INCOME PROPERTY: When Cash Cows Become Vicious Alligators

In 2008, I began attending regular lunches with a group of real estate investors in Weber County.  It was a great place to meet people with similar interests and share opportunities and best practices among each other.  I met many of my best and most loyal clients at these gatherings.

One client in particular moved here from California and began to aggressively acquire properties as the market turned downward.  I arranged for many transactions, most of them seller financed, as this particular client built a growing portfolio of properties.  This client indicated their plan was to cash flow the properties and invest in capital improvements to build equity.  That seemed to make sense.

However, by 2010, I distanced myself from this client as I learned more about their business practices and how they were operating.  They were obtaining funding from private investors based on the promise of what I considered unrealistic returns.  One particularly interesting 'trick' they used to facilitate their operations was to offer no-deposit lease terms to tenants.  The idea was that by reducing the deposit, they could increase rents proportionally or even more.  Since income property value is based on rent rolls, theoretically, this trick should increase the value of the property they owned.  If the value of the property was worth more, they could show this as an increase in equity and thus present it as evidence of their wise use of their investor-partner's funds.

The problem, of course, is that deposits are a natural and necessary part of responsibly managing property.  Also, according to the Rule of Three, there are natural limits to the price a tenant can pay in rent.  So, this client attempted to defy gravity, so to speak, by raising rents, dumping deposits, and hoping that everything would go well.

As you can imagine, they didn't go well.  When I spoke to the client's property manager in 2012, he indicated they were experiencing a 20% vacancy rate.  That was remarkable when the ambient market vacancy rate is just 4% for tenable property.  Whatever gains they were making on higher rents were being lost through punishing vacancy rates.

The other problem was that tenants had no incentive whatsoever to keep up the condition of the property.  When these tenants left, the client spent much more than was necessary to repair the units because the tenants abused the places without restraint.  And of course, since the tenants were typically low income, collecting from them for the damage was nearly impossible.

Thus, over a period of time, the business model began to unravel as investor-partners began to question their return on investment. Major cracks in the edifice began to show themselves in 2013.  At that time, this former client mailed keys back to the seller of a property they had bought via seller financing in 2008. Since that time, the former client's name has appeared on the Notice of Default list frequently as they have stopped making payments on their mortgage obligations.

Yet, in all the chaos that has descended on the portfolio of this former client, we made an interesting discovery.  Some of these properties in foreclosure have ended up with 2nd and 3rd mortgages on them.  Even more shocking, the loans came from private retirement accounts.  Finally, to ad insult to injury, many of these loans were made within weeks of the borrower defaulting on their first mortgage obligations.  It appears that while the Titanic was sinking, someone was been running up the tab at the bar.  In such situations, the private IRAs have no hope of recovering their investment as their collateral is wiped out at the foreclosure auction.  It is a sad sight.

Investors like cash cows that that produce profit each month after all expenses are considered.  The opposite of a cash cow is an alligator which is a property that needs to be fed money each month to keep operating.  It appears that this former client purchased what he thought were cash cows and through unwise decisions mutated them into vicious alligators.  These alligators have eaten their owner alive and it appears it was a feeding frenzy.