SS161: What is Due Diligence in Real Estate

SS161 What is Due Diligence in Real Estate

Due diligence is a very important part of investing in real estate. In this episode, Charles discusses what due diligence is and how it is performed.

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Talking Points:

  • You have an accepted offer and a signed contract on a multifamily property you plan to buy; one of the next steps is performing due diligence. Performing due diligence is an important part of purchasing any property. Due diligence is analyzing a property in detail before purchasing it and usually consists of hiring third-party service providers to inspect, and/or provide reports on various aspects of the property to determine its suitability as an investment.
  • There are three main buckets that due diligence will fall into. Physical, financial and legal, and environmental.
    • First is physical. You and/or your team will walk the entire property. The main items you are reviewing are the condition of the interior and exterior. Roofs, gutters, plumbing, the foundations, parking lots, common areas/facilities, etc. You are also walking EVERY unit. When we walk the units, we are taking pictures and videos of every unit (we have one person doing this), and it allows us to easily go back and review the condition of the units when we are finalizing our numbers. We are looking at the overall condition of the unit and the condition of the appliances, mechanicals, ventilation, plumbing, doors, windows, walls, electrical, and flooring and noting how much work it will take to get the unit to the condition required by our business plan. We usually have 3 different unit condition categories/rankings, and we will score the unit as we walk it. For example, you might have 3 rankings: A, B, and C. Where an A unit requires minor work, $2,500; a B unit requires $5,000, and a C unit requires $7,500. This allows you to walk the unit easily and understand what renovations will cost.
      • It is important to bring in licensed contractors and inspectors. We will normally walk the unit with the property management company we will be using for the property and hire plumbers, roofers, etc., to review and evaluate the property’s condition where an expert is required. During your inspection, you might find things that will make you want to bring in another inspector or contractor, maybe one that specializes more specifically in the problem you see, like a structural engineer.
    • Next is financial & legal. The main goal is to verify the property’s income and expenses. The most important documents you will request from the seller are the trailing 12 months of financials, the rent roll, utility bills, bank statements, and tenant leases and service vendor contracts (since some of them, like laundry contracts, will survive the sale). The rent roll analysis involves tying the financials, expenses, and income to the bank statements, ensuring they line up. While also understanding what service contracts we will inherit after the sale.
      • The lease audit involves reviewing all leases, what tenants are paying, and whether that matches the financials. We will also grade the leases and tenants. First, does the tenant on the lease actually live there and pay rent? Do they have a security deposit? How much is it? The lease audit gives us an idea of the strength of the tenant base and the likelihood of tenants fulfilling their obligations, or is there a higher probability that we might need to evict this tenant in the future? This helps us fund a proper reserve to cover potential future costs involved with evicting tenants, unit downtime, unit make-ready, and leasing costs.
    • Lastly is environmental. Always, always, always get a Phase I report. Your lender will most likely require it, but you should always get one. The phase I is a limited report that will look for traces of petroleum, dangerous chemicals, pesticides, mold, asbestos, radon, lead paint, hazardous building elements, etc. Examiners will go to the property for a physical inspection and pull public records to review how the subject property and surrounding properties were historically used. If there are any potential issues, a phase II may be required.
    • Once you have performed thorough due diligence, as the buyer, you can readjust your numbers to verify that the deal still makes sense. If there are major issues that you just discovered during due diligence, you can address these with the seller.

Transcript:

Charles:
Welcome to Strategy Saturday; I’m Charles Carillo, and today we’re going to be discussing what is due diligence in real estate.

Charles:
Have you always wanted to invest in real estate, but didn’t have the time, didn’t know where to find the deals, couldn’t get the funding and didn’t want tenants calling you. Since 2006, I’ve been buying income producing properties and great locations that provide us with consistent passive income. While we wait for appreciation in the future and take advantage of tax laws while we’re waiting and unlike your financial advisor, we invest alongside our investors in every property we purchase. Check out to investwithharborside.com. If you like the idea of investing real estate, if you like the idea of passive income partner with us at investwithharborside.com, that’s investwithharborside.com.

Charles:
You have an accepted offer and assigned contract on a multifamily property you plan to buy. One of the next steps is performing due diligence. Performing due diligence is an important part of purchasing any property. Due diligence is analyzing a property in detail before purchasing it, and usually consists of hiring a third party service providers to inspect and provide reports on various aspects of the property that determine its suitability as an investment. Now, there are three main buckets that due diligence will fall into physical, financial, and legal and environmental. So first is physical. You and your team will walk the entire property. The main items we’re reviewing are the condition of the interior and exterior roofs, gutters, plumbing, the foundations, parking lots, common areas, facilities, and you’re also walking every unit. When we walk the units, we are taking pictures and videos of every unit. We have one person doing this as we walk ’em, and it allows us to easily go back and review the condition of the units.

Charles:
When we are finalizing our numbers, we’re looking at the overall condition of the unit and the condition of the appliances, mechanicals, ventilation, plumbing, doors, windows, walls, other electrical flooring, and noting how much work it will take to get the unit into the condition required by our business plan. Now we usually have three different unit condition categories or rankings, and we’ll score the unit as we walk it. For example, we might have a ranking A, B, and C, where an A unit requires $2,500 worth of work. A B unit requires $5,000 worth of work, and a C requires a $7,500 worth of work. This allows you to walk the unit easily and understand what renovation will cost. It’s important to bring in licensed contractors and inspectors. We will normally walk the unit with our property management company. We’ll be using for the property and hire plumbers, roofers, et cetera, to review and evaluate the property’s condition where an expert is required.

Charles:
Now, during your inspection, you might find things that will make you wanna bring in another inspector or contractor, maybe one that specializes more specifically in a problem you see like a structural engineer. Next is financial and legal. Now, the main goal is to verify the properties income and expenses. The most important documents you’ll request from the seller are the trailing 12 months of financials, the T 12, the rent roll, utility bills, bank statements, the tenant leases and service vendor contracts. Since some of them, some of them like laundry contracts will survive the sale. Now the rent roll analysis involves tying the financials, expenses, and income to the bank statement, ensuring they line up for also understanding what service contract will you will inherit after the sale. Now, the lease audit involves reviewing all leases, what tenants are paying, and whether that matches the financials. We’ll also grade the leases on the tenants first.

Charles:
Does the tenant on the lease actually live there and pay rent? Do they have a security deposit? How much is it? Lease audit gives us an idea of the strength of the tenant base and the likelihood of tenants fulfilling their obligations. Or is there a highly probability that we might need to eVic evict this tenant in the future? This helps us fund a proper reserve to cover potential future costs involved with evicting tenants unit, downtime unit make ready and leasing costs. Now lastly is environmental and always, always, always get a phase one report. Your lender will most likely require it, but you should always get one. Now, the phase one is a limited report that will look for traces of petroleum dangerous chemicals, pesticides, mold, asbestos, radon, lead paint, hazardous building materials and elements, et cetera. Examiners will go through properties for a physical inspection and pull public records to review how the subject property and surrounding properties were historically used.

Charles:
If there’s any potential issues, a phase two may be required. And really this comes up if there has been any type of garage like an automotive garage on the property or dry cleaners, something like this is gonna be something that’s gonna be triggered by that phase one. They’re gonna see that it might go to a phase two or further. Now, once you’ve performed thorough due diligence as the buyer, you can readjust your numbers to verify the deals still make sense for you. If there are major issues that you just discovered during due diligence, you can address these with the seller. Hope you enjoyed. Please remember to rate, review, subscribe, submit comments and potential show [email protected]. If you’re interested in actively investing in real estate, please check out our courses and mentoring [email protected]. That is syndication superstars.com. Look forward to two more episodes next week. See you then.

Announcer:
Nothing in this episode should be considered specific, personal or professional advice. Any investment opportunities mentioned on this podcast are limited to accredited investors. Any investments will only be made with proper disclosure, subscription documentation, and are subject to all applicable laws. Please consult an appropriate tax legal, real estate, financial or business professional for individualized advice. Opinions of guests are their own information is not guaranteed. All investment strategies have the potential for profit or loss. The host is operating on behalf of Syndication Superstar, LLC, exclusively.

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