Due diligence defined is simply the process of validating the physical and economic condition of an asset. In real estate, due diligence includes reviewing documents, financial calculations, and evaluating risks. It is essentially the “doing your homework” part of real estate. When real estate agents bring up due diligence, they usually refer to either the buyer’s research prior to making an offer or the contingency period before the final closing.
It is best practice to complete due diligence before any contract is signed to ensure there aren’t any surprise issues with the commercial property you’re about to purchase. One way to ensure you’ve done your due diligence is by creating a due diligence checklist.
Beyond the physical condition of the building done through a building condition assessment, many intangibles have to be assessed. The building’s history must be researched, with all liens and obligations examined to ensure there are no unpleasant surprises.
Building owners with commercial tenants are vulnerable to sudden economic downturns; a fully occupied building with a major tenant can become an under-occupied building if that tenant goes under. So the security of any income stream that depends on tenants must be carefully evaluated too. Payment histories and tenant credit files should be examined to determine how much risk is involved.
Insurance policies on older buildings may contain a list of claims that have been filed, highlighting defects and potential liabilities. It’s well worth using the services of a lawyer or other professional advisor to help you make these assessments.
HOW TO CONDUCT A DUE-DILIGENCE PROPERTY INSPECTION OF AN APARTMENT BUILDING.
- Financial Audit Report
The financial audit report is the detailed results of an inspection conducted by a commercial real estate consulting company. They will analyze the asset’s operating history and provide a breakdown of the individual components of the operating income and expenses.
When you underwrote the deal, you likely used the income and expense figures provided in the pro-forma, and then made assumptions for what those figures would be after you took over the property. The results of this report will confirm the actual income and expenses, as well as allow you to make adjustments to your assumptions if necessary.
- Internal Property Condition (PCA) Assessment
The internal property condition assessment is an inspection report that provides you with the overall condition of the property. The assessment is conducted by a licensed contractor of your choosing.
This assessment will differ depending on the contractor. However, you will most likely be provided with a list and images of problem areas observed by the contractors, recommendations for repairs, opinions on costs to address deferred maintenance, and whether or not further inspections are required. These results will help you confirm or make adjustments to your repair and rehab assumptions and screen out deals that have maintenance issues outside your investment criteria.
- Market Condition Report
The market survey and condition report is a comprehensive comparison analysis of the sub-market. The subject property is analyzed and compared using multiple variables, including rents, unit type, occupancy, unit size, new construction, historical statistics, amenities offered, and more. This report is created by your property management company, so the thoroughness of the report will depend on who you select. The results of this report can be used to confirm your underwriting assumptions including for occupancy and rental rates.
- Lease Audit
The lease audit is a systematic examination of the leases, including the stated income and expense figures, billing methodology and lease language. Typically, this audit will be conducted by your property management company. The purpose of this audit is to verify that charges billed are accurate an in compliance with the lease terms. The most important piece of information I receive from this audit is to understand the difference between economic and physical vacancy.
- Unit Walk Report
You need to walk every single unit and that is the purpose of the unit walk report. It is a detailed inspection of every single unit, assessing the condition and characteristics of the entire unit. This report is also prepared by the property management company. However, if you so desire, you can print out a spreadsheet and perform the inspection yourself.
- Site Survey
A site survey shows the boundaries of the property, indicating the lot size. It also includes a written description of the property. The report resembles a map. There are a lot of third party services that can conduct a site survey. A quick Google search of “site survey + (city name) will do the trick.
- Property Condition Assessment
The property condition assessment is the same as the internal property condition assessment, except this one is created by a third party selected by the lender. So, you’ll have two PCAs from two different contractors, which should cover all your bases.
- Environmental Site Survey
The environmental site survey is an assessment that identifies potential or existing environmental contamination liabilities. This report is required and is conducted by a third-party provider selected by the lender. The analysis typically addresses both the underlying land and the physical improvements on the property.
- Appraisal
The appraisal is a report that determines the value of the property based on market capitalization rate and net operating income. This report will also be created by a third-party provider selected by the lender. Hopefully, the appraisal value comes back equal to or, even better, exceeding the contract price.
- Green Report
The green report is an energy audit that evaluates an apartment for potential energy and water conservation opportunities and calculates the estimated cost savings that would result from addressing these identified opportunities. The audit is performed by an energy efficiency provider. Once completed, you are sent a report with the results and recommended next steps.
As informed investors we should understand the risks associated with real estate investing and that there is no guarantee. Please do your due diligence.
What are the key elements of due diligence for multifamily investing?
The key elements of due diligence for multifamily investing include a market report, an appraisal, and an analysis of the property’s NOI and DSCR. 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.
