of our listeners will be, gain some value from hearing and hopefully some of them will have the opportunity to implement in due diligence processes in the beginning. Let's, I'd like to reframe the conversation now.

Slocomb Reed (19:25.982)
We have a fairly sophisticated listener base, John. And so they're not, they've probably been through due diligence on commercial real estate before, and they are accustomed to a conventional due diligence process. And for those of you listeners who are not, feel free to Google it, feel free to go to bestevercre.com and search due diligence and check out some of the resources that are available there.

John, let's start with that conventional due diligence process as a baseline. Putting yourself in the perspective of having just gotten an LOI accepted, getting ready to get an actual contract signed and get a, get a property tied up.

How does your approach to due diligence from the onset differ from the conventional approach? I know that you said you're going to proactively reach out to local government authorities to see if there are other opportunities available for what this property could be. You're going to look for not just confirming the financial figures that you've been given, but also trying to find the revenue that's being generated off the books. What other things are parts of your due diligence process that lead to more value add opportunities?

Jon (21:05.768)
Yeah, so I mean the standard due diligence process, I would say we get an LOI, we walk every single unit before we sign a formal contract. And then once we sign a formal contract, we tell everybody and their mother about us buying this property, which I think it differs from a lot of people who try to keep things secret because they're afraid someone's going to swoop in and steal it from the seller. But we feel very confident in our contract.

We feel very confident in the rapport that we built with the seller that we tell everybody we call brokers, we call agents, we tell our whole network, we call the city, we call the town, we call insurance agencies, like we tell everybody we know about it. And then inevitably, believe it or not, it's not that big of a secret. People know the building, people have walked the building. People know where the skeletons are buried. People know what concerned the prior owner prior guy that tried to get it developed. There's a story out there, especially when you're entering a market that you don't know all that well.

And so we've been saved from a lot of heartache, from a lot of deals, by opening up to our network and saying, hey, who knows something about this building that we don't know? And I think it's part of it is just kind of the, we would like to think that we're getting a deal of a lifetime. We don't want anyone to steal it from us. But I mean, I think we've gotten wise enough to know, people know about this building, there's some problems with it. Let's try to get ahead of those problems. And the easiest way to do that is to broadcast it and let people bring it to you. The off-market deal is great.

But there's a reason why it's off market and a lot of times it's because there's something wrong with the property that either the seller or the broker either don't want to disclose or maybe don't know about. By casting a wide net, you're able to bring those problems to the surface early and then you can figure out if you need to deal with them. One of our best deals, there was a structural problem.

But by understanding what the structural problem was, we were able to get a structural engineer on site early in the due diligence process. They were able to confirm that it wasn't that big of a deal. The property had stopped moving. There was some temporary settling for when it was built 50 years ago. It hasn't moved since. And the problem that scared three or four buyers away before that found out about it late in the due diligence process and how to make a go, don't go decision based off of a gut feeling, we were able to nip in the bud in the process with 30 days left on our due diligence and we were able to overcome that issue because we found out about it early enough to do something about it.

The problem with your diligence if you find out of a problem too late you have this gut reaction to either over negotiate and maybe get yourself out of the contract or cut bait and run. If you find out of the project early on your team can spend 30 days trying to solve the problem and that can be the different between moving forward the deal versus not.

Slocomb Reed (24:17.89)
Getting the LOI signed, then walking every unit, then signing the legally binding purchase contract.

And then once you have the property tied up, tell everyone that you've got it. So that you can let everyone who knows about that property turn over rocks and tell you the things that they've already uncovered.

Jon (24:44.188)
Yeah, because I promise you, you're not the first one to walk that property and someone sold that property to the other seller. Like there's some skeletons there.

Slocomb Reed (24:55.646)
I love that. That makes so much sense, especially coming into commercial from the residential world. I sometimes get frustrated with how long it takes to get from LOI to purchase contract. The, do you come across sellers and brokers who are either hesitant or maybe won't even allow you to walk the units or disturb their current tenants until you have a PSA signed.

Jon (25:25.06)
Um, very rarely. Um, sometimes it happens, right? Um, but, but in those scenarios, we just say, all right, fine. We'll sign a PNS that's contingent on satisfactory walkthrough of all units. And I mean, that essentially makes the PNS like garbage. And so you have two options, right? You either, you either sign that in which case don't really get anything out of it or let us walk it all in advance. And then you have a real contract.

Slocomb Reed (26:01.154)
We're going down a bit of a rabbit hole here, John, but I have to ask one more question. The only other thing about that contract, when it has the walkthrough or physical inspection contingency is earnest money and when it goes hard. I know at least in Cincinnati, there are still sellers and listing brokers who are trying to get hard earnest money day one or hard earnest money very quickly, faster than we were accustomed to pre-COVID. Because last year and the year before is the seller's expectation, right? Not the market of the moment necessarily because it's not as advantageous to them.

But are you thinking through, you know, LOI then walkthroughs, then PSA. Are you putting down hard earners money day one when that contract is signed?

Jon (27:02.612)
Very rarely, most of the time if we're getting pushed for hard deposits, we'll make the money go hard after due diligence, is normally the way that we write our contracts. So I'll give you your 100 grand or whatever as you're looking for, it'll go hard once we finish due diligence.

And then, and then we enter our financing stage. And so you're protected against us failing on financing, but I won't, I won't give people hard money without, without being up due to my due diligence first.

Slocomb Reed (27:38.89)
Yeah, that makes a lot of sense and honestly feels like the way that it should be. Frankly, whether you're a buyer or a seller, that should that, that feels to me like it ought to be the expectation that the buyer will get to do the due diligence process, but as soon as they're done, money goes hard.

Jon (28:00.468)
And maybe we've lost some deals because of that, but I'd say like it's a risk versus reward conversation. And very rarely in the commercial space are you truly finding something that no one else has looked at.

And so we're always very protective of money going hard. And the way that we try to protect that is, you know, making sure that if we're going hard, we're moving to closing and we've never not closed on a property once we've gotten through due diligence and have made the commitment that we're going to move forward with buying it.

Slocomb Reed (28:42.95)
Awesome. Well, John, uh, being that this is the due diligence mini series for the best of our podcast, I'd like to try to summarize at least what I've learned from our conversation. And then we will head into the end of this episode. There are a couple of key ideas or things here that I want to touch on. The first is that, uh, you tell sellers whenever you can be directed, I'm we're listing brokers that your due diligence process is about finding opportunity as much as it is about finding flaw, but also that is created by the fact that you're doing your walkthroughs before you have assigned PSA.

So you guys have a really solid idea of what it is that you're buying before you're, uh, you're signing the legally binding contract. The moment you sign it, you tell everyone you're buying this property that includes all of the investors locally, everyone in your sphere, but also it includes local government authorities so that they have the opportunity to weigh in during your due diligence process on whether or not there are any issues of the property that haven't been discovered yet but also whether or not there are any conversion opportunities or things that you could do to the property that the city would grant permission for that would vastly increase the value of that property or the NOI.

The two biggest opportunities that you have come across that you think our listeners should be watching for during the due diligence process are those conversion opportunities and the opportunity to engage the city, the local municipality in general in advance of the acquisition, whether it's because you want to convert a property to increase value or you know you're gonna need to work with the city to resolve issues currently going on at the property based on how it was operated prior to your acquisition.

The other big one though is making sure that you are finding the undocumented revenue that is currently in place at the property. Previous owners were keeping some revenue off the books to reduce their tax burden during ownership. You find that revenue, get it on the books.

Slocomb Reed (31:05.746)
It increases your red and OI and it increases the value of the property in return, making your sale or your refinance, uh, towards the end of your business plan that much juicier. John, assuming I've done a decent job of, of summarizing most of what you said, is there anything else you'd like to add?

Jon (31:46.828)
I mean, I think the biggest thing that I kind of stress to people is, you know, one of the things I always say is build a strong team early on. The stronger a team, the easier this gets. I feel like a lot of times in real estate, we like to compete against each other. We like to see, we like the competition. We like it being us versus them. And I try to approach it the other way. Bring as many people in as you can. Ask for help as often as you can.

And that's how you kind of get ahead of the game. I think the lone wolf in this industry has a really hard time. I think if you make it a habit to ask for help and make yourself a little bit vulnerable at certain instances saying, I don't know everything, what do you know? You inevitably find out things you don't know that you would find out 30 days after closing. And so it's better to get that information upfront even if you feel like it's exposing you a little bit.

Real estate is a big ego business. I think that the sooner you can kill your ego, the easier it becomes.

Slocomb Reed (32:58.254)
Thanks a lot of sense. And we're going to call that your best ever advice. John, thank you. Best ever listeners, thank you as well for tuning into our due diligence mini series today, learning about the opportunities we can uncover during the due diligence process. If you gained value from this episode, please do subscribe to our show and leave us a five star review and tell a friend about this episode so they can learn the same things that you have today. Thank you and have a best ever day.

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