Ten Things You Have to Know Before Closing on a Multifamily Deal
- April 25, 2018
- Author: Tom K Wilson
Let’s face it -- closing deals is tough. There are so many moving pieces, and getting together sellers, lenders, and investors together can seem like an act of God. Despite all of this, experienced investors know that due diligence is crucial and must be conducted concurrently with other aspects of a deal for a successful close. The larger the deal, the more important the due diligence. This attention to detail for due diligence applies even more so for multifamily and commercial real estate investments. In this segment, I outline my top ten due diligence mistakes that can kill a multifamily or commercial deal and how to mitigate these risks.
“I’ll do it all myself and save a lot of money. I don’t need to use an experienced partner, a syndicator, or put a together a team”. As investors, we are conditioned for maximizing value and profit. However, there are so many possible pitfalls that can be identified with the right team that the risk mitigation often outweighs potential profit savings. More sets of eyes on a property during due diligence helps increase odds of identifying problems before they kill a deal. Get an expert for every aspect of the deal, to include asset type, market, leasing, legal, tax, construction, and property management. Plus, you get to build relationships that can last a lifetime in your investing career.
Macroeconomics. “I do not see a need to waste time tracking the general market, macroeconomics and market cycles. No one seems to know for sure what is going to happen anyway”. Due diligence requires a keen look at local and national economies, politics, and other industries. A Midas complex says hot markets are a result of personal skill and will continue to improve. Reality says otherwise, and market cycles can kill even the best researched deal. Your due diligence should always include an analysis on the asset type, where it is in the market cycle, and if it is overheated and/or expensive.
Markets: “Joe said that Portland is hot. That is good enough advice for me”. Putting the cart before the horse is a very common problem for commercial and multifamily investors. Sometimes it’s easy to set your mental framework around the idea that a market is “hot”. Savvy investors will always get data from reputable sources and compare metrics like cycles, and CAP rates across similar primary, secondary, and tertiary markets. Submarkets and individual neighborhoods can make an especially big difference. These can often look good on paper, but once you walk the block red flags like parking lots that are full midday on weekdays show up. Why should this matter? If your tenant base is largely home during the work day there is a good chance they are not gainfully employed and may be putting your investment at risk.
Asset Classes. “Multifamily must always be the best asset class because people always have to live somewhere”. It’s common to conflate market fundamentals with market timing when the two are often independent. While the demand from tenants may be strong for multifamily, market cycles can put the valuation of these assets at an expensive level relative to the value. Also, Class A, B, C, and D assets all behave differently and have unique market cycles within the broader class. Understanding the nuances during your due diligence can help avoid buying an asset in a peaking market that leads to an inevitable, unfavorable market correction in value.
Product: “The inspection report should be all I need to know if it is a good product”. Understanding each party’s motivation is crucially important when performing due diligence. The seller is motivated to sell. The inspection report may or may not have been performed by a licensed inspection firm, and many of the “fringe” issues are likely not disclosed. Roofing, foundations, and deferred maintenance all follow trends in certain areas. For example, wood structures in high-humid areas, even if cleared on an inspection, are far more likely to encounter termite issues than the same structure in a dry climate.
Exit strategy: “I think I will decide in a few years when I’ll sell”. Due diligence should include both a precautionary look at factors before you purchase the property and an analysis on what environment you are likely to see when it’s time to sell. Market cycles can predict a lot, and falling property values can be a tough time to exit a property if debt is expiring or investors want out. Communicate well with partners on any investment what your ideal exit strategy is, who your ideal buyer would be, and what you might do if market conditions favor holding instead (ie refi debt, and at what rates?). Length of leases should also be considered to have a property that is attractive enough to the next buyer to make the property sell.
Underwriting: “The proforma looks good enough to me”. This is one of the top pitfalls to a deal that can get an investor into trouble. A broker or seller is going to have rosy proforma expectations that support their sales asking price. DO YOUR OWN ANALYSIS. The seller knows more about the property than you do, and is likely going to filter his or her data to reflect the best possible angle. Ask them why they’re selling. Look at how much reserves are built into the project, and what the likely capital expenditures could be during the projected hold period. Look at exit CAP rate assumptions, which can have a HUGE effect on overall IRR projections. What will CAP rates due with increasing interest rates? Is CAP compression a reasonable assumption for the market you’re in? These are all critical to backing up and reviewing seller generated proformas.
Leases and tenants: “I’ve heard that all you need to do is to look at the rent roll that the property manager provides”. Again, know the bias built into the source. Unscrupulous sellers have been known to stuff low-credit tenants before sale to create fake high occupancy appearance. Some go so far as to create fictional entities as tenants to look more attractive than reality. Walk every unit, and interview major tenants to find out how likely they are to stay and what their experience has been. Analyze the rent roll to see how staggered lease expirations are, which can put a cash crunch on the project if not well managed. Furthermore, many projects have a mix of NNN and non NNN tenants which can make rent rolls somewhat misleading. Find out the status of these details to avoid costly mistakes.
Loan: “I’m not concerned about the loan. I have a good credit score and a lot of stock value”. Loans can make or break an investment, and are a critical part of due diligence BEFORE going hard on earnest money. Commercial loan requirements, even for non-recourse, can involve considerable analysis of personal net worth and liquidity for “bad boy carveouts” in the event that recourse becomes available to the lender. Term sheets are not binding, and many lenders give different interest options based on the length of the loan before it floats with market interest rates. In the event you do not qualify, partners are available to help qualify, but they will typically require some ownership or payment in exchange. All of these need to be looked at before being committed on a deal.
Management: “Management companies must all be about the same. I’ll find one after my purchase”. The final big due diligence factor is property management. Find out the true reason of what the opportunity is. Is it vacancy? Under-market rents? Both? Typically under-market rents are a result of owner policy, whereas vacancy is directly attributed to how well the property is managed. What makes you think you can do a better job that the current owner, and why will your management solution be better? What is their track record in this asset class and submarket, and have you gotten references? Lastly, have the potential new management walk the property too -- what’s their strategic plan and do their CAPEX estimates fall in line from the seller and inspections? All of these are critical to avoid catastrophic management surprises that can plague an otherwise good project.
Due diligence is hard, and takes a lot of work. This list is just a representative sample of a very large amount of due diligence needed in every deal to make sure you are getting no surprises and understand the true scope of the challenge and opportunity as an investor. This work is typically well worth the costs, and can help flesh out and validate some of your early assumptions to gain a greater confidence of the project’s success.