Due Diligence is the careful, thorough evaluation of a potential investment. It helps the new buyer gain a complete picture of the apartment community’s repair needs as well as its potential for financial performance. It includes the evaluation of the physical asset as well as its financials.
Before you make the leap and purchase a multifamily property, you’ll need to do some homework first. This is referred to as due diligence in the multifamily industry and often consists of hiring third-party service providers to inspect and/or provide reports on various parts of the property to analyze its suitability as an investment.
If you’re planning on financing your property with a multifamily loan, much of this due diligence will also be required by your lender and will need to meet their requirements if you want to get approved. However, if you want to finance the property yourself (an extreme rarity), you’ll still want to conduct the full due diligence process to ensure you’re getting a good deal.
If you’re syndicating in a multifamily deal, you want to be in a position to make an informed decision that will increase your chances of successfully raising capital and making money for your passive investors. Understanding the due diligence process is one of the most critical steps toward making that happen.
The main aims of real estate due diligence are to thoroughly inspect the fundamentals of the property, seller, financing, and compliance obligations to reduce and mitigate financial uncertainties. The effort is not for the fainthearted. Prospective buyers must scrupulously examine zoning restrictions, potential liens, and possible encroachments on the property. Existing structures must be fully inspected to discern needed repairs and their costs.
They must determine whether or not they will absorb legacy liabilities from prior owners’ legal and regulatory violations. If the property is largely financed, they need to address their ongoing ability to make required payments to the lender. Many sophisticated commercial real estate investors consider it a best practice to commence detailed due diligence before the purchase contract is signed.
Given the vast array of documents in a commercial real estate transaction, it is important to prepare a due diligence checklist, marking off each item of concern once it has been addressed. Depending on the investor type and the entity’s financial objectives, this checklist can be quite long. Nevertheless, it would be imprudent to close a deal before appreciating and fully evaluating the risks against the rewards.
Successfully acquiring commercial real estate requires thorough due diligence to discover the vital information that may not be immediately available or apparent when evaluating a property or portfolio’s value. Hidden details about a property can be catastrophic to the financial merits of an otherwise profitable deal, transforming a transaction into an expensive mistake.
CATEGORIES OF DUE DILIGENCE
Due diligence is divided into four primary categories: property, operating history, legal, and financing. Understanding these aspects will give old and new investors a strong grasp of the commercial real estate due diligence process.
1. Property Due Diligence
These steps include research into the physical property, that is, the state of the land and any improvements on it.
- Property Inspection
Commercial real estate property inspections largely parallel residential ones. Conducted by a licensed inspector, these inspections review the building’s current condition, along with the status of major systems (e.g. HVAC, water heaters, etc). For investors, inspections provide key insight into a property’s immediate or future maintenance items.
- Environmental Site Assessments
If you buy a commercial property that has environmental damage, you become responsible for that damage, its clean-up, and potentially, legal issues arising from it. Accordingly, investors conduct environmental site assessments to identify potential contamination issues.
- Structural and Civil Engineering Issues
A property inspection will not cover a building’s structural integrity. However, if a property inspector observes indicators of structural damage (e.g. cracks in the walls or foundations), investors will likely hire a structural engineer to conduct a full structural inspection. Repairing structural damage can cost a ton of money, potentially negating a deal’s profitability.
Civil engineers, on the other hand, focus on the land itself. They can help you determine whether soil supports the future building. Additionally, civil engineers drive the utility connection process, so they’re critical to include them early in the due diligence process to determine whether a deal remains feasible.
- Initial Design Collaboration with Architects and General contractors
In conjunction with the above, property due diligence requires working with an architect and general contractor (G/C) to design the new building or renovations to an existing one. Without their professional input, an investor cannot realistically assess whether a property’s reality will align with the underwriting numbers.
2. Operating History Due Diligence
Operating history due diligence includes the past performance of some commercial real estate as an income-producing asset. That is, does this property generate sufficient net operating income to justify acquiring it?
These steps pertain primarily to stabilized properties, not land for a ground-up development, which inherently has no operating history. However, in any deal, investors need to project future operating results, and past performance can assist in this process.
- Rent Roll and Existing Leases
The rent roll outlines the key information about all units and their current tenants (e.g. rents, lease durations, renewal options, security deposits, etc.). This information helps establish your projected operating budget’s “top line,” that is, future rental revenue.
However, you shouldn’t take a rent roll at face value. To truly understand performance, investors should study the current lease agreements. Do any lease terms give tenants the right to break leases upon changes in ownership? What are the renewal terms? These are just two of the questions you’ll want to ask during your due diligence.
- Review Prior Years’ Financials
In addition to the revenue results, investors need to analyze a property’s operating expenses to fully understand a property’s profitability (or lack thereof). Typically, sellers will provide a trailing 12 (“T-12”) – a monthly profit and loss statement over the past 12 months. Ideally, investors can look at operating results for the past three years, as this will provide more insight into seasonality and trends.
- Utility Bills and Tax Records
Unfortunately, people can manipulate financial records like a T-12. As a result, to verify performance, investors should request source documents for operating expenses (e.g. past utility bills and tax records). This way you can verify that the seller’s financial statements align with reality.
Legal Due Diligence
Legal due diligence largely revolves around two elements: ownership and permissions. That is, does the seller actually have the ownership’s ability to sell the property as described, and does the municipal zoning support your future plans?
- Title Review
A title review confirms that the seller actually owns the property and that no one else has a claim to it via outstanding liens. These could be mechanic’s liens from unpaid repairs or tax liens for past-due tax bills. If you buy a property and then some prior owner or lienholder makes a claim to the property, you can get tied up in significant lawsuits. Identifying these issues before closing avoids these undesirable situations. A real estate attorney will facilitate the title review.
- ALTA Survey
Boundary surveys, as the name suggests, outline the boundaries of a property. However, in commercial real estate, investors usually opt for a more thorough ALTA survey. An ALTA goes into more detail by annotating property boundaries, current improvements, and any easements. Additionally, an ALTA survey will connect the written title description on the deed with a visual depiction of that property. In simple terms, an ALTA survey confirms that what the contract says you’re buying is, in fact, what you’re buying.
Municipal zoning rules dictate what you can and can’t do with a property. For example, cities likely don’t want developers building infant daycares in the heart of an industrial district. During the due diligence process, investors confirm with the municipality that they’re allowed to do what they want to do with a property, typically via a zoning confirmation letter. Without this confirmation, you could end up buying a property that you cannot use as planned during your underwriting.
Financing Due Diligence
The final due diligence category includes the steps necessary to make sure you can successfully finance the deal.
- Lender Requirements
Before approving a loan, lenders will conduct their own deal due diligence. But, what we’re discussing here is due diligence from your perspective. This entails working with a lender early in the due diligence process to confirm their loan terms and requirements. Without this information, you cannot accurately underwrite a deal, and you may not ultimately receive loan approval.
- Investor Requirements
Similarly, if you plan on bringing on equity investors, your due diligence should include early communication with these potential investors. This will allow you to confirm their deal requirements (e.g. minimum required returns, time horizons, maximum cash to contribute, etc.). Failing to conduct this due diligence could result in you being unable to close on a deal, as you wouldn’t receive the cash you planned on receiving.
Every real estate transaction is different and requires a unique due diligence plan. Moving too quickly and failing to perform comprehensive due diligence can create problems for even the most experienced investors.
Prior to hiring a landscaper, due diligence may include reading online reviews and asking for client references. Prior to closing a multi-billion dollar business acquisition, the background studies you take would likely be far more thorough, costly, and time-consuming.
Thorough due diligence helps commercial real estate investors avoid costly mistakes. By doing the necessary research up front, you minimize the likelihood of issues coming back to haunt you after purchasing a property.
But, regardless of scale, the goal of due diligence remains the same: take measures to protect yourself before a transaction rather than uncover problems after a transaction.
As informed investors we should understand the risks associated with real estate investing and that there is no guarantee. Please do your due diligence.
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Categories of due dilligence in multifamily investment
- Property Due Diligence
- Operating History Due Diligence