When pursuing an on-market apartment deal, one way to create a more attractive letter of intent is to offer earnest money that “goes hard” (i.e., is nonrefundable) either day 1, after a specific task – like an inspection – completed, or after a certain period of time.
When you are pursuing apartment opportunities worth tens of millions of dollars, the earnest money required will be hundreds of thousands of dollars. So, nonrefundable earnest money can be a risky strategy. If you end up closing on the deal, great. However, if you need to cancel the contract because something unexpected arises during the due diligence period, you will not receive your earnest money back.
Fortunately, you’re reading this “Ask The Expert” blog post, where we asked Ashcroft Capital’s Director of Acquisitions Scott Lebenhart “what specific things should someone do from a due diligence standpoint to be comfortable putting nonrefundable earnest money down from day 1?”
Here is what he said:
“In order to be willing to put up a non-refundable deposit Day 1, our confidence level in the deal needs to be extremely high. We spend a lot of time on due diligence in order to reach this high level of confidence prior to posting the deposit. During the underwriting and bidding process of a deal, a lot of effort is spent to understand the opportunity, evaluate the market, and create the business plan. This entails doing an extensive market analysis, touring competitive properties, and discussing loan options with potential lenders. However, once we are close to being awarded a deal where we know that we will need to put up non-refundable deposits Day 1, we take this diligence to the next level. Our goal at this point is to be as confident as we could be that we will discover no big surprises during our formal due diligence period. In order to do this, we typically perform the following tasks:
1 – Speak with a Contractor
We will have a contractor (or person with a strong capital background) inspect the property in order to confirm our capital assumptions. A seller will rarely allow us to do physical inspections of the property with roofers, electricians, plumbers, etc. until we are under contract because of liability issues, however, there have been cases where we were able to do this. Ideally, we would want to do a full, detailed inspection prior to putting up the non-refundable deposits but that usually is not the case. We therefore request as much documentation as we can so we can understand what work has been done and what needs to be done. Some items that we like to request include work order logs, historical capex budgets, and future budgets.
2 – Speak with Property Management Company
We have detailed conversations with our management company in order to ensure that they are in agreement of our business plan and assumptions on income and expenses.
3 – Speak with Lenders
We have more detailed conversations with potential lenders including sharing our proforma and capital budget with them to ensure that we will be able to achieve our projected loan.
4 – Speak with Consultants
We engage our tax and insurance consultants to confirm our assumptions.
5 – Speak with Attorney
We discuss any items of concern with our attorneys relating the zoning, title, or any other matters.
During the course of our formal due diligence, we always find a few unforeseen items but we work to make sure the impact of these findings are minimal. In order to avoid something from affecting the projected returns of a deal, we create conservative assumptions that can withstand the potential findings. In our capital assumptions we will always have a “miscellaneous” or “contingency” bucket of money to account for anything we discover and we leave cushion on our income and expense assumptions. When we need to put up a non-refundable deposit, our overall goal is to limit the number of surprises.”
In regards to point number 1, Scott says “If the management company has a person dedicated to capital, I would recommend having them do a visual inspection of the property. If not, or if you want to add another layer of diligence, we typically have a contractor walk the property. A contractor will typically be able to give you more accurate pricing on any capital needs.”
In regards to point number 5, Scott says, “When we put up non-refundable deposits, they are always subject to receiving clean title and a clean environmental report. This is generally a market standard so I would fight for this in any agreement. That being said, a title search is very easy to get so we usually do request an updated title report prior to submitting our deposit to make sure there is nothing alarming that we would find out anyway. No need to waste time and money if there is a title defect that can’t be cured.”
Overall, when you need or want to put up nonrefundable earnest money, the goal is to limit the number of surprises that come up during the due diligence period. To do so, understand the current state of the property in as much detail as possible, confirm your business plan and underwriting assumptions with your expert property management company, confirm your debt assumptions with your lender, confirm you tax and insurance assumptions with tax and insurance consultants, and address any legal issues with your attorney prior to submitting a letter of intent.
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