Due diligence is one of the most critical aspects of any real estate deal.
I don’t care how confident you are in a deal; shoddy, incomplete due diligence will invite disaster into your real estate portfolio. If you’re lucky, you’ll only leave a few thousand dollars on the table. If you’re not, you’ll saddle yourself to losing investment.
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Due diligence takes time, focus, and scrupulous attention to detail. It’s easy to get bogged down in the weeds of document review. To help keep you from losing the forest for the trees, here are 7 questions to guide you through your own due diligence process.
Where’s the paper?
- 3 years of operating statements (including year-to-date)
- 6 months of bank statements
- Utility deposit register
- Utility bills for the last 2 years.
- Property tax bills for the last 2 years
- IRS Tax returns and addenda for the last 2 years
Tenant Information
- Rent roll for the property for the last 2 years
- Security deposit register
- Payroll records
- All current lease agreements (including ad hoc concessions)
- Written property policies (pets, parking)
Management Information
- Commission agreements
- Current management contract
- List of outstanding maintenance requests
- Maintenance/capital improvement history for past 3 years
- Litigation history on the property for the past 5 years
Property Information
- Service contracts (pool, trash, laundry, extermination, etc.)
- HVAC repair history
- Elevator maintenance report
- Insurance policy and claims history for the past 2 years
- Operation manuals
- Business license
- Deed and Title policy
- Site plan, property survey, and architectural plans
- Inspection and Environmental Repo
That includes:
Financial Records
When you drop in, chat with a few tenants and neighbors. Try to get their read on the neighborhood. These are the kinds of insights you’ll never get from a seller or his broker.
If you find the reality on the ground fails to live up to the picture you’ve painted in your head, then either adjust your analysis and projections accordingly or walk away.
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Who can I talk to?
The seller’s not the only one you’ll want to talk to about a property. Here are a few more people you’ll want to reach out to:
- Contractors – Take a look at current service contracts and past repair receipts. Call those contractors and ask for their sense of the property. Some will have no idea what you’re talking about. Others will open up and give you a dissertation on everything you need to know about the physical condition of the property.
- Chamber of Commerce — It’s always a good idea to figure out what’s happening in the market. Contact the local Chamber to learn if there’s any new economic activity on the horizon, how demographics are shifting, and whether there are any financial incentives for investing in the area.
- City Planning Officials/Assessors – Head down to City Hall and do a little digging on the physical and economic history of the property. Does the property density confirm to zoning requirements? Have there been any code violations? What permits have been pulled? How has the assessed value changed over time? Have the owners contested the assessed value recently? What was the outcome?
- Tenants/Neighbors – Visit the property at least twice: once during the day and a second time at night. What do the vehicles look like? Do you feel safe? Talk to a few tenants about their experience. Do they enjoy living there? What would they change? Do they plan to stick around after their lease runs out?
What shape is the property in?
This question begins with the obvious details: property age, curb appeal, deferred maintenance, etc., but it doesn’t end there. Whether you do it yourself or hire a property inspector (recommended), the property’s going to need to be torn apart—inch by inch.
This part of the process is critical. Take your time and look at every single unit—not just a handful of them. Snap pictures. Record videos. Take careful notes.
Don’t be afraid to call in additional help. If the foundation looks sketchy, get a structural engineer out. If the HVAC looks old, get a qualified professional to assess it.
This might take a while, but you can’t afford to rush this part of the process.
What do I know about the neighborhood?
If you haven’t already, due diligence is a great time to get intimately acquainted with the neighborhood. Here are some essential questions to ask:
- What are the crime statistics for the area?
- How walkable is the neighborhood?
- Who are the major employers in the area?
- What sort of retail stores are nearby?
- Where is the closest grocery and pharmacy?
- How far are schools and parks from the property?
- How far away are the police and fire stations?
- Is there nearby access to public transportation?
Don’t forget to zoom out and look at the rental market data. Take this opportunity to re-run your analysis and check your projections against what the market is actually doing.
How has this property been run?
Dig through your paperwork (see #1) and talk to management about the current state of the property. This is where you can learn whether the property is underperforming or overperforming, as well as what you can do to improve its performance after closing.
- What is the current tenant mix?
- What has vacancy looked like (physical and economic) over the past 3 years?
- Is overall occupancy dropping or improving?
- How do the property’s occupancy rates compare with the neighborhood?
- Is the current management offering improvements, concessions, or incentives to get people in the property?
- Are any of the utilities included in the rent?
- How many leases will expire within the next 90 days?
- When was the last time rents were raised and by how much?
- How do rents compare with the market rates?
- Has the income been consistent every month?
- Do you see any inconsistencies in the income data?
- Does the P&L match the bank statements and tax returns?
- Do the maintenance expenses look realistic or are they low?
- How does the expense ratio compare to other multifamily properties in the area?
- How consistent have the expenses been over the past 3 years?
- What is the current NOI? Has it been trending up or down?
- What percentage of the gross income does the NOI represent?
What do the numbers say?
Speaking of projections, it’s vital that you check and re-check your numbers at the end of the due diligence process. Now that you’ve been able to flesh out current operating income and expenses as well as market rates, vacancy, growth, etc., you’re armed with much better information to draw an accurate picture of the property’s viability.
On top of that, your inspection will have given you a more comprehensive picture of repair and improvement costs. Taking those numbers into consideration, you’ll be in a better position to assess whether the terms of your current deal justify moving forward.
Often, they will not. But that’s not the end of the story.
What’s it going to take for this deal to make sense?
At the end of the due diligence process, you’re going to have the opportunity to either walk away or renegotiate. As you make that decision, ask yourself if there’s a number at which the deal would make sense to you. If so, what is that number?
This is why careful due diligence is so necessary. We’re not talking about guesswork here; we’re talking about a precise evaluation of the property as it is and the terms you’ll need to justify moving forward.
If you’ve done your homework, you’ll know how to come up with that number. More than that, you’ll have a bulletproof case to make to your reluctant seller.
Wrapping Up
It takes time to develop a consistent due diligence process that you can run through every time. But once you dial in the particulars and get absolutely methodical, you’ll have a reliable program to run through on every deal. That’s the kind of systems-building that leads to a successful long-term career in multifamily real estate.
For more on due diligence, check out my free book, How to Create Lifetime Cashflow Through Multifamily Properties. As always, if you have questions, come on over to our Facebook community. You’ll find 20,000 members there eager to share their wisdom.
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