A Full Explanation of the Due Diligence Process for Multifamily

Multifamily due diligence is the process of a buyer, verifying the information given by a seller, pertaining to the asset being purchased.

The key components of multifamily due diligence are physical due diligence, financial due diligence, legal due diligence, and the lease audit.

In this article I will cover the full spectrum of due diligence for multifamily including these topics-

• The 4 types of due diligence explained.
• What documents and information to review.
• What professionals should be involved in the due diligence process?
• The order of each due diligence item in sequence.
• Discussion on how a lender does due diligence on your property.
• What to do if you find issues in due diligence.

At the end I have included a multifamily property inspection checklist.

The process of due diligence usually starts after a buyer has entered into a purchase and sale agreement (PSA) with the seller. In a typical multifamily contract, the due diligence will start once the buyer has put the earnest deposit into escrow with the title company or closing attorney. Three to five days after execution of the PSA is pretty standard.

The due diligence period will usually last about 21-30 days on average. Whether these are “business days” can be negotiated in the PSA. A shorter due diligence period will be more attractive to a seller but will certainly increase risk to you the buyer.

Tip- when you can’t go higher on the price, try going shorter on the due diligence period. The faster your earnest money becomes non-refundable the more attractive the offer.

Does your earnest money become non-refundable after the due diligence period?

Yes, typically.

When negotiating a PSA, the earnest money (EM) is usually non-refundable after the end of the due diligence window. This is the point of due diligence in the first place. It allows you to check out the property and all the seller’s info before your “good faith” deposit becomes part of the equity or “goes hard”.

For this article I will assume you have completed the PSA and the due diligence period has started. I will walk you through each of the four key components of due diligence and show you what you need to do at each step.

https://youtu.be/MVRSUC3igg8

The four key components to due diligence I have given you here are from your point of view as a buyer doing their due diligence on an asset. At the end of this article, I will give you a description of how a bank or lender does due diligence on the asset you are buying and what to expect from the lender during the loan process.

Financial Due Diligence

What is financial due diligence for multifamily?

Financial due diligence for multifamily involves the process of verifying the information provided by the seller to the buyer. In this process, the buyer thoroughly analyzes the investment to ensure that the information is accurate and reliable.

What financial due diligence is NOT is deal analysis. That is a totally separate subject. Let me clarify.

Due diligence is making sure that the financial statements such as a T12 (profit and loss in a month-to-month format) that you (the buyer) have used to evaluate the deal. This means that you have already completed your deal analysis and are now using things like bank statements and/or tax returns to verify that the income (on the T12) is actually being collected.

Financial due diligence is not deal analysis. Deal analysis is what you did to decide the deal was a good investment to begin with. Deal analysis is what gave you your offer price to begin with. Due diligence is the time in which you get to verify the information provided by the seller is not fake. This is not the time to decide if the deal is a good deal or not. That’s deal analysis.

I am making this point simply for the fact that I get asked the following questions quite often when discussing due diligence.  

How do you assess the property’s value using income and expenses?

How do you assess the property’s income and expenses?

How do you evaluate the property’s location and market dynamics?

Should I receive profit and loss information from the seller for due diligence?

These questions all pertain to deal analysis not due diligence. You must analyze the deal before making an offer and that offer needs to have the highest probability of closing. Once in due diligence you are just verifying the information and condition of the asset not trying to decide if it is a good deal or not.

If you make an offer and then change the offer once under contract, that is called re-trading. I will cover that later in this article.

The financial inspection for a multifamily investment starts with verification of the profit and loss. You need to make sure that the seller/property is collecting and depositing the stated revenue as on the financial statement (P&L or T12) that you were given by the realtor or seller.

To do this you will need to request the bank statements for the property or a tax return showing the revenue generated for this asset. If you receive bank statements, you will want to get a monthly statement for each month represented on the financials. The tax return would show the total annual revenue for the asset.

What documents and financial records should be reviewed during financial due diligence?

You should be reviewing the bank statement and tax returns to prove the revenue collections of the property.

What if the seller doesn’t have any financial info?

This is most common with owners of smaller properties. The seller may not have kept financial records separate from their own personal records. Commingling of the rent and expenses with a seller’s persona bank account is common. They will likely not want/or be able to give you the financial information you need to verify the income.

If this is the case, there is not much you can do as far as due diligence is concerned. Most likely you would have discovered this lack of information in the deal analysis phase of the buying process. The only thing you can do when a seller does not have the ability to prove their collections is to reflect this risk by offering an appropriate price. A low price.

Should I hire a professional to conduct the financial audit?

Probably.

There is no rule that says you have to hire an accountant or certified bookkeeper to review the sellers’ financials, but it’s probably a good idea that you do. This certainly depends on your personal level of math and accounting skills.

Physical Due Diligence

This is the process of conducting the property inspection. The physical inspections that should be conducted are an inspection of each apartment unit as well as all common areas, office area, and any physical systems and amenities on the property (pool, boiler, laundry, etc.).

Physical due diligence can be as limited or as thorough as the buyer can afford. The more thorough an inspection the more costly and time consuming. Each buyer will need to assess each property to decide the level of inspection needed.

Note- the lender will be doing a physical and financial audit too. Discussed later.

The first step to a physical inspection is to walk every unit. EVERY UNIT.

I cannot stress that enough. The physical inspection will be unit by unit walk of the entire property. Each unit must be physically inspected.

What should be inspected in each unit?

This depends somewhat on who you have doing the inspection. If you have a professional property inspector conducting the inspection, they will have an agenda and they will inspect each unit and provide you with a list of items inspected.

I suggest that you or someone from your team go with the inspector or at least walk every unit yourself. Having a professional inspect the property is highly recommended but I also suggest that you (team member) see the inside of each unit yourself. The reason for this is because an inspector is going to be looking at the physical aspect of the unit.

Here are things that YOU should look for when walking units.

1. Is the unit occupied? Should the unit be occupied? Verify this with the rent roll.
2. Do you see any signs of people moving in or out?
3. Look at the ceilings. Do you see signs of past leaks?
4. Do the kitchens and bathrooms need updating?
5. What is the general condition of the unit compared to the average on the property?

Keep in mind that a professional inspector may or may not inspect all systems and capital expense needs. Check with the inspector to determine their scope of work.

Some items that may need to be inspected separately by a specific contractor. These are-

1. Plumbing
2. Electrical
3. Structural
4. Roofing
5. Pool
6. Environmental due diligence (typically done by lender)

If you are planning on renovating a property, you will need to contact contractors to get accurate estimates for those costs. Don’t rely on the building inspector to create a renovation budget for you. During the due diligence period you will need to bring in contractors to bid and give estimates for the repairs. This would be a good time to bring in any plumber, electrician, or other contractor to inspect any suspect systems on the property.

Lease Audit

A leas audit is tenant due diligence for multifamily properties. It is an inspection of the tenant leases and applications for each resident of a multifamily property.

The key consideration when reviewing tenant leases is to make sure that they are qualified tenants and that their accounts are not delinquent.

The lease audit can be conducted in several ways. A full audit or a sample audit. A full audit will be an inspection of each lease and rental application. A sample audit is done by conducting a lease audit on a certain percentage of the leases. This is done on larger properties.

In a sample audit, you would inspect a certain percentage of the leases (maybe 20%). If there are no issues, then you end the audit. If you find problems, then you sample another 20%. If you find more issues, you then review all leases.

What are you looking for in a multifamily lease audit?

Start with the tenant application. Does this tenant meet the leasing criteria set by the management. This will include things like credit score, income, past collections, rental history. Does this tenant qualify to be here or did the management suspend their own criteria to fill vacant units? You need to decide. Next look at the lease itself.

Do the names match from the application to the lease?

Is there property ID with the application/lease?

Is the lease signed?

Does it match the rent amount and name on the rent roll?

If you find that the leases are in order, then move to legal due diligence.

Legal Due Diligence

Legal due diligence is mostly conducted with an attorney or title company conducting the closing. If you are completing a real estate transaction without the use of legal council or a title company, you will need to conduct full legal due diligence on your own, and you are greatly increasing the risk involved with the transaction.

My opinion is that the risk of a mistake in legal due diligence is not worth the savings you may get from not using an attorney or other professional counsel to complete the transaction.

Here are some of the main items that will be completed during legal due diligence.

1. Title Examination
2. Zoning and Land Use
3. Litigation and Disputes
4. Tax Assessment and Liens
5. Historical Use and Restrictions
6. Ownership and Entity Structure
7. Easements and Rights of Way

Giving a full description of each of these items is beyond the scope of this work.

Lender Due Diligence

When a traditional lender, such as a bank, will also conduct due diligence on the assets that they are lending on. Some lenders do more due diligence and some less. For example, I find that local community banks tend not to do environmental inspections whereas Fannie Mae, Feddie Mac and CMBS lenders almost always go to that level of due diligence.

For this work I will discuss the lender due diligence process as if you were applying for a loan with a larger lender. If you are working with local banks, you may not have as in-depth a process.

The lender’s due diligence starts when you make a loan application. With the loan application comes an application fee. The lender will use (most) of this money to complete their inspections. In the multifamily industry these are called the Third-Party Reports or “the 3rds” for slang.

The third-party reports will consist of these three main lender due diligence items.

1. The appraisal
2. Phase I Environmental Site Assessment (ESA)
3. The physical needs assessment (PNA)

The appraisal is just what it sounds like. The lender will hire a third-party property appraiser to conduct an inspection of the property’s value. The appraiser will use three separate valuation methods and take an average of all three values to create the final value. These three evaluation methods are-

1. The income approach.
2. The comparable sales approach.
3. The replacement cost approach.

A lender will base the amount of their loan proceeds on a certain value. This is called loan to value (LTV). The “value” here is typically the property appraised value or the purchase price, whichever is lower.

The environmental due diligence for multifamily properties begins with the phase I environmental site assessment (ESA). The ESA will be conducted by a qualified environmental engineering firm. This is the first phase of a potential three phase process.

The inspector will conduct a review of historical records, government databases, aerial photographs (desk top inspection) followed by a visit to the property. The primary goal is to assess whether there are any indications of environmental contamination or hazards that might require further investigation.  If none are found, then that will conduct the inspector’s inspection and report to the lender.

If there are environmental issues found (or suspected) on the property, the inspector will call for a Phase II Environmental Site Assessment. This is bad.

A phase two inspection will be comprised of collecting soil, groundwater, and possibly air samples from specific locations on the property to assess the presence of contaminants. If contaminants are found the inspection will move to the remediation phase.

In the remediation and follow-up phase the owner of the asset will be tasked with the remediation of the detected contaminants. For more information on this process to go to the U.S. Environmental Protection Agency (EPA) website www.epa.gov.  

The third inspection in the lender’s due diligence process will be the physical needs assessment (PNA). This will consist of a building inspector/engineer visiting the property and inspecting the buildings and structures on the property.

The inspector will typically provide a list of items to be inspected on the day of the visit. These are some items that are typical in a PNA inspection but keep in mind that each inspection will be different.

1. Sample of the apartment units
   • Typically, one of each floor plan
   • All vacant units
2. All amenities
   • Pool
   • Fitness center, etc.
3. Laundry Facility
4. Office area
5. Roofs (possibly with a drone)
6. Signage
7. Life Safety
   • All trip hazards.
   • Rotting wood on balconies, etc.
   • Exposed wiring.
   • Any safety issues.

These are a few things to expect during the PNA process with the lender, but this is certainly not an all-inclusive list.

The PNA inspector will create a report for your lender. The PNA report will be used by your lender to determine the viability of the asset and consequently the loan. Per the PNA the lender will create any financial reserve requirements for things like needed repairs or capital expense items (CapEx).

Multifamily Due Diligence Questions and Answers (Q&A)

Q. What professionals should be involved in the due diligence process?

A. Physical due diligence- Certified building inspector.

     Legal due diligence- Lawyer in same state as property, Title company.

     Financial due diligence- CPA or certified bookkeeper.

Q. What negotiations can arise from due diligence results?

A.  A renegotiation and reduction of price is the most common result. The buyer may also ask the     seller for repair credit. This is a credit given on the price as closing to cover the repair costs discover in due diligence.

Q. What are the potential risks of not conducting thorough due diligence?

A. Absolutely endless.

Q. Are there any specific due diligence considerations for different types of multifamily properties?

A. No. A thorough due diligence as described here should be done on any investment property regardless of type.

Q. How can investors mitigate risks identified during due diligence?

A. Time is the main factor when dealing with risks identified in the multifamily due diligence process. Begin the due diligence process as soon as possible after the completion of the PSA. The faster you identify the risks the more time (and options) you have to mitigate those risks.

Q. What is an Early Access Agreement in multifamily due diligence??

A. An early access agreement is an agreement between the buyer and seller of a real estate asset that allows the buyer to conduct due diligence before the purchase and sale agreement has been executed. This is most used when a buyer is allowing the earnest money deposit to be considered nonrefundable at the signing of the purchase and sale agreement.

Multifamily Property Inspection Checklist

1. Exterior:
   • Roof: Check for signs of damage, leaks, or deteriorating shingles.
   • Gutters and Downspouts: Ensure they are clear of debris and function properly.
   • Siding and Exterior Walls: Look for cracks, peeling paint, or other signs of deterioration.
   • Foundation: Inspect for cracks, settling, or moisture issues.
   • Windows and Doors: Check for proper seals, functioning locks, and any damage.
   • Landscaping: Assess the condition of lawns, trees, shrubs, and irrigation systems.
   • Parking Areas: Check for cracks, potholes, and proper drainage.
   • Exterior Lighting: Ensure all outdoor lights are working.

• Common Areas:
  • Hallways and Staircases: Check for cleanliness, lighting, and any safety hazards.
  • Elevators: Test for proper functioning and compliance with safety regulations.
  • Lobby or Entrance: Assess the condition of flooring, lighting, and security systems.
  • Common Laundry Facilities: Check for proper equipment operation and cleanliness.
  • Trash Disposal Areas: Ensure proper waste management and cleanliness.

• Interior Units:
  • Walls and Ceilings: Look for cracks, water stains, and other damage.
  • Flooring: Check for wear, damage, and proper installation.
  • Doors and Windows: Test locks, handles, and seals for proper functioning.
  • Plumbing: Inspect faucets, drains, toilets, and pipes for leaks and proper operation.
  • Electrical Systems: Test outlets, switches, and lighting fixtures for safety and functionality.
  • Appliances: Check the condition and functioning of stoves, refrigerators, HVAC systems, etc.
  • Ventilation: Ensure proper ventilation in kitchens, bathrooms, and laundry areas.
  • Safety Equipment: Verify the presence of smoke detectors, carbon monoxide detectors, and fire extinguishers.

• Utilities:
  • Heating and Cooling Systems: Inspect for proper operation and maintenance.
  • Water Heaters: Check for leaks, proper temperature settings, and overall condition.
  • Electrical Panel: Ensure it is properly labeled, up to code, and without signs of overheating.

• Common Facilities:
  • Fitness Center, Pool, etc.: Inspect for cleanliness, proper maintenance, and safety measures.

• Legal and Documentation:
  • Leases and Rental Agreements: Review tenant leases for accuracy and compliance.
  • Permits and Licenses: Verify that all necessary permits and licenses are up to date.
  • Property Records: Ensure proper documentation of property ownership and history.

For more information like this check out my blog at www.realestateraw.com and join my Facebook group Real Estate Raw for Multifamily Investors.

Best of luck!

Bill Ham