Slumlords —How they make a buck
We hear so much about slumlords and how they steal property: They get it cheap, they collect rent, and never make any repairs. Ethical issues aside, why would these people do this — if there weren’t substantial financial rewards? The fact is, they wouldn’t.
The typical slumlord acquires property for little or no money down, probably no more than 10% down on a given property. They typically try to buy a property for between $15,000.00 and $20,000.00 per unit, no more. This has to do with cash flow considerations that we will get into later. These properties can be anywhere from a simple four-plex to a large apartment complex that has gone into foreclosure. Either way, there are reasons for a “distressed sale.” The distress may be that of the person who wants to get out of the apartment business, or that an insurance company or another lender has foreclosed on the previous owner of the apartment complex and has put the property up for auction: Sale to the highest public bidder. The distress can also be rents that do not support the upkeep of the building under typical, market rate financing conditions, especially where rent control regulations are in place.
In any case, the typical slumlord comes in, and does not argue price: They argue terms. Typically, the terms are for lower than market rate interest and a 30-year time period to repay the rent. Or anything that amortizes as a 30- year note. It may have a 10-year balloon or 15-year balloon: They really don’t care past the first five years as long as they can reduce the payment to the lowest amount possible in the first five year time period. The slumlord will then purchase the property. The seller will have little problem with the first one to five payments.
Then the complaints from the buyer begin. These complaints can range from deception on the part of the seller, undisclosed problems, and unknown problems that were not previously disclosed. This editor has seen excuses such as: Undisclosed galvanized pipes; Undisclosed environmental liability from asbestos (one of the newest — and most favored — ones I have seen); Undisclosed structural damage; And a host of other things that would cause some angst if the person were to initiate foreclosure proceedings and then have to sell a piece of damaged merchandise again. A property that they thought was in perfectly good shape when they sold it to the slumlord.
It is this point in time that the slumlord begins making either no payments or only partial payments on the note. He will use a variety of legal tricks, including stringing out the foreclosure proceedings, counter-claiming for any number of the host of previously alleged defects or undisclosed environmental liabilities, or by claiming that the entire payment had been made but that the owners of the title company have lost them. The purpose here is to realize that the intent of the slumlord is to make little or no payment to the seller or the financier for as long as humanly possible.
The most successful of these I have seen ran three years. The new owner of the property, an attorney, claimed that there was an asbestos problem and that the ceilings of the entire building were filled with what appeared to be asbestos and that it was going to cost 1.1 million dollars to remove. Well, the building was only worth $3.5 and the bank wasn’t crazy about having to invest another $1.1 million. The bank sat on their thumbs for a year and a half. Finally, they had enough, and unbeknownst to the owner, initiated a testing program on the property. They found out that the ceiling was filled with mica, not asbestos, and immediately initiated foreclosure proceedings.
As the foreclosure date approached, the owner of the property filed for protection under Chapter 11 bankruptcy laws. He forestalled the bankruptcy for another year. Eventually, the bank successfully petitioned to lift the stay on foreclosure, foreclosed, and found that they had to invest $700,000 back into a property which had not been maintained for four years.
How much money did the man make on this particular transaction? Well, the calculations are pretty straightforward. Assume a financing arrangement where the buyer pays less than 50% monthly rent per unit (4 years gross income per unit, purchase price). The apartment complex had 260 units. He purchased the apartment complex for a purchase price of $3,900,000 putting down $500,000. This left a balance of $3,400,000.
His payments on the $3,400,000 were $15,800 per month. The average rental on the units (this example is not in Manhattan) was $450.00 each. Over the period of his ownership, the slumlord kept about 85% of his units rented. So $450.00 times 221 (85% of 260 units) comes to $99,450.00 a month. Since the, er, gentleman, kept the property for a total of 37 months without making any mortgage payments, he collected $3,679,650 on a $500,000.00 investment. This means he made roughly, 19.5 % on his money every month!
That does not include the tax benefits of depreciation, nor does it include any type of overhead such as the manager he had to have on duty to make sure the rent was collected. Since the original note was a non-recourse note, the property was foreclosed, resold, and a judgment was obtained against the partnership that owned the property. The general partner was a shell corporation, and he was the only limited partner. As a consequence, no deficiency judgment can ever be collected on this particular property.
Did the bank pursue him? No! Nor was this case referred to any legal authorities to look into.
Typically, what you see is a gentleman that will own 20-30 properties, have purchased these properties from older individuals, he will not argue the price, again, he will only argue terms. So a woman asking $200,000.00 for a beat up 5 plex or 6-plex that most people would not touch, the gentleman will take in a heart-beat. Then begin the process of collecting rents and making no repairs whatsoever.
In the examples above, are any of these frauds in the dictionary definition? I think so. Are any of these frauds under the legal descriptions of fraud in the various states? Quite possibly, they are. What is the likelihood of prosecution on something like this – almost nil. As financial investigators, have we found this to be a wide spread practice? Absolutely!
So how do you avoid being a victim? Let’s take a look at the primary victims here, the financial institutions and the people who have sold the property to a slumlord. In all instances, since you have a credit granting relationship with this individual, you may — and should — run a credit report. This will get rid of 9 out of 10 of the problem buyers. These are the people who are the professional slumlords and have unpaid bills, usually across several states. In addition you should have a property inspection prior to loan done by an engineer, a proper appraisal by Certified or Licensed Appraiser, and an environmental inspection if anything untoward is found.
The more professional slumlord — the institutional slumlord in the example above — needs to be treated more carefully. With this class of purchaser you need to have an idea of the areas in which he has operated property in the past, and under what business names. Any investigator or information broker can run a quick search and get that information. Check the superior court for the counties of concern. and for all locations where the potential buyer has operated properties. The litigation will tell you the entire tale of whether this person is a victim or a victimizer. In the above example, the attorney walked out of court and told me “Well, you got this one quicker than most, but let me tell you, usually I can forestall any litigation for an entire year. I have a death in the family, a religious holiday, 2 medical appointments, and of course a conflict of schedule. Those 5 excuses can usually get me through an entire year before I have to even appear in court.”
And remember that while we have talked about slumlords and residential property, it equally applies to the loans made to buyers of properties who are not exactly SLUMlords, but buyers of distressed shopping centers, etc. By our saying slumlord, we don’t want you to miss the sophisticated buyer of commercial properties who “robs” lenders….
Let’s just recap some of the warning flags:
• They don’t argue price. This should be your number one warning flag. They don’t argue price because they don’t care what they are paying, because they are not going to pay you.
• They are most interested in what the monthly payment will be and how they can lower that monthly payment as much as possible, especially in the first few years.
• They wear a better suit than do you.
As we have seen in the e-Journal again and again, an ounce of prevention is worth a pound of cure. And again and again we are brought in, too late, by too many who get burned because they believe themselves to be too smart to need our services in exercising due diligence in financial transactions, and so never do the required — but oft-ignored — background checks, financial examinations, and physical inspections.