Due dilligence question

25 Replies

Good morning everyone,

Quick question on financial due diligence, we have an accepted offer on our first actual commercial property (8 units), the financials they sent looked good, but how do you guys verify what they sent is actually the revenue and expenses for the past years? Do you make them provide bank statements? Any info is appreciated thanks!

Best regards,

Scott

If it is not accurate you should know from the current rent rolls if revenue seems way off; and they should provide you with current leases, if you can prove they intentionally misrepresented the numbers they are probably open to legal liability especially if the real estate agent knew.  Most states are pretty strict on disclosure laws.

If they self-manage, trust but verify. If you have a current rent roll, you can project income and expenses. Your lender will tell you if they need more information, such as copies of the leases. You should renew the leases once you buy it anyway.

If the information you got was from a third party property manager, then it should be trustworthy.

@Aaron Klatt revenues I can project off current leases, I am more asking for the expense side.

@Anthony Dooley I am trying to verify haha hence the question but how would one actually verify the expenses?

Expenses will fluctuate but if you ask for the last months utility bills you should be able to get a good idea of the predictable expenses like that.

Ge their last two years IRS returns on the properties. See if they match up with what they are claiming. 

@Scott Bowles part of due diligence is gathering financial information. If they don't provide what you ask, you can back out of the deal.  I do my own math and I talk to the tenants, once under contract. The tenants tell you all kinds of information that the seller may not even know.

Historically, my expenses are about 35-40%. So I take the gross rent and multiply x .60. This gives me the net operating income (NOI). NOI divided by acquisition cost = Cap rate. Is that acceptable to you? NOI minus debt service = cash flow. Cash Flow divided by my cash out of pocket = cash on cash return. Is that acceptable? If everything is good so far, then the physical inspection of the property would be done. If you see any major repairs, submit an amendment to the contract to ask the seller to repair. If they agree, great. If not, you can walk if it is part of your contingencies during due diligence. No deal is perfect, but they need to meet certain criteria that you set based on what you expect from your market.

@Anthony Dooley 40% of gross seems a bit high but if I do that with 100% occupancy we are still cash flowing a couple hundred per month after debt service. The upside with the purchase would be in rehabbing the units and bumping rents up so I think this would still work.

@John Thedford Ill ask thanks!

Originally posted by @Scott Bowles :

@Anthony Dooley 40% of gross seems a bit high but if I do that with 100% occupancy we are still cash flowing a couple hundred per month after debt service. The upside with the purchase would be in rehabbing the units and bumping rents up so I think this would still work.

@John Thedford Ill ask thanks!

 Their tax return should NOT lie! If they refuse to provide it, odds are their figures are not the same as provided to you.

@John Thedford Yeah this is kind of along the lines of what I was thinking, thanks have you had people refuse to do that?

@John Thedford what are the chances that they exaggerated their expenses and under reported income in order to save on taxes? I would never do that, but I have heard rumors that people sometimes cheat a little. I would base my numbers on what I can actually see today.

@Scott Bowles if your expenses are less, then that is great. 40% will not be every month. If you are only cash flowing " a few hundred dollars" then I would question the asking price. Are you getting 10% or more cash on cash? If not, I would renegotiate. Any value that you add later should not be counted today. Base the value on today's numbers. If it is 50% occupied, then the value today is 50% of what it would be if it were 100% occupied.

@Scott Bowles So it's really, really, tough to verify owner-provided information.  If it's a 3rd party property manager (that would have to worry about a reputation) then the numbers are a little easier to trust.  What's even harder to fake are exports from a system like Appfolio that a property manager would use.  It would take a good amount of time (I'd imagine) to go up and create a completely set of fake data.  I'm not say it hasn't, wouldn't, or can't be done...just that it's pretty labor intensive compared to an owner creating their own Excel spreadsheet.  

Some things you'd want to watch out for:

1.) It's easy to "legitimately" lower expenses by categorizing items as cap-ex. Maybe it's $100 to repair a dishwasher but I know I'm going to sell the property next year so I buy a new dishwasher. New dishwasher is cap-ex so it isn't an "expense" in the same way that a repair would be. You make these kind of decisions 20 times over the course of the year and it can change your NOI.

2.) You can also start to skip things like quarterly pest control.  I don't know if that matters in your market but it does where I invest.  Unless you see bugs or have line-item expenses it's sometimes hard to see those items that you might see as a routine expense.

3.) Some expenses (like owner-paid utilities) you have to match up with occupancy data.  Others (think: landscaping) don't have any relation to occupancy.  So if you're seeing monthly exports you'd have to try and match those items up.  If you want 100% occupancy you have to expect to pay "100% occupancy utility bills".

Hope this helps.

Originally posted by @Anthony Dooley :

@John Thedford what are the chances that they exaggerated their expenses and under reported income in order to save on taxes? I would never do that, but I have heard rumors that people sometimes cheat a little. I would base my numbers on what I can actually see today.

 If their numbers are not as good as they claim, you can tell them you have to go by what they put on their taxes. If they are insisting the tax return is false, I would question EVERYTHING they say. Game players like to play games with everyone.

Originally posted by @Scott Bowles :

@John Thedford Yeah this is kind of along the lines of what I was thinking, thanks have you had people refuse to do that?

 You are only asking for the part of the return with the property, not their entire tax return. There is no need to worry about that. 

It's called the schedule E if they file as a business.

40% of gross seems a bit high but if I do that with 100% occupancy we are still cash flowing a couple hundred per month after debt service.

Trust me, depending on the age of the property, the expenses could even range to 60%+. This includes capEx reserve though, which cannot be skipped upon.

Yeah, but like you said this can be brought down with rent increases and implementing bill back on utilities.

@Scott Bowles , on the income side, you want to see a copy of every lease, and cross-reference the lease amount (and any increase notices) to the rent roll.  Add up all of the rents and see if that matches up with the trailing income.  You should also check the security deposit in the lease against the rent roll and inquire as to any utility bill-back procedures and see if that matches up.  Since this property is only 8 units, you could also ask for tenant estoppels which is a form that each tenant signs verifying the amount of rent, security deposit and lease term.

On the expense side, you need to build your own expense forecast.  You'll use the seller's trailing expenses as a guide but some of their expenses won't matter.

Property Taxes:  Use your own estimate of taxes based on the county's procedure for assessing value, reassessing upon sale, and the tax collector's tax rate.  Seller's expense doesn't matter.

Property Management:  Use the amount your management company will charge--seller's expense doesn't matter.

Insurance:  Use the amount that your insurance vendor quotes you.  Seller's expense doesn't matter.  You can use their reported expense as a starting point when you run your numbers, but I tend to increase it somewhat, assuming my insurance will cost more (longtime owners tend to be under-insured which lowers their cost but you won't do that).

Repairs & Maintenance:  There is a ton of manipulation that can happen here and there's not much you can do to verify the seller's figures.  And there's no way to assume that your costs will be the same as theirs anyway.  I use a figure that my experience has shown to be about right (varies by property size and age but tends to run $400/unit/year to $600/unit/year not including capX). 

Administrative and Marketing:  Not too much you can do to verify, but you'll want to create your own budget for these costs anyways.

Contract services:  Ask to see the landscaping contract, laundry contract, water softener and pool contracts, trash hauling contract, etc.  Add up the monthly charges for these contracts and see if they match the expenses shown on the financials. 

Utilities:  Ask for the last 12 months of utility bills for every utility.

Out of all of those, utilities and contract services are the ones that are the most pertinent because those expenses will probably stay about the same after you buy.  The other stuff will vary depending on how you manage, who you hire to do your repairs, etc.

@Brian Burke Thanks for the detailed response! If I use the upper estimate of $600/unit per year the deal barely makes money with a 30% down payment. Basically it just covers cap X at a few hundred dollars a month, adding up to $3K or so a year. So essentially unless I can raise rents cheaply and quickly this is not necessarily an awesome buy. Grrrrr best opportunity I have had for a while so its tough because if I cant make this work, I may just have to be resigned to sitting out of the game for a bit.

@Scott Bowles as others suggested, ideally they will give you a copy of their Schedule E. I doubt they are significantly misrepresenting income or expenses in the important categories. It is pretty hard to falsify things like utilities or rent. There is a paper trail, so it is not smart to play those games. 

I have also asked people to prepare an income/expense statement and have their CPA sign the document. If they don't have a CPA, then you can have the seller sign the document. Yes they could lie, but when people sign things, they have a tendency to take it more seriously.

Also keep in mind the 50% rule says you can expect your expenses to be 50% of rents. That includes insurance, taxes, repairs, utilities, etc. It does not include your payment. That may end up being a little high, but that just means it gives you an extra buffer.

I get bank statements and Schedule E's. I also ask for utilities statements, insurance statements, etc. 

@Scott Bowles  A quick sniff test is if the Expenses are < 25% of EGI, then you definitely want to ask for all leases and bank statements just to be sure. 

In any case, the Sellers expense report will most likely look different from your operations, so take it with a pinch of salt. 

Goodluck on the new acquisition. Thanks! - Ola 

Thanks everyone for the help!

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