They say you make your money when you buy. Well, the flip side of that is you also lose your money when you buy if you do it wrong. This is why due diligence is so important; it prevents you from making such mistakes. And when it comes to apartments and larger properties, it’s all the more important because more money is at stake.
I have unfortunately witnessed many projects go south as budgets ballooned, and deals that at one time appeared to be great fall apart and become money pits more often than I would like to recount. Given that among those I’ve witnessed, a few have been ones we have purchased, it makes it all the more unfortunate. Luckily, these headaches can be avoided or at least mitigated with proper due diligence.
First of all, it’s important to know that larger apartments and commercial properties are usually purchased on a 60-day contract versus the average 30-day contract involved with the purchase of houses and small multifamily or commercial properties. The normal inspection period until your earnest money goes hard and is no longer refundable is 30 days, whereas it is usually 10 or 15 days with houses. Of course, all of this is subject to negotiation, but it’s critical to finish your due diligence before the inspection period ends in order to get your earnest money back if something turns out be wrong with the property.
A Brief Guide to Due Diligence for Apartments
Walk Every Unit!!!
Yes, three exclamation marks are necessary. Many sellers and even some real estate agents will tell you it’s OK to walk every second or third unit. Ignore this “advice” with extreme prejudice. If you only view every other unit, do you think the seller will show you the best or the worst units? How many hidden problems are you leaving behind closed doors, only to find out later once the property is in your name? It is critical to know the condition of each unit, even if there are 100 of them. It’s a painfully long process, but no one ever said real estate was easy (or at least no one every truthfully said that real estate was easy). Often, words like “new furnaces” or “new appliances” only apply to a very small number of the units.
During these walkthroughs, you should be taking a careful inventory of the work that needs to be done and compare that to the estimate you had when you made the offer (and yes, you should have a rough estimate of necessary repairs when you make an offer). Is there a major difference? Are the units in much worse shape than the few you saw beforehand? If so, that might mean you need to re-trade (renegotiate the price after the property is under contract). Re-trading is perfectly normal, so don’t be afraid to do it. That being said, don’t plan on it going in or make a habit of it or do it capriciously; otherwise, you will get a bad reputation and agents will steer their sellers away from you.
You should also pay a lot of attention to the tenants. Do they treat their units well, or do they treat them like a rental car? Feel free to ask them questions too, such as:
- How do they like the apartment?
- Do you have any consistent maintenance problems?
- Does it get really cold in the winter or hot in the summer because of these old windows/window A/C units/old heating system?
- Is it quiet here or pretty loud?
If it’s a large building, check the Google rankings to get an idea of tenant complaints. You can also ask a few what they pay in rent and what their deposit is. You want to verify what you see on the rent roll is actually true.
With regards to inspections, I recommend getting an inspection of the roof, the foundation if any major cracks or movement are apparent and at least a few electrical panels (to make sure they aren’t Federal Pacific panels or any other brand that has been recalled). It’s also not a bad idea to get a pest and dry rot inspection. And finally, I would recommend scoping the sewer line unless the property is relatively new. The old clay tile sewer lines break down quickly, and replacing a sewer line is not cheap. You can probably get a plumber to scope the line for $150 to $200.
You should have a licensed property inspector review anything else you have questions or are unsure about. If you are relatively new, it’s worth spending extra here, but you do not necessarily need an inspector to go through each unit like you did. Instead, you can have them view a couple units and then line out the specific items you want them inspect.
And go ahead and start bidding out the work with the contractors and vendors of your choice.
Leave No Financial Unturned
Please, for the love of everything good in this world, never take a seller’s financials for granted — especially the pro forma, which is basically just an uneducated and grossly optimistic guess. Often the pro forma’s are drastically better than the property’s operating history which leads one to wonder why the seller couldn’t reach the performance their pro forma takes for granted. In all likelihood, the seller couldn’t reach it because it’s not a real possibility.
Analyze the operating statement carefully, and review each lease to make sure it matches the rent roll. You’ll need proof of deposits (such as bank statements) so you know that the money is actually being collected. Also make sure you look for tenant delinquency and don’t just assume every leased unit is paying rent. You want the economic occupancy number, not the physical occupancy. Tenants who aren’t paying rent are actually worse than vacant units because you usually have to incur the cost of evicting them. Request utility bills and contracts to make sure they are in line with the operating statement. Double check the taxes with the county, and price out the insurance with your preferred carrier or even better, get a couple quotes.
You want to review the operating statement very carefully. But especially make not of two major things:
- Bad Debts
- Misallocated CAPEX
With regard to bad debt, if they are using accrual accounting, make sure that uncollected debts have been charged off so you can see the total delinquency. Sometimes properties will carry tons of bad debt without charging it off, and thereby the books look much better than they are. Make sure you are crystal clear on who is behind and by how much. New owners often have to kick out a lot of tenants, especially if the property is a bit dilapidated.
With regards to CAPEX (capital expenditures), some owners throw things in CAPEX (i.e. not in operating expenses so they don’t count on the property’s operating statement) that don’t really belong there so the net operating income looks better. A common example of this is turnover expenses. Replacing carpet in an apartment unit is really an operating expense, or at least a recurring capital expense, which should go above the line (be on the operating statement) — yet many sellers put such expenses in CAPEX. Make sure to get an inventory of their CAPEX expenses when analyzing properties and put in “recurring CAPEX” as a line item in your analysis (usually about $250/unit per year for things like roofs or furnaces going out).
Phase One, Appraisal and Survey
Any bank loan will require an appraisal and a Phase One Environmental Site Assessment (for larger properties). Sometimes they will require a Phase Two and/or a property survey. The Phase One is vital either way. It is an environmental study, and you absolutely don’t want to buy an apartment sitting on top of a toxic waste dump. The EPA does not look particularly kindly upon such things, and the cleanup can be ridiculously costly.
It’s hard to do too much due diligence. The mistake is almost always in the opposite direction. So never skimp on it. Due diligence could be the difference between solvency and insolvency, especially with larger apartments and commercial properties.
What would you add to my list? Have you ever purchased an apartment building before, and if so, what due diligence items did you find most essential?
Leave your comments below!