When you find a property you like, either from a sales agent, or through your own efforts, you will have to conduct thorough due diligence. Conducting the due-diligence investigation in a commercial real estate transaction can be time-consuming and expensive. But failing to conduct a due-diligence investigation adequately can ruin a deal.
Here is the check list/ steps that you should make:
1. Letter of Intent (LOI). This is a letter outlining what you are willing to do in regards to price and terms.
2. Purchase agreement. You should have your real estate lawyer make one for you. Set the due diligence time table to 60 days: “in this agreement all days referenced will be construed as business days.” Having this give you a good time frame to do your research. Try this, offer more than the asking price in exchange of down payment. Split down payment. Half at closing other half 30 days -12 months (longer the better). Or, ask for interest only payments for the first 12-24 months. When negotiating a down payment, ask seller to hold 200k but they agree to only hold 100k say “if you hold 150k I will pay 6% for the first three years, 7% for the next three years and 8 percent for the term of the loan. When trying to put the minimum out of pocket money to close a deal, try “cross collateralization” this is when the mortgagee allows you to transfer your mortgage from one property to another. You must have substantial equity in another property to make it possible or you may spread the mortgage over several properties. The seller must have a strong motivation to allow it.
3. Financing. Select the lenders/mortgage professional. Send lender requirements in (which will vary from lender to lender). Set closing date.
4. If you have private money partners who help with financing the property, send them the details of the deal.
5. Get comps of apartments sold in the area that are similar. Check to see what the average unit rent is in the area. A property management company in the area should help (especially if you will use them in the future).
6. Rental income. Obtain most current “rent roll.” A rent roll is inventory/documentation showing what the rents are, and what was collected per unit. Rents should match with operating statements. Get a letter from the seller with all tenants (verification) attached to current lease. Letter should state the attached lease is true, accurate and that no other agreements have been made between the tenant and owner (some body may try to pull a fast one and have there cousin sign a lease paying $100 a month!). Letter should spell out lease and when the last payment was made.
7. Audit the leases, deposits, lease expiration dates, disputes with landlord, concessions with other tenants (like getting half off rent to clean the property).
8. 5 year pro-forma/projections of owning property.
9. Vacancy. Historic and current.
10. Ancillary income, (money coming in other than rent). Analyze this income and check to see if it comes in on a consistent basis.
11. Laundry contracts. When do they expire? Who are they with? Last time renewed? What are the landlord/vendor splits?
12. Cable/Satellite TV. When do they expire? Who are they with? Last time renewed? What are the landlord/vendor splits?
13. Operating expenses. Get the sellers list and copies of all service contracts. Review these contracts. Get copies of insurance claims for the past year, get sellers list of pending litigation (if any), environmental issues.
14. Review owners advertising contracts, all advertising cost included in pro-forma. Price what it will be for having a leasing brochure (if you are going to self manage), resident retention programs.
15. Payroll cost. # of personnel (office and maintenance). Review salaries, bonuses, leasing incentives. A number you can have to help you run the property is to have 1 person (office and maintenance) per 50 units.
16. Administrative costs. Review: equipment leases, mailing costs, telephone and internet expense, refreshments, supplies, legal (evictions and “pay or quit”) business permits, and janitorial).
17. Property Management costs. Who is the company? Review their records of the property. Is fee in pro-forma. Are their differences? Pest control costs and any other miscellaneous costs.
18. Landscape cost. Review contract. Analyze what the property looks like with them doing the cleaning. Check irrigation system. Get quotes for landscape improvements.
19. Adjusting property taxes: find out what the new tax amount will be before purchasing. Go to court house and talk with the tax accessor, asking what info do they need to review the taxes on the building? If they can lower it ask, if they can make it retroactive?
20. Security costs. Research crime reports. Ask the police if any incidents have been reported at the apartment building. Include security cost in pro-forma. Try to get a gate, and have patrolling security (making rounds).
21. Turnover cost for building. Look at turnover rate and cost per unit. Look for unusual turnover expenses (refrigerators, stoves etc).
22. Repair maintenance costs. Look at past work orders. Review past work.
23. Utilities. Gas, water, electricity, trash, other. See if building could be “sub-metered.” This is where the tenants pay their own utility bill.
24. Property taxes. Get copies tax bills for two years. Look at schedule “E”, this is where they report to the government what they have made off the property, compare this to what they want for the property.
25. Property Insurance. Get insurance bid along with flood, earthquake.
26. Reserves review past capital expenditures. Identify frequent items of concern, and make a budget by having reserves per unit per year.
27. Title issues. Select the title company. Get preliminary title. Analyze the title. Determine who pays title out of you and seller. Title fee should be included in financing. Know the transfer taxes now and what they could be when you sell. Any documentation costs? What are the escrow fees? These costs should be in the contract/agreement. Is there a survey needed for ALTA? Zoning and parking compliance verified?
28. Inspections. Physical inspections of grounds and units, electrical wiring, plumbing, balconies, see as many units as possible, HVAC, stairwell, elevators, roof, landscape, asphalt condition, lighting, carport, exterior paint, pool, reviewed capital expenditures, copies of certificates of occupancy, operating pool permits, repair and maintenance logs, recurring plumbing issues, make a list of all deferred maintenance capital expenditures estimate, estimates should resemble third party reports, garage status, condition of washer and dryer, fire code sprinklers, determine if it is compliant with the American Disabilities Act. Try video taping the property to show as proof if needed.
More on inspections
Debrief the inspectors: make sure that you understand everything that they have reported. Ask about consequences to any potential problems. Have each of them read the results from the others who did a report as well. Ask them after they have read the other reports if there anything they would like to re-inspect or anything in their report that they need to change/modify or anything they think the other inspectors should re-inspect based on what they found. Remind them that they are a team.
When you find problems
o Double check the extent of the problem
o Determine if there is a dollar amount to fix the problem
o Go over problems with seller: ask if they knew about the problem, have they looked into how much it would cost to fix, has any tenant complained about the problem, if so what did the owner do about those complaints?
o Send an addendum to the contract expressing that the seller agree to fix the problems, or reduce the down payment or price or both.
29. Last to do: make sure all the numbers are correct. Have CPA review. Have an exit strategy: refinance or sell and when will you do it.
30. Closing: closing rent roll received and reviewed. Have pro ration reviewed and agreed upon. Purchase price on contract is correct. Seller credits are credit. Closing cost correct. Payment for points reviewed and approved. Legal cost approved.