There is a lot of confusion as to how to evaluate the physical and economic condition of an apartment building or community. This will be short, but I think you’ll be able to visualize things more clearly.
Due Diligence – What is it?
Due diligence defined is very simply the process of validating the physical and economic condition of the asset. Notice, I didn’t say the process of underwriting. To underwrite is to make assumptions; educated assumptions, but assumptions nonetheless. Due diligence looks to validate those underwriting assumptions.
Does Due Diligence Guarantee 100% Accuracy?
The answer to that question is naturally, no. We can look at all of the leases and trailing financial data, and we can examine all of the physical and mechanical components. The thing to understand is that the prior financial data may or may not indicate future performance, and relative to physical DD – we can’t inspect that which we can’t see…
At the end of the day, none of this is too important. The underwriting assumptions should be based on the future financial performance, not the past. And there should be enough money in the reserve to handle all of the physical unknowns.
How this Works in Real World
Well, a proper due-diligence process includes a swarm of people taking over the office to audit the financials, people busting into each and every unit, people climbing all over the roof, etc. you get the picture – at the end of the day we leave there knowing more about the property than the owner 🙂
Big Complications to this Process
The unfortunate reality in the real world is that the selling broker has a set of qualifiers, one of which has to do with how likely they believe you are to re-trade. In other words, you offer $12.5M for the property just to get under contract, but after the DD you come back and ask the seller for $750,000 in concessions. Brokers hate that…
It is hugely important to gain a reputation as someone who performs on the contract. But, this means that your offer has to pretty much account for all of everything BEFORE you’ve completed the due diligence process.
How do you do that?
DD in the Real World
This is what it looks like in the real world. Yesterday, Sam and I made it out to tour a property. We had underwritten it and thought there was enough momentum to put boots on the ground.
Touring the property with us were the following members of our team:
- Regional PM
- Construction VP for exterior
- Construction VP for interior unit renovations
The entire team of people responsible for helping us to underwrite and execute was there. This morning a firestorm of emails later there is now an agreement on the post-renovation rents, OpEx, and CapEx.
If we get this property, the actual formal DD will be completed. But, I feel very confident that we won’t discover anything unexpected.
As a result, I am able to tell the banker and the selling broker – this offer will stand. We will not re-trade. And as to the selling broker – how important do you think it was for him to see that Ben and Sam are able to engage the entire A Class team this early in the process? Do you think it’s reaspnable that the broker will go back to the seller and advise him that Ben and Sam seem to be for real…