Using Due Diligence to Avoid Losing Money
Once we start the underwriting process for target acquisitions, the due diligence process begins. There are somethings you do not need to do until you have it under contract. The goal is to identify possible issues as early on as possible. This way, you waste as little time as possible.
The second reason is just really intimately understanding what you are buying. For example, if the property needs repairs, we can determine precisely what's required through cost estimates. The last thing we want is to get into a deal and realize we don't have enough capital to get the job done.
In this article, we will go through the due diligence process that we have put in place by leveraging the learnings from past pitfalls.
What We Do Before Putting the Deal Under Contract
There are a handful of things you want to do to vet the deal before putting pen to paper. This a list of items that we review and to make sure we are hitting our targets:
1. 12-month profit and loss (P&L) to get the history of the property
2. Most current rent roll with delinquencies
3. Perform rent survey
4. Insurance quote
5. Square footage/ unit mix verification
6. New property tax estimate
7. Confirm the seller's loan doesn't have a large pre-payment penalty that can kill the deal.
The P&L will give the historical performance. We mainly use it to dig into the expenses and see anything we can conservatively shave off. The rent roll is great to see for possible rent growth and see how many tenants may be behind. The rent survey is performed to reference where the current rent is and where they can get to today.
Insurance cost has been skyrocketing lately, so having this quote can be crucial information. Just simply verifying owner/broker supplied square footage/unit mix against the assessor information, permits, Yardi matrix, costar, and other databases can be very telling. Many times, you can find discrepancies. Once we feel comfortable with the above and the proformas seem realistic, then we can finalize negotiations.
If we do these things before going under contract, we have fewer surprises during the escrow process and avoid asking for changes to the contract or credits.
What We Do Once We’re in Escrow
We will break down here what we do by week while in the due diligence period. This period usually lasts anywhere from 30 to 60 days, though the timing is very deal dependent.
Week 1
Receive all seller documents, such as financials, leases, contracts, utility bills, etc.
Perform a professional general inspection to ensure there are not any significant defects with the property. We usually try to inspect at least 1/3 of the units. We also make sure our property manager is there to walk the property and give us their opinion.
If possible, we pull any information about the property in the city.
Review the title report for easements and recorded documents that could affect the property.
Submit financials to the lender to get the ball rolling on the loan.
Start fine-tuning the insurance quote.
We walk most of the units and measure them to verify square footage/unit mix.
Walk the property at night to observe safety and lighting.
Drive the neighborhood to get a feel for it.
Week 2
Audit all materials that are sent by the seller. Verify the income, security deposits, and expenses (utility expenses, maintenance costs, etc.). Audit the type of tenants that are living in the building by checking their applications and qualifications.
If anything, major gets called out in the general inspection, we arrange to get inspections from specialists. Create a budget for improvements.
Select the lender and order your appraisal. These can take 2-4 weeks. Therefore, it's essential to get this ordered as soon as we feel good with the condition.
Weeks 3-4ish
Hire your property manager. That way, they can get familiar with the building and be ready to get started the day after you close. Create a business plan with them.
Get any bids needed for capital expenditures (CAPEX) items for the building.
Finalize insurance.
Order any other lender-required reports like survey, environmental, and zoning.
Finalize terms on your loan.
The Organization is a Key Factor in Due Diligence
As you can see, a lot has to happen in a short period. So, it would be best if you had a game plan and are well organized. We have a pre-contract checklist and a due diligence checklist to make sure nothing is missed. There are so many items that something could easily be missed if not tracked. Another thing we always do is have our attorney review all contracts.
Things like the property manager contracts could have huge repercussions if, for example, specific fees are not considered. This is ever-changing as we learn and improve our systems and processes. If we complete everything above 100%, we should not miss important things. At the end of the day, there still will be surprises during the ownership process, but this will help positively mitigate those and ensure the success of the investment.