Real estate due diligence is essential, as every day in the United States commercial real estate changes hands. Brokerage firms handle the vast majority of these transactions.
For a fee, these sales and marketing professionals create glossy brochures, sophisticated web pages (and recently drone videos) designed to sell their product. They email prospective buyers, utilize direct mail campaigns, and call other owners in that market to bring as many potential buyers to the table as possible.
Brokers are paid by the seller to put their property in the very best light. As such, you’ll never find a document included in the sellers package that comprehensively reviews all of the challenges and problems that the seller has had with the property.
As a buyer, it pays to be a problem solver. However, you want to know about potential problems long before you purchase the property. After all, some problems aren’t fixable. So you better have a comprehensive due diligence process that allows you to see a property as it exists and not just how the broker presents it to you.
Just remember that not doing your due diligence in commercial multifamily is like marrying someone that you’ve never met. You might get lucky, but the odds are far better if you get to know each other first.
Here at 37th Parallel, we utilize a comprehensive seven point due diligence checklist. Those essential points are:
- Lease Audits
- Site Inspection
- Unit Inspections
- Specialty Inspections
- Submarket Analysis
- Comp Analysis / Rent Survey
- Environmental Assessment
While the broker’s package will include a rent roll; it’s never wise to accept it as the gospel truth. In this regard, it’s important to verify their numbers. That’s where the lease audit comes in.
During an audit we analyze every tenant file noting renters names, rent, lease terms, concessions, number of occupants, and whether they’ve had delinquencies or notices. We look to see if they’ve renewed their lease, have pets, pay extra fees like pet deposits, garages, etc.
Once this is completed, we’ll have a far better understanding of the apartment community. We can now compare it with the numbers that the broker has given us and see where discrepancies exist.
Apartment real estate due diligence must include walking the entire site, looking for deferred maintenance. The largest culprits of deferred capital include roofs, vertical surfaces (e.g. siding) and pavement. Any of these three items are expensive to repair or replace. Therefore you must get estimates as early as possible during due diligence. You want to make sure the capital budget is accurate. We look at other items also: landscaping and exterior lighting, playgrounds and other common areas are good examples where a capital project can improve the amenities of a community and make it an appealing housing choice in a submarket.
Just as the broker package will feature the nicest common areas it will also showcase newly renovated units. If you only reviewed those pictures, you might believe all the units were in pristine condition.
That’s why it’s critically important to walk each and every unit and not just the common areas.
Doing so will give you a complete picture of the physical condition of the property. It will allow you to see the deferred maintenance as well as the range of unit conditions that exist. This information is key for creating a capital improvement plan.
Unit inspections also allow you to identify any tenant outliers. Certainly some people are tidier than others and that’s what cleaning deposits are for. However, renters who are outright destructive need to be handled immediately. And you can’t do that if you don’t know about it.
It’s important to have the general contractor from your property management team present during due diligence. Any warning signs they note will necessitate a specialty inspection. It’s wise to consider similar inspections for bigger ticket items like HVAC, foundations, roofs, and swimming pools. You don’t want to be surprised with expensive repairs after the property closes.
Discovering issues during due diligence gives you options. You can walk away from the purchase, request the seller make repairs, negotiate a lower sale price, or simply accept the deal as is.
In our industry studies show that 80% of our renters already live within five miles of the property. For that reason, it’s important to know the submarket. How well the schools rate, what the crime stats look like, and how fast do residential properties appreciate in the area are all pieces of information that will affect how well the property performs. You should also know current and historical vacancy rates, absorption rates, homeownership rates, and how much new supply is in the pipeline.
That’s all information that can be obtained remotely before ever making an offer on the property. But nothing beats actual boots on the ground research. For that reason, we’ll drive in all directions within a five-mile radius of the property. We need to know what retail and office look like in the neighborhood. Are there transportation options? And how easy is it to catch a major freeway? Is their dining and entertainment options nearby that renters will want to access?
Equally important, is limiting our exposure to circumstances that makes renting undesirable. Is the property located next to excessive noise like busy train tracks or underneath a loud flight path? Are unpleasant odors present from nearby factories or wastewater treatment plants? Does the path to school necessitate children walking past inappropriate venues?
As remote as some of these examples may seem, you should leave no stone unturned when evaluating a property for acquisition. Once you own it, you own it warts and all.
Comp Analysis / Rent Survey
A large part of your capital improvement plan will come from comparing rents among properties within the submarket. It’s important to know the going rate within the submarket for interior upgrades and amenities.
Upgrades in appliances, finishes, cabinetry, flooring, and others may demand higher rents within the submarket. You won’t know that if you haven’t shopped your competition and determined the rents they receive for those upgrades. That information is critical to understand so you know whether it’s wise to inject capital or sit tight with the current fit and finish.
Environmental hazards can be problematic and expensive to remediate. That’s why it’s a must to know the historic and current environmental uses of the property and their potential effect on the soil and groundwater.
People will be living in this property and you want reasonable assurances that there aren’t any health hazards present. Obtaining a Phase I environment site assessment (ESA) on a commercial multifamily property is important.
A phase I ESA is considered the first step in identifying any potential environmental hazards. It does not include any sampling of air, soil, or water. Instead, it typically involves a current site (and neighboring sites) inspection combined with a historical usage analysis.
State, Federal, and Local records will be examined. Historic aerial photos will be evaluated. Past permits and land usage will be scrutinized. And people with extensive knowledge of the property will be interviewed.
If a phase I ESA identifies potential red flags, you’ll have the option to walk away from the purchase or move on to a phase II ESA. Phase II ESA’s involve collection and testing for contamination of soil, groundwater, and or vapor.
Real Estate Due Diligence Conclusion
As an asset class, commercial multifamily real estate has a long historic track record of positive returns. With that said, there are individual properties that you simply don’t want.
The real estate due diligence process is your time to uncover those properties. Because, once the property closes, you own it – warts and all.
Ultimately, real estate due diligence is a risk assessment of a potential investment prior to its purchase.
As important as due diligence is, it’s surprising how many people purchase properties with only a cursory analysis. We believe it’s absolutely essential to employ a broad-based, systematic process that overturns every rock no matter how big or small?
Individual active investors need to take due diligence seriously. Failure to do so can be the difference between success and failure. Our distinguished track record for profitability is largely due to employing such an extensive due diligence process.
To learn more about commercial multifamily real estate investing, download your free copy of Evidence Based Investing from 37th Parallel Properties.