In my previously published “Ultimate Guide to Due Diligence,” I wrote in depth about the ins and outs of this critically important element of real estate investing. To provide further insight, I thought it would be helpful to walk you through it, illustrating the process with an example property.
Performing due diligence can be broken down into several distinct stages, which I recommend tracking using a checklist. (And for any who doubt how important checklists can be, please read Atul Gawande’s great book The Checklist Manifesto: How to Get Things Right immediately).
My real estate due diligence checklist looks like this:
- Pre-Offer Due Diligence
- Area Analysis
- Value and Financial Estimate
- Rehab Estimate
- Post-Acceptance Due Diligence
- Physical Due Diligence
- Financial Due Diligence
- Legal Due Diligence
- Retrading (if necessary)
- Final Decision and Walking Away (if necessary)
So, let’s walk through each of these steps as I found, evaluated, and (spoiler alert!) backed out of a 74-unit apartment complex in Kansas City, Mo.
1. Pre-Offer Due Diligence
My company became aware of this property on a commercial real estate website called Loopnet. This is actually rather rare since most good deals have already been swooped up before they hit the site. But this took place back in 2012, and the real estate market was still pretty depressed.
The apartment complex was listed for only $1.8 million ($25,000/door) and had supposedly just been repositioned with its occupancy set to hit 90 percent.
We knew the area pretty well. It was mostly comprised of homes purchased by middle-class Americans. The apartments seemed almost out of place.
The neighborhood was solid, although it was off the beaten path. This isn’t good for apartments, because you won’t get drive-by traffic to attract prospective tenants.
It also lacked a bus line nearby, which isn’t great for lower-end apartments. However, most of the residents appeared to own a vehicle.
We then looked online at income and crime statistics. The stats below are from more recent years, but they haven’t changed much compared to what we found in 2012.
So, the median household income in this specific area was only a bit less than the statewide average—not bad. The crime was about 50 percent higher. But from our knowledge of the area, we knew that most of that crime was in another part of the zip code.
Zip codes can be expansive, so data on them is at times misleading. Crime may be localized in a particular part of that zip code. Fortunately, there are tools available to aid in evaluating neighborhoods.
We also looked at some nearby comps. However, with apartments, you can’t just do a standard comparable market analysis. There are too many differences between apartment complexes to try to act as if they are the same.
That being said, you can first compare the costs of rent to get a handle on similarities, differences, and what you think you’d be able to charge. Searching nearby properties on Craigslist or using rentrange.com can help with that, too.
More importantly, you can compare complexes based on their cap rate. The cap rate is just the net operating income of the property (all income minus expenses not including debt service) divided by the price.
This calculation can provide a very simple apples to apples comparison—although it gets messy in practice. (For example, it may be hard to figure out how much other owners spent on rehab at other complexes.)
From our research, we found several comparable properties:
- 95 units: $2.6 million ($27,368/unit)
- 82 units: $1.5 million ($18,293/unit)
- 70 units: $2.05 million ($27,285/unit)
Unfortunately, at the time we didn’t have a good way to figure out the respective cap rates. Instead we only had publicly available information on the MLS.
What I recommend if you intend to get into apartment buying is to bite the bullet and sign up for costar.com, which has a lot (although not all) the information you will need on larger properties.
Our initial walkthroughs looked good, as did my preliminary analysis. So, we made an offer of $1.25 million and came to terms at $1.4 million.
And that’s when the due diligence really got started.
2. Post-Acceptance Due Diligence
It’s always best to base your pro forma on real numbers. That being said, we looked at the sellers’ operating statement, which looked like this for the six months prior to the deal.
At first glance, it seemed pretty decent. They didn’t have a loan on the property, so we had to account for that. In addition, one of the biggest concerns about an operating statement is whether or not operating expenses (i.e., maintenance and turnover) are being capitalized (like building upgrades).
Oftentimes, owners can be a bit sketchy. In this case, the owners hadn’t done anything wrong. However, the property was being remodeled, so that made it very hard to determine the degree to which the operating statement was valid. Each renovated unit would be capitalized, but that would hide standard turnover costs.
I put together a pro forma all the same, although with less certainty than I would have if the property had been performing well. My initial rehab estimate was only $100,000. (For whatever reason, I made the mistake of not including that number in my initial pro forma though.)
It looked like this.
A 9.93 cap rate is really good. We were able to at least partially verify that it was better than the market from the little information we had gathered elsewhere, as well as conversations we had with other industry professionals.
And the cap rate got even better when we plugged in our (overly optimistic) rent increases. According to what I calculated, if the best case scenario were to be true, the cap rate reached as high as 14.
But then, as we began our due diligence, things took a turn for the worse. As I’ve said in the past, “The purpose of performing due diligence in real estate is to confirm what you believed to be true about a property when you got it under contract.”
And well, what we believed to be true, we found out wasn’t so.
First and foremost, we learned they were counting the leasing office as a rental unit. This is not uncommon, so you should make sure to ask the agent or owner with any apartment that has onsite management if the leasing office is included in the count.
Then, we learned that while the property was “leased up to 90 percent,” that didn’t include the scheduled move outs. The property was in fact back at 70 percent occupancy when we got it under contract. That meant this was effectively a “minor reposition.”
After that, we did the walkthrough. And yes, we walked through every unit!
No matter how many units there are, you must walk each one. If you walk only every other one, do you think they’ll show you the good units or the bad units?
We started to notice that there were a lot more repairs needed than we initially thought. For instance, many of the patio doors were shot, as you can see below.
When walking a single family home, I typically use a one-page spreadsheet based on J. Scott’s The Book on Estimating Rehab Costs for the initial estimate. Here though, we had to evaluate 74 units, so we made a larger sheet and noted any major items we came across.
We then did a quick estimate for the repairs on each unit, as well. Here’s what that large sheet looked like.
As you’ll notice, the HVAC situation wasn’t great. Much of it would need to be replaced in the next few years.
We also ordered an inspection of several units, a roof inspection, a termite inspection (because we found some possible signs), and a Phase One Environmental Survey.
The roof inspection determined the roof was functional but not in particularly good shape and possibly hiding something even worse.
The interior inspection showed other serious problems. For one, there were some mold issues.
The mold didn’t seem to stem from a roof leak, so we weren’t quite sure how to alleviate it. And the big problem with mold is not the getting rid of it part—that’s usually pretty easy. The problem is making sure it doesn’t come back.
Next up were the electrical panels. They definitely weren’t up to snuff.
Here’s what they looked like.
The purpose of an electrical breaker is to “trip” when it’s overloaded to prevent a fire. It’s been determined that Federal Pacific Panels don’t really do that, so they are a major fire hazard and should pretty much always be replaced.
Within the complex, almost every unit had one of these. Around about $1,000 a panel to replace, doing so would cost close to $70,000 right there.
And then, to add insult to injury, we received the results of the termite inspection.
By the time I was done adding up the newly discovered expenses, it totaled over four times the original rehab estimate. (And back then, I tended to underestimate such things.)
3. Retrading (If Necessary)
We played around with idea of retrading, but there were just too many problems to take on. Plus, we weren’t prepared at that time to do a reposition on an apartment complex.
In addition, we had planned to syndicate the deal and get a bank loan. We were now concerned about securing both a lender and an equity partner. For these reasons, we cancelled the Phase One (and luckily weren’t forced to pay for it).
4. Final Decision and Walking Away (If Necessary)
…we walked away.
The willingness to walk away is really the most powerful tool you can have in your negotiating toolkit. Never get so attached to a deal you can’t walk away.
This deal wasn’t for us and would have really set us back if we had gone ahead with it. We would have either struggled to make the property work and potentially been bogged down by it or failed to close for lack of financing. (That mistake would have cost us the Phase One money and perhaps our earnest money deposit.)
While it took a lot of time and energy, as well as some money (because inspections aren’t free), we made the right decision.
As JD Martin put it, “Sometimes it’s the deals you don’t do that make you rich!”
Have you ever walked away from a deal? Or wished you had? Was this real-life example helpful?
Share in a comment below.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.