JF1116: How to Perform Due Diligence on an Apartment Building #FollowAlongFriday
It’s a Follow Along Friday again! This episode is 95% answerin glistener questions anbout multifamily and other types of investing. We also get a quick update on Joe’s and Theo’s deals. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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Joe Fairless: Best Ever listeners, how are you doing? Welcome to the best real estate investing advice ever show. I’m Joe Fairless, I’m with Theo Hicks. If I sound different, I’ve just mentioned to Theo that it’s because I just got back from the dentist about 20 minutes ago, and half my face is numb… So I am drooling all over myself as we do this episode, to give you a nice visual.
Theo, we’ve got some listener questions that we’re gonna be talking about and answering, and then some updates, and I think we should go and kick it off. It’s good to be back!
Theo Hicks: It’s good to have you back, Joe. You’ve been gone for a couple weeks. I’m looking forward to asking you a couple questions about your vacation, but we’re gonna change the order a little bit today and dive straight into listener questions.
Most of these questions are around performing due diligence on apartment buildings, so that will be kind of the main theme of the episode. So we’ve got questions from three different people.
The first set of questions is from Caroline. Her first question is “What happens during the due diligence period between getting the property under contract and close?”
Joe Fairless: Well, we have ten steps that you will complete, and we’ll go through those. We have them written down… The high-level answer is that you qualify the property based on your assumptions that you’ve made in underwriting, and you see if anything is different from the assumptions that you made. So ultimately, it is a fact-finding period, and if you find facts that don’t align with what you assumed going into it, then you renegotiate or back out, or move forward and knowing that you’ve got a different set of assumptions or facts that you’re dealing with.
We wrote down ten things that you need to complete from a report standpoint for the due diligence process. And keep in mind, this is for apartment communities. If we’re talking single-family homes, then it won’t be as robust of a process; we’re talking specifically apartment communities. If it’s hotels, if it’s industrial – I don’t know, I’ve never closed on any of that stuff, so find someone who has. But if you’re asking about apartment communities – which it wasn’t mentioned exactly what you were referring to, but I’m gonna assume you’re talking about apartment communities.
Number one is a financial audit – really important. One of the lessons I learned on my first property is the importance of identifying occupancy versus economic occupancy, and the financial audit will determine that… And how you will do that is ideally you hire a third-party company to do that for you, and they will look at the bank statements and juxtapose them with the financial statements that were provided, and also with the rent roll, to make sure they all line up. And perhaps juxtaposes — or maybe cross-references is a better word.
So you’ll wanna do the financial audit, that’s number one, to determine if there are any discrepancies in the financial statements that are being reported and what’s actually being generated by the property. A huge thing that you need to take into account.
Number two is a internal property condition assessment. Basically, you want to take a look at the property and assess all the areas that need to be fixed, and areas that need some fixing perhaps in the near future, and then what is operating properly. We hire a third-party company to do that for us as well.
Number three is a market survey and condition report. The main purpose of this is to make sure that the rental assumptions that you have are accurate and that your assumptions are conservative and they’re hopefully not the market leader for what you anticipate your rent to be. That market survey is typically done by your property management company.
We always – “we” meaning Theo, myself, Frank, my business partner and the Ashcroft team – do this market survey ourselves prior to getting it under contract. We call up the comps… In addition, when we visit the property before we have it under contract, we go visit the comps… But in addition to us doing it, we have our property management partner do it as well, to make sure there’s nothing that we’re missing or that they’re missing.
File and lease audit – you’ll need a company to do the audit of the leases and the lease contracts, and make sure that they are accurate and reflective of what they’re actually paying in rent, and there’s nothing out of ordinary. Now, I know from your closing, you came across something like this… What happened again?
Theo Hicks: Yeah, I’ve actually done the lease audit on my properties, it’s just the rents that we were verbally told were not the same as the rents that were on the leases…
Joe Fairless: They were higher, weren’t they?
Theo Hicks: …they were not the same as the rents that we actually were receiving. We were told one thing – that was a middle number; the leases were the lowest number, and what we actually got was the highest number.
Joe Fairless: [laughs] That’s beautiful. Normally, it doesn’t end up good when you don’t do the lease audit. In your case, it ended up as a favorable outcome.
Five is a unit walkthrough. Surprisingly, I get a question every now and then of “Do we need to walk through every one of the units?” Yes, we do. We have to walk through every one of the units. The ones that we’re not getting access to, those are the ones we should be most suspicious of.
They can’t get a hold of the resident because there’s a dog and they can’t pin the dog up. The resident works third shift. The resident is out of town and locks don’t work – all these excuses you’re gonna hear, and all these excuses you’re gonna have to push aside and say “I know, but in order to close I still need to see the inside of the unit, because we’ve got to do our inspection of the interior.”
Theo Hicks: Another quick example of that [unintelligible [00:07:43].10] but I might as well do it now because it’s relevant to this… This happened to me for my properties too, because there were 12 units and we got into every single unit there for the inspection in the appraisal period, except for one unit. And I was like, “Oh, whatever… All the other units are fine. There can’t be anything that’s too wrong and that will cost too much money”, so I didn’t see it. Then I got lucky, but we know how like the water bills are staggered quarterly, so as we bought the property in July, we got our first water bill at the end of August… And they come in, I’m looking at them and the first one is what I expected it to be, and the second one is what I expected it to be, and the third property it’s like three times as high as all the other properties for the month. I was like, “What’s going on?”
I go over there with a plumber, because we assume there’s a leak somewhere for the water bill, and we come to the basement and we didn’t hear water running through the main sewage line… We go to the unit above it and there’s no leak in there, then we go to the unit above it, and it clicks — I was like “Oh my gosh, I’ve never seen this unit before.” And we go in there, and literally his faucet is just running, full go. I turn it off and on, and it didn’t change at all… And he says it’s been like that since he moved in, and I had no idea.
I go “Hey, do you mind if we get into your unit? We think there’s a leak in there” and he’s like “It’s been leaking [unintelligible [00:08:52].03]” and I was like, “Oh, so thanks for telling me now.” So we got in there, we had to replace the entire vanity, and now I’m looking forward to – based off of how much money we were losing from water – the repairs will pay for itself.
Joe Fairless: It was just going full on?
Theo Hicks: Full go.
Joe Fairless: Oh, man… For how long? How long had he lived there?
Theo Hicks: I think he had been there for like a couple of months. I was talking to him and I was like, “Did you ever bring this up to the last owners?” He was like, “Yeah, I told them one time, but then when they didn’t reply I just figured they’d figure out when they saw the water bill.”
Joe Fairless: Gosh…
Theo Hicks: I did, so… So yeah, make sure you walk through every single unit, because you don’t want something like that happening to you, especially if you pay for utilities.
Joe Fairless: Yeah, if there was a RUBS program – ratio utility bill back system – then that resident would have found you at where you live and be like “Hey, listen, I need this fixed, because I’m having to pay for it.”
Number six, site survey. This just shows the boundary of your property; it shows where your property line is, etc.
Number seven – property condition assessment. This is done by a third-party that the lender selects. So the lender does their assessment.
Eight – environmental site assessment. Making sure that there’s not any environmental issues that are present.
Nine – appraisal. You know what the appraisal is.
Ten is a green report, which evaluates the potential energy and water conservation measures on the property and estimates the initial investment in the cost savings to do so.
So those are the ten things; I told you high-level what you’re looking for, and then got very granular in there with the ten things for that.
Caroline, you also asked “How is the current and future property management transitioned?” Well, when we close — let’s say we closed at 4 PM on a Tuesday. At 3 PM on Tuesday our management team is outside the gate of the property, and at 4 PM, as soon as they get word we are on the property, we’re managing the property right out of the gate.
We have a process leading up to that point to make sure that they have all the information they need, and that’s why they’re so involved in the due diligence process, because they’ll be familiar with the property and segueing into it, versus it being just something that happens out of the blue.
Number three, “How do you determine the renovation plan? How do you estimate costs?” Let me answer a larger question – how do you determine the business plan? The business plan is determined based on the market and what you can do within that market. A renovation is one component of the business plan.
So how do you determine the renovation plan? You look at where is the market at and you see what can the market support in renovations. Some renovations will be higher end, some won’t be as higher end, and as far as the estimate of cost goes, well two things – one, you should have a team member, either yourself or someone on your team, who can do renovation estimates for what is needed, and then you also need – not want, but you NEED to have a on the ground management partner who can also provide those renovation estimates independent of yours, and then you give them yours, they give you theirs, and then you see what are the differences (any discrepancies) and then you reconcile.
Theo Hicks: So that wraps up Caroline’s questions. Next we’ve got a couple of questions about doing due diligence on market from Sylvia. She said “I’m new to investing and wanted to do my due diligence in choosing a stable market in which to invest. I appreciate your methodology and how you choose your market.”
Joe Fairless: Since she’s new, I’m thinking she’s talking single-family…
Theo Hicks: Yeah… And she says “If looking on the Bureau of Labor Statistics website, specifically the regional homepages – is this where I get my data to see job growth for the region in which I would like to invest, or is there something better?”
As far as I know, the Bureau of Labor Statistics does have employment data and job data, but [unintelligible [00:13:17].06] from one place, because they’re just pulling their information from the Census Bureau anyways… So I like going straight to the raw Census Bureau data to get all my market information.
Since you kind of asked what’s our methodology, the exact factors that we look at – there’s seven of them. We look at unemployment, specifically the five-year unemployment change for the market; we look at the population’s growth over five years – both the city population and also the larger metropolitan area… They call that the MSA. We look at the population age growth; on a census, they can get the age ranges and they can see how that’s changed year after year, and that kind of helps you know what type of property may or may not be in demand…
Joe Fairless: And you wanna look for millennials or — I don’t know what the generation is who’s 20 years old, but 22-34-year-olds, that’s our ideal renter population. So you want a larger population representation of them relative to others and relative to other markets.
Theo Hicks: And then we look at job diversity, which you’ve mentioned, and yes, you can find that on the Bureau of Labor Statistics, but you can also find it on the Census Bureau. You will have what the industry is, like healthcare, or public services, and it will have the percentage of the population that’s in there… And as we talked a lot about on the podcast, you don’t want to see an industry have more than 25% of the jobs, because if that industry were to take a hit, then those jobs will be affected.
Joe Fairless: Two extreme examples – Dallas-Fort Worth, 14% is the industry that has the most, so it’s incredibly diverse; that’s why we love Dallas-Fort Worth, and that’s why we’re buying in Dallas-Fort Worth. On the opposite end of the spectrum, Las Vegas has 28% hospitality, obviously… So it’s heavy-handed in tourism, in that industry. As you said, you just don’t want it to be heavy-handed at one, you want it ideally to be as diverse as possible.
Theo Hicks: That’s related to number five, which is you wanna look at the top ten employers… Similar to job diversity, if you look at the top ten employers and there’s only company that has all the jobs, that’s something to look into, as well.
Then you wanna look at some supply and demand factors. For demand, you wanna look at the rental vacancy rates. Again, this is something you wanna track over time. Then you also wanna look at the number of building permits for 5+ units buildings – that’s how the census breaks it down.
Then number seven – anything noteworthy for that market… Google that market name, google business in that market name, unemployment in that market, and see what other information you can find on that market, if there are any new jobs that are coming there, new development, things like that.
So what you wanna do when selecting a market is you wanna kind of just pick seven different markets at least, and then make a spreadsheet and log all the data for the seven different markets for all these factors, and then compare them across to see how unemployment is trending downward for this one, but is trending more downward for this market, and this market over here has got really poor demand… So you wanna do that and kind of analyze and compare, and have your market insights for those markets in order to select which one is the best.
[unintelligible [00:16:38].20] To find employment diversity, would you look at the Wikipedia page for the specific area I’m researching, or is there something better?”
Again, for the job diversity for those percentages of population in certain industries, you can find that on the census; for those top 10 employers, that might be something you can find on Wikipedia… I recommend just googling “the city name + top employers”, and somewhere in that city it’ll be logged whether it was done by the city itself or some journal in that city recording that information. You’ll be able to find that somewhere on the internet.
And finally she asks “Will you recommend an article or a book that will enlighten a new investor to analyze markets? Thanks for taking the time to answer these questions.” So there are a lot of different market reports that are released every year on an annual basis or a bi-annual basis. I know Marcus & Millichap has a really good one… Just google “Marcus & Millichap market analysis.” Another one that we use is a cap rate survey that’s done on a bi-annual basis by CBRE North America.
Joe Fairless: And these are all free reports… You just google it and you’ll find it. You might have to put in your info and give them your e-mail address.
Theo Hicks: Another report you can read is by IRR, it’s called The Commercial Real Estate Trends Report. Then there’s two more – another one is by Zillow, and this one’s actually more for understanding the consumers, understanding the demographics of the type of person that’s going to be renting or who wants to rent and why they wanna rent and what they want when they’re renting…
Joe Fairless: And what do they search for to find that one?
Theo Hicks: Zillow Consumer Housing Trend Report. Again, you’ll get different information from all of those. The overall trend of the real estate market, you’ll get it specific to multifamily, you’ll get it on the consumer end… So I’d recommend just reading those reports.
Joe Fairless: Yeah, and we hooked you up with definitely more information than you need if you’re investing in single-family. If you’re investing in multifamily, you’ve just got the whole Kit & Kaboodle for what to look for and reports to look at. If you’re investing in single-family and you’re looking for a market, then those seven items that Theo went through are relevant, and the thing to keep in mind is if you’re not gonna manage it yourself, the management partner is critical to your success.
I would personally — if I had to choose between a A+ market and a B- property management company, I would rather have a B- market and a A+ property management company, because in the long run they’ll save you money and I believe you’ll be better off. So put a high premium on finding the right management partner in your area.
Theo Hicks: Awesome. So that wraps up Sylvia’s question. The last person to submit a question was Logan, and he said “I have a specific question. I’m raising money for a deal… You said that you want to get a commitment from people and have the money lined up prior to finding a deal. This is opposite somewhat from the way single-family housing is done, as you know. So my question is in order for these brokers to take me seriously (also for my own knowledge) should I be asking for my potential investors to provide me with a proof of funds for the money when they say they have to invest?”
Joe Fairless: In order to get started, you likely will need a proof of funds in order to show brokers or sellers directly that you have the ability to close. I did a video on this – it’s a less than two-minute video. In YouTube, search “proof of funds Joe Fairless.” Search “proof of funds Joe Fairless”, and a less than two minute video will tell you exactly how to acquire the proof of funds.
I’ll give you the cliff note version right now, because I know your time is valuable, and that is go to an investor of yours, ask him or her to provide a screenshot of their bank statement that shows the amount that you need in order to close on whatever deal you’re working on, or maybe you just want a bank statement so that you can make offers on many deals; just have a price range, so you know how big of a bank statement you need. Then have them mark out their info, and why they do that for you. One, they might just be a nice person, but two, if you need to compensate them, then what I did for one of my investors is that I paid him $5,000 after we closed on an apartment community. So I was only paying him after I received money from closing on a deal. He did not receive a penny until I closed on the deal, and then once I closed, I gave him $5,000 from the closing proceeds that I received… And he loved it. It’s a great way to build loyalty with a large investor of yours. So that’s one way.
Depending on how big your deal is, instead of $5,000 maybe it’s $500, maybe it’s $100, I don’t know. Maybe it’s free, maybe they just wanna help you out. That’s just one specific example for what I did, and you can take that structure and then rework it however you see fit.
Theo Hicks: And the person that’s gonna be giving you their bank statement, the amount of money that you need in their account is what’s gonna be required as a down payment for the property?
Joe Fairless: Yeah, the equity that would be required… So if you’re looking for a million dollar property, then let’s say 35% – 25% down payment, 10% miscellaneous closing costs etc. So $350,000 proof of funds for a million dollar property. So use that 35% rule and you’ll be good.
Theo Hicks: Awesome. That wraps up the listener questions, and we’re gonna move into some updates. We haven’t done this for two or three weeks now.
Joe Fairless: Two, three weeks, yeah. I was in Italy, and at the dentist, and all sorts of fun things… [laughter]
Theo Hicks: I wanna ask you, what was the most enjoyable part of being in Europe? Was it your first time going over there?
Joe Fairless: First time.
Theo Hicks: Okay.
Joe Fairless: I was eating lasagna for lunch and dinner seven days in a row.
Theo Hicks: Really?
Joe Fairless: I love lasagna.
Theo Hicks: I love lasagna, too.
Joe Fairless: In Italy – eating lasagna in Italy for seven days in a row for lunch and dinner.
Theo Hicks: Did you just try different lasagnas at different restaurants?
Joe Fairless: Oh yeah, everywhere. The best one I had was in Venice, and it was just right on the water, and it was delicious. The worst one I had had no meat sauce in it at all, it was just lasagna noodle, which I didn’t realize that’s what lasagna is – the actual noodle. I thought it was the big meat chunk, and everything. It’s just like a millimeter tall of three pieces of noodle with some pesto sauce in the middle… I was like “Someone deflated the lasagna, or I don’t know what happened here…” But it was pretty authentic from what I was told, but it didn’t satisfy my appetite.
Theo Hicks: And anything else from a business perspective?
Joe Fairless: One thing I noticed, and this is a business perspective – we’ll see how it applies in real estate, but certainly any entrepreneur who has a restaurant or something like that… And that is it’s so obvious that when a group of people are sitting down at a restaurant, it attracts more tourists to that restaurant, compared to if the restaurant has zero people, that restaurant takes a long time to get people to gravitate towards it, because no one wants to be the first person sitting down. We witnessed this time and time again.
There would be two restaurants, both empty; Colleen and I would just randomly choose to pick one, and then once we sat there, over the next hour the place would be packed, and the other restaurant – zero people. And we did this randomly, and we did it like four, five times. People will see “Oh, they’re eating there and they’re eating there – okay, we’ll eat there too, it must be good.” There’s no rhyme or reason.
So my idea for them was if I’m a local restaurant owner, what I would do is I would pay a couple to just sit there, have a bottle of wine [unintelligible [00:24:43].07] their wine, and that’s it. And guaranteed, they would make ten times return on their investment paying for a $30 bottle of wine and some bread and maybe some cheese. It’s a business decision that these individuals need to make. I don’t know how that applies to real estate, I can’t make the connection, but that’s just an observation that I have from a business standpoint.
Theo Hicks: My recommendation would just be – a restaurant is real estate, and I know you’ve interviewed people on the podcast before who bought restaurants before [unintelligible [00:25:12].03] They seem very difficult to run.
Joe Fairless: Yeah.
Theo Hicks: Anything else?
Joe Fairless: Yeah… Outside of my trip, from a business standpoint, we got a 304-unit under contract. We’re closing 5th December, and I think the last Follow Along Friday we did I had just closed on a property in Dallas, a 244-unit. That was 31st August. Now we’ve got another one under contract, a 304-unit, so we’re excited about that.
Theo Hicks: Is this the biggest deal you’ve done to date?
Joe Fairless: Unit size, yes. Transaction size, yes too… So yeah.
Theo Hicks: Congratulations. I’ve got one interesting thing that happened, and I’m gonna ask you a question about it to see if you have any input, but… I’ve had a lot of difficulty finding certain appliances for the units, specifically an 18-inch dishwasher. I don’t know where those things are… I was going on Craigslist, I was going to resell shops, where people donate old appliances; everyone has those 24-inch ones… It’s so difficult to find 18-inch dishwashers.
I was thinking, okay, so whenever I see one of these dishwashers I should probably buy it, because what happens if a dishwasher goes down? If it happened and then I had to wait four weeks to replace it, that doesn’t look good.
So my question was, I wonder if you’ve ever come across this, but — you probably have, because you have a lot of apartments, but what do they do for appliance inventory at your larger apartments? Do they have a couple of fridges and a couple of stoves on site, just in case someone’s breaks and they can replace it instantaneously? Do they wait for it to break down to buy one, or how does that work for larger apartments? To kind of figure that out and figure out how I can scale that down to my size.
Joe Fairless: Three different ways. One is you can buy in bulk, and then have them stored at the group that you purchased them from, and then they’ll just ship them to you as you need them… But you can buy in bulk, because you get that big discount. That’s number one.
Number two, you just do what you’re doing – you replace it as needed. You just go and buy something from a local vendor.
Three is that if something breaks down and you need to replace it immediately, you can pull from a vacant unit and use that, and then replace the vacant unit over a longer period of time, so that you immediately address the resident’s issue and then you have a little bit more time with the unit that no one’s living in.
Theo Hicks: Okay, that makes sense. For the larger apartment, that vacant one would be very helpful. For ours, hopefully we’re at 100%… So I think for now I literally plan on going on Craigslist a couple times a week and seeing if I can find any of those dishwashers, because a dishwasher or a stove is expensive, and —
Joe Fairless: What are they, $300?
Theo Hicks: I don’t know, I think more than that. The ones I was looking at were around $500.
Joe Fairless: That’s expensive.
Theo Hicks: I was very surprised. I was expecting a couple hundred bucks… I don’t know why I was expecting that. So I recommend anyone, for your rentals, or if you’re flipping houses – if you go on Craigslist, they have some very nice appliances on there for sale. The ones I bought for my apartments were very nice.
Joe Fairless: But Craigslist is local…
Theo Hicks: That’s a good point.
Joe Fairless: That’s just where you live.
Theo Hicks: I would definitely recommend checking it out if you live in a big city, or if you’re near a big city…
Joe Fairless: A big city like Cincinnati… If we’ve got good ones, then I’m sure anyone who lives in another big city will have plenty to look at.
Theo Hicks: I saw [unintelligible [00:28:37].17] that we have at our house for like $300 on there… I was like —
Joe Fairless: Do you also get stabbed when you meet up with the person, though? [laughs] And then they take $300 from you?
Theo Hicks: I’m with a truck, so I have my contractor pick all this stuff up, so [unintelligible [00:28:52].29]
Alright, so that’s all the updates I have. There’s some miscellaneous things… You’ll have an interview released on Tuesday with Josh…
Joe Fairless: Yeah, Josh Dorkin, the founder of Bigger Pockets. You know him… He is going to be on the show this Tuesday, and guess what? We did a little special thing, a two-part interview. So this Tuesday it’s part one, and then the conclusion of the interview will be the following Tuesday, part II. Enjoy it.
Theo Hicks: Should we mention the Best Ever Conference as well?
Joe Fairless: Yeah, we’ve got the conference… The early bird tickets are through Halloween. If you haven’t made plans to attend, then first off, shame on you. And secondly, let’s go, come hang out, see us in Denver. It will be an educational experience, it will be fun, and I will say that you’re gonna come away thinking this is truly the best ever conference you’ve been to. I can say that because we had some exit interviews and surveys with last year’s attendees and that’s what they said.
Theo Hicks: Awesome. As always, if you’re listening or you’re watching, make sure you subscribe to the podcast on iTunes and leave a review for the chance to be the review of the week. This week we’ve got Carafus… Carafus says “Joe’s extremely knowledgeable about the business of real estate and fundraising. Always great information and no BS. He asks his guests great, thoughtful questions, he’s also very well-spoken and articulate, which is rare in this industry. I listen daily.”
[unintelligible [00:30:32].16] articulate part. I have to agree, you speak very well.
Joe Fairless: Well, unless half of my face is numb from the dentist chair…
Theo Hicks: It’s perfect for today, then…
Joe Fairless: Thank you for those wonderful words, I sincerely appreciate it. This show is because all of you listening – that’s what really drives us, so I’m grateful and I much appreciate it.
BestEverConference.com is the website, I wanted to mention that.
Well, Theo, I enjoyed bringing it back, and Best Ever listeners, I’m grateful you are listening. I’m looking forward to talking to you soon.