TOP 5 DUE DILIGENCE ITEMS ON ANY MULTIFAMILY PROPERTY
by Guest Contributor~Mathew Owens, CPA
After reviewing hundreds of multifamily properties and acquiring multiple value-add multifamily buildings there are a few tricks of the trade that are extremely important to review in order to protect yourself and gain an understanding of what exactly you are buying. Many investors make the mistake of not backing up their numbers and end up acquiring a building with much more operations work than originally thought. There are literally hundreds items to pay attention to when acquiring a multifamily building and it would be impossible to go over all of them in this article but here is my top 5 due diligence items to go through when acquiring any multifamily building.
When reviewing any specific apartment building to acquire the preventative maintenance can make or break your deal. Investors tend to understand when acquiring single family homes that you should look at the roof, HVAC system, plumbing, electrical, appliances and all of the major systems. However, when purchasing a multifamily building these costs are amplified significantly. If you are buying a 100 unit building you may have 100 AC units, 100 dishwashers, 100 water heaters, 100 units with old plumbing, a huge roof to replace in the future, 100 units with windows and doors. To get a true assessment of your capital expenditures its important to make a list of all of these items and do a full inspection outlining the useful lives of the major systems. it is extremely important to do this so your costs do not run away from you. For example, if you are reviewing a 100 unit building you want to understand how many water heaters need to be replaced now, how many units might need to be replaced in the next 5 years, 10 years, 15 years and more. It might cost approximately $500 to purchase and install each water heater and that could be a $50,000 expense on a 100 unit building. When looking at your cash flow streams into the future, it is important to outline and allocate funds monthly into a reserve account for these types of items to insure you do not have huge expenses coming that you are unaware of or not ready for. It’s like budgeting for that new car or new home you want to buy, you need to allocate funds in your budget for these types of future capital expenditures.
UNDERSTANDING YOUR RENT AMOUNTS
Is the building at market rents currently? If you improve the units in various ways is there upside potential in rents? How much would it cost to upgrade your units and the property in order to achieve these rents? If you were able to increase rents how much value would you create in cash flow and equity in the property? These are some of the questions you want to ask yourself when acquiring a new building. Personally I do not want to ever purchase a multifamily building without some type of upside potential in rents unless it’s already undervalued and performing really well on the cash flow front. Never assume you can come into a building and increase rents just because you purchased the property. Typically you will need to do some form of improvements in order to increase rents. We will upgrade the units as well as the exterior of the property through landscaping, new paint, security and more in order to increase rents. However, when you do have upside potential that means there is potential to force appreciation on a building. Multifamily buildings are valued based on the cash flow that they produce so increasing rents and decreasing expenses can add a substantial upside potential in the property’s value.
KNOWING YOUR VALUE FOR FINANCING PURPOSES
Financing on multifamily buildings have some huge differences compared to single family homes. Appraisers will look at the cost per unit comparable sales, how much the property cash flows, the condition of the property, future maintenance issues and more when appraising your building for a bank. Banks will typically lend up to 60% – 75% of the value when financing multifamily buildings and there are a lot more lenders that will finance loans of $1 million or more compared to lenders that will finance low balance or less than $1 million loans. This makes it much easier to buy larger buildings than smaller buildings. You also need to pay very close attention to your debt to income ratio on the building. Most lenders will require the building to cash flow at least 135% of the loan payment so many times depending upon the cash flow of the building you are buying the lender will back into the loan amount depending upon the appraisal and cash flow that it produces. When getting financing there are also much different insurance requirements the banks require with extended coverage compared to single family home insurance providers. Banks typically do not want to finance properties that have no operations history as well and many sellers do not have this type of detail which can hinder financing capabilities as well. If you have high vacancies that can also preclude you from obtaining traditional bank financing as well so you may need to purchase with a bridge loan or private financing and then refinance after occupancy is up and you can show performance.
REVIEW THE BACKUP FOR ALL OF YOUR INCOME AND EXPENSE ITEMS
Electricity, water, sewer, gas, landscaping, insurance, property taxes, administrative expenses, payroll, management fees, legal expenses, bad debts, marketing and leasing costs, repairs and maintenance are all items to review in detail and backup when acquiring a new building. Reviewing all of the utility statements for an entire year or more is crucial when analyzing a building. Many sellers will try and provide you with statements for the last few months because they know it is at a time of the year when the utilities are low so it is imperative to review a full cycle of utility statements. Never take a sellers insurance estimates, always get your own. You do not know what type of coverage the seller has versus what you have. You don’t know if the seller lied to the insurance company to keep rates down (which happens more often than you would think). Check the property taxes with the assessor’s offices and review to insure no special assessments have happened or are planned in the future in that area. How much maintenance are they claiming to have spent on an annual basis and on a per unit basis, and is it reasonable? This can fluctuate greatly depending upon if the owner fixes items, replaces items or capitalizes their expenses to exclude them from the net income on the property.
REVIEWING LEASES AND TENANT BACKUP INFORMATION
Always line out all of your leases with start and end dates, security deposits and delinquent tenants, then review in great detail. One trick many selling agents know is that a building that is not occupied is hard to finance and therefore hard to sell. They will instruct owners to fill them any way they can even if it means they are leasing to unqualified tenants. This is a HUGE problem and will cost much more money in eviction costs, repairs and maintenance upon move out and re-leasing costs down the road. Look for multiple leases with very recent start dates over the last few months. Look for low security deposits, which can be negotiated at closing as credits if you think they are inadequate. Look to see how many vacant units as well as delinquent tenants you have, which indicate probable turnover if they do not catch up, and build these turnover costs into the analysis. For any of the recent tenants review the tenant applications and qualifications if possible. And if you cannot review them, you may want to negotiate that into the pricing because it is a potential cost down the line.
There are obviously a ton of additional due diligence steps to do when analyzing any building but these are my top 5 after entering contract on a deal. Additional items to look at are surveys, environmental studies, and market analysis, inventory of equipment and furniture, litigation history on the property, historical financial statements, inspection reports, title issues and much more.
I hope this article gave you some insight when analyzing a multifamily building and what items to focus on when trying to tell if you have a good deal or not. Happy investing!
Mathew Owens, CPA~ MPO@OCGProperties.com