due diligence on a 12 unit

[Barri Griffiths]

I just went under contract on a 12 unit in Cincinnati. I was wondering what do you recommend doing in terms of due diligence? As things stand ill be using the current owner as the property manager, which means that it'll be challenging to use him for any of the due diligence. What I'm thinking so far is, ill need an appraisal, an inspection, a walk through of all of the units, checking all the leases, and the tax records to see if they match what I've been given already. Is there anything else you'd look to do on a small apartment complex like this? Might it be worth it to pay a company to do a financial audit?

Thanks in advance

Barri

[Nick Schoch]

@Barri Griffiths Congratulations on finding a new investment. If you intend to finance it, I would let the lender do the appraisal since the lender won't use yours (conflict of interest) and you'll be paying for the one they order.

Ideally you would have a trusted advisor that has closed similar transactions and can guide you through the process. A good sales broker or an attorney that focuses on real estate can be helpful here.

That said, I think you're on the right track.  

You can go pretty deep here, but stay focused on what matters: will you be able to generate the stream of cash flow that you are buying?

• Ask the tenants to confirm the reported rents on the rent roll (i.e. get estoppels).
• Verify the rents aren't more than 5% above market rent for comparable units to ensure that as units turnover, you can re-tenant and maintain your cash flow. 
• Verify the reported expenses are reasonable (generally within 35-50% of income). 
• I would ask the owner for the income tax forms for the past 3-years on the property. This is a good crosscheck to confirm income and expenses since owners have an incentive to under-report income and over-report expenses to reduce their tax liability. I would ask the seller to explain any discrepancies. In addition, lenders will ask for this information if you intend to finance the property.
• Review the condition of the property to determine if there is deferred maintenance.
• Review Yelp and Google for any tenant reviews to understand any issues residents might have with the property. If there are any, hopefully they are limited to the current owner and manager not the property or location. This would also be useful to know if you're going to allow the current owner to be a manager.
• Regarding keeping the manager on, you'll want to talk to some of the tenants to get their perspective on management. You'll also want to establish a management agreement with them that gives you flexibility to switch to another firm if necessary.

You don't have to vest title in a business entity if you're investing by yourself. I worked at a bank where about half of the 5+ unit borrowers were sole proprietors/revocable trusts. The other half were business entities. Check out these stats from NMHC that indicate about 34% of 5-49 unit properties are held directly.

Many investors are scared into structuring their direct investments into LLCs to limit liability. This may not be as fool proof as they think (see here and here). Even if it were fool proof, the protection is only for your outside assets. It does not protect your property equity. I would think you would want to protect that equity. By analogy, this would be like having airplane passengers wear parachutes instead of focusing on what it takes to keep the plane in the air.

I think a better way to protect your equity is to:

1. Maintain the condition of your properties and operate fairly and ethically with constant regard to the law
2. Purchase insurance to cover any inadvertent negligence and/or simple bad luck
3. Vest title in a business entity that fits your partner, business, and tax strategy

Good luck on your purchase.