The Ultimate Guide to Performing Due Diligence on an Apartment Building
After putting a deal under contract, the due diligence process for an apartment building is much more involved and complicated in comparison to that of a single-family residence or smaller multifamily building. For the due diligence process on an SFR or smaller multifamily building, the lender will likely only require an inspection report and an appraisal report in order to provide you with financing. And then for your own knowledge, you’ll perform your own financial audit, comparing the leases and rent rolls with the historical financials to make sure the rental rates are in alignment.
When you scale up to hundreds of units, the increase in the number of potential risk points is such that the lender will require additional reports prior to financing the deal and you will want to obtain additional reports before deciding to move forward with the deal.
For the apartment community due diligence process, you’ll want to obtain and analyze the results of these 10 reports:
- Financial Document Audit
- Internal Property Condition Assessment
- Market Survey
- Lease Audit
- Unit Walk
- Site Survey
- Property Condition Assessment
- Environmental Site Assessment
- Green Report
In this ultimate guide, I will outline the contents of each report, how to obtain them, the approximate cost of each (for apartment communities 100 units or more) and how to analyze the results.
1 – Financial Document Audit
The financial document audit is an analysis that compares the apartment’s historical operations to your budgeted income and expense figures you set when underwriting the deal.
For the audit, a consultant will collect detailed historical financial reports from the sellers, including the last one to three years of income and expense data, bank statements and rent rolls. The output of the analysis is a detailed spreadsheet of the asset’s historical income, operating expenses, non-operating expenses and net cash flow which are compared to the budgeted figures you provided.
The summary will take on a form that is similar to a pro forma, with the income and expenses broken down into each individual line item for an easy comparison on your end. They will also provide you with an executive summary document, which will outline how to interpret the audit, what data was used to create the audit spreadsheet and an explanation of any figures that deviate from your budget.
To obtain this document, you will need to hire a commercial real estate consulting firm that specializes in creating financial document audits. An approximate cost for this report is $6,000.
When you initially underwrote the deal, you set the income and expense assumptions based on how you and your team will operate the property once you’ve taken over. These assumptions came from a combination of the trailing 12 months of income and expense data and the current rent roll provided by the seller and the standard market cost per unit per year rates for the expenses.
Once you receive the results of the financial audit report, you want to go through each income and expense line item and compare them to the assumptions in your underwriting model. Ideally, the consultant that performed the audit already compared the results to your provided budget, made adjustments based on their expertise and any inputs you provided and commented on any discrepancies.
If any discrepancies were found or if the consultant recommended any adjustments, discuss them with your property management company to see if you need to update your budget. If you and your management company come to the conclusion that the budget needs to change, make the necessary adjustments to your underwriting model.
2 – Internal Property Condition (PCA) Assessment
The internal property condition assessment (PCA) is a detailed inspection report that outlines the overall condition of the apartment community.
A licensed contractor will inspect the property from top to bottom. Based on the inspection, the contractor will prepare a report with recommendations, preliminary costs and priorities for immediate repairs, recommended repairs and continued replacements, along with accompanying pictures of the interiors, exteriors and the items needing repair.
Being an internal report, you will be responsible for hiring a licensed commercial contractor to perform the assessment. An approximate cost for this assessment is $2,500.
During the underwriting process, you created a renovation/upgrade plan for the interior and exterior of the apartment community, which included the estimated costs. Once you receive the internal PCA, compare the results to your initial renovation budget.
The results of the internal PCA are preliminary costs, not exact costs. However, they will most likely be more accurate than the assumptions you made during the underwriting process. Therefore, if there are discrepancies between the contractor’s estimated renovation costs and your renovation budget, update the underwriting model to reflect the results of the internal PCA.
Hopefully, your initial renovation assumptions were fairly accurate. And ideally, if you made very conservative renovation cost assumptions, you discover that you over-budgeted and can reduce the costs in your underwriting model.
3 – Market Survey
The market survey is a more formal and comprehensive rental comparison analysis than the one you performed during the underwriting phase.
For the market survey, your property management company will locate direct competitors of the apartment community. Then, they will compare your apartment community to each of the direct competitors over various factors to determine the market rents on an overall and a unit type basis. A few key points on the market survey analysis is to make sure that your property management company uses apartment communities that are upgraded to a similar degree as how your apartment community will be post renovations and not in its current condition, that are in similar neighborhoods and that were built within a similar time period.
When initial underwriting the deal, you set your renovated rental assumptions based on a combination of performing your own rental comparable analysis and, if the sellers had initiated an upgrade program, proven rental rates. Compare the results of the market survey to your initial renovated rent assumptions. If there are any discrepancies, update your underwriting model to reflect the results of the market survey.
4 – Lease Audit
The lease audit is the process of examining the individual leases at the apartment community.
Your property management company will collect all of the leases of the current residents at the apartment community and perform an audit. They will analyze each lease, recording the rents, security deposits, concessions and terms. Then, they will compare the information gathered from the leases to the rent roll provided by the owner, recording any discrepancies.
Unless the current property management company was extremely incompetent, the discrepancies should be minor, if there are any at all, and it should affect your financial model.
5 – Unit Walk
A question my apartment syndication clients ask a lot is “when I am performing due diligence, do I need to walk every single unit?” The answer is a resounding yes! And that is the purpose of the unit walk report. It is the inspection of each individual unit at the apartment community.
During the unit walk, your property management company will inspect each individual unit. The purpose of the unit walk is to determine the current condition of each unit. So, while conducting the unit walk, they will take notes on things like the condition of the rooms, the type and condition of appliances, the presence or absence of washer/dryer hookups, the conditions of the light fixtures, missing GFCI outlets, and anything else that stands out as a potential maintenance or resident issue.
Once you receive the unit walk report, compare the results to your interior renovation assumptions to determine the accuracy of your interior business plan.
Do the number of units that require interior upgrades match your business plan? Is there unexpected deferred maintenance that wasn’t accounted for in your budget? Are there a high number of residents who will need to be evicted once you’ve taken over the operations?
Using that data, you can create a more detailed, unit-by-unit interior renovation plan and calculate a more accurate budget. Make any adjustments to your interior renovation assumption on your financial model.
Most likely, your property manager will perform the market survey, lease audit and unit walk report, and they will usually do it for free. However, ask the property manager how much they will charge you for these three reports if you do not close on the deal. And if you have to hire a 3rd party to create these three reports, the cost is approximately $4,000.
6 – Site Survey
A site survey shows the boundaries of the property, indicating the lot size. It also includes a written description of the property. The report resembles a map.
There are a lot of third party services that can conduct a site survey. A quick Google search of “site survey + (city name) will do the trick. I recommend reaching out to multiple companies to get a handful of bids for your project. The approximate cost for the site survey is $6,000.
The site survey report will list any boundary, easement, utility and zoning issues for the apartment community. Generally, if a problem is found during the site survey, the bank will not provide a loan on the property. So, if something does come up, your options are limited and should be addressed on a case-by-case basis. If the problem can’t be resolved, you will have to cancel the contract.
7 – Property Condition Assessment
The property condition assessment is the same as the internal property condition assessment, except this one is created by a third party selected by the lender. The cost is approximately $2,000.
Analyze this reports the same way that you analyzed the internal PCA. Then, compare and contrast the results of the two PCAs. Maybe the lender’s contractor caught something that your contractor did not, and vice versa.
8 – Environmental Site Survey
The environmental site assessment is an inspection that identifies potential or existing environmental contamination liabilities. It will address the underlying land, as well as any physical improvements to the property, and will offer conclusions or recommendations for further investigations of an issue is found.
The environmental site assessment is also performed by a 3rd party vendor selected by your lender. The approximate cost is $2,500.
Similar to the site survey, if the vendor identifies an environmental problem, the lender will not provide a loan for the property. Again, these issues should be addressed on a case-by-case basis.
9 – Appraisal
The appraisal determines the as-is value of the apartment community.
An appraiser will inspect the property, and then calculate the as-is value of the apartment community. The two appraisal methods that will be used to determine the value of the property are the sales comparison approach (i.e. comparing the subject property to similar properties that were recently sold) and the income capitalization approach (i.e. using the net operating income and the market cap rate).
The appraisal report is created by an appraiser selected by your lender. The cost is approximately $5,000.
Once you receive the appraisal, you should compare the appraised value to the contract purchase price. The lender will base their financing on the appraised value, not the contract price. Therefore, if the appraisal comes back at a value higher than the contract price, fantastic! That’s essentially free equity. However, if the appraised value is lower than the contract price, you will have to either make up the difference by raising additional capital or renegotiate the purchase price with the seller.
10 – Green Report
The Green report is an optional assessment that evaluates potential energy and water conservation measures for the apartment community. The report will include a list of all measures found, along with the associated cost savings and initial investment.
The report is created by a 3rd party vendor selected by your lender. The approximate cost is $3,500.
The green report, which is the only document that won’t disqualify a deal, will outline all of the potential energy and water conservation opportunities. It will list all of the opportunities that were identified, the estimated initial investment to implement, the associated cost savings and the return on investment. Deciding which opportunities to move forward with should be based on the payback period and the projected hold period of the property.
For example, following energy efficient opportunities were identified at an apartment project my company had assessed:
- Dual pane windows
- Wall insulation and leakage sealing
- Roof insulation
- Programmable thermostats
- Low-flow showerheads and toilets
- Interior and exterior LED lighting
- Energy Star rated refrigerators and dishwasher
After analyzing the investment amount and cost savings, the opportunities we implemented, and the associated savings and payback periods were:
- Low-flow showerheads: 1-year payback, $16,827 annual savings
- Exterior LED lighting: 14.4-year payback, $3,236 annual savings
- Pool cover: 1.5-year payback, $409 annual savings
The reasoning behind the low-flow showerheads and pool cover was that we planned on holding the property for 5-years, so once we paid back the initial investment amount, it was pure profit. We ended up losing money on the exterior LED lighting project. However, we installed these lights to increase resident safety.
You will find that the green report will list ALL opportunities, even if the payback period is absurdly long. If we implemented all the opportunities identified in the example above, the overall payback period would have been 91.9 years, with the longest payback period being 165 years for the Energy Star rated dishwashers. Unless we decided to hold onto a building until we died or unit they’ve discovered an immortality serum, we will stick to the opportunities that either result in a payback period lower than our projected hold time or address a resident safety concern.
How to Pay for the Due Diligence Reports
Usually, the costs of the due diligence reports will not be due until closing. So, when underwriting the deal, make sure you are taking these costs into account when determining how much equity you need to raise.
Other times, you will need to pay for a due diligence report upfront. If this is the case, you can do one of two things. You can come out-of-pocket and reimburse yourself at close. Or, you can take a loan from a third-party (maybe one of your passive investors) and reimburse the initial loan amount with interest at close.
Review the Results of Your New Underwriting Model
Based on the financial document audit, market survey report, lease audit report and green program report, you either confirmed or updated your income assumptions. Based on the financial document audit, you either confirmed or updated your expense assumptions. Based on the two property condition assessments and the unit walk report, you either confirmed or updated your renovation budget assumptions. Based on the appraisal report, you either confirmed the accuracy of the purchase price or determined that you have the property under contract at price that is below or above the as-is value. And based on the site survey and environmental survey, you determined if there is anything that disqualifies the deal entirely.
Once you have received the results of all 10 due diligence documents and made the necessary adjustments to your underwriting model, you need to re-review your return projections. If you had to make drastic changes to the income, expenses or renovation budgets in the negative direction, then the new return projections will be reduced. In some cases, the return projections will be reduced to such a degree that the deal no longer meets the return goals of you and your investors. Also, if an issue came up during the site survey or the environmental site assessment, which is rare, it will need to be resolved prior to closing. If the seller is unwilling or unable to address these issues, your lender will not provide financing on the property, which means you will have to cancel the contract.
If the updated return projections fall below your investor’s return goals, adjust the purchase price in your underwriting model until the projected returns meet your investor’s goals again. Then, explain to your real estate broker that you want to renegotiated the purchase price and state the reasons for doing so.
If the seller will not accept the new contract terms, don’t be afraid to walk away from the deal. At the end of the day, it is your job to please your investors, which means providing them with their desired return goals.
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