Due Diligence is More than Collecting Reports and Info

Much of the current debt debacle is a function of investors collecting information and checking off boxes.  Due diligence is not an exercise.  Diligence is a process.

Effective due diligence requires analysis to verify revenue potential, expense assumption, market demand, and on and on.  We will look more closely into the required efforts to collect the necessary information, to ferret out the needed facts and factors, and to finally analyze, assess, and plan to mitigate risk, assure value, identify and capture opportunity, and achieve investment goals.

Effective Due Diligence Can Create Millions in Value within a few weeks or months

A couple years ago, we identified successfully acquired a small property and doubled its value  in only a few months.  This success was created by careful examination of the surrounding competitors, property expenses,  and lease contracts.  We successfully increased monthly revenue 10% the first month and 33% in the first quarter.  By the close of the first year revenue was  up 50% from closing and the value  was almost double generating a 3X value increase for initial investors.

Achieving this kind of result requires more than cursory  analysis and requires high end financial and operational review.

2010 Multifamily Due Diligence Discussion Overview

Earlier today, I completed a post outlining critical due diligence areas for investors.  I will be using this broad “outline” of topics to guide and complete a detailed review of critical investor due diligence considerations.

If any would like to participate in this, please offer comments to the original article or as we cover items, I’ll be happy to add and credit your thoughts as part of the broader dissection of multifamily  investor due diligence.  Selecting investments in the  apartment industry is a complex and broad area covering much more than the initial review that I have offered.

Additionally, I will be reposting the original article from time to time as I identify and add more subjects to the outline that I’ve overlooked so far.

General Guide to Multifamily Investment Due Diligence

Successful multifamily investment requires careful consideration of a range of areas supported by carefully prepared information, research, and analysis for these areas. This is known as the due diligence process. A well executed due diligence assures appropriate funding, strengthens the total financial plan and therefore potential returns, and finally leads the way to completing a successful investment.

This article does not seek to provide all the necessary steps to effective due dilingence. The point of this article is to highlight in as a great of detail as possible what each of the due diligence areas are and the importance or purpose of the particular area.

Due diligence can be divided into some key general areas:

1. Sales contract negotiation and details,
2. Financial needs including the appraisal, debt & equity structure, budgeting, and distribution & exit plans,
3. Operational expense needs,
4. Physical infrastructure needs and inspection including associated reports,
5. Legal and title requirements,
6. Market factors,
7. Management and staffing,
8. Operating agreement / investors contract,
9. Resident issues and analysis

Each of these areas is multifaceted bringing information demands, investment opportunity, and risk management requirements. We will explore each of these in limited detail below as a foundational comprehensive look at the due diligence discipline required evaluating multifamily projects for investment or acquisition.

The sales contract is not normally considered a due diligence item by most investors. Nevertheless, we recommend reviewing the contract specifically focusing on:

1. Items to be provided during due diligence,
2. Requirements to maintain occupancy, revenue, and quality of residents in place and being added,
3. Requirements to allow ongoing inspection by the purchaser,
4. Requirements to correct day-to-day maintenance,
5. Processes should an insurance company repair occur during the contract period as well as guidelines for value adjustments should units be lost to acts of God or other insurance addressing repairs,
6. Requirements regarding background and credit check of the existing residents and new residents added while under contract, and
7. Pre existing liabilities

The sales contract should have specific financial considerations protecting the integrity of the investment post closing.

Financial requirements will include past utilities costs, recent property improvements, dates of roof replacement, dates of paving and sealing, a review of the appraisal, project budget, historical income and expense statements, and project pro forma financials. Additionally, the investment should be supported by a fixed investment management, exit, lending, and banking service plan.

Operationally and physically, the keys inspection areas are type of electrical wiring, HVAC, roofs, termite inspection, metering, trash, age of appliances, acreage, unit by unit inspection, building inspection, grounds inspection, paving and sidewalks inspection, amenities facility inspections and punch list development, development of and review of environmental and property condition reports. This should include photos showing the best of the property for marketing, investor development, and lender support purposes. Also, photos should capture and record major structural and physical issues.

The operating agreement should be reviewed for budgeting, capital expenditure management, sales and acquisition rules, status with state and local authorities, occupancy certificates if applicable, status of tax payments, survey encroachments, survey parcels, and other legal guiding documents and forms.

The market and submarket studies are critical elements for due diligence. The study should result in a detailed marketing plan that flows down to a set of actions designed to:

• Improve customer satisfaction,
• Improve retention,
• Drive traffic,
• Close leases,
• Increase revenue

Developing the marketing plan and market information includes collecting the following:

1. Economic trends,
2. Major employers,
3. Economic demographics including per capita income, industrial employment breakdowns, etc,
4. Lists of local businesses, shopping and restaurants of interest to residents,
5. Lists of local churches and religious groups of interest to residents,
6. Lists of clubs, schools, government facilities, colleges, universities, points of interests,
7. Ethnic, racial, education, and age demographics,
8. Comparable rents and amenities,
9. Comparable sales,
10. Housing inventory, price, and rental information

Additionally, the marketing information should include photos of nearby shopping, schools, points of interests, signage, comparable properties, etc. These photos combined with the other information will be a part of the larger plan for the investment, part of property websites, ILS website info, etc.

Today marketing should include a clear and detailed management plan for online marketing plans.

The Company should have an articulated proven plan for screening and managing resident issues from initial contact, to day-to-day operations, and finally to eviction or moveout.

The management company must demonstrate proven accounting, reporting, leasing, property maintenance, improvement management, resident screening, resident management, expense management, and investor reporting capability. Also, the management company should a clear concrete resume of skills, education, and experience relevant to delivering all of the above items. Further, the management company should have articulated plans for acquiring and maintaining management skills needed to support the investment.

Finally, the investor should spend enough time with the principals to assure comfort and trust regarding communication and management capacity to assure the success of the investment.

In summary, the above article provides a general outline of the major due diligence issues. While in no way, conclusive and totally comprehensive this article can serve as a good starting point for an effective due diligence process.

Understand Expenses Based On Your Own Experience and Not on History

During the course of pursuing a new acquisition years ago, the seller of a property that had my attention responded to my request for historical expenses in an unusual, but in my opinion, insightful way. The seller’s response was that if the buyer didn’t understand what the expenses would be then he/she should not be considering such a purchase. You may feel this is arrogant. You may believe the seller has no right to take this position. However, in my opinion this seller in a single statement highlighted a key point that bankers and other investors can use to avoid poorly conceived multifamily investments.

The serious purchaser should either directly or indirectly know the answer to this question. No doubt there are exceptions (which by the way this seller was quick to acquiesce to including 1) utilities and 2) recent improvement costs to name a couple.

However, as a buyer, you should be able to relatively accurately assess many costs. Landscaping is a function of the acreage. Water costs are predictable and variance points to issues with the water systems on the property. Insurance cost should be predictable from the remainder of the portfolio. Painting, HVAC, carpentry, and flooring expense should be predictable based upon the property inspection. Salaries are driven by local labor costs and the type of resources your business desires to place on the property.

Additionally, choices you will make as a manager may drive costs up or down sharply. I’ve seen C class property owners routinely install carpet without a pad. While I don’t agree with practice, certainly this cuts operating costs. Paint choice can dramatically effect make ready costs. Converting to individual meter to group is another greate expense altering choice.

Other points that can effect cost are your customer service and advertising goals. These items may be significantly impacted by location. Heavy traffic locations can place significant pressure on the management staff. This in turn can lead to unplanned hiring requirements.

Finally, pooling renting resources to allow supporting more properties from a single location can have a significant effect on personnel costs.

If as an investor, you don’t have the skills to evaluate your expense profile a third party manager can be an invaluable resource for this issue. However, don’t blindly accept any manager. Ask the prospective manager to:

1. Provide references from past managers,
2. Provide examples of their costs for similar properties in either the current market or at other similar properties offering similar labor and physical cost factors.