Financial Due-Diligence Addendum - Feedback?

Question

I was going over my P&S Agreement, and realized there is no section in there which would allow me to nullify the contract and get my earnest money back if I discovered the rental income was not what the RE agent had told me. I then realized there was also no way to get out of the agreement if there were "unexpected" expenses the RE agent "mistakenly" forgot to tell me about, or some tenants weren't paying their rent.

I wrote up an addendum that hopefully addresses most scenarios that would turn a deal sour. Any feedback would be appreciated.

The Addendum reads:

Seller must provide the following documents within five (5) days of signing the Purchase and Sale Agreement:

1.	Copy of Current Leases: Seller must provide copies of all current leases. 
2.	Current Tenant Rental History: Seller must provide the previous 12 months of rental history payments from current tenants. Rental history must be in the form of rent rolls, bank deposit history, pictures of rental checks, or a statement of the financial health of the property as certified by an accountant. Statement of the financial health of the property must include rent history as well as current rental income. If Seller is unable to provide rental history then Seller must provide tax returns from previous two years as to verify rental income of the property. 
3.	Year to Date Profit and Loss: Seller must provide a summarized financial statement for 2011 and a year-to-date summarized financial statement for 2012. Each of these statements shall include total collected rent and any expenses, including maintenance, utilities paid by the Seller, or any other expenditures related to the property.
4.	Copy of Management Contract: Seller must provide copy of property management contract if Seller uses a management company for the property.  
5.	Recent Repairs: Seller must provide breakdown of any repairs or upgrades performed on the property within the last year. Additionally, Seller must provide breakdown of any work done on roof since 2005, including replacement, repairs, or upgrades performed on the roof. 
6.	Necessary Repairs or Upgrades: Seller must provide list of repairs or upgrades that may be necessary for the property.
7.	Recent Tax Bill: Seller must provide copy of most recent tax bill for the property.

Within fifteen (15) days from when Buyer receives items 1 – 7 above from Seller, Buyer shall notify Seller of an unsatisfactory rental history, as defined below, or that current lease rent rates below $700 for any currently-leased unit is unsatisfactory. An unsatisfactory rental history entails:

1.	Late payment by more than twenty days by the same tenant, more than two times in the last twelve months.
2.	No payment for more than one month by any tenant within the last twelve months.

Unsatisfactory rental income history or unsatisfactory lease rent-rates, as defined above, shall afford Buyer the right to terminate the contract. If the Buyer elects to terminate the Contract, the Contract shall become null and void, and the Deposit shall be immediately returned in full to the Buyer.

Should the Buyer find exception to any of the foregoing materials including rental income history, profit and loss statements from the last two years, or any of the items described in points 1 through 7 above, then and in its sole opinion, the Buyer may terminate the Purchase Agreement upon written notice to the Seller prior to the fifteen (15) day period as stated above. Upon giving of such notice of termination the Purchase Agreement shall become null and void, and of no further force or effect and the Deposit shall be immediately returned in full to the Buyer.

J Scott · Answer

Why not something more simple:

1.  Seller must provide you requested docs (list them) within 3 days of binding agreement.

2.  Buyer has 7 days after receiving requested documentation to back out of the deal for any reason.

Having a general due diligence contingency (instead of specific circumstances in which you can back out) makes it less complicated to back out if you're not happy with the information you receive.

Brian Burke · Answer

I'm surprised that 1 through 5 and 7 aren't in the P&S, I've seen those clauses, or ones worded similarly (or equivalent language) in the contracts I've signed as a buyer and seller.

As a seller, I'd reject 6 because it requires me to speculate and opens me up to liability. I'm already required (in the states I'm familiar with) to disclose known defects, but this item seems to imply a higher standard.

I'd also reject that whole second section about the late rent stuff.

Not to say you couldn't propose the language, heck go for whatever you can get that protects you, but you might find that you won't get agreement on all of it.

That doesn't matter though, because your due diligence period (the way you worded it in 1-5) allows you to back out of the deal if you discover that the financials aren't what was represented.

Regardless, you should consider having your attorney review your contract.  You might be surprised to learn that the contract already addresses your concerns, or that there is something else in the contract that unfairly works against you.

Brian Burke · Answer

Will, the existence of construction loans does not mean that all of that money actually went into the property. Some of it could have gone toward acquisition or the take-out of existing financing. Very little of it may have gone toward actual improvements. Without the seller's cooperation and providing receipts, there is no way to know what went into the property.  I've even seen cases where unscrupulous owners have supplied false invoices to the lender to draw off the construction loan, so it really means nothing.

As to your question on tenant estoppels, this is a document that the tenant fills out and signs attesting what their rent is, the lease term, and the security deposit that was paid.  You would normally use these to audit the leases provided by the seller, but in this case the estoppels may be all that you have to work with and would have to be taken at face value.

Dennis Tierney · Answer

Will KThat's good to know that you've been able to get 3rd party confirmation of the rehab. Congrats on getting the bank loan in place. Sounds like you're ready to go. I agree that you'll probably need to evict a couple of deadbeats but don't let that deter you. I took on an apartment in 2007 that was 75% occupied with rehab needs and needed to evict more, but, it was worth the effort as it cash flows nicely now and it was purchased well below market price as you have done. Good luck.

Will K · Answer

Steve Babiak So the typical rent in that area is about $700-$800. What are tenant estoppels? These are two separate buildings, and I already have pre-approval loans for residential properties, and the P&S agreement is a residential type.

Dennis Tierney I pulled the $600k number off a title search, showing that construction loans were taken out for each property in the sum of $300k each. The bank has already informed me they wont take into consideration rent for this property, but none-the-less pre-approved me for a $180k residential loan.

Dennis Tierney · Answer

Will KBeing of the skeptical sort, with the seller refusing to supply basic information about the property I would be very wary about believing she put $600,000 rehab into the property. This is truly "buyer beware" territory.
If you are going to leverage the purchase you will have a hard time getting the bank to put up money with no financials/rent roll history  to give them.

Steve Babiak · Answer

Why aren't YOU figuring out what the market rents are for such units?  After all, in the end when YOU buy it, you will be the one dealing with it; having some seller's word, or some agent's word, that rents are some (unrealistic) number will still leave YOU stuck - will you just want to "blame" them then?  Tenant estoppels for the already rented units will give you some idea of what you will receive while that tenant remains - but the market number is what you can expect to get if they leave.

Once you are certain of the rents, and you are confident in your assessment of the condition of the units, then you can base the income analysis on your own numbers.

Unfortunately, expenses also can be embellished by a seller to seem more favorable, and with vacant units landlord paid utilities won't be getting run up as high.  The "50% rule" is a guideline to attempt to deal with this.  Prior year tax returns might also be useful (to get bigger deductions, the landlord might embellish the tax return figures opposite of how they might be embellished to convince a buyer to buy).

One other thing that comes up is whether this is two separate parcels and buildings you are buying, or one single six unit property.  In my area, two 3-unit buildings would fall under residential type of P&S agreements (draw up two if needed), but a 6-unit falls under a commercial P&S agreement.  How those are drawn up does vary ...

Will K · Answer

Dennis Tierney Brian Burke I submitted the P&S agreement with my Financials Addendum (described above) attached.

The RE Agent representing the seller phoned me yesterday informs me that the seller says because she is already being lowballed for the property, she is not guaranteeing anything concerning finances of the property, nor information on roof age, maintenance done, etc.

Given the background of the property above (the seller put around $730k into the property she is now taking offers of $180k for) I somewhat understand where she is coming from, however I am hesitant to purchase something without at lease seeing the leases and perhaps a few months of the previous rental history. The Seller's RE Agent tells me she wont even sign anything that guarantees shell hand over the leases after the Agreement is signed.

What are my options here? It is a 6 unit property, with only 4 of the units currently rented. One is section 8, and her apartment looked very homely and well taken care of, so I would be certain she is paying whatever portion of the rent she may be responsible for. The other 3 units were occupied by bachelors, two units did not have anyone there when I visited the property at 10am, but there was one unit where the tenant was there playing xbox at 10am on a Tuesday with his friend, and his apartment was a pigsty. No real damage, but just a slob's pad.

It looks like I might be facing eviction of 2 tenants right off the bat, which would drop occupancy down to 33%, at which point it would flow cash-negative.

The units are completely renovated with all new appliances and HVAC equipment, and fully occupied the property has a healthy CAP rate, so this would be a great deal with some redirection. However, the only thing I have to go off of for rent records is the RE agent's word. She has not provided any leases or rent income history.

I was thinking of dumbing down my Financial Addendum and only demand that I get copies of all current leases and rental income history of the last 6 months. If I cannot get this should I pass on the property?

Will K · Answer

@dennis tierney the RE agent told me the current monthly rental income, so my analysis and offer was based on what she told me. i requested leases but haven't seen them yet.

It was listed at $260k and i offered $180k, expecting to get ignored. The RE agent ran it by the seller, and then sent me a PS agreement.

Although, the RE agent tells me theyre getting other offers and all signed Ps agreements (and earnest money) is due by this friday to be considered. The RE agent just sent me all the docs for review late tuesday. Almost feels like theyre trying to rush me into signing it and handing over the cash.

The other catch is that its a short sale. The deal is for two townhouses, 3 units each, so a total of 6 units. Seller bought them as shells for $130k total in 2005, and then took out almost $600k in construction loans to turn the shells into 3-unit townhomes, so properties that the seller put $730k into i would be getting for $180k. This is contingent on the bank OKing the short sale, which based on the above criteria does not sound likely.

Dennis Tierney · Answer

One thing I would suggest: don't even make an offer until youv'e already seen the last 2 years financials, year to date financials and the current rent roll. I can't see how you even make an offer without having those to decide how to value the property. To get the assurance on the rents you have the owner supply estoppel letters signed by the tenants.

Financial Due-Diligence Addendum - Feedback?

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