How To Conduct Due Diligence on a Multifamily Asset
Due diligence minimizes risk and uncovers rewards in multifamily property acquisitions.
After identifying a multifamily property for purchase and reviewing its basic information-such as construction date, unit types, and rent roll-what comes next? Whether it's your first or tenth acquisition, enhancing your due diligence procedures is crucial.
LoopNet consulted Jack Brundige, Chief of Portfolio Management at Waypoint Real Estate Investments. With over 28,000 multifamily units under management across the U.S., Brundige is an expert in assessing multifamily acquisitions.
Based on our conversation with Brundige, here are the top 10 components of the due diligence process for multifamily assets:
- Assessing the competitive set.
- In-person property tour.
- Know your residents.
- In-person tour of competitive properties.
- "North, south, east, west analysis."
- Conducting inspections and determining capital costs.
- Building a budget.
- Opportunities for revenue growth.
- Evaluating supply threats.
- Market stability versus volatility.
"I think a lot of people look past some of those subtle features [of the due diligence process] and it either bites them, or sometimes it's a missed opportunity," said Brundige.
Assessing the Competitive Set
Brundige explains that the process starts with understanding the property's submarket. Identify assets in the same area that were built around the same time and offer similar units and amenities. These comprise your competitive set. "Before visiting a property, I'll have the team analyze all information on comparable properties," says Brundige.
Analyze data on rental and occupancy rates, as well as concession packages like free rent or gift cards. Information sharing among property owners and managers is common, so obtain data from the property's management. This phase, called the "desktop analysis," is conducted remotely. The next step involves an in-person field assessment.
In-Person Property Tour
Once you've completed your desktop analysis, it's time to tour the property in person. Your review of the building should be focused on three primary elements: common areas, such as the lobby and hallways; amenities, like fitness centers and pools; and the units. For the common areas, you'll want to consider their general condition, functionality and cleanliness. Regarding amenities, Brundige advised that you should analyze how they are laid out and organized within the property, and consider the advantages and disadvantages of that structure.
While surveying the units, Brundige advocates evaluating them from the perspective of a potential renter. "How [do the] the units profile? How spacious are they? Do they have nice appliances? What do the countertop finishes look like? Do they have any deck [or outdoor] space?" These are the aspects of a unit that a renter experiences intimately each day and will determine how much they are willing to pay for that unit.
Multifamily Properties for Sale
Know Your Residents
After considering the property from a renter's point of view, Brundige counseled that you park yourself in the lobby or leasing office and see who the residents are and how they use the space. "It gives you a sense of who your resident base is," Brundige said. He added that this qualitative review should be, "followed-up with some more data-driven analysis based on information that the on-site teams have on the income profile of your residents." Existing ownership or management should also provide intelligence about the residents' employment background, as well as local employment drivers in the submarket.
In-Person Tour of Competitive Properties
After touring your prospective property, the next step is to review your competitive set in person. Assess these properties the same way you inspected your potential asset, focusing on amenities, common areas, and various unit types. Brundige notes that management personnel at competing properties are often willing to grant access for brief tours if you are honest about your investment intentions. After your tours, compare and contrast the attributes and challenges of each building with those of your property.
"North, South, East, West Analysis"
For the final phase of the in-person assessment, Brundige advised that you return to your prospective property and undertake a process that he refers to as the "north, south, east, west analysis." This, essentially, is an attempt to put yourself in the proverbial shoes of a resident at the property. Brundige said, "Start at your property and drive in all directions, walk in all directions; really try to experience what it would be like to be a resident at this property and what is attractive about it and what may be a detraction. Does it feel too far away from the grocery store? Is it cool that the park is across the street? Is it noisy?" Endeavoring to understand the resident experience at the property in this manner can give you a unique appreciation for the qualitative virtues and weaknesses of the property.
Conducting Inspections and Determining Capital Costs
After touring the property and assessing the local market, bring in third-party professionals for thorough inspections. They will examine the age of the roof, condition of mechanical components, potential tripping hazards, and flood and drainage issues. An environmental report is also necessary to identify any contamination on or near the property.
Based on these assessments and your analysis, identify anticipated capital costs for the near-term and over a five- to 10-year period. These costs may include necessary repairs and optional improvements to add value and enhance revenue. Brundige emphasizes evaluating upgrades in units and amenities to improve the resident experience and drive rental rate growth.
Verification of Profit and Loss Statements (T12)
Verifying the profit and loss statements (T12) is crucial for financial due diligence. The T12 provides a detailed breakdown of the property's financial performance over the past year.
To verify the T12, request bank statements and tax returns. Ensure the revenue and expenses in the T12 match these documents. If the seller cannot provide these records, consider the risk and adjust your offer accordingly. Hiring a professional accountant can also help ensure accuracy.
By verifying the T12, you confirm the property's actual financial performance, aiding informed investment decisions.
Building a Budget
Understanding ongoing operating expenses is crucial. Brundige cautions new investors against relying too heavily on existing operating expenses. "It's essential to look at that information but also do your homework," he advises. Ask questions and gather insights from industry contacts and local service providers.
When Waypoint acquires a property, they start by building a budget from scratch without reviewing existing expenses. Brundige explains, "We generate what we think is an appropriate budget from all operating perspectives, including staff." This approach, though daunting, is simpler than it seems. For service contracts, such as landscaping or cleaning, Brundige suggests getting bids from providers. "Many will be happy to provide information, hoping to get your business after acquisition," he says. Also, review local labor costs and utility expenses.
Once you've built your budget, compare it to the existing one. Adjustments may be needed based on unique property characteristics. Brundige emphasizes reviewing existing service contracts to understand discrepancies. "Look at the actual contracts and their scope. If they're only cutting the grass once every two weeks to save costs, maybe that's not the right approach," he notes. Ensure you have the ability to terminate current providers if necessary.
At the end of this process, you should have a final budget that includes operating expenses and anticipated capital costs. Align this budget with the property's revenue to determine the asset's net operating income.
Opportunities for Revenue Growth
Once you have determined the property's anticipated net operating income based on its existing revenue and your proposed budget, Brundige advises the next step is to assess potential revenue growth. Analyze the rents at your property relative to your competitive set. "Are the rents priced correctly? Is there an opportunity to increase them?" Brundige asks. Enhancing rents might require improvements to the property, the units, or both. Sometimes, there's just a dislocation between current rents and the market.
Forecasting rent growth involves analyzing local market dynamics and the potential for new supply. Determine if you can expect standard inflationary increases, around 3%, or if the growth could be more significant.
Evaluating Supply Threats
By now, you should have a solid understanding of your existing competitors within the submarket. However, it's crucial to be aware of any planned or under-construction multifamily buildings that could add new units and compete directly with yours, potentially impacting your property's revenue growth.
Brundige recommends starting with CoStar data to track new development activity across the country. This data is useful for larger markets, but in smaller submarkets, you may need to dig deeper. Brundige and his team often visit local city halls to review construction permits and variances to uncover additional development activity.
During the "north, south, east, west analysis," pretend you are a developer to determine the best locations for new properties. It's also essential to assess the general municipal attitude towards development. If the municipality allows easy construction, it could lead to oversupply and falling rents in the future.
Market Stability Versus Volatility
Brundige emphasizes the importance of a "stabilizing factor" when evaluating a property or market. Stability can come from being a state capital or having a concentrated industry, like tech companies in Austin or insurance firms in Hartford. Universities are also beneficial as they don't typically relocate or reduce enrollment, providing consistent demand.
Volatility is a major red flag. Prospective buyers should review historical market data to identify trends in rents and occupancy. Significant fluctuations without clear reasons indicate potential risks, making future predictions challenging.
It's crucial to scrutinize the property's historical financial records, especially rental income. Look for patterns in monthly revenue rather than relying solely on 12-month averages. Identifying declines or underpriced units can reveal potential value-add opportunities and help protect your investment.
This article was updated on 7/29/2024
