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 first two weeks are crucial for success because this is when you find out whether the property is worth the price you are paying. There are six essential due diligence steps for a multifamily deal that you will want to take in these first two weeks, and if you fail to complete any of these, it could be fatal for your deal. Continue reading to find out more.
6 essential Multifamily Due Diligence Steps
- Reviewing contract terms and items
- Conducting in-depth market analysis
- Scheduling contractors and conducting property inspections
- Lease audit
- Reviewing seller documents
- Check city code and review the city’s inspection reports.
#1 Reviewing contract terms and items
There are several types of multifamily purchase and sale agreements/ contracts. The most common are:
1. Realtor Associations. For example, in North Texas, NTCAR & TAR are some of the most used contracts.
2. National Brokerage Contract. Marcus & Millichap is an excellent example of a national brokerage contract. A lot of national brokerage houses have standardized contracts.
3. Seller attorney drafted. The seller’s attorney prepares those contracts without using any standard forms. If this is your case, you need your attorney to review the agreement.
Whatever the contract type, I strongly recommend that your attorney reviews the agreement. Also, you can ask your attorney to draft a contract for you.
Multifamily PSA addendum/exhibit types:
The most common addendums that we find in PSAs (Purchase & Sale Agreements) pertain to financing.
They cover:
- Third-party financing
- Loan assumptions
- Seller financing
Other important addendums include:
- Lead-based paint addendums (especially for the properties constructed before 1978).
- Inspection addendums are also quite common.
- Information about the brokerage services, disclosing broker representation.
You might be wondering about the seller’s disclosure. Seller’s disclosure is only necessary for single-family properties. Multifamily properties, including fourplexes and duplexes, do not require the seller’s disclosure. As a result, you will often notice the seller crossing out any of the seller’s representations in standardized multifamily contracts related to the property’s condition.
Therefore, it is your responsibility as a buyer to examine the property and conduct your due diligence thoroughly.
Multifamily contract timeline and schedule
Inspection period. In the other article about making an offer for a multifamily deal, we mentioned that we recommend a rule of thumb of 21 days. Here is an example of how the due diligence period looks like in a multifamily LOI:
Once you execute your PSA, it is assumed that you have conducted your inspections. However, depending on the situation, you can negotiate anywhere between 14 to 25 days. Sometimes market conditions dictate a shorter period. Remember that the timing is critical. If you have 14 days – you have 14 days. Here is an example of a title, survey, and property materials review from an actual multifamily PSA:
However, if the deadline falls on a holiday or a weekend, it is pushed to the next business day. If you can’t meet the contract timeline due to an emergency or a force-majeure, you need to speak to your broker and negotiate to change the deadline. In different types of contracts, you will see a feasibility period. Remember that the feasibility period and inspection period are interchangeable terms.
Independent consideration of dollar amount. Any contract should have independent consideration, the non-refundable earnest money or how much it costs you to put the deal under a contract and do the due diligence. Whether you buy this deal or not, the seller keeps this amount. It can be anywhere from $0 to a couple of thousand USD. It all depends on your negotiations.
Delivery of the seller’s information. Such as which seller documents will be delivered and the timeline for you to receive them. This is a crucial contract term, and the seller must deliver those documents at the closing.
Anyway, the seller should have prepared all these items when they put their property for sale. You can notice if the seller doesn’t have their act together and does not manage their property professionally if they cannot pull this information within seven days.
#2 Market analysis
The goal of the market analysis is to build a projection & business plan that is as accurate as possible. The market analysis consists of the following:
- Market & Submarket current state & trends.
- Direct competitor research and analysis.
- Market analysis will determine the direction of your business plan and changes to the products and services you want to have at the property.
- Another objective of the market analysis is to help you develop your financial projections.
Levels of market analysis for a multifamily deal
#1 High-level market analysis or level 1 analysis
In one of our previous articles, we spoke about the importance of defining your multifamily property criteria before locating the property. When defining criteria, you will have to conduct high-level market research using online tools, such as:
You need to look for the following information:
- What are the property classes in this location?
- What are the average rents per square foot?
- Average occupancies across the location
- CAP rates for different property classes
- Market trends, including micro-economic indicators, such as demographics, employment rates, average wages, education levels, income levels, and new multifamily construction statistics.
#2 Detailed property location analysis or level 2
Once you located the property and have done a high-level multifamily financial analysis, you will need to go through the following steps before making an offer for your deal:
- Get the multifamily property package from your broker or seller. Broker packages often have rental competition. This information will help you identify the direct competition you need to visit, whether by driving by, online research, or in-person visits. You need to compare both similar-sized (±50 units) multifamily properties and properties near your location that are the same size, age (±5 years), and class.
- Use online tools to find recent sales comps and check property records and additional rental comps to identify other rental comps not included in the broker package.
- An online market survey of your direct rental comps. You can also do an in-person survey by visiting properties before sending your offer if you have enough time. Some online tools you can use include:
- www.alnsystems.com – a very powerful tool for comps research.
- www.loopnet.com – a tool that every multifamily deal sponsor or individual buyer should have. For passive investors, a free account is sufficient.
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- www.realpage.com – an excellent tool for market research. They have 66 quarterly reports that cover 100 real estate markets. One quarterly report costs $750, and the annual subscription is $1850/ market.
- www.costar.com – you can find and analyze multifamily properties, including your comps.
- www.poconnor.com – specialized in Texas. So if you are buying in Texas, it is a handy tool to get the data for your market analysis, especially free updates on the apartment markets.
- Do a high-level property inspection or a drive-by, then the property tour once you are confident that this property is likely to match your criteria.
#3 Market analysis before the contract is signed or during due diligence. Level 3
This level of market analysis needs to be done when your offer is verbally accepted and before signing the contract. If you couldn’t complete it during that time, you have to conduct it during your due diligence period.
The steps you need to take are:
- Visit the direct competition and check the quality and professionalism of the staff.
- Check how the property looks, whether it is clean, has new or old fixtures, what amenities they have, the level of deferred maintenance, etc.
- Check the competitors’ occupancies and rent prices per square foot. It’s crucial that you consider the amenities when looking at the pricing. Concessions are essential too.
- Finally, you have to check how utilities are handled at the property.
Market analysis has to be the 2nd part of your business plan after your Executive Summary.
#4 Schedule and perform property inspections
During your first week, you have to schedule all of the inspections:
- A roofer to check the roofs and the gutters.
- A contractor to check the entire exterior, including but not limited to the exterior wood, the brick veneer, the railings, the balconies, the patios, the sidewalks, the staircases, etc. The contractor has to look at deferred maintenance.
- Inspect interiors. Walk all the units, the office, the common areas, the amenities, the laundry rooms, the clubhouse, etc. Again, you must look for deferred maintenance and value add opportunities.
- Conduct a WDI inspection. WDI stands for wood-destroying insects or termites. You need a contractor to walk the entire property for evidence of WDI.
- Conduct an electrician check, including electrical panels, the lighting on the exterior, the electrical connections, and any issues with the current electrical code.
- Plumbing inspection. The plumber must check the sewer lines for breaks in their integrity.
- Check the foundation and drainage.
- Have a contractor inspect the parking area, landscaping, and amenities, including the laundry facility and the pool area. Think about other types of amenities that you could create on this property.
- Air conditioning inspection. The contractor needs to have a look at the age and condition of every condenser unit. If there is a chiller system, the contractor needs to check the cooling tower, the heat exchangers, the pumps, the compressors, etc. If there are boilers, they need to be checked as well.
To help you with this process, here is an actual due diligence checklist for one of the multifamily properties we’ve recently acquired:
Guide your contractors
Remember that you need to guide the contractors when doing inspections of the property. Most of the time, they are just looking for deferred maintenance. However, you need to tell them to look for value add improvements as well. Unless you tell them what to do, they won’t tell you how to improve the property value.
For example, if you plan on doing unit upgrades, you need to be specific about what a unit upgrade means for you. Are you going to put in new flooring? New appliances? New countertops? Or will you resurface the existing countertops? Giving your contractors specific information on what upgrades you plan to do will help you get more thorough info about the property and the bids for these improvements.
Exterior
Think about the landscaping and if you are going to change it. Do you want to change the property’s paint and exterior? Are you going to change the signage? Then you need to have a sign company and your exterior contractor come to the property and provide you with bids.
It’s crucial to schedule all these different inspections and contractors in synergy. Because you would not want to end up in a situation where you’ve inspected 20% of the units with a foundation contractor and then check another 10-15% with an electrician.
Does the property match your expectations?
If you want to add things to the property that aren’t there, you need to include this in your due diligence and get bids. The end purpose of due diligence is to confirm that the property matches your expectations.
Therefore, if your rehab budget, including capital improvements and value-add improvements, is $500,000 and after your due diligence is still in the $500,000 range, the property matches your initial expectations.
Sample multifamily condition assessment
Once your contractors complete inspections, you should receive a condition assessment with the costs of repairs. Here is an example from an actual condition assessment of the roof:
And the same thing for the foundation works:
#4 Multifamily Lease Audit
A lease audit consists of going through all the lease files and ensuring that they are complete and consistent. Then you have to complete the leases to the rent roll. Remember that lease is a legal document, so if the numbers on the rent roll are different from the lease, you need to take the lease number as the correct one. In many cases, wrong numbers on the rent roll can be caused by human error.
The next step is to compare the rent roll to the P&L. They should match up closely. Following this, you need to walk all the units (you can walk 50-60 a day, so you should be able to complete a 300-unit property within a week) and compare the number of actual vacant units to the number on the rent roll.
#5 Review Seller’s Documents
One of the essential parts of the multifamily deal’s due diligence is reviewing the seller’s documents. Therefore, in addition to the rent roll and leases you require for the lease audit, you should request:
- An inventory of personal property.
It includes office equipment, coffee machines, etc. It is important that you know what the seller is taking with them when they leave the property. This is what this inventory looks like as an exhibit to a PSA.
- Copies of all the contracts.
For example, the trash contract, cable contract, etc. Some contracts have a 3-year term (like the electrical contract), and you may not be able to terminate or change them. Therefore, you need to include them in your financial calculations. Laundry contracts can be as long as ten years.
- Warranty documents.
- Leasing & commission agreements.
- Request utility invoices for 12 months (you can use ready-to-go invoice templates to save your time), specifically, electricity, water, gas, and trash. They should match the P&L.
- Review major repairs done in the past 24 months that will give you an idea about the recurring problems on the property.
- Ask for the list of capital improvements done in the past 36 months.
- Analyze the previous 24 months’ P&L to help you understand the operating history in-depth.
- Environmental reports and engineering studies.
#6 City code
As a part of your due diligence, contact the city to request all of their previous inspection reports for the past 12-24 months.
Conclusion
All of this due diligence needs to be done in the first week or two. Because if you find something odd, a major item that prevents you from moving forward, or realize that the property is not what you expected (doesn’t match your criteria) – you can walk away easily before applying for loans. Once you’ve determined that the property is a solid deal and fits your criteria, you can proceed with loan applications.
