Chapter 9
Leakage
In the first week of July, Dana Tran had asked the three property managers for every service contract at every building the funds owned, and the contracts came in through the rest of the month in whatever shape each manager kept them. One sent a folder for each property, every file named the same way. One sent a single scanned document hundreds of pages long, in which somebody had fed part of the stack through the copier upside down. The third sent a courier with two cardboard boxes. Dana carried them up the stairs herself and set them beside her desk, and Owen spent a Saturday at the scanner by the printer, feeding them through a folder at a time.
On Monday the second of August, at nine, Owen laid a single page on the long table downstairs. Andy sat at the side with Maggie, Arturo, Dana and Tom.
The page said what the review would read. Two years of every manager’s monthly reports for every building the funds had owned in that time, in the one shape Owen had put them in since June. The general ledgers behind the reports. The bank statements Tom received for each property. The capital budgets and every draw against them. Every contract in Dana’s boxes, and every file the funds kept on an investment the firm did not control. Under that, in two sentences, it said what the agents would do with all of it. They would read it and compare it, building against building and month against month, and write down anything that did not agree, with the page it came from and the name of whoever at the firm owned that building or that line. Before each run they would write a note saying what they meant to do, and Arturo and Dana would read the notes first.
At the foot of the page was Anika’s signature, dated the Friday before, under two lines she had written on Owen’s record of the overnight runs since July. Read only, from copies in one review folder Owen keeps. Nothing live and no mailboxes.
“And when it finds something?” Arturo said.
“It leaves a page in the review folder with the documents under it,” Owen said. “Whoever owns the building decides whether it’s right.”
“Most of the buildings are mine.”
“Then most of the pages are yours.”
Arturo nodded once and wrote something on his pad. He had been Head of Asset Management for a month.
Andy turned the page toward himself and read it again. For two years the firm had read every one of these reports the way it always had: a month at a time, one building at a time, by whoever had that building that month. He could not think of a single day when anybody had read all of them at once.
Maggie slid a sheet across the table to Owen. It was the management company’s own list of vendors, every subscription and service the firm paid for out of its own pocket, from the IT vendor down to the coffee. “Put us in it too,” she said.
Owen added a line at the bottom of his page while she watched, and turned the page back to face the table.
On Thursday Dana called Andy over to her desk on his way back from the kitchen.
The agent had built a table of every service contract in the boxes. There was a row for each, and the columns ran across two screens: the building, the vendor, the service, the date the contract began, how it renewed, what it took to end it. The last column was headed Last bid, and in it the agent had written the date of the last time anyone had asked another vendor for a price on the same work. It had searched the contracts, the correspondence files Dana had copied into the review folder and two years of payables to fill it in. Down most of the column it had written none found.
Dana scrolled. Trash hauling, pest control, landscaping, pool service, the gate system, the fire alarm monitoring, the leases on the machines in the laundry rooms. Most of them renewed themselves every year on the anniversary unless someone sent written notice, some by certified mail, inside a window that closed weeks before the date. A few renewed for three years at a time.
She stopped at a landscaping contract at a Fund II property in Durham.
“The seller’s manager signed this,” she said. “We assumed it at closing, with everything else on the seller’s list. It’s renewed itself every year since. Every year the price goes up by whatever the back page says, and every year the person who’d have to read the back page is somebody new.” She tapped the screen beside the property name. “That site’s had a new manager almost every year since we bought it. The one there now has never seen this contract. Nobody up here knew it existed.”
Andy read the row. He remembered the closing week for that building, the way he remembered most of them, as a long list of things that could wait. Keep the seller’s contracts for now, he had said, across more than one closing table. Rebid them after the first year.
“How many are like this?”
Dana scrolled to the bottom and back to the top, slowly, so he could see the column go by. “Most of them,” she said. “I don’t think anybody did anything wrong. Everybody was busy, and a contract like this never calls to tell you it renewed.”
Under the table the agent had drafted a short letter for each manager, listing that manager’s contracts whose windows would open before the end of the year and asking for three outside bids on each. Dana read the first one, deleted the opening sentence, wrote her own, and sent it over her name. Then she did the second and the third.
Maggie’s own list had come back from the same run, shorter. By four o’clock she had cancelled two subscriptions the firm had been paying for since before Fund III, one of them for market data on a city it had stopped buying in.
Owen brought Arturo the page on the Triangle buildings on Tuesday the seventeenth, and Andy, who had come down the floor to ask Tom about something else, stayed to read it over Arturo’s shoulder.
The agent had laid the same line side by side for every building the funds owned, month by month across two years. Turnover and make-ready was the cost of readying an apartment for the next resident. At most of the buildings the line rose and fell with the move-outs, the way it always had. At the buildings one manager ran for Funds II and III in Raleigh and Durham, the line had dropped almost to nothing in October two years ago and stayed there. In the same month, at the same buildings, the capital line had gone up by about the same amount. The rent rolls showed units turning at the usual rate.
At the bottom of the page the agent had written what it could tell and what it could not. Variance flagged. Turnover cost appears to have moved from operating expense to capital at this manager’s properties from October two years ago. Reported NOI at these properties is higher by about the same amount. Cause not determined. Proposed: confirm with the manager and inspect recently turned units.
Arturo read it twice without touching the mouse. Those were his best buildings. For two years the commentary he wrote for the LP reports had called them ahead of plan, and Andy had repeated the phrase to more than one investor, on more than one call, with some pleasure.
“It could be a real program,” Arturo said, to the screen. “If they started putting new flooring in every unit that turns, that’s an upgrade. That’s capital.”
“Then the units will have new flooring,” Owen said.
Arturo looked at him for a moment. Then he picked up his phone and booked a seat on the first flight to Raleigh the next morning.
His email came in on Thursday at 6:40 in the evening, from the airport, while Andy was still at his desk.
Andy,
The variance is real. It is upstream of us.
I walked every unit that turned in July at two of the properties. Fresh paint, carpet cleaned, new blinds in some, a handyman’s day in each. No new flooring, cabinets or fixtures. Every one was booked to capital.
The manager’s controller says they moved to a new accounting system in October two years ago, and in the move they set any unit turn above a dollar threshold to post as a unit upgrade, for all of their owners. Nobody told us. Our underwriting carries turnover as an operating cost, which is correct. For nearly two years our reports from this manager have shown NOI the buildings did not earn.
I have asked them to restate both years. I recommend three changes:
1. Tie each manager’s monthly report to its general ledger and bank statements every month, before the numbers go into anything of ours.
2. A clause in every management agreement: no change to how an expense is classified without written notice to us beforehand, and a log of every change, which we can read.
3. Owen’s check should compare the turnover cost at each building with the units that actually turned, every month.
I will sign off the review’s other Triangle findings myself before they go to Maggie.
Arturo
Andy read it at the round table, with the floor emptying behind the glass.
He knew the line as well as any on an operating statement. The cost of turning a unit came back every time a resident left, as surely as the water bill, and an owner paid it out of the rents before he counted what the building earned. Capital was the money that made a building better or made it last longer, a new roof or a kitchen gutted to the studs, and it was paid for outside that count. Move the paint from the first list to the second and NOI went up by exactly the cost of the paint, with nothing at the building any different.
He went through the email once more from the top. Every property it named carried a value in the funds’ books, set each quarter on the NOI the managers reported, and every LP in Funds II and III had a statement with that value inside it. So did the lenders on those buildings, and the auditors who had signed both year-ends.
He sent Arturo a text before he stood up. thank you for going. all three.
The three changes went in before the month was out, each with a name beside it. Tom ran the first tie-out at the end of August, every manager’s report against its own ledger and the property’s bank statement before any of it reached the firm’s models, and found nothing at two managers and a missing security deposit refund at the third. Anika wrote the clause in an afternoon and sent amendments to all three managers. The Triangle manager’s regional vice president called Arturo to say no owner had ever asked his company for anything like it, and signed on the Friday. Arturo sent the lenders on those loans corrected operating statements for every month since the change, after he had run each loan’s coverage test on them himself, and every loan still passed. Tom called the fund auditor and the administrator before the corrected numbers went anywhere else.
Owen rebuilt his check to set each building’s turnover cost beside the move-outs on its own rent roll, and ran it back over the two years. He turned his screen so Andy could see the first flagged row, dated October two years back.
“Two years ago,” Andy said.
Owen did not answer. He scrolled down the column of flags, one for every month since, and stopped at the last.
The broker’s corrected insurance schedule came on Thursday the twenty-sixth of August, and Dana read it standing, the way she took any call she cared about.
For as long as she had worked at the firm, each manager had named insurance its own way on its monthly report. One called it Insurance, Property. One called it Risk Management. The third split it into two lines with names nobody at the firm used. Every quarter Dana recoded the three into the firm’s single line by hand, then tied the total for each building to the share of the premium the broker had allocated to it under the firm’s master policy. Every quarter the totals missed by a little, a different little each time, and every quarter she had carried the difference on a tab of her workbook and gone on to the next thing.
In the second week of August the agent had read the policy’s schedule of locations against the list of buildings the funds owned. The schedule still listed three properties the funds had sold since 2024, a Fund I building in Dallas among them. Every building in the program had been paying its share of a premium that included buildings the funds no longer owned.
Dana had found the sale dates herself, then the closing statements, then the emails in which she had asked the broker to take each building off. Each time the broker had answered that he would.
The endorsement removed all three, with the return premium and an apology two paragraphs long. Dana read the endorsement and skipped the apology. She forwarded the endorsement to Tom with one line, for each property, by Friday, and opened her workbook.
The tab was the last one on the right. She sat with it open for a moment, two years of small differences in a column, every one with a question mark beside it. Then she deleted it, saved the file and went to get a coffee.
The next day, Friday the twenty-seventh, the capital call notice from the other sponsor came in. Tom filed it in the review folder that afternoon, and the agent read it there.
In the spring of 2022 Fund II had bought a non-managing member’s interest in a large garden property in San Antonio that another sponsor controlled. It was the only investment in Fund II where somebody else made the decisions, and the firm earned no fee on it. The sponsor’s managing member ran the deal, its own property management company ran the building, and its own construction company had run the renovation. Fund II received a quarterly report, voted on almost nothing and answered capital calls.
The notice ran to two pages. It called for new capital from every member to cover interest through the end of the year, an operating shortfall and unplanned repairs to the building’s roofs and plumbing. Andy had seen a hundred like it, and so had Arturo, who knew the property and had driven past it often enough to say it looked tired. Fund II’s share came to two point four million, due in two weeks.
The agent had set the notice against the deal’s operating statements and the member reports in Fund II’s files. Its page was short.
Use of proceeds, lines 5 to 7: deferred construction management fees, accrued property management incentive fees, repayment of a member advance. The payees share an office address with the managing member. The same companies appear in the operating statements as the property manager and general contractor. Whether the operating agreement permits paying these amounts from a capital call: not determined. Proposed: read the agreement’s provisions on affiliate transactions and capital calls before funding.
Owen sent the page to Anika with the notice under it, and Andy found her reading both when he stopped at her door on his way out.
She went down to the files room and came back up the stairs with Fund II’s copy of the operating agreement, bound, with the 2022 tabs still on it.
“Monday,” she said.
She read it over the weekend from the cover to the last exhibit. When she brought it to Andy’s round table on Monday the thirtieth, the inside of the front cover was covered in small pencil tally marks, one for every place the agreement mentioned an affiliate of the managing member, and four pages carried flags.
The first set out the fees the managing member’s companies could charge, in an exhibit, and said that any payment to an affiliate beyond them needed the consent of the other members. The second was the default provision: if a member failed to fund a call on time, the others could fund its share as a loan at a high rate of interest, and if the loan was not repaid the defaulting member’s interest would be diluted. The third gave every member the right to audit the company’s books on notice. The fourth was a single sentence near the front, in the section on the managing member’s duties.
She read it to him. “Except as this agreement expressly permits, the managing member shall not take any action that benefits the managing member or any of its affiliates at the expense of the other members.”
“What happens if we don’t fund?” Andy said.
She told him. A partial wire would still be a default on the rest. At the end of it Fund II owed the other members a loan it had not chosen at a rate it would not have agreed to, and the building still needed the interest paid.
“And if we do?”
“Then Fund II has paid its share of their fees,” Anika said, “unless we say in writing, before the money moves, that we’re paying under protest and keeping every right this agreement gives us.”
“Can we?”
“Nothing in here stops us.” She closed the agreement on her hand to keep the place. “I’d like an hour with them before we decide anything. I want to understand the intent behind the call.”
They drove down to San Antonio on Thursday the second of September, Arturo at the wheel, Anika in the back with the agreement on her knees. On the way they agreed on one thing: they would ask questions for an hour and argue about nothing.
The sponsor’s offices took the top floor of a low building off 410. The principal met them at the elevator himself, a big man about Andy’s age with a firm handshake and a photograph of the property, framed, on the wall of his conference room. His chief financial officer sat beside him with a binder of her own.
“Walk me through the call,” Andy said.
The principal did. Arturo nodded at the parts he could see from the street. The renovation had run long. Rents on the finished units were behind plan. The lender had begun sweeping the property’s cash when the coverage test failed in the spring, and the interest still came due every month. There were roofs that should have been replaced in the first year. He did not hurry, and nothing he said was anything Arturo could have contradicted from the parking lot.
Anika let him finish, and let a moment go by after that, before she opened the agreement to her first flag.
“Lines five through seven,” she said.
The chief financial officer turned to them in her binder. “Deferred fees to our construction company and our management company, and the advance he made to the property in January to cover payroll.” She looked up. “Our companies have carried this deal without being paid since the renovation began.”
“When the call is funded,” Anika said, “who’s paid first?”
“The lender and the interest reserve. Then the deferred amounts. They’ve waited the longest.”
“And your own share of the call?”
“We fund our share,” the principal said, “like every member.” He leaned back. “We’ve put more into this deal than anybody at this table.”
Andy did the arithmetic in his head while the chief financial officer found the schedule. The managing member would wire its share of the call on one line, and its companies would take it back, and a good deal more, on the three lines below. When the call was done, its money in the deal would be smaller than it was that morning, and every passive member’s would be larger. He glanced across the table at Anika. She was writing, and did not look up.
“I appreciate your time,” Andy said, at the end of the hour, and meant it. The principal walked them back to the elevator and shook each of their hands.
Nobody said anything until Arturo had them on 35, heading north.
“He believes every word of it,” Arturo said.
“He’s owed the fees,” Anika said. “The agreement says when and how. A capital call from the rest of us isn’t in it.”
Andy watched the outlet malls go by at San Marcos.
“We fund all of it,” he said. “Under protest. Then we audit the call.”
“I’ll have the letter to you tonight,” Anika said, and opened the agreement again.
The letter reached Andy at ten that night and ran a page and a half. It said that Fund II would fund its share of the call, two point four million, by the due date, under protest. It said that Fund II reserved every right it had under the agreement, named the duty clause and the consent provision by section, and gave notice that Fund II would exercise its right to audit the books for every dollar of the call. Andy signed it for Fund II’s general partner at eight on the morning of Friday the tenth of September. Anika sent it at 8:20. Tom released the wire at eleven and put the bank’s confirmation in the folder behind the letter.
On the morning of Wednesday the fifteenth, Maggie laid one sheet of paper on the long table downstairs. Arturo, Dana and Tom sat down on one side of it, and Andy took the chair at the end.
It was a single typed page, and every figure on it had a name beside it: whoever had signed off the finding it came from.
At the top was what the review had found in the firm’s own funds once the people who owned each finding had checked it: the contracts that had been rebid, the utility charges the properties had not billed back to residents, the insurance correction and the small items behind them. About eight hundred thirty thousand of NOI a year. Beside it, at a five and three-quarter cap, about fourteen and a half million.
Under that was the Triangle line. About four hundred twenty thousand a year of turnover booked as capex. At the same cap, about seven point three million off the marks.
At the bottom, after a ruled line, about seven million net of the markdown.
“Say it the way you’ll say it to the LPs,” Andy said.
“A building is worth what it earns in a year, divided by the cap rate. That’s how a buyer prices it, and it’s how we mark it every quarter.” She put her pen on the second line. “The Triangle buildings never earned that four hundred twenty thousand. Divide it by five and three-quarters percent and you get about seven point three million of value that was never there. It’s been sitting in the marks for the better part of two years. It comes out this quarter, all of it.”
Arturo kept his eyes on the line with his name beside it.
“And the eight thirty?” Andy said.
“Real, and it reaches the marks a month at a time, as the savings show up in the statements.” She moved the pen to the bottom. “When it has all shown up, the marks are about seven million above where they started. The investors see the markdown first.”
“Before the good news.”
“Before any of it.”
Tom had a page of his own under his hand. “I reran both funds’ waterfalls on the corrected numbers yesterday,” he said. “The promote accruals come down with the marks. Nothing already paid has to come back.”
Below the net, set apart at the foot of Maggie’s page, was one more line, with her initials beside it.
Construction fee billed on two years of capitalized turnover: about forty-two thousand. Refunded to Funds II and III, 15 September.
“We bill that fee on the capital budget,” Andy said.
“We billed it on paint,” Maggie said. “Tom wired it back at nine.”
“Who asked for it?”
“Nobody.”
“It comes out of the construction fees.”
“This year’s, once,” Maggie said. “And the fee we were earning on their turnover doesn’t come back next year either. I’ve taken it out of the recurring line.”
Arturo looked up from the page at that, and then at Andy.
Under the page was a letter Beth Ann had drafted to the investors in Funds II and III. It said what the manager had done and when, what it meant for the value of their interests this quarter, what the firm had changed so that it could not happen again without someone seeing it within a month, and that the fee had already been returned. It did not use the word variance. Andy signed it at the table and slid it across to Tom to take up to her. The corrected Fund III pages went to the pension’s head of real estate that afternoon, with a note from Beth Ann on what had changed and why.
The audit took most of October. Anika ran it with Tom and an outside forensic accountant, a page of requests at a time, and the agent read each answer once Tom had filed it, set it against the call notice and the deal’s bank statements, and left its pages in the folder for the three of them. The sponsor’s lawyers wrote twice. The second letter was shorter than the first.
On Friday the twenty-ninth of October, seven hundred ninety thousand dollars came into Fund II’s account from the deal: Fund II’s share of what the call had paid the sponsor’s own companies. The bank’s description read return of affiliate payments, Fund II share. Tom matched it against the claim before lunch and brought the confirmation to Andy’s office.
Andy read the description line, in the bank’s capitals across the top of the page, and handed it back.
“Beth Ann will want this for the letter to Fund II’s investors,” he said. “Tell her the interest and the roofs stayed paid.”
Tom took the confirmation back to his desk and filed it in the folder behind the September letter, on top of the wire that had gone the other way.