Due diligence on a property purchase is always critical — you never know what you will find

Dec 1

This is the true story of a 42-unit multifamily sale.

Our experienced sales team creates due diligence checklists for every transaction. The checklist process helps us with our consistency and helps our “buyer” clients get better results. Most of the time, as we work our way through the “due diligence” process of a property purchase, we find a few things wrong, have the seller address and remediate the issues, and move on to close the deal.

Recently, we were involved in a complicated transaction of an almost-new multifamily property with numerous issues. We organized property inspections, financial reviews, and surveys to help the buyer better understand the property. Of course, the buyer hired an inspector to complete a unit-by-unit property inspection as well as other specialized inspectors to check other property systems. What we found onsite really surprised us for a property that was only one year old and fully rented.

Property inspections

The inspector found multiple construction issues:

Failed windows (covered by a manufacturer’s warranty).
Some kitchen exhaust hoods in inoperable condition.
Bathroom and bedroom door handles not latching.
Leaking shower heads.
Uncompleted roofing.
Incomplete exterior painting.
Joist hangers missing for one hallway roof area.
Rows of young trees planted just about two feet away from the foundation and siding.
Property fence uninstalled on several sides of property lines.
Gutters not installed properly.
Gutters with a reverse grade.
Gutters installed without downspouts.
Loose downspouts not properly fastened against siding.

All items that could have been resolved before a property was listed for sale.

Financial review

In addition to the physical inspections, the financial review of the property was also very revealing. The current property manager was unable to find all of the rental agreements for the tenants, and their accounting team had difficulty delivering current financial statements and rent rolls that matched the lease agreements. There were many discrepancies in the financial statements.

The management company was fired by the seller during the due diligence time frame. Here are some examples of the property manager’s disorganization that made the buyer and the lender nervous:

Leases and rental agreements were missing.
Some security deposits could not be correlated to the financial statements.
Operating documentation and aging reports took weeks to obtain.
Could not find several contracts affecting the property, such as a monthly landscaping contract and maintenance contract for stormwater maintenance.
The discovery of several missing water invoices. A sewer line had been installed, but never billed for by the city. Turns out, there was no sewer account, and there were therefore no sewer bills! No one caught it. It took four months to get a monthly sewer bill from the city for the property (so we could include it in the underwriting and get a loan).
No onsite manager or offsite manager-rented units.

Replacing the property manager (a great call by the seller) put us on more solid footing with better accounting detail and controls.

Operations and underwriting

We approached this deal two times. The first lender made it impossible for us to meet the needs of the buyer and we walked away from the deal. A few months later, we tried again with a different lender. The second lender was easier to work with.

To get to the highest sales price, the seller increased the rents two months before they put the property on the market. This unfortunately created a significant tenant turnover and left us with vacant units that needed to be filled so the property would qualify for financing.

Lenders require a three-month look back at the rents and a review of the trailing 12 months of expenses to confirm that the current rents and expenses are sustainable. Given the recent rent increases and unit turns, that was difficult for the seller to deliver.

Other due diligence items

We completed a property survey and found that the fence lines were not lined up with the survey boundaries. We came to an accommodation with the Seller and purchased an extended ALTA title insurance policy to manage this risk.

The land for this project had been previously owned by a church. The back exit for the property ran over the church entry. Upon further research it became evident that the church and the property did not have cross easements and shared road maintenance agreements. Those needed to be drafted and recorded to allow us to get financing and care of those easements, driveways, drains and shared landscaping.

Summary

Because the banks were still so conservative, the buyer could not close with the terms they agreed to until the economic occupancy was at least 95%. Upon reaching the set goals, the property was successfully closed, and the buyer was finally able to meet all of their 1031 Exchange requirements.

The complicated transaction would have surely scared off an inexperienced investor. However, we all have to start somewhere, and it is in situations like these when it is so critical to have the right team with the right expertise, equipped and ready to negotiate on your behalf. The key to a successful real estate transaction depends on a thorough property evaluation, starting with financial reviews and preliminary title reports, extending to property inspections and level one environmental and property surveys, and ending with onsite visitations and interviews with operational staff. No steps should be skipped because an artificial timeline might force you to close quickly. Transactional due diligence is critical to successful long term property ownership.

Every property we make an offer on for our clients has some kind of issue. Either repairs are needed because items are broken or do not meet the current code, financials are not documented carefully, or there is environmental damage to the property. Owners and buyers of real estate need to prepare themselves for potential problems so they can properly mitigate and be aware of potential risks. A proactive seller might even hire a property inspector to find and make repairs before listing a property for sale. You might discover things you did not expect, but forewarned is forearmed and makes for better transactions and smoother ownership down the road. Skipping due diligence costs a buyer dearly when they find open issues that will directly affect their return down the road.

Clifford A. Hockley, CPM, CCIM, MBA

Cliff is a Certified Property Manager® (CPM) and a Certified Commercial Investment Member (CCIM). Cliff joined Bluestone and Hockley Real Estate Services 1986 and successfully merged that company with Criteria Properties in 2021.

He has extensive experience representing property owners in the sale and purchase of warehouse, office, and retail properties, as well as mobile home parks and residential properties. Cliff’s clients include financial institutions, government agencies, private investors and nonprofit organizations. He is a Senior Advisor for SVN | Bluestone.

Cliff holds an MBA from Willamette University and a BS in Political Science from Claremont McKenna College. He is a frequent contributor to industry newsletters and served as adjunct professor at Portland State University, where he taught real estate-related topics. Cliff is the author of two books, 21 Fables and Successful Real Estate Investing; Invest Wisely Avoid Costly Mistakes and Make Money, books that helps investors navigate the rough shoals of real estate ownership. He is the managing member of a real estate consulting practice, Cliff Hockley Consulting, LLC., designed to help investors and commercial brokerage owners successfully navigate their businesses. He can be reached at 503-267-1909 , Cliffhockley@gmail.com or Cliff.Hockley@SVN.com.