In my continuous search for the best multifamily real estate investments, I was in Texas last week doing due diligence on a 100+ unit apartment complex. Due diligence is the process by which you confirm that all of the facts of a deal are as they have been represented to you by the seller. Before this point, we had been evaluating the submarket. We ran various financial scenarios and determined an offer price. We put in a letter of intent to buy. It was accepted and a purchase and sale agreement was negotiated using attorneys. All of this was done remotely.
It was now time to go onsite and evaluate the property. This detective work isn’t glamorous and is often tedious. Nevertheless, it is necessary and crucial if you want to keep your money safe, healthy, and growing. Not doing your due diligence is like marrying someone you have never met. While you may strike a match, the odds are far better if you get to know each other first.
Through the broker, the seller has made representations to you concerning the age and condition of the property as well as the current occupancy and the revenue that it generates. It is incumbent upon you to verify that those representations are, in fact, true.
Everyone does on site due diligence a little differently. In my mind, there are five essential elements:
- Lease Audit
- Unit Inspections
- Submarket Verification
- Rent Comps (Shop your competition)
- Physical and Specialty Inspections
LEASE AUDIT
Most doctors, dentists, and other health care professionals are familiar with chart reviews. Sitting down at a big table, we went through every tenant file noting things like:
-Name-Pets
-Rent-Pet Rent
-Lease Terms -Pet Deposits
-Concessions -Work Orders
-# of Occupants-Notices
-Delinquencies -Addendums
-Renewals
Prior to making an offer, we had received a rent roll and profit and loss statements. Now is the time to confirm that the owner is actually getting the rents they claim. It is not uncommon to see a discrepancy between what was represented and what is actually happening. Your guess is as good as mine, but I suspect some owners inflate their rent rolls in an attempt to garner a higher price.
You also want to verify the deposits. Owners are required to keep tenant deposits in a separate account. At close, that money will either be transferred or credited over to the new owner. Verification of the actual number is important as you will be on the hook for the renter’s deposit when they move out.
Pay particularly close attention to files with lots of work orders, notices, and delinquencies. These can be indications that you have a problem unit and or tenant.
UNIT INSPECTIONS
Visual inspection by walking each and every unit is a must. What is the condition of the units? Does it have any upgrades? Are there things that need to be repaired or replaced? Are there any warning signs or safety concerns? Is there functional obsolescence? Are there any tenant concerns – like multiple pets, hoarding, excessive number of occupants, unapproved alterations, illegal activity?
VERIFICATION OF SUBMARKET ANALYSIS
As mentioned in a previous post on submarket analysis, 80% of your tenants already live within five miles of your property. Prior to making an offer on this property we checked schools rankings, crime scores, residential home appreciation and a host of other statistics. We had a pretty good idea of what the submarket was like. Now that we were actually there, we took the time to drive in all directions around a five mile radius from the property. We noted the types of retail, dining, entertainment, and services available in the neighborhood. We drove around the schools and looked for environmental issues that might be a concern. While these things might sound trivial, you will struggle with your investment if you buy downwind from a dairy or in the noisy flight path of a busy airport.
Other things we look for are what do the residential homes look like? How close to public transit is the property? How accessible is the property to freeway entrances and job centers? What do the competitor apartment complexes look like and how close are they?
RENT COMPS / SHOP YOUR COMPETITION
When we first evaluated this property, the broker provided us with a rent comparison analysis. This is a list of properties within a relatively close proximity to the asset you are analyzing and the rents they charge.
The question you always have to ask yourself is, are those true rent comps or did the broker cherry pick the highest rent properties, with better amenities, in nicer locations to make you think there is room to grow rents? The best way to find out is to shop your competition. You can probably get your property manager to do this for you, but I personally like to go and see the other properties, view their amenities, and inspect their model unit.
Either you or your manager will have to pose as a prospective renter. After completing this process, you will have a good idea of what rents range for A, B, and C properties in your given submarket. You should also have an idea of what you can reasonably expect to raise rents to by adding amenities and or performing interior unit renovations with upgrades.
PHYSICAL AND SPECIALTY INSPECTIONS
Inspecting big ticket items like roofs, swimming pools, foundation, boilers, etc. are best left to professionals. If you are uncertain of the condition of any of these items, it is best to get a professional’s opinion before purchasing.
Also environmental issues can be a problem. Phase I environmental reports are required by some lenders and not a bad idea even if they are not. The last thing you want to find is a hazard on your property after you already purchased it. The previous owner will deny ever knowing about it and the problem is now yours to fix.
SUMMARY
In summary, due diligence is a necessary and critical piece in evaluating a property to purchase. Verifying that the owner’s representations are true and correct is critical before the property closes. Due diligence will allow you to walk away from the property, negotiate repairs, or re-trade on the price if you find unexpected problems or misrepresentations.
P.S. The best real estate investments that create financial growth for doctors, dentists, and other busy professionals are those that have been completely vetted prior to purchase via the process of due diligence.
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Dennis, this is a great article to read and you gave lots of sound insight to multifamily due diligence. Reminding me that everything for sale isn’t profitable.
Jerome Minor
Sacramento Ca