As you might already be aware, our primary focus is buy-rehab-hold. Many times over the years, deals have looked great on the first walk through, and the numbers have come up solid, but upon further inspection, we have found issues that caused us to change our minds about the deal.
It’s important to do a thorough physical and financial inspection of a deal to make sure the deal will meet (and even exceed) your expectations. You also want to make sure that the data the seller gives you to evaluate the deal is correct. This includes everything from the rent tenants are paying, the utility expenses and even what use the property is zoned for.
Discovering that a piece of data you used to evaluate the deal is incorrect can kill a deal. Discovering it too late can be much worse.
When we buy a property, every one of our agreement of sales includes two clauses around inspections. One clause allows us a phase called the Due Diligence phase. This phase typically takes 15 to 30 days and is the time period when you can do all inspections. The second clause allows us to ask the seller to make repairs, request a discount in price (called a re-trade) or exit from the deal altogether as a result of what is found during the inspections.
This article is dedicated to the Due Diligence phase and what we typically do to make sure the deal will meet our expectations.
The level of detail you will go into during due diligence will vary depending on the size of the property. You should do some level of all the inspections below, even for a single family home.
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3 Crucial Inspections to Make During Due Diligence
1. Document Inspection
This is the first and typically the most straight forward part of due diligence.
In the agreement of sale, we ask for specific documents to review. Most of these are readily accessible by the seller, and we just want to make sure they have them on hand. Some of the easy ones include the deed to the property, a copy of their insurance policy, copies of all tenants’ leases and a recent real estate tax bill.
If the seller can’t produce one of these things, it’s a red flag that deserves further examination and may uncover more data. Perhaps the tenants living in the building don’t actually have written leases. Perhaps the property is in a flood zone, which would become evident on their insurance policy.
Another document that the seller may or may not have on hand is a land survey of the property. If the owner doesn’t have a survey, you should consider having one performed on your own to confirm that things like fences, driveways and utility poles don’t cause a boundary issue between you and a neighboring property.
The last stop on your document inspection should be to the local municipality. There, you want to confirm that the property is zoned for its current use, that it is registered as a rental property (if that’s required in your area), and that there are no violations filed on the property.
Document inspection/review should take you no more than a day once you have everything in hand.
2. Physical Inspection
Just like a homeowner’s inspection, when you purchase a home, the physical inspection of a rental property is dedicated to uncovering things that may become a problem down the road.
For every deal we do, we perform a detailed walk through of the building.
We look for two things: upgrades we want to make and safety concerns. Upgrades usually include the things that make a unit rent easily, like new kitchens and baths, new light fixtures and appliances. Safety concerns include things like missing smoke detectors and undersized electrical breakers. In New Jersey and Pennsylvania, the local township performs a Certificate of Occupancy inspection on every sale, which focuses on safety.We typically rely on their inspection to uncover safety code violations.
We do all of the above for just about every purchase. As the deals have gotten larger, we’ve implemented some of the following additional physical inspections:
- Roof inspection: For mixed use or multifamily buildings, we have a roofing contractor come out and give us a full assessment of the roof condition for a very reasonable fee of $100. The report includes pictures and a brief written report. He also includes an estimate to repair any damage.
- Structural inspection: Structural repairs can be expensive, but they can be remediated. If we see something that looks suspicious with the building foundation or the framing (typically in the basement), we bring in an engineer. For a small fee, he will do an inspection and write a report of his findings.
- Boiler inspection: For multifamily buildings with one boiler heating multiple units, we will have a heating contractor inspect the heating system to determine its current health and life expectancy beyond closing.
- Fire inspection: When there are hardwired smoke detectors or fire extinguishers in the common area of the building, we have a contractor inspect them to make sure they are working properly. Most municipalities will require this to get a clean certificate of occupancy actually.
- Environmental inspection: This sometimes comes up for properties larger than a single family home and will just about always come up if you are getting financing from a local bank. It involves making sure there are no environmental hazards on the property. These hazards are a threat to the local environment and include things like an abandoned underground heating oil tank or asbestos insulation on heating lines or lead based paint.
The inspection needs to be done by a third party company hired by you (the buyer). It can be a very light inspection called an Environmental Analysis Survey or a full blown analysis called a Phase 1 Study. If any issues arise, the seller is obligated to remediate them, and the inspector is obligated to report them to the local environmental authority. Whether or not to perform an Environmental Inspection is really up to your lender, if you have one.
Once you complete your Physical Inspection, you want to go back to the owner and either get more clarity on some of these items or ask for them to remediate certain things (especially if an environmental issue comes up). You may even need to ask for an extension of the Due Diligence period to complete your investigations, as sometimes getting one question answered leads to another. If you find something that is going to cost you big time in the future, you can ask the owner for a potential discount before closing.
3. Financial Inspection
Before you put the deal under contract, you should have completed a financial analysis of the deal.
If it met your profit requirements, you made the offer and moved forward. There is a potential problem here: the fact that you had to use numbers you assumed were correct. This includes everything from the income numbers to the expenses — all these were probably given to you by the current owner or their realtor and need to be validated.
When I am evaluating a properties financials, here’s what I ask for:
- Lease review: In the document inspection, we got copies of the leases. I look at the lease for three financial items: what they pay in rent, their security deposit and what they are responsible for. The last item is very important.
We are purchasing a mixed use building with a group of investors right now. I was reviewing the leases yesterday and saw that one of the storefront owners is responsible for 25% of the snow removal fees. That was on the 4th page of their lease — and could have been overlooked easily. Because I found that, I probably made us $500 a year in reimbursements from the tenant!
- Utility bills: I always ask for 12 months of utility bills for anything that is in the landlord’s name. You definitely want to get at least 12 months because you want to see the utility cost fluctuates through all 4 seasons.
In my part of the world, here in New Jersey, gas bills are much higher in the winter. Another reason you want 12 months of utility bills is that water and sewer will fluctuate greatly with vacancies.
- Real estate taxes: I once looked at a property where the realtor listed the taxes to be $6000 per year for a 3 family building (welcome to New Jersey, everybody!). Once I started our due diligence, I found that the taxes they had quoted were from 3 years ago. The new tax rate was $7500 per year.
It actually was an honest mistake, but lazy on the realtor’s part. The taxes hadn’t been updated in the MLS in years, and they didn’t bother to contact the tax collector to confirm the taxes, which we did during due diligence. Imagine if we had taken the realtor’s word and gone to closing.
- Maintenance: This is a tough one. You really need to take a close look at the building during the walk throughs. If you get an owner who is willing to be honest with you and show you their actual expenses, you can get a feel. Most owners I deal with “forget” the time they had to patch the roof for $1500 or leave out things like grass cutting or snow removal in their maintenance estimates.
You can also go with a rule of thumb on this one, which is risky, but it works. I usually estimate between $400 and $600 per unit per year in maintenance on a multifamily and am not too far off most of the time.
- Management: Most realtors use crazy numbers for management, like 4% to 5% per year. I have yet to meet a management company that will take a contract to manage anything less than 100 units for less than 8%. In our case, we manage the property with our own management company and charge 10% for the service.
Although it makes brokers unhappy that I blow away their projections for profit by increasing the management fee, it is way more realistic. And as a side note, even if you are planning to manage the property yourself, put in a management fee anyway just to be safe. If the numbers work with it, you can always hire someone later.
- Insurance: This one is pretty straight forward. In the document inspection, you should have gotten a copy of their policy. Take that and send it to your preferred carrier and ask them to price it out. Just have them adjust it to meet your desired deductible, replacement cost, etc.
- Capital expenses: This is the forgotten expense — but one that will come back and bite you years later. Capital Expenses are things like boiler replacements, roof replacements, major apartment turnover and common area upgrades.
You need to set money aside for these things year over year, even if you don’t do them, so that you have a reserve for when that roof does need repair or the electrical in your building needs to get upgraded.
Once you’ve crunched all the numbers above, you either validate the profit projections you had when you made your offer, or you show them to be false. If the numbers are far off and you put that clause in your offer (see the beginning of this article) you can go back to the owner and ask for a price adjustment to meet your original expectations.
You may not get everything you want, but if you did your homework, you can show that the property does not perform as they said it would.
I view the purpose of Due Diligence to be validation and long term planning. The validation is of the financial performance of the building and the expectations I have for the physical condition of the property. The long term planning comes in when I see that roof report or find out that the boiler has 5 years’ worth of useful life. The Due Diligence period is a time to really get to know my new asset so I can keep it performing over the years.
Some people use the Due Diligence period to look for places to get a discount. I have done that, too — but don’t get caught up in it. You should make an offer you are willing to stand by up front, not use the Due Diligence phase to get to your price.
Have you done some other things for Due Diligence that I missed?
Thanks for reading and please leave me a comment!