As a syndicator and passive investor, it is important to know what to do once you find a deal. Today Joe and Theo explain the first parts of the due diligence process with apartment communities. For passive investors, you’ll want to know what your sponsor has done and see their findings in the due diligence as well as see their business plan for the apartment community. As a syndicator of apartment communities, it is important to not only perform the due diligence, but also be able to effectively communicate what you found to your passive investors. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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Mentioned in this episode:
YouTube: 10 Documents Required When Performing Due Diligence on an Apartment Building
YouTube: Costs for the 10 Due Diligence Items for an Apartment Building
Podcast: JF1116: How to Perform Due Diligence on an Apartment Building #FollowAlongFriday
Podcast: JF1130: Costs For The 10 Due Diligence Items For Apartment Buildings #FollowAlongFriday
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TRANSCRIPTION
Joe Fairless: Best Ever listeners, how are you doing? Welcome to the best real estate investing advice ever show. I’m Joe Fairless, and this is the world’s longest-running daily real estate investing podcast. We only talk about the best advice ever, we don’t get into any of that fluffy stuff.
We’re doing Follow Along Friday. It’s a three-part series, and this is part one of three. Theo, how are we kicking it off?
Theo Hicks: As Joe said, this is will be part one of three, and what we’re gonna talk about is the entire process, starting from once you secured the contract for an apartment deal as an apartment syndicator, up until the close. So for kind of high-level, we’re breaking it down into three distinct parts. Today we’re gonna be going over the due diligence process, and then next week or the next Follow Along Friday we’ll be going over the financing, and then the third part will be about securing private money from investors.
If you’ve been a loyal listener of this show, it was actually back when me and Joe were together in front of that background, we went over in detail the ten different due diligence reports that you need to obtain… So if you need a refresher on that, the title of that YouTube video is “10 documents required when performing due diligence on an apartment.” We’re gonna touch on each of those reports, but we went into detail on how to find those, how much they cost, things like that, in the last episode.
Joe Fairless: Do we know what number that is?
Theo Hicks: I’m not sure. Grant, if you’re listening, if you can go find that and toss that in the comments of the Facebook Live, I’d appreciate that, and then we’ll put it in the show notes of the podcast as well.
So before we go into how to actually review these documents once you’ve obtained them, we wanted to quickly talk about how you actually pay for these things. Joe, do you wanna just kind of explain briefly how to pay for these actual due diligence documents?
Joe Fairless: Sure. With all the documents, you will compensate the vendor at closing. There might be a local vendor who requires payment upfront; that’s not typical. What’s typical is that for everything you’ll compensate the individuals who do the inspections, out of the proceeds from closing. Perhaps your real estate attorney, if you’re working with him or her for the first time, will want some sort of retainer upfront, but more likely they’ll want to be compensated every month, they just bill monthly, so you might have to pay a month or two worth of fees, or they would agree to simply be compensated at closing; especially if you’ve worked with them before on anything else, they should be fine with that. And though the compensation comes from the equity that you bring to the deal, so you allocate equity for the closing costs, and that is what is used to compensate the individuals and the companies who do these reports.
Theo Hicks: Perfect. If you were to come out of pocket for any of the things up front, you will be reimbursed for that at the closing, as well. Okay, perfect. So how do we review these reports?
Basically, when you’re underwriting a deal before putting it under contract, none of the assumptions you’re making are based on the T-12 (trailing 12) expenses and the rent roll that the real estate broker or the owner sent you. Obviously, that’s all you have, that’s what you’ve used to make those assumptions. Once you’re doing the actual due diligence, you’re going to essentially go in there yourself through a vendor to look at the actual on-the-ground each of the individual units, as well as all of the financial documentation to finalize your assumptions.
So one of the first things that you’re gonna do during due diligence is finalize your income and expense assumptions. The two reports that you need for that are the financial document audit, and the lease audit report. As a refresher, the financial document audit is a consultant that will go in there and look at all of the actual hard financials of the property to determine what the various revenue and expense data actually are, and then they’ll send you a report that basically compares what they found to the budget that you created. If there any discrepancies, they’ll explain why, or if there are reasons why something went up or something went down, they’ll have kind of a written explanation. The report will come in a PDF form, but there will be data tables that will say your budget, their budget, any notes that they put on it…
So you wanna use that and kind of review this with your property management company and go and look at your underwriting assumptions, and go line item by line item and compare to what this audit discovered to see how accurate your assumptions are.
For example, let’s say the maintenance assumption is $25,000 a year, and that’s what you got from the T-12 or based off of the market range of expenses, and they get the financial document and they discover that maybe the owner included some maintenance expenses as capital expenditures or something, and they’ll say “Oh, it’s actually $30,000/year.” In that case, it’ll kind of be up to you to determine with your property management company if you’ll need to increase that cost. That’s the financial document audit.
The other one is the lease audit report, where essentially your property management company goes through every single lease and looks at the terms and the language of the lease. For this particular aspect of the review and to kind of finalize these income/expenses; you’re gonna make sure that the actual rent and any other types of fees that are being charged, like carports or whatever, match up with the rent roll that you used during the underwriting process. Usually it does, but if it doesn’t, that’s something else that you’ll need to update as well, because obviously, if the rents are different, then the income is going to be different after you take over the property.
So that’s the first part, to finalize your income and expense assumptions. Anything about that, Joe, that you wanna talk about?
Joe Fairless: Nope, all good.
Theo Hicks: Perfect. So the next important part of the process – this is assuming that you’re going to be performing some sort of renovations – if you’re a value-add investor, like Joe, you are going to create a renovation budget during the underwriting process. If you have experience underwriting, you’ll be able to essentially just look at a unit and determine “Is it gonna be $4,000 to update this to what we want? Or $7,000?”
I know for our underwriting and the types of deals that we look at it’s generally between 4k and 7k for a unit, depending on the condition and how high of a value-add we’re gonna do. But you want to, of course, finalize this and get the actual numbers during the due diligence process.
The two reports that you need for this — I guess it’s technically three… There’s the property condition assessment, which you’ll have a third-party contractor perform, and then also the lender will perform their own. Basically, what that’ll do is the contractor will walk the building and they will break apart the conditions into three different categories. It will be anything that’s immediate repairs, recommended repairs, and then continued or ongoing replacements.
This is kind of self-explanatory. The immediate are things that need to be replaced right away, either right when you take over the property or before you even buy it. Recommended repairs are things that you don’t necessarily have to do, but are recommended by the contractor, and then ongoing repairs would be things that “Okay, the roof has got a life of 20 years, and you’re at the 15-year mark, so expect to have to replace the roof within five years.”
So this PCA is more for the exterior of the property. I’m not so sure if they actually walk through each individual unit… So this is the report that will help you finalize your exterior budget, so HVAC, siding, roof, lights, parking lot, things like that.
Joe Fairless: Every unit is walked through, and I’ll also say on the first part and on this part, you’d mentioned initially it’s on the T-12, so you’re making sure it lines up with the T-12… But then also, in addition to the T-12, you’re making sure it lines up with your assumptions that you have in place for where you can take the property in the future. So in addition to the T-12, it’s also helping verify that the renovation premiums are able to be achieved. And in this category in terms of looking at the units, we’re looking at the units, we’re seeing how much work is needed to be done currently, but then also we’re keeping in the forefront of our mind where we wanna take the property and these units relative to the rent comps that we’re going to be competing against in the future, and make sure that those cost assumptions are lining up.
Theo Hicks: That’s exactly what I was gonna do next… The second report that you need to look at for the renovation budget – again, as you’d mentioned, this also ties into the rental premiums that you want – is the unit walk report. That’s when the property management company literally walks through every single unit, and depending on the property management company, they’ll have essentially their own checklist of what they’re actually going to look for.
So they’ll look at the condition of the appliances in the kitchen, the plumbing in the bathroom, they’ll look at the conditions of the floors, the carpets…
Essentially, an extreme overview of the actual unit, as Joe mentioned, looked at 1) deferred maintenance, so if there’s anything that needs to be fixed up front to either make that rent-ready if it’s vacant, or something that you know you’re gonna have to fix once that unit turns over… But secondly, you’ll also want to log information to determine what you need to do to that unit to bring it to the level that you want to get the rental premium that you want.
For example, a unit doesn’t need any deferred maintenance, but your plan is to put in new floors, put in backsplash in the kitchen, put in stainless steel appliances – this is an example – and every single unit has black appliances, has vinyl floors or something and no backsplash, then technically that’s not a maintenance issue, that’s a renovation. So that’s where that unit walk report will help you determine exactly how much money you’re gonna need to spend per unit in order to bring it to rent ready, and then to bring it to the actual level of upgrade that you want to get the rental premium that you want.
On that same note, I’ve kind of combined together actually how to figure out these rental rates – there are a few ways to do this while you’re underwriting. One way is to do a full rental comps yourself; that would be finding not recent sales, but finding similar apartments in the immediate area that are renovated to a similar degree, they’re built around the same time, they have the same type of operations in the sense of they all have the utilities paid by the same entities, so either the tenants or you… And you’ll look at the rents for those, and compare them to the rents that you currently have to determine what your rents will be once you’ve gotten to that level of upgrade.
But if the current owner has already performed some upgrades that you planned of just replicating, you can use their proven rental assumptions… That means that they have recently upgraded these units. It’s not like they upgraded one unit that year and then they’ve gotten it to rent, and you say “Oh, well everything is gonna be like that.” It has to be they’ve renovated 10-15 units, and probably even more than that, Joe… How many units would you say they would need to have renovated in order for it to be termed as a proven model?
Joe Fairless: It’s usually not necessarily a specific number, it’s more of a percent. I’d say 10% would be the minimum. My ideal scenario is buying from a seller who has renovated 15%. That’s certainly proven the model, and there’s certainly a whole lot left to add value to, unless I’m incredibly familiar with the submarket, and if that’s the case, then 0%. I don’t care if they’ve proven the model, because I already know the units can get a rent premium, so I want to be able to realize all of that additional value through the work that our team does.
Theo Hicks: Yeah, so it’s enough for it to be proven, but not too much that they’ve already done too many renovations that you’re not gonna be able to get that value-add play.
Okay, so that’s a second way to determine the rental premiums – proven rental premiums. Then the third way is kind of a hybrid… Let’s say you are buying a property that they had done some renovations to, but you wanna go above and beyond that when you buy the property. Then you can use the proven rental comps to figure out the baseline of what you can get if you replicated what they did, but then you also need to look at actual rental comps or other properties in the area that have similar units to what you plan on doing above and beyond them, in order to determine what the rental premiums are going to be.
So those would be the three ways to do it prior to the due diligence process, and that’s how you get your rental premium assumptions. In order to confirm them, you’re gonna use the market survey report, which is a detailed rental comp that is performed by your property management company.
So they essentially do the same thing that you did, but since they have access to the MLS, they can run an automated report to provide you with a detailed PDF file of all of the different apartments that they used, and the upgrades for those buildings, and then the rents that they’re able to get, and then you can compare that to what you plan on doing… So to confirm or change your rental premiums. So that is the third aspect of the review.
The first is finalize your income and expenses, second is to finalize your renovation budget, third is finalize your rental rates. The last one is to confirm the property value. So you have submitted an offer at a certain price, and generally speaking, the lender is not going to loan just based off of that purchase price; they’re gonna loan based off of the actual value of the property, and that will be based off of the appraisal. The lender will have their appraiser going there and appraise the property. Do they do the cost approach, and then the sales comparison approach, Joe?
Joe Fairless: Yeah, they do the sales comparison approach and the income approach… So how much income does the property generate, and then based on sales comps, what’s the valuation of the property that way.
Theo Hicks: Exactly. And so you need to [unintelligible [00:15:26].24] because that’s what that lender is gonna use when they’re loaning on the property… So that might throw everything off if the appraisal comes back at, let’s say – I mean, an extreme example is a million dollar lower than your purchase price… Where are you gonna get that million dollars from, and how is that gonna affect your actual returns? So that’s something that the lender will have someone going there on their report for you, it will do two different approaches, and then they’ll basically spit out a value for you that the lender will use. I’ll go over at the end what you actually do if something in your underwriting changed. I just wanted to hit on the last two categories.
So finally, on the fifth one, is you wanna look at the site survey and the environmental survey to see if there’s any deal breakers, basically. These are things that if there’s an environmental issue, like there’s a massive gas tank buried in the backyard or something… I think I heard a story about an apartment built on a location where there used to be a gas station, and there were gas tanks underneath… And obviously, that’s something that needs to be addressed before you’re buying the property, because the lender is not gonna give you a loan for that type of property.
And then the same for the site survey, if there’s something wrong with the boundaries, or something… Those are all things that are going to essentially disqualify you from getting a loan, so unless you’re planning on paying for the property with all cash, that’s something that either the owner needs to address before selling it, or the deal is just not gonna be able to happen at this moment in time.
So those are just two reports that basically are just kind of binary – it’s either gonna pass, or it’s gonna fail. If it failed, will the seller fix it, or is it even fixable, or are you just gonna have to pass on the deal?
And then lastly you’ve got two reports that are essentially value-add reports – you’ve got a green program report, and then you’ve got the RUBS program report. With the green program – an environmental consultant will go in there and analyze the property to see if there’s any energy saving measures that could be implemented. For example, could you put in low flow showers and toilets? Those are things that I know you guys usually do, because the ROI is really high. Something as simple as putting on a pool cover will save you a lot of costs… And there’s other things that will have the ROI for implementing this; so it requires an investment, and there’s a cost saving associated with that investment.
If it’s five years, or three years and your business plan is five years, then of course it’s something you wanna do. I know I was looking at one of the green reports and it was like “Put in energy-efficient dishwashers”, and your ROI is like 96 years, or something like that. Obviously, that’s probably not something that you wanna do unless you’re putting in dishwashers for different reasons… Or you’re putting in stainless steel dishwashers in order to demand a rental premium.
That report will be broken out, you’ll look at that and look at the ROI, and then figure out what you want to do and what you don’t wanna do.
Something else that you wanna take into account for this is if there’s anything safety-related… For example, I know you guys will put exterior LED lights, that necessarily don’t have an ROI that’s within your hold period, but it also increases residence safety with having spotlights outside of the units… So that’s something else you wanna take into account – the cost savings, but also “Will this increase the safety?”, because that’s something that will indirectly affect the demand of your property.
Joe Fairless: Yeah.
Theo Hicks: And then the other one is the RUBS program. Sometimes you buy a property and this will already be done, but if it’s not, this is something that you wanna get a contractor out there to analyze the property to determine how much of the utilities you can bill back. So the RUBS program is essentially a bill-back program where it’ll determine how much of the utilities are being used per resident, and then you’ll be able to bill that back to the resident and that will be essentially another income that you’ll be collecting.
So the green report and the RUBS program are two things that are kind of like value-add reports. As far as I understand, they’re not required, but they’re something that you want to do in order to add that extra value to the deal.
Joe Fairless: And with the RUBS program it’s basically a rent increase for your residents, so you’ll want to know what the competition is doing, and if they’re not doing it, then keep that in mind, that it will be more dollars out of pocket for the residents, so make sure that your market is strong enough. By strong enough, I mean has a low vacancy for your submarket, so that if you do have the resident turnover, you can bring in other residents who will be paying the bill-back for the utilities.
Theo Hicks: And that vacancy number – that will be included in that market survey report that your property manager will do. So just to summarize, first you finalize your income and expense assumptions by looking at the financial document audit report and the lease audit report. Then you finalize your renovation budget from the internal property condition assessment and the unit block report, finalize your rental rates from the market survey report, and as you mentioned, you need to pull the vacancy from that for the RUBS.
You will confirm the property value with appraisal, you will see if there’s any deal breakers on the site survey and the environmental survey, and then you will review the green program report and the RUBS [rewbs] report to see…
Joe Fairless: RUBS [rubs]
Theo Hicks: RUBS [rubs]… What am I saying, rewbs?
Joe Fairless: Rewbs, you’re talking real fancy.
Theo Hicks: to see what additional value can add. So at this point let’s say for example you unit walk report and you realize that your interior renovation budget is gonna be $1000 more per unit than you expected… So you’ll go back to your financial model and you’ll type in that increase, and then let’s say your returns – whatever the returns that you’re looking at for your investors, like cash on cash return during the hold period if it’s an IRR number, and let’s say that dips below… Let’s say you were projecting an 18% for an IRR, and it gets down to 15% IRR.
At this point this is something where you will have to renegotiate the purchase price. So at this point after you reviewed all these documents, that’s when you get with your real estate broker to have a conversation about renegotiating the purchase price. And again, the seller might accept that, they might counter, or they might say “No, I’m not doing that. [unintelligible [00:21:29].23]”
So when you obtain your actual contract, there will be a due diligence timeline, and during that due diligence timeline, basically the deal is contingent on the due diligence… So as long as there is that contingency in the contract, you are able to back out if it’s within the specified timeline that is on the contract that you and them agreed to.
So you want to make sure that 1) you get these reports done within the timeline; 2) you reviewed them in time, and 3) you’re able to negotiate that purchase price before the time expires.
That is essentially the part one of what happens once a syndicator — either you as a passive investor wanting to understand the syndication process… It is part one of three parts of what this indicator will do between the contract and close.
Next week will be going into the [unintelligible [00:22:19].04] process of securing financing from the lender. So is there anything else you wanted to talk about about the due diligence before we move on, Joe?
Joe Fairless: No, I just wanted to thank you for walking us through that. It was very thought out and methodical, and certainly a question that we get frequently, so I’m glad that we addressed it. Thanks a lot.
Theo Hicks: Awesome. So do you have any updates?
Joe Fairless: Yeah, real quick updates… Let’s see. We’ve got 890 units under contract. We’ll be closing in the next months – June and July – on those properties; it’s in total three properties. We are continuing to do the due diligence, as you just described, on those properties, and then we sold the property earlier this month, and we’re selling another property this coming Monday. We’ll be doing some 1031 exchanges on both of those deals, so we are in the process of looking for exchange properties for those two deals… So very active, and most importantly, we are keeping our head down on the existing portfolio that we have, and focusing on the performance of those… Really focusing right now on generating online reviews; just an area of focus that we have, so we’re doing some residence community events, encouraging them to write reviews, having laptops at those events for them to do so. I am excited about what we’ve got going on right now and where we are headed.
Theo Hicks: Congrats on the sale, and congrats on the two new properties under contract. Maybe we’ll have a recap where we’ll talk about that one specific deal, taking a full cycle and any lessons that you learned from that.
Joe Fairless: Yeah, that’s cool.
Theo Hicks: Alright, so just to wrap up, make sure you guys check out the Best Ever Community on Facebook (that’s at BestEverCommunity.com) in order to answer the question of the week, to be featured in the blog.
This week’s question – and hopefully Joe likes this one a little bit better – is “What is your process for staying up to date on the national real estate market and your local real estate market?” So ongoing-wise, what types of reports are you looking at, what types of articles, new sites, are you going to actual events to keep up to date?
For me personally, what I do – I got this from Joe – is Google Alerts. I have a Google Alert set up for my city plus the word real estate. I have one set up for apartments, for multifamily, and for unemployment, and I think I have one for jobs, too.
And then, I’m not sure they have this in every single city, but I have the Biz Career newsletter sent to my inbox. [unintelligible [00:25:03].08] That’s actually a really great resource for local developments in business. Unfortunately, you have to pay; I think it’s $100/year, but the money is totally worth it, and I think if you do that, you get newspapers sent to your house at the same time.
Then for a national level I look at a variety of commercial real estate reports. I’ve got the acronyms for them, so I don’t know exactly what these stand for, but I’ve got the CBRE biannual Cap Rate Report, there’s a RCLCO quarterly report, which is just the state of the real estate market for that past quarter; the IRR Trends, the PWC Trends, and the Marcus & Millichap Forecast. Those three will be things that are forecasts or trends for that actual coming year.
If you just google “CBRE biannual cap rate report” it will come up; you don’t need to know exactly what that stands for at this moment in time.
Joe Fairless: I do stuff similar to what you mentioned, and the only thing I’d mention in addition to that is the majority of our portfolio is in Dallas-Fort Worth, therefore I have a paid subscription to the Dallas Morning News, and on my phone I have a little shortcut to the business section of the Dallas Morning News, so I can just click that and then I get all the latest business news. I’d say 25%-30% is real estate related, so that keeps me up to date on the DFW market in particular.
Theo Hicks: A hack I discovered on that Dallas website – you only get like a couple of articles before you have to pay for it… If you type in the URL and when it terminates the download you hit the Stop loading button, you can just read the entire report without having to have a paid subscription or anything. That’s just a hack; it may not work on every single one, but that’s just something that if you guys need to see the report, you guys can do that.
The last thing that we’re gonna talk about is the Review of the Week. This week’s review is from Eric. He says:
“Joe, who is typing during your podcast? Tell the amateur to stop.”
Joe Fairless: And now it’s gonna be “Who’s got the barking dog in the background during your podcast?”, and that’s gonna be Theo, that’s his fault… So it was not a friendly review, it was a review of feedback, that’s for sure. So just to read it again, in case Theo’s puppy dog, who’s barking at something, he couldn’t hear it… Eric says — and this is all caps, by the way:
“JOE, WHO IS TYPING DURING YOUR PODCAST!? TELL THE AMATEUR TO STOP.”
So what happens when we get this type of feedback? One, I ask “Can it serve me?” and absolutely, it can serve me. The execution of the feedback – I don’t like it; I don’t like how they were very aggressive, but I appreciate them caring enough about listening to the content that they’re upset, seemingly – since it’s all caps – about the quality, so that I wholeheartedly embrace.
Anytime I get feedback like this, whether it’s about the podcast, or real estate, or whatever, I first think to myself, “How can it serve me? How can it serve the greater good for what we’re doing?” That’s why I chose to select this review as our review of the week… Because it certainly was not a review on iTunes; this was an e-mail, actually, through my website.
So 1) who’s typing? It was me. 2) Most importantly, I have purchased a quiet keyboard, and it is being delivered today, so that should not be a problem anymore. And then also, I had our editor come by yesterday, and he worked with me on some sound settings, so that the sound will be enhanced. So Eric, even though I don’t like your execution on how you sent me a message, I appreciate your passion for the show and I’m grateful that you’re a loyal listener, and more importantly, I’m grateful that you called out something that needed to be fixed.
I also have implemented a process within my team, so that we can catch this stuff internally and it doesn’t get to the point where it upsets people. So thank you for your feedback, and we have it addressed. That should be fixed in the future.
And also, there are things that come up on a daily podcast… Even though we’ve done about 1,400 episodes, things still come up where we have to enhance the process. For example, today and our connection was cutting out throughout our conversation, so now a next step I’m gonna take is I’m gonna talk to the team and get something fixed on my computer. It might not happen for the next week, but it will get fixed.
I appreciate all the comments, and if you are enjoying the podcast, then please a review on iTunes; that will be very helpful. If you do have feedback for how we can continue to enhance the experience for you as a Best Ever listener, then feel free to give that as well via personal message; don’t put that in iTunes, we don’t wanna hear that in iTunes. Just do a personal message, we’ll get it fixed, and then you can write the review in iTunes. I think you can e-mail info@JoeFairless.com for any of that feedback.
Thanks again for spending some time with us. I hope you got a lot of value from this conversation, and we’ll talk to you soon.
