One of the biggest mistakes investors make is cutting corners during the due diligence process. While investing in rental property homes can be lucrative, failure to perform thorough due diligence can cripple an otherwise promising investment.
Here are 9 steps every investor should take before closing on an apartment building.
1. Financial audit
The purpose of a financial audit is to fact-check the numbers provided to a prospective buyer by the listing agent. The buyer should collect at least two years of trailing financials, 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 the investor to make adjustments to any assumptions they included in their original pro forma, or projection of a property's cash flow.
2. Property condition assessment
Similar to a home inspection, a property condition assessment helps commercial real estate investors determine the condition of the asset they’re interested in purchasing, leasing or financing. That will shed light on any repairs or improvements that will be needed in the near future.
3. Market survey
Before making an offer, a prospective investor has probably run some numbers on the property given an initial understanding of the market. They should then verify those assumptions by having a third party conduct a market survey.
The 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. The prospective buyer's broker and/or property manager should be able to conduct the market survey. Doing so will help confirm underwriting assumptions relative to rents and occupancy rates.
4. Lease audit
Leases determine how much income the property will generate, for how long, and how consistently. 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 potential liabilities.
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 a prospective buyer should be aware of before purchasing the property.
5. Title search
The title, which is often mistaken with the deed, is the transferable right to the property in question. A would-be buyer 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.
The prospective buyer will then receive a Preliminary Title Report (PTR), which 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. These should be carefully reviewed by a real estate attorney before closing.
6. 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 found 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.
7. 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 a lender 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.
This is a condition of most commercial loans. An appraisal 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 the prospective buyer disagrees with the appraised value, they can challenge the appraisal and request another, though they will pay for that of your own pocket. The bank will then usually take the average of the two appraisals.
9. Walk-throughs of every unit
Last but not least, buyers should 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. A walk-through of every unit before closing prevents surprises down the road.
A property management company can guide buyers through the process and provide a report upon completion.
All of these reports can certainly add up. Costs will vary depending on the size, location and condition of the property as well as factors such as who ordered the reports and their scope.
Buyers should budget at least $20,000 for the due diligence process, which can usually be rolled into and paid as part of the closing costs. The upfront investment may seem steep, but no buyer should skip over the due diligence process.