How many times have you seen something in a store that looked amazing? On an impulse, you buy it, only to discover that it has problems later on – like maybe the build quality isn’t particularly remarkable, or it’s not quite what you needed. Fortunately, at a store, you can hopefully return the item and get your money back. With real estate, there’s no return period. That is why due diligence in real estate is critical!
It’s crucial to ensure any investment you make aligns with your objectives and will be a helpful addition to your portfolio before you commit any real money. You may have heard the term “due diligence” before as a way to avoid making costly mistakes and losing money unnecessarily on transactions. What is due diligence in real estate, though? Here’s what you need to know and how it can help you avoid costly mistakes!
What Is Due Diligence in Real Estate: A Brief Primer
What does due diligence in real estate mean? The concept of due diligence comes from the investing world. Its formal definition is “research and analysis of a company or organization done in preparation for a business transaction.”
When you buy stocks, you probably do some research on the company first. You might research their price-to-earnings ratio or whether or not the company is profitable. Similarly, if you’re looking to buy a company, you’d want to go over its books to ensure that it is beneficial, makes the money the owners say it makes, and is an investment that will suit you for the long term.
Real estate is no different. Before investing in real estate, you’ll want to know that the property you’re buying is an investment that will align with your goals and that there are no surprises. As noted in the intro, there are no return periods for real estate, so you need to know everything you can about the property before you close the deal!
The process of researching, learning about the property, understanding its financials, and assessing its value is known as due diligence. What is the due diligence process in real estate? The short answer is that it is the process of doing this research for a real estate transaction. It is something that all investors should do before they finalize any real estate transaction!
Due Diligence: What Should Investors Look for in a Real Estate Property?
Given that due diligence involves researching the property before finalizing the sale, the question, of course, becomes: what should investors know about their investment before they fully agree to it?
There are two different stages of due diligence in real estate. The first stage is what you’ll need to source from the owner and assess before submitting an offer, and the second is what you’ll need to evaluate after submitting an offer, but before finalizing the deal.
Before Submitting an Offer
Before submitting a letter of intent, your due diligence efforts should focus on determining whether you think the property would be a good fit for your overall portfolio and, if it is, what type of an offer would make the most sense. In other words, at this stage, you’re looking to understand more about the property’s potential and less about the property itself.
As such, investors at this stage typically like to research:
- Area and neighborhood – is this property in a high-quality area with a lot of upward potential, or is it in a less-than-ideal neighborhood where it may depreciate further?
- Financial statements – if you are buying a property that already earns money (like a multi-family unit), you’ll want to get a sense of the financials. How much revenue is the property bringing in, and what are the expenses? Do you think the multifamily property has the potential to push rents based on the comparable properties in the submarket?
- Financing options – if you make the purchase, how will you pay for it? If you’re looking for a lender, you’ll need to find ones that will initiate a loan for your project. If you’re looking to create a real estate syndication, you’ll also need to start looking into that. No matter what you choose, you’ll need to perform due diligence on financing options to ensure that you can follow through with funding if the seller accepts your offer.
Once you feel the above, due diligence shows the investment is a quality purchase, the next step is to submit an offer. Assuming the seller accepts that, you’ll begin the next phase of due diligence!
After Submitting an Offer- The Formal Due Diligence Period
Once the seller accepts your offer, you have now entered the formal due diligence period. This term represents the time between offer acceptance to deal closing. Since you are under contract, none of the deal terms can change. As such, your due diligence focuses on ascertaining whether the premise of the deal (i.e., what the seller told you) is accurate. If it’s not, well-structured offers permit the buyer to walk away!
Therefore, after submitting an offer, the focus of your “what is due diligence in real estate” research should be:
- Physical inspections of the property – you’ll want to have an appraisal and a property condition assessment(PCA) done, walk the property and check the condition, and generally make sure the building is up to code.
- For due diligence for a multifamily property such as an apartment complex, you will want to perform a few additional measures such as a lease audit, environmental report, and market survey. You can access our complete multifamily due diligence checklist below.
- Financial inspections – typically, you’ll want to look at the profit and loss statements review tax returns, contracts, accounts, property taxes, and more. If you are buying a larger commercial property such as an apartment complex, you will need to source additional documentation such as the t-12 and rent roll. You’re essentially verifying the financial due diligence that you did before you submitted the offer. If there are any discrepancies, your offer may need to change or may no longer be valid.
- Legal issues – lastly, you’ll want to ensure the building doesn’t have any legal surprises. Check pending litigation, and get insurance and title quotes.
If you obtain a mortgage, your lender will likely ask you to do much of this during their due diligence period. Of course, you are always free to do more if you feel it is necessary! The above list should be a rough guideline of what you will want to check.
What Is Due Diligence in Multifamily Real Estate: An Example for an Apartment Complex Offer
Here’s a quick example of what due diligence you’d look to complete for an apartment complex with the above in mind.
The Due Diligence Process For an Apartment Complex
- Analyze the market and the submarket
- Verify the property’s income and expenses
- Calculate the property’s net operating income (NOI)
- If the real estate property meets your investment criteria, you’ll submit an informal offer called the letter of intent (loi).
- Work with your commercial broker to agree on a price and terms with the seller.
- Finalize the Purchase and Sale Agreement (PSA)
- Begin the due diligence period
Example Of DD in Action
Let’s say you have an interest in buying a 100-unit apartment complex downtown. Before submitting a letter of intent, you’d want to do all the necessary research on the market to ensure your offer makes sense.
The most intuitive place to start is the neighborhood. The downtown core has undergone a significant revitalization, and units downtown are in high demand and are renting for more than they ever did before. Most research shows that rents will likely increase over the next 3-5 years, as will property values.
If you are interested in the submarket, next up is analyzing the property’s income and income and expense. Anyone looking to sell will have some basic financial information available like the rent roll and T-12.
If the apartment complex fits your investment criteria, it’s time to submit a letter of intent (loi).
Upon submitting your loi, you will work closely with the broker to negotiate with the seller and finalize the sale prices and terms of the offer, such as earnest money and the timing of your due diligence period.
So when is the due diligence period? Upon the seller accepting your offer, and now you are under contract, and your due diligence period beings.
When it comes to the due diligence period for commercial properties such as a multifamily complex, the due diligence period commonly takes between 30 and 60 days. However, the due diligence period can be longer or shorter depending on the terms negotiated in the offer.
Now, that your offer is accepted you’ll dig into the financial, physical, and legal aspects of the due diligence process.
You’ll look at the balance sheet and the cash flow statement. You’ll check any liens on the place and what the owners are currently collecting in rent. Additionally, you’ll want to verify tax returns submitted to the IRS to ensure the income has some consistency to it (and ensure there are no hidden tax obligations!). For the sake of this example, let’s assume the financials perfectly align with the pro forma financial statement.
Physical inspections are also necessary. You’ll want a professional inspector to look at the building and ensure there are no hidden surprises (like termites). You’ll also want to make sure the building is up to code, and all utilities, plumbing, HVAC, and mechanical systems are operational. Let’s say the physical inspection doesn’t reveal surprises.
Lastly, you’ll want to ensure the building has no legal issues. You’ll want to make sure there’s no pending or future litigation. Additionally, you’ll want to verify that all workers have been paid and make sure the company is not in any regulatory trouble with the government.
Upon verifying all this, you’re now ready to close on the offer! You’ve taken a look at everything beforehand and can have confidence that your investment will work out!
Multifamily Real Estate Due Diligence Checklist
To ensure you have thoroughly completed the due diligence process, we have put together a multifamily real estate due diligence checklist for you to utilize throughout your due diligence period.
What does due diligence mean? As noted above, it’s the process of thoroughly researching an investment before you make it! Indeed, due diligence is a safety net as it protects investors from buying something based on a faulty premise. When you develop a strong due diligence mindset and checklist, you’ll have confidence that the property you are acquiring is a solid investment!
Therefore, before you invest in anything, take your time to make sure the investment meets your expectations. A little bit of time before the deal can save you years of challenges down the road!
We hope this article provided you with clarity on the due diligence process in real estate! If you are interested in learning more about Disrupt Equity’s multifamily real estate investment opportunities, please visit our investment page here. On this page, you can go through our investor’s Frequently Asked Questions as well as submit a form to be notified of our upcoming investment opportunities!