In order to analyze the investment suitability of a multifamily apartment, investors will need to conduct and rely on specific inspections, assessments and reports. In this series, I’ll list six as a basic due diligence checklist that investors, as well as most lenders, will and should use to ensure the deal is a good one.
Market Study
A market study, sometimes also referred to as a market survey or a market report, analyzes the subject property’s market and submarket in order to help determine the property’s estimated occupancy level, market value, absorption time, and other data. The study, which is also generally conducted and provided by a third-party real estate consulting firm or data aggregator, will additionally examine market trends such as housing need, local multifamily rents, supply and demand, and other market conditions which could impact the property’s long-term profitability. With regard to lenders, it’s important to note, for some types of multifamily loan product, such as a HUD 223(f) loan, a borrower may need to use an approved third-party consultant. Be sure to ask your mortgage broker or lender for guidance on this as a requirement.
Financial Audit
A financial audit is when the investor and/or a third-party service and lender will investigate the property’s financials. This audit includes the examination of the property’s trailing 12 months of income and expenses (T-12), the last 3 years of the profit and loss statement (P&L), and an in-depth rent roll/lease analysis. Ultimately, the information will accurately show the property’s profit capabilities, as well as help craft a prediction of future operation performance. During this Covid pandemic, it would be prudent to mitigating investment risk to look at each aspect of every lease, including the tenant billing schedules, unpaid or late payments trend renters, and units leased at a discount or given freely to a property manager.
Appraisal & Unit Walk
Perhaps the most important part of the due diligence process, an appraisal attempts to estimate the market value of a multifamily property. This will typically need to be conducted by a professionally licensed appraiser who is licensed in the area where the property is located. The appraiser will generally use several methods to price the property, including looking at the property’s NOI (Net Operating Income) and DSCR (Debt Service Coverage Ratio), as well as comparing it to similar multifamily properties in the local area. If an appraisal comes significantly below the asking price for the property, you (and your lender) may want to think twice about moving forward or retrade (renegotiate the sales price) the deal.
No matter how great a property appears to be on paper, a physical look should always be completed. A unit walk allows an investor to look at the physical condition of each unit to assess potential issues and problems that otherwise may have been missed. As an efficient use of the time being spent, jot down ideas and plans for possible upgrades and value-add improvements while touring the units and grounds.
Property Condition Report
A property condition assessment (PCR), sometimes referred to as an engineering report, or a capital needs assessment (CNA), is a third-party report that examines the current condition of the property and how much it will cost to maintain it, cure deferred maintenance, and to replace aging building parts when they require it. It can also be utilized to help calculate replacement reserves, funds that are set aside for future property repairs (and required by certain lenders). Specific PCRs are generally required for Fannie Mae and Freddie Mac Multifamily loans, as well as for HUD multifamily loans and other lending institutions.
Title Report & Site Survey
A title report is required by multifamily lenders in order to determine the legal status of the title of the property. It helps to ensure there are no competing legal claims to the property from past owners, their spouses, other lenders, relatives, or parties that have previously worked on the property and put a mechanics lien on it for non-payment. A title report is also generally required to get lender’s title insurance, which most lenders require, as well as owner’s title insurance, which most investors should generally consider purchasing. In most cases, title reports (and title insurance) require an investor/borrower to first order a site survey of the property, which confirms the exact boundaries of the property and lot size.
Green Report
This is not necessarily a required report, but as an investor that wants to maximize the highest profitability of any potential purchase, I recommend it. A green report will identify ways to increase the energy efficiency and money saving opportunities hidden within a property. These include, but are not limited to, special windows, roof or wall insulation, new thermostats, LED lighting, and energy-efficient appliances. For example, replacing vintage toilets with water conservation grade ones could potential lower the water bill by 40%. Be sure to ask the third-party service provider to include in the report a cost and the RO of each upgrade; ROI meaning the time it would take for it to pay for itself in the form of energy cost savings.
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