April 7, 2024

JF3503: How to Spot and Fix Poorly Operated Properties — the Due Diligence Show ft. Adrian Otto




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, Adrian Otto, president and managing director of Whitestone Capital and CEO of WPG Property Management, joins Slocomb to discuss his due diligence process when walking properties, specifically how to spot and fix poorly operated properties.

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Slocomb Reed (02:39.889)
Best ever listeners. Welcome to the best real estate and investing advice ever show. I'm Slocom Reed. Today we are joined by Adrian Otto for an episode of our due diligence mini series. This is the series in which we discuss during the acquisition process, the things that commercial real estate investors are doing to identify not only the possible issues with the properties they are looking to acquire, but also, the possible opportunities to add value, increase income and force appreciation. Adrian is joining us from Tampa, Florida.

He is the president and managing director of Whitestone capital, which focuses on value add and middle market apartment complexes in Florida. He's also the full-time acting CEO for WPG property management. Originally started as a vertical integration for Whitestone capital. They are also now offering third party management for apartment complexes in the markets in Florida where they currently own. They have recently gone full cycle on five deals. Their current portfolio is 232 units of multifamily and 320 beds of student housing. Adrian, can you tell us a little bit more about your background? And then I want to dive into due diligence.

Adrian Otto (04:05.646)
Sure, well thanks again for having me. So my background, I'm originally from Germany. I moved to the United States in 2016 when we first had the idea that we would wanna diversify our holdings as a family. We sold some of our portfolio of multifamily in Germany and moved over here to Tampa, Florida. So I first moved out here to kind of oversee our portfolio. We hired some third party management companies in the beginning.

And that's really how we got started and how I kind of got into the industry. And then we just built it from there grew quickly our portfolio. And at some point decided that we really needed management in house because we really weren't happy with what the third party management companies here locally were doing with our assets. So that's when we decided to build that management arm as well.

Slocomb Reed (05:02.089)
Nice. So our topic for today is how to spot and fix poorly operated properties. So Adrian, can you tell us a little bit about your process, both pre LOI and post LOI, post contract, you know, when you're in a formal due diligence process, can you tell us more formulaically what your process is for identifying potential issues and value add opportunities. And then we'll see if there are some examples we can dive into.

Adrian Otto (05:36.21)
Sure, sure thing. So when we constantly look at deals, where we look at all deals, pretty much that fit our investing criteria, our box in the state of Florida. So 80s construction and newer multifamily deals in major markets in Florida, minimum kind of 100 units per building range. So when we identify an opportunity, they usually either come off market as from brokers or they come as marketed deals from the various brokers that are active in the state of Florida.

So when we first get them, we typically have a profit and loss statement and a rent roll that we dive into and analyze. So we'll sort the rent roll, we'll kind of start on our initial underwriting. And then we look at major issues within that profit and loss statement as a first thing. Right, a lot of people, especially, people that don't have professional management, their profit and loss statements will be all sorts of inaccurate.

So we'll kind of dive in and see how are these profit and loss statements written? Is there anything major that we could cancel out, strike out that are not part of typical operations or at least not part of our typical operations? And then we just dive in. I mean, we're on a first quick, quick underwriting, we'll look at the, usually the broker assumptions. We'll always take those with a grain of salt, but we look at what their rent comp assumptions are, we'll look at their expense assumptions, and we'll use those figures to do a quick back of the napkin underwriting to see if we're in range of guidance with the brokers. If we are, and it does make sense for us to dive deeper, at that point we typically do an onsite visit. 

So what that means is, most of these deals, because they're value add deals, have some sort of improvements that we're planning on doing, typically physical improvements, renovations that we're planning on doing. So when, yeah.

Slocomb Reed (07:38.136)

Slocomb Reed (07:42.021)
Uh, it's, it's a bit early to interrupt you. Sorry for that, but, um, you brought up the profit and loss statements and, uh, your review of those also my words, uh, but your meaning, I think when you're looking at amateur operators or mom and pop, uh, self-managing owners, those P and L's can be pretty far from the norm with regards to which expenses are included,
and how much each of those expenses is. So that's a natural opportunity for, uh, finding hidden income or hidden NOI for forcing, you know, value add type appreciation, especially in situations where you have one of those more difficult to translate P and L's have you, are you also finding that the brokers presenting these in their OMS uh, are making pro forma projections, uh, for what a new operator would do with the property that are, uh, different significantly different from, uh, from the way that you would operate it financially.

Adrian Otto (08:55.518)
Yes, absolutely. I mean, we, I think the most difficult thing is when you have these unsophisticated mom and pop operators, like you said, is the way that they account on their profit loss statements. So typically if sophisticated assets are run on accrual based accounting, they're their P&L, so at least from what we're seeing, and that's very easy to decipher when someone really does like that cash based accounting, it's hard, hard to look at that.

So the brokers will often take these P&Ls, use the income, and then use almost, let's say 80, 90% pro forma on their expenses and their brokers, they're trying to sell the deal, so they're getting really aggressive on some of their assumptions on payroll, on insurance, which is a big issue right now in the state of Florida, and in the US in general. There's very aggressive assumptions that we really have to look at and make sure that these would work for us, or if they don't, we have to underwrite to what's real. Yeah.

Slocomb Reed (09:56.049)
Gotcha. So we're recording in, in the first quarter of 2024, quick recap for people listening to this in the far future. We are experiencing a time in the market cycle where it's been a year plus since sellers, uh, we're experiencing valuations at the top of the market cycle.

And we're at a moment now where the vast majority of sellers and the vast majority of buyers still aren't meeting because of the very rapid increases in interest rates that we have experienced that may be over for now, but we still see sellers and buyers that are far apart. And so brokers are much more likely to create those aggressive expectations. I mean, they're brokers, they're salespeople in the first place, and they're working on behalf of the seller, but that's exacerbated by the market of the moment.

So, it's easy to assume especially if you're looking at OMS right now. It's easy to assume that a Broker pro forma just has to be dialed back to reality and that it's the property is Just not going to perform as well as the broker expects because the market has shifted both in the revenue Side but also on the expense side with insurance and utilities Cost of debt all those things when you're looking at those aggressive broker assumptions, and let's throw in the amateur operator P and L's as well.

What hidden value add opportunities have you been able to find? Places where you might actually be able to drive revenue and force appreciation that the brokers and the current owners have missed.

Adrian Otto (11:46.882)
So I have seen some properties that are owned by what I call like legacy owners, mom and pop owners that own the property for a very long period of time. Oftentimes if they own multiple properties or even if they just own that one property, they'll run expenses through the profit and loss that really don't belong there. So I've seen people have their personal travel on their P&Ls. I've seen people with their personal vehicles or or staff costs or even renovations that were done on their personal residence that they were putting on the P&L of the asset. So, I mean, that's immediate right there, right? These are not part of the normal operations of that asset. So we can strike that out and immediately generate some value. Other than that, we've, I mean, we've seen...

Adrian Otto (12:44.17)
Really, I mean, from...

I lost my chain of thought there.

Slocomb Reed (12:49.445)
Yeah, it's a tricky question too. So, and this little piece isn't going to end up in the episode, but it's a tricky question. That's why I asked it is because this is such a tricky question.

Adrian Otto (12:59.806)
Yeah. Sorry, can you repeat the question again? Just maybe I get there.

Slocomb Reed (13:03.921)
The question was aggressive broker projections, amateur operator P and L's. What are the, what are the opportunities for increased revenue and, uh, forced appreciation that brokers are still missing right now?

Adrian Otto (13:23.63)
Okay, so I think there's some additional ancillary revenue items that can be generated on site that are often not portrayed in the broker pro forma. So things that come to mind on larger properties is bulk internet agreements where you, we buy internet for the entire community at, call it $30 a unit.

The average tenant in our portfolio spends about $70 on the internet if they were to contract directly with the internet provider. So we can buy it at $30 a unit and resell it to the tenant at $50 a unit. That's $20 a unit obviously in revenue for the property or profit for the property. And that's something that's a lot of the times the brokers don't put on there. And just really understanding where rent comps are.

I mean sometimes, it really depends on the broker, OM, but sometimes we feel like that rents can go a little higher than the broker maybe portrays because we maybe understand the immediate neighborhood a little better. Or we understand that with our rents, with our renovations, we can push rents to a certain level that maybe beyond what the broker is showing. But I think ancillary income to sum it up is really the only place where sometimes a broker is missing the mark.

Slocomb Reed (14:47.409)
Gotcha. Adrian. I, this conversation is the result of me interrupting you from talking about your deep dive into the property after you've seen the offer memorandum and you think the numbers may pencil out. Let's get back to that.

Adrian Otto (15:01.582)
Sure. So after we've done our back of the napkin, quick and dirty underwriting, we make assumptions usually on renovations, right? We think, and that's usually the OM kind of shows the path or the property already has a couple of renovated units. They're achieving 100, 200, $300 rent premiums over the unrenovated ones. So typically our business plan would involve some sort of the improvement of either continuing the seller's business plan or adding an exterior package onto the mix.

So we're making those assumptions. We haven't seen the property in person yet. Broker pictures in the EOM is always very pretty. So we like to go out and actually look at the assets. So once we're out there, typically we bring our general contractor that we're partnering with on these deals and we really just dive down into the capital expenditure side of things, make sure that our assumptions really do meet our initial underwriting.

Also just getting a feel for the property, feel for the neighborhood, touring the comms. We like to mystery shop the comms, so we're actually, we'll pretend to be tenants or prospective tenants at the comparables that are maybe achieving a premium over the asset that we're underwriting at the moment. And really just trying to understand what are they doing better than the asset that we're underwriting?

Is, are the units nicer? Is it the management? And then we also just look at generally the, like some of the hazard type items that we usually don't underwrite with in the beginning, but if there's any trip hazards, we need to take care of any of these ancillary, like capital expenditure items that will come up, we'll identify those in our onsite visit. So once we've done that, I mean, back to the desk and we really just now dive deep into the underwriting, really make sure we tighten down our numbers. And then if it makes sense, we'll, we'll underwrite, we'll write, write an LOI.

Adrian Otto (17:10.85)
That's gonna be the process.

Slocomb Reed (17:10.865)
Gotcha. Yeah. Tell us more about your process after you have an accepted LOI with regards to due diligence.

Adrian Otto (17:20.43)
Sure, sure. So once we have an accepted LOI, I mean the PSA gets kicked off to the attorneys. We have the attorneys go back and forth and agree a PSA to and once the PSA has agreed to I mean we typically like to see a 30 day due diligence period where we also stipulate that we'll get all the documents in the first five days of the due diligence period because historically I mean we've had it where we've received leases two days before our due diligence period expired.

And then half of those leases were incorrect expired. So that kind of puts us into a bad position. So we like to put that in there now that we'll request all the documents that are material to our due diligence. We have a little checklist that we'll send out to the broker is like, Hey, this is everything we're requesting within five days of the executed PSA or five days into due diligence period.

So for the physical DD, we go out there with the contractors. The contractor will go out and bid out the entire project and the renovations where there's subcontractors. We'll usually have a roofing inspection done by a roofing partner. We usually have a plumbing inspection done where we, depending on the age of the asset, if it's a newer product, we don't typically do that, but if it's 70s and 80s or even 90s, we always have the lines cameraed to make sure there's no surprises down the road because that can be very costly.

I just, I had a deal in St. Petersburg, Florida where we didn't do that. And we found out into our ownership that there was a massive route going through the main sewer line of that building, which then ended up costing us almost $35,000 at the time to fix and that was something we didn't budget for back at the time.

So, we kind of learn from our mistakes and we really want to be thorough in our physical due diligence. If there's anything that comes up that's, that's a question, we do call in experts. Like we had a property that 232 units that we're buying in also in Tampa Bay. And there were some questions by our exterior due diligence with the structural integrity of the building. There was some washout under the foundation and we were just concerned. So we, at that point called in the structural engineer to give us an opinion.

Adrian Otto (19:46.126)
Because obviously if a building collapses, I mean, that's kind of worst case scenario, it can cost a lot more than spending that extra $2,000, $3,000 for the structural engineering.

Slocomb Reed (19:51.577)
Right? Yeah.

Adrian Otto (19:57.73)
Yeah, that's kind of the that's for us to verify structural integrity kind of the big ticket items for interior due diligence In the past we've done it on smaller assets We bought the first couple small deals where we really went in and checked every outlet and made sure everything's working We don't typically do that right now So right now what we'll do is we'll walk every single unit.

There's a checklist where we'll if there's different renovation types and different renovation levels within the rent roll we'll just want to verify that what they're saying on the rentals accurate. Um, we'll also overall just evaluate the condition of the unit. We'll evaluate the big ticket items. So the HVAC in Florida and the, um, water heaters, those are kind of the big ticket items inside that we'll want to make sure and note down the H when they were installed, typically you can find those on the systems just so we have an overview later down the line and we can plan and budget accordingly for useful lives, right?

I mean, water heater, kind of the rule of thumb for us is we know it lasts anywhere from seven to 10 years. So if we'll go through and do our due diligence and find that all water heaters are 15 years old, I mean, that's something we'll need to address because we know, okay, if not right now, they will be coming due very soon and we'll need a budget for that. So those are kind of some of the tickets that we look at.

Slocomb Reed (21:41.333)
Adrian focusing on hidden opportunities to force appreciation. Are you, we've already discussed P and L and broker pro forma. So when you're doing your, uh, your physical walkthroughs, verifying the rent role, checking through the lease agreements, comparing them to the financials that you were given by the broker, are you finding uh, forced appreciation opportunities that may have been missed.

Adrian Otto (22:16.694)
Absolutely. I mean we So depending on who the seller is on the other end So I'll give you an example on the 232 units we bought in Tampa Bay When we did our lease audit there and we try to verify Verify that we found a ton of leases that were expired actually out of the 232 units and the property was almost fully occupied At the time there were only 12 leases that were accurate meaning all the other ones were expired, not signed.

There was just incorrect data on there, which made the lease as null and void. So for our business plan, this deal was badly operated. Renovations weren't done since the deal was billed. Basically nothing was done since it was built in 1975, I believe.

So we saw this as an opportunity. Obviously it's an issue, right? If you look at it as an ownership from an asset management perspective, it's a huge problem. But when we're buying this deal, we underrode with a specific velocity of, okay, we're knowing this is the amount of units that come due or that expire. These amount of leases come and expire every month, right?

For now, for the next year, we know exactly how many leases expire every month, and we can find that from the rent roll, because the rent roll usually has a start date and an end date for each lease. So we kind of projected out how many leases are coming due every month and how many units can we renovate if we don't renew those leases.

So now when we went through the physical due diligence and we looked at the leases and we did the full lease audit, we found that only 12 leases were actually accurate. So we were able to kind of shift the timeline and make, made it work in our favor. We were able to renovate more units faster and force that appreciation faster. So that's one of the ways that we're able to do that.

Slocomb Reed (24:14.033)
Yeah, that makes a lot of sense. What about let's move to the physical due diligence. You're there with your contractors to get bids. You already have an idea at least big picture of what your renovation your general renovation plan is going to be while you're on site with your contractors. What are the opportunities that you've been able to uncover?

Adrian Otto (24:40.918)
I think we on our back of the napkin underwriting, we always budget, I mean, pretty cautiously. So we'll put a lot of money in areas. So once we're actually on site, this is what's kind of called the sub buyout periods for contractors, right? When they actually go out there, we always communicate with the contractors to work with. Look, if we're doing the initial due diligence, if we're doing the initial underwriting, I need to have an estimation of what this is going to cost me.

If it's the pool or whether it's the roof or the windows or whatever we're doing, whatever the plan is, I need some rough numbers from these guys and they know, and this is what we communicate to them. Like, give me the almost like a worst case scenario. So we'll know that because we don't wanna go into due diligence and then find out that the roof that we underwrote with $400,000 for replacement costs is now gonna cost us a million dollars.

And then we look stupid when we go back to the brokers because they've communicated, hey, roofs need to be replaced, right? So we don't wanna do that. So we always give them, give me the worst case scenario, give me the highest number and then we'll work down from there.

So that's what we've been doing with the contractors really during the sub buyout period, negotiating, seeing ways where we can potentially save some money. I mean, on the unit renovation is one thing that we like to do. When back a year or two ago, appliances were a big shortage. Sure, sure remember it's been really tough getting appliances kind of peak COVID, right? So I think what we've been able to do is just given the size and the scope of the renovations on the projects that we had at the time is even link multiple properties together because we own, we owned a couple of deals and we did a bulk order of appliances directly from the manufacturer. Right?

So those are things that usually my contractor was going to buy them. But this is one thing, like if you go and buy whatever, three appliance sets a month, that's going to cost me 28, 2900 dollars for the stainless steel appliance set. And if I go out and I buy 70 sets at once, we'll figure out storage with storage containers on site. And we know we're putting in call it five to 10 units of appliance sets a month and we can get them for 1800 dollars instead of 2800 dollars. I mean, that huge savings right there.

So those are the types of strategies that we start to discuss during the physical due diligence with the contractor, seeing where we can maybe fix something instead of replacing it or seeing if there's any sort of scale advantages that we can use.

Slocomb Reed (27:53.025)
Adrian, there are a lot of questions I want to ask you, but unfortunately it's time to conclude this interview. On that note, Adrian, what is your best ever due diligence advice?

Adrian Otto (28:08.35)
I think is really look at the rental and look at leasing trends. A lot of brokers, especially recently are putting performers out there and with rent comps that are just unreal, right? Comparing a 2010 built property with your 1970s built property with different amenities. So really look at and understand what the comps are and where you can get those rents too. And look at the internal leasing trends.

I think, we've seen deals recently where the last five or so signed leases are lower than the last, you know, leases that were signed six months ago. So I think really looking at that and seeing where trends are going at the property, what the trends are around the property and into comparables and really making sure that that's achievable.

Slocomb Reed (29:01.657)
Awesome. Last question. Where can people get in touch with you?

Adrian Otto (29:05.71)
I can, you can reach me on LinkedIn. I think that's the best way, or you can email me at adrian at WPG slash management.com. Both of those work, but LinkedIn, LinkedIn's always good.

Slocomb Reed (29:18.053)
Awesome. Those links are in the show notes. Adrian, thank you. Best ever listeners. Thank you as well for tuning in. If you've gained value from this episode and from our due diligence mini series thus far, please do subscribe to our show. Leave us a five star review and share this episode with a friend. You know, we can add value to through this series and through our episode, our conversation today. Thank you and have a best ever day.

Adrian Otto (29:45.302)
Thank you, Slocomb.

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