The Good Stewards Real Estate Podcast

How Apartment Due Diligence Should Be Done Part #1

Episode Summary

As always your due diligence period is the most important to verifying and solidifying your deal regardless if it’s a single-family or apartment. Taking on an apartment complex is a different kind of animal because if in your initial preview of the property, you’re seeing the two best units and the rest are trashed, the deal becomes very different. We’re going to outline how more seasoned investors should prepare for apartments.

Episode Notes

Why Due Diligence is Critical:

1:40: Due diligence is about as important you can get. And it's even more important when it comes to apartments. You make a mistake on apartments, it just compounds it over and over and over again.

2:53: You want to make your own proforma based on their operating history and the market as well as what you think you can do with the property.

3:50: The idea behind due diligence is basically take what you think is true of the property from your pre offer analysis, your estimate based on the few units you've seen, the financials you've seen, the pro-forma you put together.

Apartment DD Specifics:

6:45: Walk and inspect every unit.

9:00: Get roof inspections, pest/dry rot, perhaps even a Phase One.

13:53: $500,000 HVAC and AC conversion from chiller system story.

15:03: FARE, Future anticipated rehab expenses.

Planning for Turnover:

17:11: Ryan’s “buying an eviction” approach is significantly more expensive with an apartment..

19:40: You’re buying into a community, you’ve got to upgrade the community in addition to the property.

Apartment Repositions:

20:24: The 39-unit rehab was budgeted between $400,000-$500,000. Actuals have passed $2M, but the deal still works out.

24:50: Be conscious of complete repositions, 12-units took Andrew 6 months alone.

Connect with the Good Stewards:

Episode Transcription

Amanda: [00:00] On the 39-unit we budgeted about half of the purchase price, which was $400,000 to $500,000. And since we've purchased it, we've spent $2 million on it. We've got it back, it works out, but we didn't exactly hit our budget numbers.

Ryan: [00:21] Welcome to The Good Stewards podcast, the only podcast dedicated to seasoned real estate investors who want to maximize the cashflow potential in their business. We are “buy and hold” investors with a thousand plus properties and markets across the U.S. who bring an insider's view into the nitty gritty details of real estate investing. If you're looking to develop the mindset teams and systems that can dramatically build your real estate business and network, you're in the right place.

Ryan: [00:54] Welcome to this episode of The Good Stewards podcast. I'm Ryan Dossey.

Amanda: [00:57] I’m Amanda Perkins.

Bill: [00:59] I'm Bill Syrios.

Andrew: [01:00] And I'm Andrew Syrios. Welcome everyone. Again, please check out our website, thegoodstewards.com. You can find our podcast there as well as our free eBook. Today we are going to dive into due diligence, particularly due diligence on apartments. I think we've said multiple times. Due diligence is one of the most important things you can do. It's often overlooked. It's almost always done less well than it should be. And we have plenty of experience doing that ourselves in each market we've been in.

Ryan: [01:28] Guilty.

Andrew: [01:31] We're all guilty as charged to one degree or another. Even now, even after harping on this bandwagon for many, many years, I still make mistakes here. So, due diligence is about as important you can get. And it's even more important when it comes to apartments. With houses it's very important, but at the same time, you make a mistake on a house, you can lose some money. You make a mistake on apartments, it just compounds it over and over and over again. And there's more places to screw up as well. Plus, an apartment can be sort of a never-ending sinkhole. You keep pouring money into it and then people start leaving and they need to fix up their units. And then the people whose units you just fixed up, they trash their units and they leave. And so, it's just over and over and over again. A house, usually you get done with and you move on.

Ryan: [02:22] It's real passive.

Andrew: [02:25] And so, I mean the first part with apartments is when you get apartment under contract, I mean you should do some work up front. This is not a matter of like, oh, you just throw out random offers. Of course, get an apartment under contract and then you go look at it. You should walk through, you should look at the exterior, you should look at least a couple of units. You should get the rent roll and the operating statement. If the proforma is nice so that usually if you're getting a seller provided proforma, it's usually bogus. So, you want to make your own.

Amanda: [02:51] We sometimes call it the “pro-fakea”.

Andrew: [02:53] It has been called the pro-fakea. You want to make your own proforma based on their operating history and the market as well as what you think you can do with the property. If their utilities are off the chart, then maybe, put some money into figuring out why that's the case. Maybe new windows, maybe fix a leak, whatever, and then you can reduce the utilities down to what you think market is. But you should be reviewing these things, creating your proforma, looking at the units, asking a lot of questions, asking like, is this the general condition of these units? Try to see,

Ryan: [03:27] They're not going to show you the worst ones right off the bat. [Inaudible 03:29]

Andrew: [03:31] But you should ask how many are down, like how many units are just simply unleasable at this time. See a couple and kind of make an estimation of how bad this is for the apartment at large. No one is going to show you every unit right off the bat before you have even put an offer in. They're going to show you a couple and they're certainly not going to show it if it's a large 100-unit complex, 50-unit complex. Even if it's an eight, you're probably going to see about two at most. That's how you put your offer together. But once you have in the contract, that's when due diligence begins. You want to take what you have. The idea behind due diligence is basically take what you think is true of the property from your pre offer analysis, your estimate based on the few units you've seen, the financials you've seen, the pro-forma you put together. Take that and make sure it's true because usually at least part of it is not true. It might not be a big thing. It might not matter that much, but at least something in there that you thought was true is not. And guess what? It's always in the same direction. Shockingly, you're never surprised like, oh, this property is so much better than I thought it was. It's in such better shape and condition than the…

Amanda: [04:35] It’s making so much more money than I anticipated.

Andrew: [04:40] Just like you almost never go under budget. You almost never assume the property is worse than it is. You almost always assume it's better. These are mistakes that are always made in one direction.

Bill: [04:53] And as you're doing your due diligence, you're also engaged in negotiation. It's kind of a rolling negotiation to some extent because you're communicating to the seller that well, if everything is what I think it looks like from these two examples that are the best ones that you have on the premises, then I think this is where I'm going with a number. But if it's not that quality, then we'll have to talk about it, kind of thing.

Ryan: [05:23]Yeah, I think especially verifying the info they give like on things like utilities, like Andrew mentioned. Even on like smaller multifamily. There was a duplex we were going to buy and an owner paid utilities. He was like yeah, yeah, they're like $300 a month and we called the utility company and they were $900 a month on a property that was pulling in, I think $1100 in rent. So, it's like, yeah, no, we're good.

Andrew: [05:48] Trust, but verify. Or in the case of due diligence, don't trust at all, verify and then verify again. There are several things you want to look at. The first thing, there's just a rule pretty much without exception, is that you want to walk every single unit. And so, there could be 100 units on the property, there could be 200 units on the property and that would suck. I've done one with 74 units and that took all day and it was not fun, but it's what you need to do. You need to figure out what all the units’ condition is. And if you're under contract to sell it, this should be something that sellers are wanting to do. Now, if you're a bigger operation, you can have one of your underlings do it, but make sure they put together a very, very thorough report.

Ryan: [06:33] Hopefully none of our underlings listen to this.

Andrew: [06:38]  I'm sorry, your trusted valued employees. That’s a go. I mean, that must have been, that must have been a slip, but we can cut that out. But you want to walk every single unit, you want to put an estimate of how much it will cost to repair those units because often there's a lot of, it's beyond just TLC. There's significant upgrades need to be made to these units. Oftentimes we’re buying properties from either the bank or from Mon Paul landlords who've had a long time. They've cut corners. They haven't done the consistent work that needs to bring the property up. You're going to need your place, the carpets of countertops to appliances, the vinyl, the paint. That adds up. You've got $5,000 to $10,000 per unit if you're doing something like that.

[07:22]  Now you shouldn't do just standard little like basic unit turns. But if you've got to replace, you got to plan on replacing half that building's appliances. That's an expense, one, you should have accounted for upfront, but you need to make sure when you're walking these units. You can get professional inspections and I recommend them. There are different ways to approach it. One, you could have the inspector look at every unit. That would be extremely expensive. Usually we have them look at maybe a couple of units and then specific things that we're looking for. So, there's all sorts of different professional inspections you can get. But if the roof is other than new, you should have it looked at.

Ryan: [08:05] Especially if it’s flat.

Andrew: [08:06] Especially if it's flat, absolutely. If it's flat, that's bad first of all.  You don’t want it to be flat. It’s more expensive to replace and you need to replace it more often. But yes, you should definitely inspect if it's flat. I haven't seen any studies or evidence on this, but it certainly seems to me that people install flat roofs wrong much more often than they install regular roofs.

Ryan: [08:29] They are also so expensive. I mean...

Bill: Yeah, membrane roofs, now that you nearly, everybody puts membranes on, but they're very expensive. They are actually very effective though once you have a membrane.

Ryan: [08:43] I’m more just like a flex seal it. Just kind of get up there and rattle-can that sucker on.

Andrew: [08:47] Yeah, just use the foam.

Ryan: [08:49] Slumlording 101.. How to flex seal a roof.

Andrew: [08:54] By the way, that's our new podcast, Slumlording 101, coming out next month. Foam learning one-on-one. I don't know. Okay. But yeah, so roof inspections, you can get Pest & Dry Rot inspections, especially if you see any signs of rot or soft wood or anything like that. It's probably worth doing. It's worth doing on any major apartment complex you're buying. If you're doing a house and you see any sort of evidence that there's been termites or like mud tunnels or soft water or soft spots on the floor, take a look at it. Apartment is probably worth checking out for carpenter ants.

Ryan: [09:26] Mice, cockroaches.

Andrew: [09:28] Particularly termites and carpenter ants. Those are the ones that are the worst because they chew your property up. If it's a property over 25 units, really, there's no great mark. You should get a phase one, which is an environmental study to make sure that the property doesn't have an underground, oil tank or something like that.

Amanda: [09:48] That's two fold because oftentimes a commercial lender is going to require that. So, if you maybe have a creative way of financing on the front end and you're not getting a commercial loan, you might want to know what you're in for because you don't want to have be stuck remedying problems.

Andrew: [10:03] Phase ones aren't that big like $2,500. They're worth doing for an apartment. The risk first reward, like most of the time it'll be fine, but if you get that underground oil tank or some…

Ryan: [10:16] Or if you pay cash or you use private money and then find out, it used to be a gas station. Good luck.

Andrew: [10:23] The odds are in your favor, but you're risking everything if it goes wrong, so get it. Now you might have to get a phase two if they show problems. If you need a phase two, that probably means it's time to renegotiate, which we can talk to because those are expensive. That's when they start digging and doing soil samples and things like that. Occasionally you might meet an ALTA survey. These are pretty expensive, but they are just to check the boundaries of the property and what's on it. Usually you don't need that, but if there's some sort of boundary or easement issue you might need that.

Andrew: [10:51] I would recommend, especially for newer investors to get some professional inspections, particularly having an inspector at least walk one or two units, kind of check them out and look at any specific items you might have questions about - The HVAC, the plumbing, etc. Get Pest & Dry Rot and for an apartment, get phase one.


 

Ryan: [11:07] I would say especially with apartments, especially with properties you're purchasing at a discount because they need work be very cautious of boiler and radiator systems.

Andrew: [11:18] Oh, yes. That's a good point.

Ryan: [11:19] We had a five unit we bought that has been our project from hell for the last two years and we got everything done. Like, wow, this is awesome. And all of a sudden, our boiler's not working. And then we get the boiler fixed and all of our radiators start leaking. And it actually made more sense from a cost as well as a rent perspective for us to switch everything over to HVAC, which meant, all kinds of new permits, all kinds of new, I mean, running ductwork where there was none. So, I would say particularly if you're looking at a complex that's on like boiler and window units, you got to think about long term. What kind of residents are you going to get that want to use a boiler system in 2020? What sort of turnover are you going to have when that doesn't heat well enough or heats too well? And then just kind of the hidden cost there.

[12:17] Bill and I had looked at a 25 or 30 unit and one of the big reasons we chose not to pursue it, well, there was a lot of reasons that we chose not to pursue it, but one of the bigger ones was the boiler system and set up was just like, I mean, we're talking like auto zone mechanic hodgepodged together and it was just kind of a ticking time bomb. Something just to kind of be cautious of, especially if you have something like that to go out in winter. All of a sudden, you're paying a lot of money to house a lot of people while you're trying to get something fixed.

Amanda: [12:53] Right. And to note, nobody's really putting boiler systems in, which means there aren't a lot of people that are really qualified to fix them. And so, it's going to be more expensive and sometimes the parts don't exist. All sorts of things that come in there. So just be mindful.

Andrew: [13:10] Yeah, there are some newer boiler systems that are pretty great, but a lot of times, if you're not dealing with one of those newer systems…

Ryan: [13:18] They don’t usually come with those.

Andrew: [13:20] Every once in a while. We bought one apartment that did have newer boiler systems and they were like, they had them inspected and I definitely recommend that. But, yeah, usually you're dealing with those old…


 

Ryan: [13:31] Thomas the tank engine barely rolling coal burner.

Andrew: [13:34] Yeah, that's just… Yeah, that’s a big problem and you need to probably expect to put some serious money into that. Maybe even upgrade to HVAC, which is going to… Or a furnace system. And that's going to cost a lot. I know, dad, you had some serious issues as one apartment for, with a chiller system, right?

Bill: [13:53] Yeah. We bought one that had a chiller system as a matter of fact…

Ryan: [13:56] For those of us that are under the age when that was around, what is that?

Bill: [14:03] So, this thing, it would heat the entire, like buildings. We had a couple of large buildings, like 20-unit buildings and these things would heat and cool these buildings. And it's just a monstrosity, that we actually ended up trying to sell it because there are other people who are looking to buy these units used because they have the same problem that you have unless you switch over. We eventually switched everything over to HVAC and AC on this complex to the tune of $500,000 or something. It was an expensive proposition.

Ryan: [14:37] Is that like the hot and cold water thing?

Bill: [14:41] Yeah. Well, it cools it by water. Yeah. But it doesn't… Actually, some of them are also connected to the plumbing system, which just makes a bigger nightmare and usually all in the slab, which means that you're tearing up concrete anytime you have a leak. So, it is just, yeah, it is something to  tread, very cautiously about. And that kind of leads me to think about one thing. When you're looking at a property, you're evaluating what needs to be fixed now, but also what needs to be fixed later. Because you may have residents living there that you're assuming are going to continue to live there maybe for months, maybe for years. But when they move out, you know you're going to have to face serious expenses because one, they've been able to live in it as is, but the carpet's bad, the vinyl’s bad, a lot of things need to be changed. And you also want to upgrade the rents, which is another factor you're looking at the apartments - What is your upside, what kind of value add can you bring to it? So, in your due diligence, you're thinking of those aspects as well. We have a term, an acronym. I guess we call FARE - Future Anticipated Rehab Expenses. FARE. And you need to pay the FARE whether you pay it immediately or in the future, you realize that as an expense coming your way, like a freight train or maybe not. Maybe it's a slow-moving train, but it's certainly coming your way. So, what's your FARE - Your Future Anticipated Rehab Expenses?

Ryan: [16:13] I would also say on that note, sometimes it's a very fast moving freight train. And don't assume - Oh, well, it's 90% occupied, all of these people are going to stay, they have “been paying”. Which is something we're going to talk about here in a second. But don't assume that that's a can that you're going to get to kick down the road very far. We had a 12 unit we bought that, like on paper looked great and it was like everybody picked up a meth habit in 30 days. I don't know if it was just, they didn't like that we wanted them to now pay rent or what, but we had like, okay, these are in decent shape. Our turns on those of average, right about $10,000 a unit, but we thought we're going to have basically $120,000 of construction over the next several years. Okay. This is perfectly doable. I think we've paid out 80 or 90 of it in the first 60-90 days.

[17:11] I would say I treat houses when I'm buying them as if when they're occupied. Like I'm buying an eviction. Right? It may look okay right now, but it may not when they're done with it. Or let's assume they're going to leave day 31. What kind of cash do I need to have set aside for this? I would treat apartments very, very similar. The people I know that do these successfully, they pretty much budget to purchase the property, get everybody out, multi-six figure renovation, turn the entire complex, raise rents and re-lease. I think a lot of new investors, myself in particular, get clobbered when they think they can treat apartments the same way they treat a house or a duplex of like, well they're there and they're paying and we'll just fix stuff as they leave. You run into more of, I think a community issue when you have said 15 people that are used to living together and it's kind of who you hang out with is where you're going to end up. So, I would just say be, be cautious of that, that you may not get to kick that can down the road quite as like Andrew mentioned. It's never been longer than I've expected. So, it's always come back…

Bill: [18:27] Well, you're almost always looking for a value add property that has an upside and the upside is often to rehab it and increase rents. You're often facing problems, issues that you're going to have to deal with and don't undershoot how much those are going to cost you. Budget those out. Make sure you are aware that is an expense. We bought two multi-families in Dallas that we went through the same set of circumstances. Essentially, within two years, one was a 39-unit one was a 37-unit. Within two years, every single resident, virtually, there may have been one or two exceptions, had the leave for one reason or another. That meant there's a lot of holding costs, a lot of rehab costs, and you've got to figure that, that could be your set of circumstances if you're buying a property that is in real need of a fix up. The resident base, the rental renters in the property is a very valuable thing if it's a solid rent-paying, a pride of ownership kind of a community. But oftentimes you're not buying that. You're buying something much less pride of ownership. It could be drug issues, could be prostitution issues. You're buying into a community, that you've got to upgrade the community. Not just the property but the community. And that is a piece of work.

Ryan: [20:03] You've used the expression before, Bill, if you're renovating the tenant pool of the property as well. I think people would find interesting, if you know the number, Amanda, how much was spent on renovation and holding costs on that. Because I know it's a big number.

Amanda: [20:17] How much did we budget or how much should we spend?

Ryan: [20:20] Let's do both because I think that's a good thing.

Amanda: [20:24] Wow. On that latter, the 39 units, we budgeted about half of the purchase price, which was, $400,000 to $500,000. And since we've purchased it, we've spent $2 million on it. We've got it back. It works out. But we didn't exactly hit our budget numbers, not by a long shot. In the first one, we got a smoking deal on the property in the first place, we bought it for $10,000 a door. So, we were all in at purchase price, $360,000. And I think our budget was around $150,000. And we initially, the first time we did it, we probably spent about the same as the purchase price, a little more on rehab, so $10,000 a door.

[21:15] And then we've done, I mean, we've owned that for quite a few years now, so we have significantly more in it, but it was an entire apartment community reposition. We brought in a whole new kind of resident. The first one that we did that we bought in 2011, it was a tough situation. It was basically a flop house, crack house, just not something that you want to own. So, we knew going in, everybody had to go. And the area in that, it was built-in has really improved in the last nine years that we've owned it. And so, there was a lot of community changes anyway.

[21:59] After our first round then we did kind of more upgrades. But it's gone up in value a lot. And both of those are good assets for us and they cashflow well. We manage them very well. But we weren't even close on our budget. And I mean, I want to say that we, I mean, it was early in the apartment buying game, we definitely weren't newbies to buy hold. We were newbies to this market. And so, just lots of lessons learned. If you don't have pockets filled with money to learn those lessons, I mean, we had to come up with it, one way or another, but some people might not have the resources that we had to do it. So, you would just be stuck. You'll be stuck with a property you couldn't finish and couldn't rent.


 

Bill: [22:52] And the word “reposition”, which is a good word Amanda used, is the word for a property like this. And it should scare you to use that word “reposition”. I've known people who've taken on 300 to 400-unit complexes that had to be repositioned. And that's a kind of thing that can bring you down and not just financially, but it's kind of something you got to give your life to. Now at the end of the road, it could be well worth it. If the numbers work out, it could be the golden child that funds your entire retirement.

Amanda: [23:27] Well, if, yeah, I mean, if I go back to the first one we acquired the 36-units at $10,000 a door, last appraisal, it was approx..., it was valued, two and a half million dollars. I mean, it's worked out well for us. But we've had appreciation in the market. We had some things that you can't always count on. We also do a really good job at repositioning it and finding the right community and a resident base, people that will pay their rents, not necessarily on time. We get what we put into it. And so, we get a lot out of it because we put a lot into it.

Ryan: [24:11] I think one of the thing I would highlight on these is the timeframe. Typically, these deals, this is not a flip for six months later you're like, wow, that was a pleasant experience and it's not, we've made $1 million. A lot of the times with these, this is more of a long-term play. This is probably going to take a couple of years. And I think that's just something for investors that have maybe done a couple of BRRRR deals and like, wow, I got all my cash back in seven months. This is a little bit of a different animal. So, I would say proceed with caution.

Andrew: [24:50] We just finished a 12-unit apartment complex a little bit ago and I mean, it was exhausting. The construction side of it took six months. That was just 12-units. It was a complete reposition. If you're going into 100-unit apartment looking for a complete reposition…

Ryan: [25:07] You're going to live there.

Andrew: [25:10] You should be, if you've got 10 years of experience and done lots of deals and okay, fine. But if you're just getting into real estate or have a little bit of experience, not the thing you should be doing. You should be looking for performing deals, value adds or minor repositions like slightly underperforming or you can slowly upgrade the tenant base by doing some various improvements with things like this.

Bill: [25:30] Having a trusted contractor that you really are confident in something like that is pretty key. Bringing them along in evaluating it and very likely the person who might be doing the work because that it’s a long-term commitment and you're going to need somebody by your side that you trust.

Ryan: [25:54] These are typically the different caliber than your residential. This isn't two guys in a truck. This is five trucks. You're typically dealing with a larger, more established business. But that also typically you're going to pay more. This isn't your electrician that's going to rewire something for $1000. This is ideally a crew that's going to come in and knock stuff out. But we ran into some challenges trying to turn a residential contractor into a commercial contractor and they struggle. It's a different animal in and of itself.

Andrew: [26:42] There's a thousand rabbit holes you can go down with due diligence and the whole process of pre-positioning. I think we should circle back around to the main focus here. I think we need to make this a two parter and have the second part be on analyzing the financials and also renegotiating or packing out when you get there.

[27:05] So, the main focal point I think of due diligence on the whole, at least on the material side on the actual physical aspects of the building is that you want to walk every single unit. When you're going through there, you want to put a budget together. You want to split it, really preferably split that out. What are the FARE? What are the things that eventually you're going to have to pay for and what are the things that you're going to have to do now? For the units that are down, the exterior. There are often a lot of things to do on that. You want to get inspections to make sure that there are no big problems you're unaware of and also to verify certain things about the roof or pest and dry rot or things like that. And then you want to take those, you add up all those budgets and make sure that that expense is very close to what you thought it would be. And if it's off, like early on, I usually tell like when I put the property contract, usually I put it in writing in an email or perhaps in the LOI what my expectations are, what I think the building is. If they want to correct me on that and say no, no, no, no, it's much more rehab than that or the units are much worse than that, they can let me know. If not, I have that there and I can point to that if there's a problem. Like if there's many more down here, it's much more rehab to be done. There's an underground oil tank, it’s an EPA superfund site.

Ryan: [28:23] They’re a slumlord.

Andrew: [28:24] Or whatever. I can point to that and be like this is my expectation. This is that. But I think we're closing in on the 30-minute mark here. I think this is probably a good place to wrap up due diligence for apartments part one. And we will move into due diligence for apartments part two, where we discuss looking over the leases, looking over the financials, looking over the tax returns, verifying, getting verification of that the tenants are actually paying rent, the numbers they put on the rent roll and the operating statements are actually true. Putting together your own proforma, verifying, verifying those numbers and then renegotiating or walking from the deal if necessary. So, we'll make this a two parter. To be continued. I know we're all just waiting with bated breath, but again, thank you for joining us and please check out our website, thegoodstewards.com. Download our free eBook. Follow us on Facebook and we very much appreciate you for joining us.