5 due diligence action items for every prospective multifamily investor

In today’s competitive real estate market, investors need to move quickly. In doing so, however, eager investors might inadvertently skimp on due diligence to seal the deal.

This is a HUGE mistake, according to seasoned real estate professionals. A property that you anticipated to be a successful investment could end up being a loss-leader. Failure to do thorough due diligence could ultimately put your entire real estate portfolio at risk.

At a minimum, we recommend that investors take these 5 steps to do your due diligence on multifamily properties before closing any deals.

#1: Conduct a Financial Audit

A financial audit is typically conducted by a third party, and it will fact-check many of the assumptions you may have about the property. A comprehensive financial audit requires at least 3 years of trailing financials (such as bank statements); at least 1 year of monthly profit and loss statements; a copy of the current rent roll (including the term, deposit, payment history, and any housing subsidies accepted); at least 2 years of tax returns; and utility bills for the past 12 months.

A financial services consultant will use this information to analyze the property’s operating history. They’ll be able to provide a detailed overview of operating income and expenses. That way, you aren’t putting blind faith in the numbers provided to you by the listing agent. A financial audit will allow you to make tweaks to your pro forma, thereby evaluating the income-generating potential of the asset before you close on the property.

#2: Conduct a Property Condition Assessment

Most homebuyers will get a home inspection before closing on a property. The equivalent in commercial real estate is a property condition assessment (PCA). A PCA determines the present physical condition of the property and provides a professional opinion on any improvements that may be needed in the future. It also entails researching municipal databases—such as the health, building, and fire departments—to ensure that the property is compliant with all local codes.

The final report (known as a property condition report) will include a detailed cost table that provides an estimate for repairs. Buyers can use the PCR as a negotiation tactic to secure a lower purchase price. In some cases, a buyer might elect to walk away from the deal altogether if the PCR indicates that expensive repairs are on the horizon.

#3: Conduct a Market Survey

Depending on your familiarity with the area, you may have some basic assumptions about the property’s rent potential—but how well do you know the market as a whole? What’s your target demographic? How stable is the local economy? Will these units be competitive in the marketplace?

That’s where a market survey comes in handy. It helps to verify your assumptions about the local market. The property in question will be evaluated relative to comps in the local market with several criteria taken into consideration, such as rents, unit type, occupancy, unit size, amenities, etc. If you’re working with a real estate broker or property manager, they should be able to run this analysis for you relatively easily.

#4: Conduct an Environmental Inspection

An environmental inspection, often referred to as a “Phase I Site Assessment,” will indicate whether there are serious problems (such as asbestos, lead paint, underground oil tanks, and wetlands) that will need to be addressed.

While environmental issues are important for all real estate buyers, they are critical to commercial real estate investors who may inadvertently be purchasing environmentally harmful waste products in large quantities. Remediation costs can be steep. A Phase I study is particularly useful when you’re looking at properties located in dense, urban neighborhoods, or in areas with an industrial legacy.

#5: Conduct Walk-Throughs of Every Unit

It’s common for investors to tour a handful of units in a multifamily property before submitting an offer—but before closing, you should be sure to conduct a walk-through of every unit. You might hear excuses—so-and-so is out of town, or she works late nights and I don’t want to bother her—but those excuses could be covering up larger issues. Don’t take the risk. Insist on walking through each individual unit, no matter how similar the listing agent claims they might be.

During your walk-throughs, ask tenants if they’ve had any problems with their unit. This information can be incredibly insightful. Case in point: We once worked with an investor who failed to inspect each unit before closing. A few months later, he was surprised to get an astronomically high water bill. As it turns out, the kitchen sink had been leaking for months. The tenant had apparently notified the previous building owner (who obviously never corrected the issue) and did not feel obligated to raise this as an issue with the new owner. The lesson here is clear: Always walk through every single unit prior to closing on a multifamily property.

It’s likely that your lender will require other due diligence items (like a title review and appraisal) prior to closing. These are pretty standard and, for the most part, out of your control.

When all is said and done, the process of conducting due diligence for multifamily properties can cost thousands (or even tens of thousands) of dollars. But don’t panic! These costs can usually be rolled up into your financing and amortized over the lifetime of your loan.

Have you purchased an apartment building? If so, which action items would you recommend in conducting due diligence for multifamily properties? Share your comments below!