Fundamentals of Due Diligence for Apartments

Due diligence is always extremely important, but when it comes to apartments, especially large apartments, due diligence becomes all the more important.

I have witnessed a lot of projects fall to pieces as budgets exploded and properties that appeared to be great deals became money pits more often than I would like to think about (especially since this has happened to me a few times). These nightmares can be avoided, or at least mitigated, with proper due diligence.

Apartments are usually bought on a sixty day contract rather than the average thirty day contract involved in houses and small multi-family. The normal inspection period until your earnest money goes hard and cannot be refunded is 30 days. All of this is subject to negotiation of course, but it’s important to finish your due diligence before the inspection period ends in order to get your earnest money back if the deal isn't what you initially thought.

Some real estate agents and sellers will tell you it’s fine to walk every other unit or every third. Do not follow this advice! If you only view every other unit, the seller will likely show you the best ones.  It is extremely important to know the condition of each unit in and out, even if there are one hundred of them. Often phrases like 'new HVAC' only apply to a small number of the units.

Take an inventory of everything that needs to be done when you walk through the property. And look at the tenants too. Do they treat the units well or not? Feel free to ask them questions. Ask them if they like living there and if there are persistent maintenance problems. This can be very helpful in figuring out the overall condition of the property

With regards to inspections, I recommend getting an inspection for the roof, the foundation if there are any signs of trouble and perhaps the electrical panels/system . It’s also a good idea to scope the sewer lines.

You should have inspectors review anything you have concerns about. If you are relatively new, it’s worth spending extra here. You don't necessarily have to have an inspector go through each unit, though. 

The next step is to look at the financials. Never take a seller’s financials for granted. I refer to pro-forma's as pro-fake'as because they are basically useless. Review each lease to make sure it matches the rent roll. Check the taxes with county and request contracts and utility bills to make sure nothing is out of line. 

Make sure to look out for bad debts and  misallocated CAPEX. With bad debt, if they are using accrual accounting, make sure that uncollected debts have been charged off so you can see the total delinquency. Go through the rent roll and make sure you know exactly who is behind and by how much. It is not uncommon for new owners to have to kick a lot of old tenants out.

For CAPEX, some owners throw things in CAPEX that have no business being. The goal is to make the NOI look better. Turnover, for example, is sometimes put in CAPEX when it doesn't belong. Make sure to get an inventory of their CAPEX expenses and when analyzing properties and put a line item for recurring CAPEX in your analysis (i.e. roofs or furnaces going out).

Finally, if you are getting a bank loan, they will demand an appraisal a phase one and sometimes a survey. Even if you are not getting a loan, you should still at least order a phase one as you don't want to buy a property with a major (and expensive) environmental problem.

I hope that provides some help and illustrates how important proper due diligence is. I have gotten out of bad deals I thought were good because of good due diligence and bought deals I shouldn't have that hurt me later because of poor due diligence. So make sure to never skimp on due diligence!

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