Due Diligence for Apartment Investing

What Due Diligence Do You Need to Conduct Before Purchasing a Multifamily Property?

Before you make the leap and purchase a multifamily property, you’ll need to do some homework first. In multifamily industry, this is referred to as “due diligence,” and often consists of hiring third-party service providers to inspect and/or provide reports on various parts of the property to analyze its suitability as an investment.  If you’re planning on financing your property with a multifamily loan, much of this due diligence will also be required by your lender and will need to meet their requirements if you want to get approved. However, if you want to finance the property yourself (an extreme rarity), you’ll still want to conduct the full due diligence process to ensure you’re getting a good deal. 

Basic Due Diligence Checklist for Apartment Investors

The major reporting requirements for both borrower and lender due diligence include: 

  1. Financial Audit Report 

  2. Market Report 

  3. Property Condition Assessment

  4. Lease Audit/Rent Roll Analysis

  5. Unit Walk

  6. Environmental Site Assessment

  7. Appraisal

  8. Site Survey/Title Report 

In addition, some additional reports may be required (or desired), depending on a borrower’s individual situation: 

  1. Green Report

  2. Seismic Report

Now, we’ll break down each of these reports in a bit more detail: 

Financial Audit Report 

In most cases, borrowers will first look to a property’s income and expense statements, including their trailing 12-months (T-12), and the last 3-years profit and loss (P&L) statement. They will then generally make projections about how the property will operate in the future. However, these projections alone aren’t enough to make a solid decision about the property’s future profitability; instead, borrowers will generally want to hire a real estate consulting firm to examine the property’s historical financial statements. This can help reveal any concerns or inconsistencies, as well as making sure that a borrower’s projections are generally accurate. 

Market Report

A market report, sometimes also referred to as a market study or a market survey, analyzes the subject property’s market and submarket in order to help determine the property’s estimated occupancy level, market value, absorption time, and other data. The study, which is also generally conducted by a third-party real estate consulting firm, will additionally examine market need, local multifamily rents, supply and demand, and other market conditions which could impact the property’s long term profitability. It’s important to note that, for some types of loans, such as HUD multifamily loans, a borrower may need to use an approved third-party consultant. 

Property Condition Assessment

A property condition assessment (PCA), sometimes referred to as a capital needs assessment (CNA), or a physical needs assessment (PNA), is a third-party report that examines the current condition of the property and how much it will cost to maintain it (and to replace aging building elements when they require it). It can also be utilized to help calculate replacement reserves, funds that are set aside for future property repairs (and required by certain lenders). Specific PCAs are generally required for Fannie Mae and Freddie Mac Multifamily loans, as well as for HUD multifamily loans

Lease Audit/Rent Roll Analysis

A lease audit is a third-party report that examines the current leases for a commercial or multifamily property. It can be done by the property management company that is currently managing the property, but if you think they may be biased, you may want to use a different firm. This process will often initially involve looking at a property’s rent roll, but will usually go much further than that. In fact, a lease audit will usually involve looking at each aspect of every lease, including tenant billing schedules, unpaid or late rental payments, and units that are being leased at a discount or given freely to a property manager. 

Unit Walk

A unit walk, is, much as it sounds, a physical walkthrough of each and every unit. No matter how great a property looks on paper, or even how great an appraiser or inspector says it looks, nothing compares to actually seeing the property in person. A unit walk allows you, as a buyer, to look at the condition of each unit to assess potential problems and issues that others may not have noticed. Plus, you might also begin to get ideas for various upgrades and value-add improvements that may be able to make the building a more profitable investment in the future. 

Environmental Site Assessment

Just like a market report and a property condition assessment, most lenders require borrowers to get an environmental site assessment or ESA, before they will approve them for a loan. Most properties will only need a Phase I ESA, though some properties may require a Phase II. A Phase I ESA will look for any traces of petroleum products, dangerous chemicals, pesticides, or other contaminants that could endanger the residents of a property. It will also look into mold, asbestos, radon, lead paint, and other potentially hazardous building elements, as well as any previous environmental liens that have been placed on the property. If the Phase I ESA determines that there is a significant contamination issue with the property, in general, lenders will require that a borrower order a Phase II ESA, which will take samples of the affected area for further testing. 

Appraisal

Perhaps the most important part of the due diligence process, an appraisal attempts to estimate the market value of a multifamily property. This will typically need to be conducted by a professionally licensed appraiser who is licensed in the area in which the property is located. The appraiser will generally use several methods to price the property, including looking at the property’s NOI and DSCR, as well as comparing it to similar multifamily properties in the local area. If an appraisal comes significantly below the asking price for the property, you (and your lender) may want to think twice about the deal. 

Site Survey/Title Report 

A title report is generally required by multifamily lenders in order to determine the legal status of the title of the property. It helps to ensure there are no competing legal claims to the property from past owners (or their spouses, lenders, or relatives), or parties that have previously done work on the property (i.e. mechanic’s liens). A title report is also generally required to get lender’s title insurance, which most lenders require, as well as owner’s title insurance, which most investors should generally consider purchasing. In most cases, title reports (and title insurance) require an investor/borrower to first order a site survey of the property, which confirms the exact boundaries of the property, as well as determining/confirming the exact size of the lot. 

Green Report 

A green report helps to determine what, if any, opportunities there are to increase the energy efficiency of a property. These could include special windows, roof or wall insulation, new thermostats, LED lighting, energy-efficient appliances, and a variety of other upgrades. The report will also generally include the cost and the ‘payback’ period of each upgrade (i.e. the time it would take for the upgrade to pay for itself in the form of increased energy savings). 

Seismic Report

For properties located in certain areas which are at high risk for earthquakes, a lender may require a borrower to get a seismic report, also referred to as a seismic assessment. The assessment will generally take the form of a Probable Maximum Loss (PML) assessment, which will estimate the risk of structural damage estimate in a worst-case scenario.