Due Diligence Guide for Multifamily Property Investments
Due diligence in multifamily real estate is a multifaceted process that involves evaluating every aspect of the property, from its legal status to its physical condition, tenants, and future profitability. Below, we break down the key elements of due diligence to help you navigate this complex phase of the transaction.
1. Title Review
A title review protects the buyer by confirming that the seller has the legal right to transfer ownership and that no encumbrances or claims could hinder this transfer.
Key Steps: Engage a title company or attorney to conduct a title search. Look for unresolved liens, unpaid property taxes, and encumbrances such as easements that could affect future use or development. Ensure that the seller holds clear title and that the property is not tied up in legal disputes.
Common Issues: Title defects like judgments, undisclosed heirs, encroachments, and boundary disputes can delay or derail a transaction. Particular attention should be paid to CC&Rs, covenants, and / or easements, impacting the property. Obtain copies of all documents and review with counsel to avoid binding issues that will stay on title.
Quote. Understand the estimate for a standard vs. Extended title policy and what requirements the title company has for closing under each policy. An extended title policy will typically require a new Alta Survey.
2. Status of Seller
It is crucial to evaluate the legal and financial standing of the seller, particularly if they are a business entity.
Organizational Documents: Review the seller's corporate/company charter, operating agreements, bylaws, and other organizational documents to confirm that the entity has the legal authority to sell the property. Make sure the person signing the sale agreement has the authority to bind the seller.
Foreign Status: If the seller is a foreign entity, ensure compliance with the Foreign Investment in Real Property Tax Act (FIRPTA). This law requires foreign sellers to pay capital gains taxes on real estate sales, which could affect the transaction.
Financial Condition: Assess the financial stability of the seller. If the seller is in financial distress, they might rush the transaction or cut corners on property upkeep.
3. Survey Review
While obtaining and reviewing a survey may be a part of your title review, it should be treated as a separate check on the status of the property. A current, detailed survey reveals critical information about the property boundaries, improvements, and any encroachments.
Key Elements: The survey should show property lines, easements, rights-of-way, utility locations, building footprints, and fences. Verify that no structures are encroaching onto or from neighboring properties and that the property complies with local setback and zoning rules.
Encroachments & Setback Violations: Survey discrepancies can cause legal issues or affect property value. For example, a neighbor’s fence encroaching onto your property could lead to future disputes.
4. Lease Review
Thoroughly reviewing the leases on the property is critical for assessing potential risks and cash flow stability.
Key Aspects: Focus on lease terms (duration, renewal clauses, rent escalations), termination conditions, and tenant responsibilities for repairs or utilities. Review tenant security deposits and prepaid rent, if any, to confirm they have been handled in accordance with local laws.
Tenant History: Investigate the payment history of existing tenants, their creditworthiness, and any ongoing disputes. Verify whether tenants have been given notice of the sale and whether they are likely to remain after the transaction.
5. Rent Roll Review
The rent roll provides a snapshot of the property’s rental income and tenant occupancy, offering insights into the property’s current performance.
Verify Consistency: Ensure that the rent roll matches the lease agreements in terms of rent amounts, lease durations, and tenant names. Check for discrepancies like units listed as vacant but generating income.
Vacancy and Delinquency: Pay attention to the occupancy rate and any delinquent payments. A high vacancy rate or high rate of tenant defaults could signal operational issues or a market downturn.
6. Walkthrough Inspection
A physical walkthrough of the property provides first-hand knowledge of the building's condition that might not be fully captured by formal reports.
Items to Inspect: Pay close attention to common areas, roofing, structural integrity, HVAC systems, plumbing, and electrical systems. Look for signs of deferred maintenance or potential safety hazards like rust, deteriorating handrails, or fire code violations.
Hidden Costs: During the inspection, estimate the potential cost of deferred maintenance or required improvements. These could significantly impact your ROI.
7. Property Condition Assessment (PCA)
A PCA is conducted by professionals to evaluate the overall state of the building and its systems, identifying both immediate and future repair needs.
Structural Elements: Inspect the roof, foundation, walls, and windows for damage. If the property is older, anticipate higher repair costs, especially for systems like HVAC or plumbing.
Mechanical Systems: Inspect major mechanical systems to ensure that they are in good working order and comply with current codes. HVAC systems, elevators, and boilers are expensive to replace, so consider their condition when negotiating.
Capital Expenditures: Make sure you receive a detailed list of capital improvements made by the seller over the past several years, as well as any projected capital expenditures.
8. Environmental/Hazardous Material Review
Environmental issues can be costly and time consuming to remedy, making a HazMat review essential for protecting your investment.
Phase I Environmental Site Assessment: Obtain at least a Phase I ESA for the property. This assessment identifies potential environmental liabilities such as contaminated soil, underground storage tanks, asbestos, and mold. If the Phase I report identifies risks, a Phase II ESA, involving soil and water testing, may be necessary.
Legal Implications: Ensure compliance with federal, state, and local environmental regulations. The presence of hazardous materials can lead to legal liabilities and significant cleanup costs.
9. Tenant Issues
Tenant-related issues are a significant component of multifamily due diligence, as tenant satisfaction and retention directly impact cash flow.
Eviction History: Review the property's eviction history, tenant complaints, and rent collection records. A high turnover rate or frequent complaints may indicate underlying management or maintenance problems.
Lease Defaults: Investigate the number of lease defaults or late payments over the past 12-24 months. A property with frequent tenant turnover or defaults may require stricter tenant screening processes.
10. Zoning and Land Use Review
Ensuring the property complies with local zoning laws is essential for maintaining or expanding its use.
Zoning Compliance: Confirm that the current use of the property is compliant with local zoning laws. Verify whether the property is grandfathered in under old zoning laws and confirm it complies with any new zoning requirements.
Future Development: Research any planned developments in the area that could impact property value, including new construction, changes in zoning laws, or infrastructure improvements.
CC&Rs: As noted in the Title Review section above, obtain and review a copy of the latest Covenants, Conditions, and Restrictions that affect the property. CC&Rs are often benign, but can cause serious issues for future development and use of the property if restrictive covenants are missed.
11. Governmental Matters
A review of governmental compliance ensures that the property conforms to all applicable regulations and that it is in good standing with local authorities.
Permits and Violations: Check for any unpermitted work, outstanding code violations, or fines from local authorities. This includes fire safety, electrical, plumbing, and health and safety compliance.
Licensing: Ensure that all necessary permits and licenses for multifamily properties, such as rental licenses or occupancy permits, are up to date.
12. Financial Review
A thorough examination of the property's financial statements is crucial for understanding its past performance and future potential.
Operating Expenses: Review operating expenses to ensure they align with industry benchmarks. Excessive costs in areas like maintenance or management fees may indicate inefficiency or hidden issues.
Tax Liabilities: Assess the property’s tax history, including any appeals or adjustments, and calculate future tax liabilities based on anticipated valuation changes after the sale.
13. Market Analysis
A market analysis helps assess the future growth and profitability of the property within its local context.
Demographic Trends: Analyze population growth, employment rates, and income levels in the area. Properties in growing markets tend to appreciate in value and offer better rent growth prospects.
Rental Demand: Investigate local rental demand, including the current vacancy rates, rental rates for comparable properties, and expected future demand.
We hope this short guide helps you keep in mind the critical aspects of your transaction that require thorough examination to minimizing the risk of unpleasant surprises after closing. Careful due diligence empowers you to make well-informed decisions, protect your investment, and maximize returns. If you have questions about your transaction, or anything real estate related, be sure to reach out to the team at Holmquist & Gardiner at Holmquist + Gardiner | Real Estate Lawyer in Seattle, Washington (lawhg.net).