Due Diligence For Multifamily Investing Explained

Due Diligence For Multifamily Investing Explained

Due Diligence For Multifamily Investing Explained

One of the most important and earliest tasks for the general partners in multifamily syndications is performing due diligence. 

This term refers to all of the deeper analysis you conduct once you have a property under contract. 

Your goal is to confirm your assumptions about the property as well as make sure there are no issues that went undisclosed. 

This process encompasses both a financial and physical review of the property.  

Your purchase and sale agreement needs to include and specify all the due diligence tasks you will be performing once under contract and the seller must be willing to cooperate with these items in order for you to move forward.

Remember that one person doesn’t have to do all of this on their own and proper due diligence for multifamily purchases requires a team working together to tackle every action item under what are typically tight time frames before closing on the property. 

When you’re raising money from your investors, it’s your responsibility to leave no stone unturned.

Financial Review:

Due Diligence For Multifamily Investing Explained

Trailing Twelve:

As investors, it’s imperative that we run through every scrap of data on the property’s financial history.  Once you have a property under contract, this process should begin in earnest. 

Carefully review the property’s
trailing 12 or t-12, which is a term that simply means that last 12 months of income and expenses. Review and compare with the property’s rent roll and make sure the numbers make sense and everything matches up.

Income and Expense Reports

Get the last 2-3 years of income and expenses reports to see if there are any aberrations from year to year. 

For example, if the water bill was significantly higher for several months two years previously, you’ll want to understand what the source of the issue was to know if this is something that might cause you trouble down the line as well. 

Perhaps you inquire and find that one unit had a broken toilet. 

You’ll then know that you should double check to make sure that toilet was replaced properly, as well as find out if the other units in the complex are still using the same model of toilet and assess how likely it is that the problem will re-occur.

Prior to putting a property under contract, you should have already identified a property management company that you plan to employ upon closing. 

Have the property management company help review all the financial information as well.

This provides a second set of eyes that operate in the market and may be able to notice potential issues you might have missed. 

Remember that the seller should be willing and able to provide all the necessary financial documents you need to complete your review. 

If the seller is not transparent, do not move forward with the deal.

You have to assume that they might be hiding something.  Keep in mind that mom and pop owners might have spotty record keeping. 

Mom and pop owners are a favorite target for multifamily purchases as the asset is typically being mismanaged to some degree or another, allowing you to purchase the property at a discount and add value during your ownership. 

This can be a bit of a double edged sword, however, during your financial due diligence, as these kinds of owners may be less systematized and it might take some effort to parse through their records to verify your assumptions. 

This is something that must not, under any circumstances, be overlooked or skipped, even if the data is disorganized.  

Remember that your lender will also be reviewing all of this information and most certainly won’t be willing to provide a loan if the information provided doesn’t make sense or the numbers don’t add up. 

This is great because both you and your lender will be working independently to analyze the property and verify that all of your assumptions are correct.  

Lease Audits:

The lease audit is typically performed in tandem with the property inspection (see below). 

As the name implies, you will be combing over every line of the existing lease agreements. 

What you’re looking for here is confirmation that the rental rates in the leases match the ones being presented to you in the rent roll. 

You also want to be sure there are no secret concessions that had not been disclosed.  An example of that might be that the landlord had leased to a tenant two years previously with the promise of their last month’s rent being free. 

Now that the previous owner is selling, that free month would become your responsibility! 

Some other things to look out for here are making sure the security deposit numbers line up and that any additional fees, such as pet fees, are clearly stated in the lease agreement in order to make them binding.

Service Contracts:

When you assume control of a multifamily asset, there will in all likelihood be existing contracts in place with the previous owner for a variety of services needed to manage the property, such as trash removal. 

Be sure to carefully review all contracts that are in place at property. 

You can choose to either continue these contracts, if they seem reasonable to you, or cancel them. 

These might include snow removal or vending machine vendors, for example. 

Get an idea which of these services are essential to your business plan, cancel those that are not, and re-negotiate or get other estimates for services you believe to be overpriced for the market.  Your property management company will be able to assist you in doing so. 

As investors, it’s imperative that we run through every scrap of data on the property’s financial history.  On

ce you have a property under contract, this process should begin in earnest.  Carefully review the property’s trailing 12 or t-12, which is a term that simply means that last 12 months of income and expenses. 

Review and compare with the property’s rent roll and make sure the numbers make sense and everything matches up.

Get the last 2-3 years of income and expenses reports to see if there are any aberrations from year to year. 

For example, if the water bill was significantly higher for several months two years previously, you’ll want to understand what the source of the issue was to know if this is something that might cause you trouble down the line as well. 

Perhaps you inquire and find that one unit had a broken toilet. 

You’ll then know that you should double check to make sure that toilet was replaced properly, as well as find out if the other units in the complex are still using the same model of toilet and assess how likely it is that the problem will re-occur.

Prior to putting a property under contract, you should have already identified a property management company that you plan to employ upon closing. 

Have the property management company help review all the financial information as well.

This provides a second set of eyes that operate in the market and may be able to notice potential issues you might have missed. 

Remember that the seller should be willing and able to provide all the necessary financial documents you need to complete your review. 

If the seller is not transparent, do not move forward with the deal.

You have to assume that they might be hiding something.  Keep in mind that mom and pop owners might have spotty record keeping. 

Mom and pop owners are a favorite target for multifamily purchases as the asset is typically being mismanaged to some degree or another, allowing you to purchase the property at a discount and add value during your ownership. 

This can be a bit of a double edged sword, however, during your financial due diligence, as these kinds of owners may be less systematized and it might take some effort to parse through their records to verify your assumptions. 

This is something that must not, under any circumstances, be overlooked or skipped, even if the data is disorganized.  

Remember that your lender will also be reviewing all of this information and most certainly won’t be willing to provide a loan if the information provided doesn’t make sense or the numbers don’t add up. 

This is great because both you and your lender will be working independently to analyze the property and verify that all of your assumptions are correct.  

The lease audit is typically performed in tandem with the property inspection (see below). 

As the name implies, you will be combing over every line of the existing lease agreements. 

What you’re looking for here is confirmation that the rental rates in the leases match the ones being presented to you in the rent roll. 

You also want to be sure there are no secret concessions that had not been disclosed.  An example of that might be that the landlord had leased to a tenant two years previously with the promise of their last month’s rent being free. 

Now that the previous owner is selling, that free month would become your responsibility! 

Some other things to look out for here are making sure the security deposit numbers line up and that any additional fees, such as pet fees, are clearly stated in the lease agreement in order to make them binding.

When you assume control of a multifamily asset, there will in all likelihood be existing contracts in place with the previous owner for a variety of services needed to manage the property, such as trash removal. 

Be sure to carefully review all contracts that are in place at property. 

You can choose to either continue these contracts, if they seem reasonable to you, or cancel them. 

These might include snow removal or vending machine vendors, for example. 

Get an idea which of these services are essential to your business plan, cancel those that are not, and re-negotiate or get other estimates for services you believe to be overpriced for the market.  Your property management company will be able to assist you in doing so. 

Physical Review

Due Diligence For Multifamily Investing Explained

Area Survey:

Prior to submitting your LOI, you should have already surveyed the area using google maps. 

While this can give you a good impression of the area, you should take it a step further and drive through the area immediately upon entering the due diligence period. 

This can fill in the gaps in your understanding that can be really difficult to grasp from a computer chair. 

I can tell you as both an investor and multifamily developer, it’s always wise to drive through the area. 

Real estate values can vary from neighborhood to neighborhood and you need some degree of boots on the ground in the early stages to solidify your understanding of the submarket.  

Comparable property data can only take you so far in some cases, especially if it’s a densely developed area with older housing stock and a low annual volume of sales. 

You might not have enough data to understand street-to-street differences, but you can pick up on details like the condition of the buildings or some kind of functional barrier separating it from areas that are physically close, but have different rental rates. 

Let’s say that you’re targeting class A properties in upscale neighborhoods. 

You’ll want to confirm that the property you have under contract has easy access to local amenities, transportation, and that the quality of the local commercial real estate stock is high and shows signs of new and continued investment into the economy. 

If you’re investing in workforce housing, those items would still be important if you had them, but you might be looking more closely at parameters like renter to homeowner ratios and population density.

Comparible Property Analysis:

Ideally you should tour similar properties nearby as this is the best way to hone in on these details.

That way you can get a hands-on look at what amenities, finishes and fixtures they might offer. 

You can also get an idea of unit sizes and layouts, which is information that you should already have an idea of from your initial research, but is often difficult to truly dial in without a physical review. 

Getting familiar with the other housing options your prospective tenants will be looking at in your market is essential as you can’t really understand what the expectations are for the rental rates you hope to charge otherwise.

Property Inspections:

Be Proactive

You need to be proactive and hit the ground running in scheduling all of your inspections immediately upon signing your purchase and sale agreement. 

The property inspection is critical in order to verify that the property is in good working order and there are no serious issues. 

It also presents an opportunity to dial in your value-add capital expenditure budget. 

Don’t Skip a Single Unit, Be Thorough

Remember that your team must enter and inspect every single unit and every inch of common area.  Property inspections for multifamily properties above 100 units take several days to complete.

For example, say your research shows that comparable properties average a 60/40 mix with 60% of units having remodeled kitchens within the past 5 years versus 40% of units with older kitchens. 

If you perform a thorough property inspection, you might find that the property you have under contract has a mix closer to 30% of units with remodeled kitchens versus 70% with older ones. 

You’ll know that you want to hit that 60/40 sweet spot that your comparable properties are operating in and can budget accordingly.  

Make sure your selected property management company has systems in place for performing inspections. 

A good property management company will typically perform this service for free or for a low cost if you plan to partner with them during your ownership.  This is a good test to see if the property management company is actually worth partnering with. 

Some Examples

A thorough property inspection requires specialized knowledge that you will want when your team assumes control of the asset.  

For example, say you were targeting class C workforce housing apartments that were built 30+ years ago. 

These older properties have common, but hidden problems brewing beneath the surface that you might not notice without experience. 

One such problem would be leaking o-rings on older toilets that have slowly seeped into and begun to rot the sub-floor.  It may be as simple as giving the toilet a light shake to be able to tell this is occurring.  

Another example that would be included in a thorough inspection of an older property would be scoping out the utility lines. 

Issues with sewer lines, for example, could cause severe functional issues and health hazards that would require immediate and costly repairs. 

Experience is Key 

Without experience with these techniques that may seem simple, but you’re likely ignorant of, lots of issues will go unnoticed and rear their head sometime during your ownership.  

Make sure your team conducts a thorough inspection of all the building systems, as well as the condition of the grounds of the property. 

Physically inspect the building envelope, including the walls, windows, roof, siding and foundation to check for any damage and figure out the remaining lifespan of each component. 

The property’s plumbing, heating, and electrical systems should also be tested to ensure they are operational and up to code.

Check for any deferred maintenance

Even issues you may think to be minor, such as potholes and cracks in parking lots or diseased trees that may fall over sometime in the near future are important for safety and liability reasons, both to you as the property owner and to your lender.

TIP: Material suppliers can help you budget for any repairs that might be necessary.  For example, roofing supply companies can survey your roof using a drone and specialized software to provide you with an estimate for the cost of the roofing materials, as well as measurements you can provide to roofers to get their estimate for the cost of the installation.  Roofs are measured by the square. One square is 100 square foot area of the roof. 

Lender Inspections:

Your lender will also be performing their own inspections.  The most important one for the process of securing your debt will be the property appraisal.  Lenders may also require an environmental survey of the property, depending on the property’s history, proximity to certain business such as gas stations, and state or local regulations.

Prior to submitting your LOI, you should have already surveyed the area using google maps. 

While this can give you a good impression of the area, you should take it a step further and drive through the area immediately upon entering the due diligence period. 

This can fill in the gaps in your understanding that can be really difficult to grasp from a computer chair. 

I can tell you as both an investor and multifamily developer, it’s always wise to drive through the area. 

Real estate values can vary from neighborhood to neighborhood and you need some degree of boots on the ground in the early stages to solidify your understanding of the submarket.  

Comparable property data can only take you so far in some cases, especially if it’s a densely developed area with older housing stock and a low annual volume of sales. 

You might not have enough data to understand street-to-street differences, but you can pick up on details like the condition of the buildings or some kind of functional barrier separating it from areas that are physically close, but have different rental rates. 

Let’s say that you’re targeting class A properties in upscale neighborhoods. 

You’ll want to confirm that the property you have under contract has easy access to local amenities, transportation, and that the quality of the local commercial real estate stock is high and shows signs of new and continued investment into the economy. 

If you’re investing in workforce housing, those items would still be important if you had them, but you might be looking more closely at parameters like renter to homeowner ratios and population density.

Ideally you should tour similar properties nearby as this is the best way to hone in on these details.

That way you can get a hands-on look at what amenities, finishes and fixtures they might offer. 

You can also get an idea of unit sizes and layouts, which is information that you should already have an idea of from your initial research, but is often difficult to truly dial in without a physical review. 

Getting familiar with the other housing options your prospective tenants will be looking at in your market is essential as you can’t really understand what the expectations are for the rental rates you hope to charge otherwise.

Be Proactive

You need to be proactive and hit the ground running in scheduling all of your inspections immediately upon signing your purchase and sale agreement. 

The property inspection is critical in order to verify that the property is in good working order and there are no serious issues. 

It also presents an opportunity to dial in your value-add capital expenditure budget. 

Don’t Skip a Single Unit, Be Thorough

Remember that your team must enter and inspect every single unit and every inch of common area.  Property inspections for multifamily properties above 100 units take several days to complete.

For example, say your research shows that comparable properties average a 60/40 mix with 60% of units having remodeled kitchens within the past 5 years versus 40% of units with older kitchens. 

If you perform a thorough property inspection, you might find that the property you have under contract has a mix closer to 30% of units with remodeled kitchens versus 70% with older ones. 

You’ll know that you want to hit that 60/40 sweet spot that your comparable properties are operating in and can budget accordingly.  

Make sure your selected property management company has systems in place for performing inspections. 

A good property management company will typically perform this service for free or for a low cost if you plan to partner with them during your ownership.  This is a good test to see if the property management company is actually worth partnering with. 

Some Examples

A thorough property inspection requires specialized knowledge that you will want when your team assumes control of the asset.  

For example, say you were targeting class C workforce housing apartments that were built 30+ years ago. 

These older properties have common, but hidden problems brewing beneath the surface that you might not notice without experience. 

One such problem would be leaking o-rings on older toilets that have slowly seeped into and begun to rot the sub-floor.  It may be as simple as giving the toilet a light shake to be able to tell this is occurring.  

Another example that would be included in a thorough inspection of an older property would be scoping out the utility lines. 

Issues with sewer lines, for example, could cause severe functional issues and health hazards that would require immediate and costly repairs. 

Experience is Key 

Without experience with these techniques that may seem simple, but you’re likely ignorant of, lots of issues will go unnoticed and rear their head sometime during your ownership.  

Make sure your team conducts a thorough inspection of all the building systems, as well as the condition of the grounds of the property. 

Physically inspect the building envelope, including the walls, windows, roof, siding and foundation to check for any damage and figure out the remaining lifespan of each component. 

The property’s plumbing, heating, and electrical systems should also be tested to ensure they are operational and up to code.

Check for any deferred maintenance

Even issues you may think to be minor, such as potholes and cracks in parking lots or diseased trees that may fall over sometime in the near future are important for safety and liability reasons, both to you as the property owner and to your lender.

TIP: Material suppliers can help you budget for any repairs that might be necessary.  For example, roofing supply companies can survey your roof using a drone and specialized software to provide you with an estimate for the cost of the roofing materials, as well as measurements you can provide to roofers to get their estimate for the cost of the installation.  Roofs are measured by the square. One square is 100 square foot area of the roof. 

Your lender will also be performing their own inspections.  The most important one for the process of securing your debt will be the property appraisal.  Lenders may also require an environmental survey of the property, depending on the property’s history, proximity to certain business such as gas stations, and state or local regulations.

Invest with Winterspring

Invest with Winterspring

Due Diligence For Multifamily Investing Explained
Due Diligence For Multifamily Investing Explained
Due Diligence For Multifamily Investing Explained
Due Diligence For Multifamily Investing Explained