Get Your Ducks in a Row When Buying Multi-Family Properties

By Kyle Pulis

Due Diligence is one of those things that people talk a lot about, usually expressing how essential it is to their investment strategy. However, while talking to investors about due diligence on specific properties, I always hear statements like, “Oh that’s nothing, it should be OK”, “That’s way too expensive, I’ll bring a friend to come look at it”, or “My buddy paid $$$ two years ago, so it must be worth much more by now”. As far as I’m concerned it’s phrases like these that are the cause of most real estate catastrophes.

Proper due diligence is the backbone of any purchase and can make or break an investment. It is there to make sure that your excitement and emotions don’t blind you from seeing potential problems that could end in disastrous results. It is important to have experts that are unbiased and experienced to offer you a second opinion and ensure your investment decision is a safe and secure one.

Luckily, within the multi-family marketplace, investors are forced by the lenders to perform the most essential parts of the due diligence process. When an investor approaches a lender for a mortgage, the lender will usually respond with a checklist of required due diligence steps and an approved list of companies to complete the work. Personally, I think this is genius. It forces investors to get out of their own way and hire approved experts to complete the work, all the while lowering the bank’s risk of default.

The usual due diligence required by the bank typically includes Building Value Appraisal and Engineered Building Inspection reports. A Phase 1 Environmental (sometimes also required by lenders) and a Fire Prevention report are also important elements within a comprehensive due diligence strategy.

Depending on your investment strategy for the building, you may place greater importance on some steps rather than others. Considering your plans for the building, a less than perfect inspection report or the need for a phase two environmental may not be a big concern if you were already planning major renovations. Likewise, if after the appraisal process, you realize you are slightly over paying for the property, depending on your predicted after-reno value, the deal may still be worth pursuing.

Looking for a turnkey property is, however, one strategy where you will want to make sure the property is performing exactly how you were expecting. This is where placing equal importance on all steps is essential and when issues come up, you will need to create a plan to remedy them before lifting conditions.

By reviewing the following steps, investors can secure their acquisition and move forward in the buying process, knowing that they’ve got their bases covered.

Building Value Appraisal

You will have already had a Chartered Surveyor look at the property you’re interested in and given their report on it for you. But when a bank is deciding to loan out money on a property, the bank first needs to prove that the building is worth the amount the investor is asking for. This is where an accredited appraiser comes in. This appraisal must be completed by a trained and accredited professional (on the bank’s approved list) and is designed to protect the buyer and bank from thinking the building is worth more than it actually is. The building value appraisal will take into consideration the sales history of the property and the value of comparable properties in the area, but will be most heavily weighted on its operating financials.

Every building is assessed as if it were a business. It has operating income (rents) and expenses (taxes, utilities, etc.), which should result in a profit. This left over profit (aka Net Operating Income) is what appraisers are going to use to assess the building’s value. The higher the NOI of a building, the greater is its worth. Appraisers will take the building’s NOI and use a local market multiplier known as a CAP rate to compare these figures to other buildings sold with similar size and financials in the area. This gives the banks and the purchaser the confidence they need in confirming the building is worth its purchase price.

Now, even though banks will lend up to this appraised amount, they will also complete their own internal valuation with much more conservative numbers. This amount is usually lower than the investor and appraiser think it is worth. The bad news is the banks typically use the lesser of their value and the appraised value to issue the loan. So, don’t get too excited when the appraiser comes back at the value you want; save that bottle of champagne for when the bank’s commitment letter comes in.

Engineered Building Condition Report

Just like a home inspection for a single-family home, a certified professional will come to the property and assess the building’s overall condition. Investors must make sure they use a company that works specifically with multi-family buildings. These companies have more experience in assessing the condition of items that are unique to multi-resident properties, for example: larger boiler systems, flat roofs, balconies, and elevators. Their report will also take into consideration the condition of elements such as electrical systems, plumbing and ductwork so that buyers are protected against having to shell out for further maintenance issues at a later date. They’ll also be able to advise on any renovations or repairs that need to be done, such as installing a Boiler water treatment or any structural work that may need doing.

If something serious comes up on this report, it’s important that you get it fixed quickly. For example, if there has been a burst pipe in the property, contact an emergency plumbing company in Brisbane (or a company local to your area). You won’t be able to sell the property whilst it’s unsafe. However, it should be kept in mind that plumbing problems and electrical problems are quite different than each other. While you can fix a plumbing problem easily by calling regular plumbers, your electrical problems might need you to call somebody like a Sydney level 2 electrician for handling complex works (like an underground or overhead electrical inspection). So, it would be recommended that you take the time, research enough on the Internet, and choose a reputed firm which has qualified electricians.

It is also recommended that the investor be present during the inspection so they can see all the little things that the inspector notices that sometimes don’t make it into the final report. This way, the investor can see first-hand how serious some concerns may or may not be. The reports are often several hundred pages long and confusing. So, being there with the inspector and having the ability to discuss the issue right then and there will give investors the comfort they need to make a more educated decision.

Buyers can often ask for reports in various formats in order to disseminate the information to a large number of investors for review.

Fire Prevention Report

The fire prevention report is typically completed by a private company, not the local fire department. Most times, a seller will not have a recent report from the fire department and will not allow you to have them come in. The reason for this is that, if the fire department shows up and finds issues, they will document them and the seller will be forced to fix them regardless if you end up buying it or not. For this reason, private companies that know the local fire code inside and out are used to assess the building instead. Any issues are then presented as recommendations and are not enforceable by the municipality.

The report will include comprehensive details on the various fire safety systems already in place within the property, and identify areas of concern in terms of meeting fire safety standards.

Systems such as sprinklers, fire panels, emergency lighting and emergency doors will all be reviewed to ensure they perform as expected. In addition, the fire prevention report will also assess the building’s structural safety in the event that a fire breaks out. The report’s creation will be a cohesive effort between several stakeholders in determining the safety of the property and any additional changes that have to be made to get the building up to code.

Phase 1 Environmental

The objective of the phase one environmental due diligence process is to determine whether environmental contaminants have affected the land or water in or under the property area. This phase one process requires a non-intrusive look into the history of the land and the properties immediately surrounding the land. Inspectors want to find out if there is a possibility that the property has been contaminated. If the land was previously used for agricultural purposes, the odds are you are fine. However, those with a building that is located close to an old/current gas station and without proper records of the soil being cleaned may have a problem.

The phase 1 process is fairly quick and painless. Two weeks should be sufficient for completion. However, if the phase 1 results come back with some potential concerns and a phase 2 is needed, this is when things can get expensive and drawn out. A phase two environmental review includes a much deeper look into the building’s history and many soil samples will have to be taken to confirm the state of the soil.

Risk-Averse Investors can Assure Value through Due Diligence

We know the exceptional value that multi-family investments can provide. The due diligence required for multi-family properties is crucial to the investment’s security. It’s a process that can help investors outline the risks and the benefits of their purchase and it empowers buyers with information on potential upgrades that could help significantly boost a property’s potential rental return. For those who complete the research and work with trusted professionals, due diligence is the first step toward rewarding multi-family ownership.

Kyle is the Co-Founder of Pulis Investment Group which offers investors a Hands-Free, RRSP eligible opportunity to invest in apartment buildings. Winner of REIN’s Rookie of the Year, Multi-Family Player of the Year, Leslie Cluff Memorial Player of the Year and Top 10 Player of the Year awards. Kyle can be reached at: kyle@pulisinvestments.com.