The Key to Understanding Due Diligence in Multifamily Real Estate
Written by: Tina Welch, VP of Acquisitions, Madera Residential
What is Due Diligence?
Due diligence in real estate encompasses what feels like an overwhelming number of overlapping reports and inspections but can generally be broken down into the following areas: Legal, Lender, and Property due diligence. But, what is due diligence in real estate?
Typically, due diligence takes place between the execution of the purchase and sale agreement (PSA) and closing date, unless the seller agrees to an access agreement which may grant access to this information prior to PSA execution. The due diligence period can be as little as 30 days and up to 180 days.
Due Diligence in Real Estate
Legal Due Diligence
Legal due diligence will usually be performed by the buyer and seller’s legal counsel and includes items such as title search, taxes, zoning, property rights, refusals, and easements. During the legal due diligence, the buyers counsel is helping to ensure that the seller owns the property and has legal right to transfer the deed with the clear title to the buyer. They work to ensure no legal liabilities exist that would materially affect the buyer after closing. This information is then shared with the lender so all parties are up to date on any potential areas that could delay the sale.
Lender Due Diligence
Lender due diligence will take place simultaneously with the legal and property due diligence. The purpose of the lender’s due diligence is to get approval from the loan committee to issue the loan for the purchase of the property and to ensure all items are received prior to closing.
During this time, the lender will order third party reports (zoning, appraisal, Phase 1 engineering, survey, and property condition). The third-party reports will usually be ordered by the lender but there are times when the buyer may be required to do so.
The lender will also review all historical financials and work with an insurance group on a statement of values/other insurance requirements. It is important for the buyer to work with an insurance broker to advise on insurance selection and to ensure all insurance requirements are met before closing.
Property Due Diligence
Property due diligence is the responsibility of the buyer and focuses on the on-site management and construction components of the due diligence process. The goal of the on-site due diligence is to inspect the property and ensure that it is in the condition the seller has promised, and primarily to prepare for your takeover plan.
Depending on whether the property will be self-managed or third party managed, the buyer will either conduct the on-site due diligence themselves or have a team of third parties perform it on the buyer’s behalf. Either way, it is great to have knowledge of how the process works to make sure no items are overlooked.
Multifamily Due Diligence Checklist
Components of property due diligence include unit walks, file audits, service contract reviews, staff interviews, and construction team walks.
Unit walks - depending on if the buyer plans to do a full renovation of unit interiors or not will determine the level and number of units you wish to enter. Walking 100% of the units may be necessary to ensure there is no major damage to units such as water leaks, missing appliances, or deferred maintenance.
File audits - are usually performed by the incoming property management staff. The team will review each individual lease file at the property. During the file audit, management will be checking that rent/other income amounts and tenant information match the rent roll. If there are any errors found, corrections will be sent back along to the seller to be made prior to takeover. Staff interviews will also take place simultaneously with the goal of gauging interest in the staff to remain at the property after the takeover.
Contract reviews - Every property has utility and service contracts in place that would be transferred to the owner upon takeover. As such, the buyer typically has 30 days to review and make contract decisions based on their willingness to assume or cancel these services upon takeover. The level and number of contracts on a property will be determined by the class of the property. As an example, Class A properties typically have a larger number of third-party service contracts that can include concierge, security patrol, valet trash, IoT and cable/WiFi agreements. It is important to understand that canceling any services the residents are accustomed to receiving can have a negative impact at takeover.
Construction - The construction component and level of diligence will again be determined by the business plan, but should include some basics such as deferred maintenance, life safety issues, and code compliance. Having a team of seasoned professionals either in-house or third party can reduce the number of headaches after takeover along with better prepare how to use capex dollars.
Understanding due diligence in real estate may seem complex at first, but a well prepared tactical plan that includes ownership of each task will ensure through execution. Creating your own due diligence checklist for multifamily is helpful for consistency. It is critical for a successful takeover and the long-term execution of the buyer's business plan.