Reviewing Historical Financials During Due Diligence

First, relying on the current owners’ historical financials for an expectation of your operating expense is fraught with risk.  Essentially, you are making the assumption that you can and will operate the property  in very much the same way the seller is.  This assumption can prove incorrect for a wide range of reasons.  The risk averse investor must bring a clear understanding of their expenses to the closing table and be guided heavily  by this understanding.

This earlier point stated, historical financials provide much needed hints about a given property’s costs for some key areas including: 1) utilities, 2) key  maintenance issues such as appliances and air conditioning, and 3) landscaping.

Your costs for labor and management, cost of supplies, and cost of contractors are brought to the  property by your mode of operating.

The last factor determining your cost is the combination of your physical inspection of the property, the property condition report, your market study, and your operations and management plan.

Each of these items should be combined to create your financial projections.

Blake Ratcliff

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Physical Unit Inspection

The inspection should be thorough.  Whether completed by the investor or their representative, short cuts can costs very large amounts of money.  The key to an effective inspection is a unit checklist.  The list should review every item:

1. Verify floor plans,
2. Take photos of each room, appliance, and system before beginning,
3. Check each item in the units:

• Plumbing including type of pipes, condition of pipes, etc,
• Electrical including number of circuits, amperage of circuits, type of wiring, location of meters and distribution
• Waterheaters,
• Leaks under cabinets, around faucets, drains, and signs of water damage through the unit,
• Condition of carpet including type and condition of pad (to the extent it can be determined),
• Condition of dry wall and style of paint for walls and ceilings,
• Condition of exterior and interior doors, doorways / frames,
• Condition and type of insulation,
• Condition of cabinets and hardware,
• Type and condition of lighting and other fixtures,
• Toilet conditions,
• Tub and shower condition,
• Window condition (air leaks, signs of water leaks, single pane, etc.)
• Condition of HVAC, heating, and cooling.

All systems should include collecting brand and model.  Find out where the complex gets supplies for these systems.

The inspection should result in by unit photos and lists of all current condition factors.

Property Condition Report Short Comings

Lenders require and rely on the property  condition report because in concept this report should identify  all immediate  requirements, establish needed reserves, and either support or debunk the  purchase price of the asset on the basis of physical status.  Unfortunately, as investors making this  assumption is risky.

First, the report  writer will not have actual sources bid required improvements and therefore estimates of costs are often useless.

Second, the report writer normally does not actually  physically  inspect each and every item individually relying on samples.  This can lead to large oversights.

Third, the report writer’s  skills are not normally as global as the report will require.

Fourth, the report writer does not have your vision of where the project will go which weakens the product.

Fifth and possibly most important, the report writer’s cash is not on the line.

The prudent investor will therefore rely on a physical inspection of each and every unit, building, amenity, and grounds item (if I’ve not been clear, the investor will physically inspect every item).  If the investor is unable to do this, the investor should use every available means to gain as comprehensive of understanding of the asset as possible and discount significantly for this handicap.