Thanks to attorney and multi-family investor Charles Dobens for this excellent and insightful article on due diligence, which we found on the MultiFamily Insight Blog:

“What is the biggest mistake new investors make in multifamily due diligence?  Due diligence is where many new investors start to go astray.  They find a deal, make offers, get an offer accepted, put it under contract and then start the due diligence process.  During the due diligence process their entire focus is centered around the real estate. They interview and negotiate rates with property inspectors.  They set up a date and time that they will go through each and every unit looking for the most egregious example of poor management so that they can go back to the seller and negotiate a repair allowance.

“The owner of a bad property will see this coming a mile away and be prepared for it.  They will inflate their purchase price to make you pay the repair allowance WITH YOUR OWN MONEY.  They will play hardball with you and structure the terms of the repair allowance such that the dollars come out of the deal in an in-kind transfer and not in cash.  You, at the end of the day, end up with a property that has a list of needed repairs and no cash to fix it.

“But that is not where your focus needs to be.  Here’s where the new investor goes astray.  After the property inspector has completed his task and submits his beautiful 100-page report that you pay for, you will review it and look at the last page that gives a dollar amount as to the needed repairs.  You then go back to the broker and open the negotiations all over again and I can assure you, they are lying in wait for you to return.

“But the problem with this over-dependence upon the inspection report is that, no matter what the inspector finds, it can be fixed with one thing – Money.  Just name your price and the roof is fixed. Get three bids and the foundation is fixed.  The brokers focus, along with yours and everyone else is on the real estate.  This is exactly where you should not be focused. 

“What business are you in? Real estate or multi-family?  You are in the multi-family business. What generates revenue in the multi-family business? The factory or the product?  The product, or in our case, the leases, is what generates revenue.  How much time and money have you spent up to this point in the due diligence process analyzing the value of the leases?

“See, when you show up with your inspector and walk the property with your clipboard and flashlight, the real deal is not going to be found in the units. The real deal is going to be found in the filing cabinets in the manager’s office. That is where you should be spending the majority of your time.  Now don’t get me wrong, you will still need to do a complete and thorough physical inspection. But that should be secondary to your “product” analysis.

“Why is this so important?  Because you need to understand the types of things that can destroy your business overnight.  Hurricanes, tornadoes, floods?  Nope, you can buy insurance to protect you for those events and in some cases, you might end up better off.  Leaky roofs, broken pipes, appliances that don’t work?  Nope, those happen all the time and it just takes money to fix.

“What can destroy a property faster that a property inspector never finds?

“So what can destroy your business overnight and that can’t be fixed with money?  The answer, just so we can keep it in the business realm, is bad customers.  More specifically, felons, drug dealers and those convicted of violent crimes.  Nothing can clear out a nice apartment complex faster than the news that a sex offender has just moved in.  Not only will you lose existing customers, your property will quickly get the reputation as being the place where felons can go and live.  That is the kiss of death for any property.

“Let’s discuss the repair allowance. What do successful people do?  Successful people do those things that the rest of the world won’t do.  In this case, the seller is expecting you to come back with a list of items that shows all the things wrong with the property.  He is seeing you coming a mile away because he played the same game when he bought the property.  In addition, his broker is preparing him for it and they have already strategized with a response.

“But you are not like all the other investors.  You look at this business as a business.  You look at the strength of the customers as the strength of the asset and you will negotiate accordingly. When you complete the inspection and set up a meeting with the broker to review, you will have two sets of reports.  The first one will be the property inspection report. That will have a dollar figure at the bottom.  The broker will nod his head, let you know that he will present this to the seller and then ask the waiter for the check.

“This is where you distinguish yourself from every other investor.  “Not so fast, Mr. Broker, there is one more thing,” you say in your best Colombo imitation.  This is when you bring out your analysis of the leases.  This is where you show the broker that fifty percent of the files were lacking criminal background checks.  This is where you show the broker that there is no income analysis done on any of the residents and therefore the sales pitch that the rents are below market and can be increased is meaningless because there is no way to tell if the current crop of residents could even afford an increase in the rent.

“The broker will do one thing;  stare at you with the blankest look you have ever seen and wonder what comeback he could possibly muster.  He has done absolutely no analysis in this department so he will not have any facts on the table to respond back to you.  You will be in complete control of the deal.

“Let’s say just the opposite is true. After your analysis, you cannot find anything wrong with the resident files. They are completely up to date and accurate.  If that is the case, start getting serious about buying that property. It might be as good as you think.  I do spot reviews on my properties to make sure that the files are up to date. I review credit and criminal background checks all the time and make sure that everything is in order.  That’s the type of business you want to buy.”

BTW:  There’s a lot more insighful articles on the MultiFamily Insight Blog, take the time to visit and read more.  You’re welcome.