What is Due Diligence and Why it Matters
Once a property is under contract the ownership team moves into the due diligence phase of the acquisition process. Let’s review some of the key elements of this process.
Due diligence can be roughly divided into physical and financial aspects. Physical due diligence involves a property inspection, neighborhood tour and competitor set evaluation. Verifying property condition, neighborhood quality and the status of competitor properties in person is key to ensuring the validity of assumptions made prior to due diligence. Typically, initial research into these areas is accomplished remotely through various internet data sources. Once you have decided to acquire a property those assumptions need to be verified first hand.
The property inspection involves a walk-through of every residential unit, non-residential buildings and exterior spaces, and physical inspection of every aspect of the physical infrastructure. Frequently, this will involve trade contractors, the property management team and ownership team. The intention is to verify the physical condition of every aspect of the property and to refine the budget for deferred maintenance repairs and any planned renovations. This information ultimately gets incorporated into the financial underwriting for the property, but it also ensures that there are no surprises after the transition to new management occurs. In addition to property condition, a better sense of the tenant base is achieved by walking each unit and seeing how the tenants live and organize their physical spaces.
The neighborhood tour involves driving a one to two mile radius around the subject property to validate the socioeconomics of the neighborhood. The type of property being acquired and the planned investment strategy will determine what is acceptable for your investment whether that is an A, B or C grade neighborhood. However, it is important that the neighborhood match your expectations and match the investment strategy. This means looking at what types of single-family neighborhoods are nearby and what the quality of local retail appears to be. You may also consider neighborhood walkability as well as note accessibility to major roads and freeways.
Evaluating competitor properties in-person is also a helpful, information generating exercise. Much of competitor evaluation can be done online, but an in person, secret shopper style visit to the two or three best comparable properties can provide a very accurate idea of what current rents, unit amenities and property amenities are. Any move-in specials or other concessions can be determined in this way as well. This is the last best chance you have to validate your assumptions about these properties as competitors and about market rents.
During financial due diligence it is important to validate all property expenses. Up to this point you will have relied upon what has been provided to you by the current owner through the broker. This is most often a straightforward excel file show the last 12 months’ income and expenses. Now you want to evaluate the actual bills and invoices to confirm the accuracy of the financial statements. It is entirely possible that books have been poorly kept or that they are simply incorrect. This is especially relevant when acquiring a property from a small scale, “nonprofessional” owner where they may be self-managing the property. It is in this evaluation that you will want to ensure that none of the expenses have been underestimated to a significant degree. Such an error can have a large impact on financial underwriting. Another aspect of expense validation is to review all contracts that the property has with service providers to ensure that they are current and in-line with the assumptions that were made during the initial underwrite. You will also note whether you want to retain the current service providers by renewing the contracts or find other options based on evaluating the current contracts.
Finally, it is essential to review all tenant leases in detail. You must verify that the income numbers provided on the trailing 12-month financial statement matches up with rents as outlined in the leases. This also applies to other income items such as pet rent, late fees, application fees and so on. And though it may seem obvious it is important to ensure that all leases have been properly executed. That is, each element of the lease must be properly filled out with the appropriate information and all elements requiring signature are executed by both parties. If not properly executed, the leases in part or in their entirety, may not be enforceable.
These are some of the key elements of due diligence that are necessary when acquiring a multifamily property. Attention the many details is part of securing the investment of your time and money.