9 Steps in Due Diligence Process
One of the biggest mistakes we see investors make is cutting corners during the due diligence process. While apartment buildings can be lucrative, failure to perform thorough due diligence can cripple an otherwise promising investment.
Here are 9 steps we suggest every investor take before closing on an apartment building:
- Hire a third-party to conduct a financial audit. The purpose of a financial audit is to fact-check the numbers provided to you by the listing agent. You’ll want to collect at least two years of trailing financials (e.g. bank statements), a current rent roll, and at least three months’ worth of prior rent rolls. A financial services consultant will use this information to analyze the asset’s operating history and provide a detailed overview of operating income and expenses. The results of this report will allow you to make adjustments to any assumptions you included in your original pro forma.
- Complete a property condition assessment (PCA). Similar to a home inspection, a PCA helps commercial real estate investors determine the condition of the asset they’re interested in purchasing, leasing or financing. The PCA will shed light on any repairs or improvements that will be needed in the near future.
- Do a market survey. Before making an offer, you probably ran some numbers on the property given your initial understanding of the market. Verify your assumptions by having a third party conduct a market survey. The subject property will be evaluated relative to comparable properties in the sub-market based on a number of variables, including rents, unit type, occupancy, unit sizes, amenities, etc. Your broker and/or property manager should be able to conduct a market survey for you. Doing so will help confirm your underwriting assumptions relative to rents and occupancy rates.
- Audit leases. You’re buying an income-generating property and the leases can determine how much income the property will generate, for how long, and how consistently. As such, lease audits are just as important as physical inspections of the property. A lease audit will verify lease amounts, dates and signatures and will provide valuable insight regarding cash flow and the potential liabilities driving your investment. The audit will note any special deals or concessions that have been made as a condition of the lease—like a temporary rent discount or use of laundry facilities. It will also provide information about any pending tenant actions, such as late payments or eviction notices, that you should be aware of before purchasing the property.
- Complete a title search. The title, which is often mistaken with the deed, is the transferable right to the property in question. You must ensure the seller actually has title to the property and if so, that the title is clear of any liens or other claims against it. Most sellers will be sure to obtain clean title before putting the apartment building on the market, but that’s not always the case. A title search will reveal any marks on the title. The report you’ll receive is known as a Preliminary Title Report (PTR) and will include a description of the land, the type of estate, who holds title to the estate, and any claims against the estate. It will list any liens, restrictions, special assessments and more. The PTR should be carefully reviewed by your real estate attorney before closing.
- Conduct a site survey. A site survey, sometimes called a land survey, is a graphic depiction of the property in question. This is an updated version of the description you’ll find in the property deed, which may use outdated landmarks like roads that have been reconfigured. A site survey helps clarify the property boundaries, lot size, and topographical details. The final report will include a written description of the property as well as identification of any easements, setbacks, or other restrictions on the property.
- Do an environmental site survey. These are often referred to as a “Phase I Site Assessment,” a technical term that describes the process of evaluating any potential or existing environmental contamination and liabilities. This report is typically required by your lender during the due diligence process and will be completed by a third-party. The final report will include an assessment of both the underlying land and physical improvements on the property – such as the potential for underground storage tanks or asbestos-containing building materials.
- Get an appraisal. This is pretty straightforward and a condition of most commercial loans: an appraisal report determines the value of the property based on market comps, cap rates and net operating income. The report will be completed by a third-party provider selected by the bank. If you disagree with the appraised value, you can challenge the appraisal and request another – though that will need to be paid for out of your own pocket. The bank will then usually take the average of the two appraisals.
- Perform walk-throughs of every unit. Last but not lease, conduct a final walk-through of EVERY unit. The condition of some, even most, of the other units is not always indicative of the others. Do yourself a favor: do a walk-through of every unit before closing on the property to prevent surprises down the road. A property management company can guide you through the process and provide a report upon completion.
All of these reports can certainly add up. A few thousand dollars here, a few thousand dollars there. Costs will vary depending on the size, location and condition of the property as well as who ordered the reports, the scope of the reports and so on. In general, we suggest budgeting at least $20,000 for the due diligence process, which can usually be rolled into and paid as part of your closing costs.
The upfront investment may seem steep, but trust us – you don’t want to gloss over the due diligence process. You could end up with major unplanned expenses otherwise.