What questions I'm asking during due-diligence, and why it's OK to walk away.

[Jeff Schemmel]

Context: I'm an investor-friendly real estate agent in Minneapolis/St. Paul.  On this deal, I was representing a moderately experienced buyer whom I have worked with twice previously in a purchase of a relatively new small multi-family building.

This is my review of a transaction that did not make it to close, which highlights the process of going through an inspection period with an experienced investor-friendly agent and how that process worked correctly for the buyer.  I am going to focus on specific actions we took that brought forth critical information during the due diligence period.  I learned a ton during this process while being able to take some intentional steps to protect my client.

I'm going to do my best to explain this without divulging specific details, as I don't believe in having anyone shamed and I do not intend to break my clients' right to confidentiality.

The property in question was less than 1 year old, built by a local builder who held full ownership free and clear of any debts.  We presented this seller with a contract-for-deed offer which was accepted after some negotiation.  We were allowed in one of the three units prior to being under contract.  Normally, I would expect to see all units prior to writing an offer and that is still what I recommend; however, my client chose to proceed without seeing the other units when prompted; presumably because the building was so new.

First lesson: do your best to see all units before writing an offer.  This isn't meant to be an ultimatum, but just a reminder to do it even if it feels like an inconvenience or a formality.  In a competitive situation, this isn't always possible or the best recommendation, but in most circumstances you should try and plan for it.


First step in due diligence - > PROBING QUESTIONS!  Here's my list on top of the obvious request for all current lease agreements.  

Occasionally, and when I have reason to, I'll ask some or all of these questions before offering. In a competitive market, it is a real disadvantage to be seen as a "skeptical" or "needy" buyer. So I make this decision carefully, and most of the time I probe deeply once under contract.

1.  Are or have any tenants been delinquent on rent, fees, or utilities they are responsible for since the inception of their leases?
2. Please provide proof of on-time payment of rent, during the tenancy, for existing tenants.
3. What method is currently being used to collect rent? (online payment, venmo, cash/check, etc).
4. Please provide proof of utilities paid on time and in good standing for water/sewer and trash/recycling.
5. Are there any unresolved tenant disputes, outstanding repair requests, or complaints from any existing tenants?
6. Are there any landlord and tenant agreements not specified in the lease agreements?
7. Are any of the existing tenants utilizing Section-8 vouchers, rental assistance, or social/ placement programs of any kind?
8. Can you provide proof of renter's insurance policies for all current tenants?
   
9. Are there presently any open permits on the property, and what is the reason and status?

Here is one I added to this list specifically resulting from this transaction:

      Are there any persons or pets presently living in any of the units that are not included in the lease agreements?

Let's dig in to the answers on a few of these that sparked further conversation and discussion between my client and I

Proof of rent paid & method of payment

When the seller provided "proof" of rent paid, as well as the method of payment, we found the seller was collecting significant amounts of rent in CASH every month.  We were provided photocopies of handwritten receipts of rent paid, which also had large gaps in time and did not match the amounts shown in the lease agreement.

The above is uncommon, and in my opinion, should be seen as a risk to a buyer.  Not only is it unsafe to collect over $7,500/m in cash, it also begs the question "why" each party goes to and from the bank with so much cash as a preferred option.  You can come up with your own reasons why all tenants would be paying in cash.  My client was actually OK with this, but when we dug further into the inaccuracies we did find there were verbal agreements for parking spaces and pets that were NOT included in the lease agreements.  

The Inspection:

I can't stress enough how important it is to hire a reputable and qualified inspector.  In Minnesota, an inspector is not required to have any licensing or certifications, although the best inspectors are ASHI-certified.  For this job, we hired a notoriously thorough and reputable inspector and they did exactly what we needed. 

We did the following inspections:

1.) drone inspection of the roof.  Thankfully having such a mild Minnesota winter allowed us to even see the roof.
2.) a full interior inspection of all units (standard)
3.) a sewer scope -> Yes even on a new building.  NEVER skip this. It's by far the best ROI I've had on inspections in my career.

The inspection revealed a multitude of issues we had a hard time comprehending for such a new property.  I'll list a few below, and then talk about what ultimately caused my client to feel it was in her best interest to walk away.

1.) Significant defects in the roof and siding resulting from improper handling of materials, and improper installation.  GOBS of caulk.  Obscene amounts of caulk in places it shouldn't be.  This was especially wild, considering the defects we found presumably should not have passed a city permit inspection; however they had.  When prompted, the city said they don't go on the roof because it's unsafe. (what?!)

2.) We found twice as many people actually living in the home as what was shown in the leases, amongst pets, including a ferret.  There were hand-built, wood-framed, walls in two of the units creating pseudo-bedrooms for the additional occupants. (remember when I recommended viewing all units before offering?)

3.) Double-tapped breakers, all dishwashers did not function at all, multiple sinks and faucets actively leaked, Improperly installed flooring that had buckled, very high humidity in one units was causing moisture damage, furnaces full of drywall dust, radon systems that were not air-tight in the sump pit, and the list goes on and on.

I listed just a few of what would ultimately be the longest repair request I've drafted in my career.  There were many bids, and hours of discussion over how to properly proceed once all of this had come to light.  With the seller being the builder, these were even more important.  Imagine telling a seller he messed up badly and we don't trust him to fix the mess.  

The Cancelation:

In Minnesota, a buyer can send a cancelation during the inspection contingency period,  and expect to get all their earnest money back; and that's exactly what we did.  After a few hard phone calls, and several weeks of back-and-forth, my client decided the lack of trust in the seller, and the multitude of issues were too much for even the best deal on paper; and this may have been excellent.

As agents, we constantly walk the line when it comes to judging a "good deal".  My personal investing goals are almost always different from my client's goals, and at every turning point in a transaction, I do my best to respect that line and not try to inject personal opinions.  In this case, we both felt it was no longer in my client's best interest to proceed and were able to agree it was best to back out.  One might also argue it's a shame to lose $1,000+ in inspection costs and time, however, my perspective is that money was well invested given the lessons learned and bullets dodged.

I will do my best to answer any questions.  Again, I expect to keep this anonymous and I will not divulge specific prices, addresses, etc to protect the confidentiality of the parties to this transaction.

[Tim Swierczek]

Great post @Jeff Schemmel Lots of great points. The most underrated is a tenant who pays by cash. It's a huge red flag.

[Jeff Schemmel]

@Tim Swierczek thank you.  This one challenged me quite a bit, and I learned a lot.  The cash thing made me very nervous as well, but what it revealed was that answers the seller had previously provided were conveniently incomplete.  When we dug further about the inaccuracies, we realized that the answers the seller provided about verbal agreements or things known but not included in the lease actually existed but he just did not divulge.  Those things turned-out to be very material, and even against rental regulations.

[John Mocker]

Jeff,

I would suggest another questions/request for info to add to your due-diligence:    

"have there been any claims reported to you, submitted to the Insurance carrier, or that you are aware of, during the past 5 years"

I would also suggest that you request that they get the "Loss Runs" (report of claims) for the past 5 years from the current owner.  They can request it from their Insurance carriers.

[Jeff Schemmel]

@John Mocker good tip.  I usually get tipped-off to recent claim history from insurance, but that may not necessarily come during the due diligence phase so it makes a lot of sense to ask up front.

[Scott Schnabel]

Fine example of a buyer’s agent looking out for them. Well done. 

[Jordan Moorhead]

Great case study @Jeff Schemmel! Every agent who works with investor buyers or househackers should read this!