Due Diligence For Apartments

Due diligence is vital when it comes to any real estate investment. And with regards to large apartments, it is substantially more important than houses. More money is at stake, so mistakes are all the more costly.

I have witnessed (and occasionally been part of) more deals than I’d like to remember go terribly wrong as budgets swelled and properties that once appeared to be great deals became nothing more than money pits. Luckily, these headaches can be avoided, or at least mitigated, with proper due diligence.

Multi-family properties are generally bought on a 60 day contract instead of the normal 30 day contract involved in the sale of houses and small multi-family apartments (such as duplexes and fourplexes). The normal inspection period until your earnest money “goes hard” (when you can no longer back out of the deal without losing the earnest money) is 30 days. All of this is subject to negotiation, but it’s important to finish your due diligence before the inspection period ends in order to get your earnest money back, if for whatever reason you need to back out.

Walk Every Unit

Some real estate agents and sellers will tell you it’s OK to walk every other unit or every third. This is terrible advice, do not follow it! If you only view every other unit, what are the odds the seller will show you the best units versus the odds they will show you the worst? It is critical to know the condition of each unit, even if there are 100 of them. Often words from the seller like “new furnaces” or “new appliances” only apply to a small number of the units.

During these walkthroughs you should be taking an account of the work that needs to be done and compare that to the estimate you made when you originally made the offer.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 such as, “How do they like the apartment?” or “Do they have any consistent maintenance problems?” Also, if it’s a large building, check the Google rankings to get an idea of any 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 if they look old (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 to make sure they are not broken or in disrepair.

You should have inspectors review anything you have questions about. If you are relatively new, it’s worth spending extra here, but it’s not necessary to have an inspector review 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 throughout the building.

Evaluate the Financials

Never take a seller’s financials at face value. Review each lease to make sure it matches the rent roll and request contracts and utility bills to make sure they are in line with the operating statement. Also make sure to double check the taxes with the county and price out the insurance with your preferred carrier to make sure everything is in correct.

Other than simply verifying the accuracy of the operating statement, there are two major items to look out for:

1. Bad debts: If the seller is 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 absolutely 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 in disrepair.
2. Misallocated CAPEX (capital expenditures): Some owners throw expenses into CAPEX that don’t belong there so they can take them off the income statement and make the net operating income look better. A good example is turnover expenses. Make sure to get an inventory of their CAPEX expenses and add back in anything that is actually an operating expense. And when analyzing properties, put in a category for recurring CAPEX (i.e. carpet replacement or furnaces going out) to get a better picture of what the property’s actual expenses will be.

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 do not want to purchase an apartment sitting on top of a toxic waste dump. The EPA is not very 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.