Due Diligence: How-To Guide
Due diligence is your opportunity to find all the problems the seller didn't want to tell you about.
A regular feature I do is called “Deal or No Deal”, where I find a random property on the internet and go through my underwriting process to determine if it is worth buying.
In previous articles here and here, I outlined my 3 step process for evaluating a property:
Does this generally meet my screening criteria? Yes, go to 2.
Does this pass the sniff test a.k.a. back of the napkin math? Yes, go to 3.
Perform underwriting.
This article will focus on the next step of my acquisition process: Due diligence.
What Is Due Diligence?
Due diligence is the time period between signing a contract and the last day you can walk away from the deal and still get your earnest money deposit back (unless you are one of those lunatics that has your earnest money go hard at contract signing). Depending on the deal size, this time period may range from a week to 30 days - or longer if it is a big and/or complex transaction. The properties I focus on are in the 30 days or less bucket.
The purpose of due diligence is to:
Verify all the financial and physical assumptions you made during the underwriting process using the broker’s pro forma
Sniff out any problems that the seller was not forthcoming about or may not even be aware of
Make adjustments to your underwriting to reflect new information
Now let’s get to the nuts and bolts of what I do during the due diligence process. Keep in mind I buy multi-family only. Due diligence for other real estate asset classes will be a little bit different.
Priority Of Tasks
This is my rough priority of tasks during due diligence. This order helps reduce the possibility of burning a ton of money early in the process. Finding out it’s a garbage property on day 30 and walking away having spent potentially thousands of dollars on nothing except free inspection reports for the seller wouldn’t be the best feeling.
Financial due diligence: This is going through all of the detailed financial information requested from the seller with a fine toothed comb. I can do all of this myself, so the only expense here is my time.
Physical due diligence: This mostly consists of physical walkthroughs of the property and any inspections, such as sewer line video scoping, radon tests, mold tests, etc., and reviewing property records. At this stage, depending on what you can do competently yourself, you will likely have to pay for some inspections services.
Legal due diligence: I save this for the end because lawyers aren’t cheap. I try to do the bare minimum of legal work during due diligence, but sometimes it is unavoidable to start some things earlier than desired as you can’t always wait 30 days for due diligence to end before starting title work or the loan process if you have a contract to close within 60 days.
Pro Tip: Do not be lazy! Go into every unit, mechanical room, basement, etc., no matter how many units you are buying. Do not take “no” for an answer. Not physically walking into every unit to assess condition is a potential huge risk you are taking that requires minimal effort and/or just sticking to your guns.
Documents To Request From The Seller
I like to ask for a ton of docs because I’m an information nut - the more info I have, the more I can potentially lower my risk. Depending on the seller, they may not have some of these docs. I always make sure to tell the seller that it is OK if they can’t provide something, as some less sophisticated sellers may get overwhelmed with such a big list of docs. I’m currently under contract on a $4.5 million portfolio with a seller that doesn’t have a computer and some people doubted me when I sent this tweet:
My list in general order of priority is:
P&L reports: Last 3 years
Trailing 12 month (T-12) P&L
Rent roll: Name, Unit, Rent $, Security Deposit $, Lease Start, Lease End
All leases
Insurance policy & premium
Radon test reports
Mold test reports
Tenants in arrears: Name, $ amount
Insurance loss reports: Last 5 years
Fuel bills: Last 24 months; I ask for 2 years because fuel usage can vary significantly from year to year.
Electric bills: Last 12 months
Water & sewer bills: Last 12 months
Plowing bills: Last 24 months; I ask for 2 years because snowfall can vary significantly from year to year.
Landscaping bills: Last 12 months
Trash removal bills: Last 12 months
Balance sheet: Last 3 years
Service contracts
Original applications of current residents: I want to assess the quality of in-place residents.
Equipment & building warranties
Maintenance schedules & logs
Property survey
Notice of any litigation or violations
Environmental reports
Once I receive the docs, I will then begin performing due diligence.
The Due Diligence Grind
Due diligence can be a mentally numbing process. Auditing 50 leases in a sitting can do some real damage to your brain, even if you have a tiny real estate brain like me.
Some of these things can be outsourced, like lease auditing, but I don’t buy anything big enough yet to need to outsource, so I suck it up and just do it. There’s a lot to be done, but it’s like the saying: How do you eat an elephant? One bite at a time.
I list the following tasks in a priority order, but it is almost impossible to do everything in a perfect series order. Many will have to be done in parallel.
Financial Due Diligence
Determine your loan terms
I will issue a quote request to lenders ASAP after contract signing. Once I receive term sheets, I then compare to what I used for underwriting assumptions and adjust my analysis as needed.
I may or may not pick a lender at this point depending on the lender I am planning to use. For agency debt, there is a significant non-refundable application fee (around $15,000) required to start the loan process. For obvious reasons, I would want to push initiating this as far back into the due diligence period as possible.
Determine your insurance premium
I will issue a quote request to my insurance broker ASAP after contract signing. Once I receive, I then compare to what I used for underwriting assumptions and adjust my analysis as needed.
Audit all leases
I create a spreadsheet to log all of the important items I need to know from the leases:
Resident name
Rent amount
Security deposit amount
Lease start
Lease end
Utilities landlord is responsible for
Max occupancy
Pets allowed
Parking spaces allocated
Required disclosures (vary by state): lead paint, smoking policy, energy efficiency, radon level, etc.
I audit leases early because I need to know the gross potential rent and to verify the utilities I am contractually obligated to provide in order complete to downstream tasks.
Some of the things I included on the lease audit aren’t required for financial due diligence, but I compile all the info at one time to limit having to open the leases several times as I will need the other info in the future, for things like automating the creation of estoppel documents.
Verify gross potential rent (GPR)
Now that I have audited the leases, I know exactly what the residents are paying for rent. I then compare the actual gross potential rent to what I used for underwriting assumptions and adjust my analysis as needed.
Estimate annual turnover
I estimate approximate annual turnover, which is an input into the financial model I use, by using the in-place lease start and end dates. I care about this as it impacts estimated vacancy rate and turnover costs.
Review seller P&Ls
I will spend a lot of time looking at these. With any luck, these are received in Excel format so they are easy to manipulate. My favorite is receiving hand written P&Ls - yes, Nick Huber (@sweatystartup) isn’t making this up when he talks about this.
I will adjust them as needed to take out any personal expenses and make a note of any major missing expenses. For example, many times a mom and pop seller will not show a property management fee as they self manage.
When reviewing seller P&Ls, what I am looking at is:
NOI: How far off is it from my underwriting assumption? If it seems to be significantly off (high or low), I will dig into the individual line items to see what is driving the variance.
OpEx ratio: Does it fall within a reasonable range (usually 30-40%)? How far off is it from my underwriting assumption? If it seems to be significantly off (high or low), I will dig into the individual line items to see what is driving the variance.
Economic vacancy: Based on the gross potential rent I calculated, what is the seller’s actual economic vacancy (physical vacancy + credit loss)? Is it reasonable based on my understanding of the local market?
Note: For economic vacancy estimating, the gross potential rent I calculated using the current lease rates is likely higher than the gross potential rent that was in place for the P&L time period. You’ll never be able to accurately recreate past years’ rent rolls to get a highly confident GPR, so take the estimated economic vacancy from seller P&L’s with a grain of salt.
Determine your property tax amount
If I haven’t already done this during initial underwriting (which I almost always do), I will review the property tax rate history for the town/city, call the assessor, and finalize my estimate of property taxes in year 1 and moving forward. Property tax is one of your biggest expenses and can really bite you if you don’t do your homework on it. Never assume the seller’s property tax amount will be your amount.
Verify utility expenses
I do the lease audit prior to this to verify what utilities I will be responsible for. I create a spreadsheet of each utility and log the monthly expenses. I then compare the actual utility bills to what I used for underwriting assumptions and adjust my analysis as needed.
Note: Remember that utilities are a variable cost based on occupancy. If a property has been 15% vacant for the last year, you will need to adjust the actual utility expenses higher, assuming your plan is to get vacancy closer to 0%.
Review service contracts
I will go through the contracts to see which ones I will need to assume, what the costs are and determine if I will continue using the current provider or will get new ones. If I want to get new providers, I will issue quote requests ASAP. I then compare the in-place contract costs and/or quotes to what I used for underwriting assumptions and adjust my analysis as needed.
Review balance sheets
With any luck, the seller actually has balance sheets and has them down to the line item detail. I will dig through them to find all the capital expenses that have been done and to see if there are any smaller expenses that are being hidden on the balance sheet. A neat trick by a seller is to place an operating expense on the balance sheet as it increases NOI and ultimately the property value. If I think any nonsense is happening, I will adjust my underwriting to increase the repairs and maintenance expense.
Assess tenant quality
If I am able to get the in-place tenant original applications, I will go through them to see credit score, income, etc. to assess the overall tenant quality. If I’m really motivated, I will log on a spreadsheet to aggregate the overall numbers.
Final check of financial model
At this point, I have gone back and verified everything from my initial underwriting at the time of the contract. With any luck, there were no major changes required, so I won’t need to adjust the selling price (called retrading - sellers love this lol).
Physical Due Diligence
Physical walkthrough of all units, mechanical rooms, common areas, etc. During this walkthrough I will log the condition of everything capex related (parking lots, sidewalks, roofs, stoves, refrigerators, flooring, cabinets, fixtures, water heaters, EVERYTHING) down to the unit level on a spreadsheet I have created prior to the walkthrough. I try to keep it simple with rating on a scale of 1, 2 or 3 (25%, 50%, 75% life remaining). I then calculate the average rating of each item and compare to what I had assumed for my initial underwriting and adjust as needed.
I always have a trusted contractor walk the property with me. I’m fairly knowledgeable in this area, but I will never be as competent as someone that builds stuff for a living.
During the walkthroughs, I will try to have any third party testing done at the same time to limit disruption to the residents. For example, I will place mold test kits in certain units during the walkthrough and will return a few days later to pick them up.
I will also meet with the current property manager during the walkthrough to try to learn where the bodies are buried on the property.
Because I buy mostly in small/very small markets, the reality is there will probably be no certificates of occupancy on file and nobody will give you anything in writing saying the units are OK to occupy. To mitigate this risk, I have the fire chief walk a few representative units with me to confirm life safety requirements are being met. If the fire chief knows I am trying to do the right thing, they will likely work with me on any issues I may encounter in the future. Bonus points if I can get the code enforcement person to walk the property, as well.
Issue quote requests for any major CapEx items needed
If I found anything of significance during walkthroughs, I will issue quote requests to vendors ASAP and adjust my underwriting assumptions as needed.
Verify/add value add opportunities
After logging everything during my walkthrough, I then look at the items I had estimated value add opportunities for and verify if these are still true or need to be modified. Also, I determine if there are any new opportunities.
For example, when I do a walkthrough, I always make note of the hot water heating system. If the building is using a boiler, this is usually an easy value add project to reduce fuel costs with hybrid hot water heaters, plus the bonus of extending the boiler life.
Review city property records
Many times these are now available online, but in some smaller towns it is easier to just go into the town office and ask to see the property file. They will then bring out a giant folder with every piece of paper ever logged for that property in the last 50 years - site plans, building permits, code violations, etc.
Review environmental database
Many states have an online database that tracks any environmental site issues. This doesn’t take long and is a quick risk mitigator in the event there was ever a nuclear waste dump on the property.
Review maintenance plan and logs
The purpose of this is to get a sense of how attentive the seller is to maintenance and to get a qualitative sense of your repair and maintenance expense assumption.
Legal Due Diligence
UCC, tax, judgment lien search
This is the bare bones legal expense I do during due diligence. Most of the other legal expenses you may start incurring during due diligence will be related to the title and loan docs, which will usually have different contract deadlines than the due diligence period.
There may be more legal stuff I should be doing during due diligence that people smarter than me can tell me about.
Next Steps
After I complete due diligence and am happy with everything, life is easy and I notify the seller I will be moving forward to a smooth as silk closing. LOL, this never happens when looking at the type of properties that I do.
If I’m not happy with the due diligence outcome, I have two options - walk away or try to renegotiate the price (known as retrading).
Pro Tip: The ethical approach to retrading is to bring up an issue with a seller as soon as possible. Waiting until the last minute to try to squeeze the seller is a very scummy approach.
I have never straight up walked away from a due diligence finding, but I would if it was something that was insurmountable - or even worse a straight up deception from the seller. If I can’t trust the seller (not the selling broker, don’t even get me started), I will not buy regardless of how good of a property I think it is.
Retrading is never easy. The seller will refuse to admit there is an issue most times or that, “You aren’t being realistic.” The listing broker will tell you 57 different ways why you should overlook the issue, why you should be using a 5% vacancy rate instead of 6%, plus any other BS they can have roll off their tongue. There is pretty much nothing a broker can tell me that will change my mind at this point, short of telling me there is a previously undisclosed gold mine on the property.
I’m fully transparent with my due diligence findings and will open up my underwriting to provide complete transparency on the changes from my contract underwriting to due diligence. Sometimes this approach works and sometimes it doesn’t.
I recently had a contract to purchase a $12.2 million property. During due diligence, I found significant NOI discrepancies from the broker pro forma (this is my shocked face) and a ton of deferred maintenance I was not willing to amortize over my hold period, resulting in a new value of $11 million. When I presented my findings to the listing broker, he didn’t care. His response was, “The seller thinks he can get $12 million for the building.” It was a short conversation and I just moved on. Flash forward 60 days and the property closed for $12.2 million with another buyer.
Am I now second guessing myself? Not a chance. Maybe the next guy knew something I didn’t, but I don’t care. I would have been sweating bullets buying at a $12 million price.
I don’t buy real estate to increase the stress in life. I buy real estate to reduce it.