Due Diligence: Purchasing Multi-Family Investments

When it comes to purchasing multi-family properties, due diligence is even more important than it is with houses. More money is at stake, so mistakes are all the more costly.

I have witnessed many projects go south as budgets ballooned and properties that once appeared to be great deals become money pits more often than I would like to recount (especially since it has happened to me more than once). These headaches can be avoided, or at least mitigated, with proper due diligence.

First, it’s important to note that larger multi-family properties are generally bought on a 60 day contract versus the average 30 day contract involved in houses and small multi-family. The normal inspection period until your earnest money “goes hard” is 30 days. All of this is subject to negotiation of course, but it’s important to finish your due diligence before the inspection period ends in order to get your earnest money back.

Walk… Every… Unit

Some realtors and sellers will tell you it’s fine to walk every other unit or every third. IGNORE THEM! If you only view every other unit, would you garner the seller will show you the worst units or the best? It is critical to know the condition of each unit, even if there are 200 of them. Often words like “new furnaces” or “new appliances” only apply to a very small number of the units.

During these walkthroughs you should be taking an inventory of the work that needs to be done and compare that to the estimate you made when you made the offer. You should also pay attention to the tenants.

Do they treat their units well, or do they destroy them? And feel free to ask them questions. How do they like the apartment? Do they have any consistent maintenance problems? Etc. Also, if it’s a large building, check the Google rankings to get an idea of tenant complaints.

With regards to inspections, I recommend getting an inspection of the roof, the foundation if any major cracks or movement are apparent and at least a few electrical panels (to make sure it isn’t a Federal Pacific panel or another that has been recalled). It’s also a good idea to scope the sewer lines.

You should have inspectors review anything you have questions about. If you are relatively new, it’s worth spending extra here, but you do not necessarily need an inspector to go through each unit like you did. Instead, you can have them view a couple units and then line out the specific items you want them inspect.

Review the Financials

Never ever take a seller’s financials for granted. Review each lease to make sure it matches the rent roll. Request utility bills and contracts to make sure they are in line. Double check the taxes with the county and price out the insurance with your preferred carrier.

Two things to watch for in particular are 1) bad debts and 2) misallocated CAPEX. With bad debt, if they are using accrual accounting, make sure that uncollected debts have been charged off so you can see the total delinquency. Go through the rent roll and make sure you are crystal clear on who is behind and by how much. New owners often have to kick out a lot of tenants, especially if the property is a bit dilapidated.

With regards to CAPEX, some owners throw things in CAPEX that don’t really belong there so they can take them off the income statement and make the NOI look better. A good example is turnover expenses. Make sure to get an inventory of their CAPEX expenses and when analyzing properties, put in recurring CAPEX as a line item (i.e. roofs or furnaces going out).

And for the love of everything good in this world, never take a seller-provided pro forma at face value.

Appraisal, Phase One and Surveys

Any bank loan will require an appraisal and a Phase One (for larger properties). Sometimes they will require a Phase Two and/or a survey. The Phase One is vital either way. It is an environmental study and you absolutely don’t want to buy an apartment sitting on top of a toxic waste dump. The EPA is not particularly forgiving about such things.

Overall, the moral of the story is to never skimp on due diligence. It could be the difference between solvency and insolvency, especially with large multi-family properties.