When buying a real estate property, you want to make sure that what you are buying is going to fit your needs and requirements at the very least. If you’re buying a multifamily property as an investment, you want to make sure that it’s actually going to make you money before purchasing. Hence, it is right that you spend some time making sure that you know what you’re buying and that you’re getting a fair deal. So, you go through the process of due diligence to uncover all the problems with the property and enable you to make a sound investment decision. It isn’t as much to convince yourself how great of a deal the property is but more so that you’ll have some degree of confidence that you’re buying smart.
This is the topic in one of my conversations with Dylan Marma, a due diligence expert in commercial real estate. We talked about how due diligence works, the importance of having the right team, what should be on your checklist, and more. I’d like to share some nuggets here in this blog. If you’d like to listen to the full podcast, click here
When should due diligence happen?
Due diligence typically takes place after a buyer puts the property under contract to purchase. When the Purchase and Sale Agreement (PSA) is signed, the clock starts ticking and the buyer usually has 30 days to complete the process. Dylan, however, warns that you may be forced to shorten the due diligence period in a competitive market with multiple buyers placing bids on the property.
“With even bids, the next way for you to compete when you know you can’t go any higher in pricing, is ‘by terms’, that is, shortening the due diligence period or sometimes, money going hard on day one meaning a portion or the entirety of your earnest money is now non-refundable no matter what takes place during the due diligence process,” explains Dylan. He advises buyers who have plans to redevelop the property to negotiate a lengthy due diligence period to ensure they can obtain all documents and permits required to execute their plans.
Is it possible to do pre-due diligence work before the property goes under PSA?
Typically, the terms of the PSA are negotiated between buyer and seller after a letter of intent (LOI) has been signed. Between the LOI and PSA, there’s often a week time span. “There’s a lot of things that you can do during this time. You can even work out an agreement with the seller that they’ll make the property or the units viewable prior to the PSA,” says Dylan.
He suggests taking advantage of this time to do surface-level due diligence, conduct market research and survey local properties, coordinate with your due diligence team, engage your syndication attorney, get in touch with your lender, and get access to relevant documents. “It’s really getting all the due diligence team members involved and prepared and getting all the pieces in place and ready to go through the process,” Dylan sums up.
Why is a tenant-applications audit important in due diligence?
More than a lease audit that looks at each aspect of the lease (billing schedule, rental payments, etc.), Dylan puts more importance on a tenants’ application audit. This can give you more information than a lease audit, he says.
“An application audit will tell you the employment and income profile of the residents there, their credit scores, their length of stay, their rental history, family status, who else is on the property,” says Dylan, explaining that this information is crucial when you are projecting occupancy rate and potential income of the asset.
“There can be a big change in the demographics as times change and areas evolve. So, going through the applications is extremely important. That is the one thing that is beyond your standard list of documents,” he adds.
What should be on my due diligence checklist?
Dylan recommends paying attention to the following items when building your due diligence checklist. Most items in the list are required by lenders for multifamily loans.
- Site Survey/Title Report
A title report determines the legal status of the title of the property ensuring that there are no competing legal claims to it. A site survey, which is required to secure a title report, verifies the size and boundaries of the property.
- Phase I Site Assessment or Environmental Assessment
Check for termite infestation, traces of dangerous chemicals, pesticides, or other contaminants that could endanger the residents.
- Property Condition Assessment
Check code enforcement, scope plumbing lines (run a camera down on the plumbing lines)
- Financial Audit
This gives a detailed overview of historical operating income and expenses and will help you evaluate the income-generating potential of the asset. Items to check include:
- X years of trailing financials (such as bank statements)
- Monthly profit and loss statements
- Current rent roll including the term, deposit, payment history
- Tax returns
- Utility bills
- Certificate of occupancy
- Capital improvements. Not only do you want your operating statement, but you’ll want to know what kind of money they have put into capital improvements that are going to materially impact the property.
- Flood maps/seismic report
Assess the need for insurance
- Vendor service contracts
Trash, cable, building maintenance, etc.
Check every single one to see the viability of continuation, renegotiation, or termination to reduce expenses
- Insurance loss runs
- Pending litigation
More tips to ensure a smart and smooth due diligence process
Do Walk-Throughs of Units
Nothing compares to actually seeing the property in person and going through as many vacant units as you can. A physical walkthrough allows you to personally look at the condition of each unit and assess potential problems and issues that may arise. Check some occupied units and talk to the tenants, as they can provide some helpful insights.
Have a strong, competent team
The right team is paramount to doing proper and thorough due diligence. “Bring someone in the team that’s smarter than you,” says Dylan. The key is that you have expert team members in specific fields, each skilled in important factors that would be a major threat to you.
Identify the things that you can’t live with and those that you can
Oftentimes, multifamily properties have the “as-is” clause in the contract, stipulating that the buyer will assume all the problems with the property with no room for renegotiation. Early on, you should establish expectations and know which aspects are acceptable and which ones are non-negotiable.
“Identify the things that you can’t live with and make a clear list of those so that even before you go into due diligence or go into contract, you have that clearly spelled out. You have already checked all the boxes so you’d know exactly when you could move forward or when to just walk away,” ends Dylan.
Purchasing a multifamily property is always a daunting experience worsened by the fear that what you anticipated to be a successful investment could end up being a loss leader. While you can never completely know what you’re getting until you’ve bought, proper due diligence will help you limit the problems and minimize capital risk. With thorough planning and a robust due diligence team, you could very well be on your way to growing your business and building your wealth through multifamily investing.
Life Bridge Capital is here to guide you in the world of multifamily investing. If you’re interested, we’ll be happy to talk to you. You can email [email protected] and reach out, and we’ll schedule a call.