This is Part 3 of a 4 Part Series.
Because this is an active deal, with both an existing tenant and partners, I can’t reveal certain deal terms. However, I will do my best to share what I've learned.
If you missed either of the first two parts, please click below for the appropriate article...
Roughly six years into the ownership of our Rosewood Retail property, one of the partners decided she wanted to sell out. A couple years prior, Bobbi (not her real name) had gone through a divorce and a year later relocated to another state. She was involved in another partnership with us and had chosen to sell her portion of ownership earlier. It had gone very well for her as detailed in The Little Property That Could – A Partner Wants Out.
Now, Bobbi decided she wanted to sell her portion of the Rosewood partnership. After running the numbers, the news wasn’t good.
If she still wanted to sell her 25% stake in the partnership, Bobbi would actually get less money than she originally put in.
It was a tough reminder that an investment property’s value is tied to its net income which is a function of both income and expenses.
When we first purchased the Rosewood Retail property, we knew the roof and HVAC (heating / ventilation / air-condition) had some issues.
We dealt with most of the HVAC issues right away by getting on a quarterly maintenance contract. However, there was still an occasional breakdown. Those will occur but in the scheme of things, they’re pretty minor.
What wasn’t minor was the roof. Initially, there was an occasional leak that would show up on the soffit, the overhang that protects customers entering and leaving our tenants' businesses. We’d also get the random complaint about a leak inside a tenant’s business.
To combat the reported leaks, we’d send a roofer out to perform patches. We also hired the roofing company to do seasonal inspections: one check at the beginning of spring and one at the beginning of fall. The roofers would get up on the roof, clean the drains, and inspect for any damage. They also would make minor repairs. Anything other than minor would then go on an hourly rate. There were always hourly rate charges for additional repairs.
I’m not saying this company was doing anything wrong. They helped on other properties and there were no hourly rate charges on those roofs. It’s just that this roof was in bad shape.
The leaks weren’t bad at first, but over time they grew. Correspondingly, our number of calls to the roofing company increased.
Every time the roofing company did their seasonal inspection, they submitted a report along with photos on the condition of the roof. They’d always recommend replacement. The cost was substantial and to replace the roof would require a cash injection from each of the partners.
This property was a thin deal from the start. It wasn’t a homerun and we all knew that. Every month we put a few dollars into the savings account, but then something would break. Mainly, it was an HVAC or roof issue.
We knew those two building systems had issues going in and we still bought the property.
Death by a Thousand Cuts
What was occurring, over and over, was essentially the same call. A leak was reported and I’d send out the roofer. They’d repair it and send a photo of where the fix was done.
Rinse, lather, repeat.
The partners didn’t want to pay for a new roof at the time. It was a cash call scenario – that’s when the partners must put extra money in the pot.
I was in growth mode during the early years of our partnership, trying to build up some semblance of a savings account. I’d recently gone through a divorce, so cash was at a premium. Bobbi was in a similar scenario. The other partners were in a better position, but they didn’t want to pony up for a new roof either.
Therefore, we continued to limp the property along. We took good care of the building, except we never fully addressed the roof, always putting band-aids on a life-threatening wound.
The truth was finally revealed to us through the numbers.
As I said at the beginning, a investment property is valued on its income.
As an example:
If a building generates $50,000 annually in rents, but has $15,000 worth of expenses, it’s going to be valued on $35,000 of Net Operating Income (NOI).
$50,000 -15,000 = $35,000
If an investor expects a return of 8% (or what we call a capitalization rate), the value of the property would be $437,500.
$35,000 ÷ 8% = $437,500.
Rents are typically locked in by a lease and cap rates are often affected by the market. The one thing a landlord can do every year to impact the value of his property is control his expenses. Therefore, if expenses run wild, it can kill the value of a property.
Let’s imagine that your annual expenses jump to $20,000, but everything else remains the same.
$50,000 -20,000 = $30,000
Apply the cap rate:
$30,000 ÷ 8% = $375,000.
That $5,000 worth of expenses impacted the property’s value by $62,500!
The roof expenses, those tiny cuts that happened throughout the years, didn’t seem like that big of deal when we didn’t think about selling. However, the moment one of us wanted out, it came back to hurt in a big way.
Bobbi was extremely disappointed when she saw the numbers. Frankly, so was I. The little, irritating expenses had eroded the value of our property.
The bright spot was that we could get the value back. However, it would require a capital call. We would have to invest money into the building by installing a new roof.
All the partners, including Bobbi, were brought into the discussion. It was clear avoiding to repair the roof had impacted our annual net operating income. We finally needed to make the decision to repair the roof.
I got several roof bids. One roofing company recommended a complete tear off and start over. Their bid was almost double the other bids. The other two bids were for overlays.
Bobbi decided she didn’t want to put in any additional cash into the partnership. The reality is a roof project doesn’t increase value of a property, it only protects it. The roof is expected to be there.
Bobbi decided to take the payout based on the lower value of the project.
Each of the three remaining partners contributed money to buy Bobbi out of the partnership. Later we would each add several thousand dollars more so we could fix the roof.
Do it Now
Sometimes you can put off things off for various reasons. Painting a building is one of those. Maybe the paint looks fine or is slightly faded. However, it’s not failing and doesn’t create a hazard to the actual building. Dragging your feet on this work won’t result in additional expenses.
A building system like a roof, HVAC unit, electrical or plumbing, can result in bigger problems if smaller issues aren’t addressed immediately.
Had we addressed the roof earlier, we would still have had a partnership cash call, but we would have avoided years of related roof expenses. We slowly bled our property because we didn’t “yank the band-aid” off and address the problem.
Real Estate Doesn’t Always Go Up in Value
If the Great Recession disproved anything, it was the myth surrounding the idea that real estate always goes up in value. That’s a bunch of b.s. It’s a great investment, but it can be affected by a multitude of things. The national market, the local neighborhood and mismanagement of expenses are just a few things that can impact a property’s value.
Blindly believing that a property will go up in value puts you into a position to get stung like we did. We weren’t focused on the little things, the small expenses that were eating away at us every year. When we finally needed to value the property, we’d lost roughly 20% of value due to high expenses related to repairs. This was proved again later when we refinanced to get a new loan (without taking additional capital out) and had to use the financials from the previous year when the roof expenses were out of control.
Not All Capital Improvements Add Value to Your Property
Except for the reduction of roof repairs, the unfortunate things about a roof replacement is that it doesn’t increase the value of your building. Tenants expect the roof to be there, just like four walls.
You can’t see a new roof. You can definitely see the effects of a failing roof (leaks, dark spots on the ceiling, etc.), but you won’t see the positive effects of a performing roof. It’s like trying to see air. When it’s doing its job, a roof isn’t seen.
Also, a roof doesn’t make a commercial property look any more appealing to a tenant. Most likely, a tenant will go through their entire tenancy without ever stepping foot on the roof. They expect it to do its job just like you expect them to pay the rent.
A new roof doesn’t suddenly make a property more desirable to the market, thereby allowing you to command a higher rent. However, it could affect you negatively come renewal time. A tenant who has spent years battling roof leaks isn’t likely to stick around for another five-year term, are they?
A new roof isn’t likely to add value to your property, but a failing roof will definitely detract from it.