Background Check

Due diligence facilitates acquisitions behind the scenes.

Even though due diligence isn’t the first thing that comes to mind when people think of multifamily acquisitions activity, which is going strong this year, this behind-the-scenes endeavor is an integral part of acquiring any property. While there are certain issues that have become more important than others at certain times, the due diligence process itself hasn’t changed much over recent years.

Jane Maushardt, senior vice president of acquisitions, Wood Partners, a multifamily developer and investor, says, “As we go through time, certain issues come up that become more important. There was a time when asbestos was a big deal, then water intrusion, mold. At one point radon was a big thing. The inspections and all the indemnification work become standard practice, but from a standpoint of determining whether you are buying what you think you are buying, I don’t think the due diligence process has changed that much.”

Due diligence processes that firms undertake typically involve the same sort of basic research to check out the physical condition of the property, its legal situation and business potential. As well, input on the local market provides additional perspective about the acquisition’s investment potential.

Studying the property

At the property-level, the inspection involves studying the building’s rent rolls, taxes, occupancy and expenses and getting a property condition report from engineers that looks into factors such as the building’s roofing, structure, electrical systems and HVAC systems. An environmental report, and mold and moisture reports, also help shed further light on the building’s condition. A legal review on the building’s leases,  zoning and title situation; compliance on matters such as the Americans with Disabilities Act; existing vendor and service contracts; as well as any litigation the building is involved in, are also typically parts of the process.

The building’s insurance contracts are also scrutinized. If the property is located in a flood or earthquake-prone zone, the process would also ensure that there is adequate insurance for such hazards. An indepth look into the existing tenant profiles could also help determine the tenants’ credit standing and demographics in terms of age and income.

Pinnacle, a Dallas-based firm that manages and invests in multifamily properties, also looks at crime statistics in a neighborhood to get a feel for the health of the neighborhood going back a year or two, according to Jeremy Edmiston, Pinnacle’s vice president, client services.

Pinnacle also does an audit of the building’s utilities in order to see if there is any way of adding value. Edmiston says, “We tend to find that there might be savings in utility management going forward based on the provider that’s being used and the system that’s in place.”

While the basic process to determine whether a property is worth investing in is not very different from one firm to another, what makes the difference is in the interpretation of the information. Ogal Claspell, vice president for realty investments with Passco, an Irvine, Calif.-based multifamily investor, points out that experience is important in this regard. For instance, they might find a building that’s being run on a payroll that is much below what Passco thinks is necessary to operate a similar building.

Claspell says, “In that case, the data is the same no matter who looks at it, but we’re going to mine our experience to come up with a number that makes more sense to us. Or we’re going to try and understand why they operated so low compared to what we thought. Maybe they know something that we don’t; maybe there’s something unique about that property.”

Market characteristics

Another aspect of due diligence is to understand the local market the property is located in. Thus, research is conducted to examine the economics of the market, as well as the demographics—such as the age and income profile—of the people. Getting input on the total number of units on the market, the local vacancy rates and the market history in terms of past sales prices is also helpful.

To get market input, due diligence managers turn to various research firms such as REIS, MPF Research, Axiometrics and PPR. While these firms provide local input, their reports tend to be standardized. In order to get the idiosyncratic local input, managers also talk to local people, such as property managers  and other real estate professionals. They could also draw on their own past experiences in the case of markets that they are familiar with. And, various third-party reports are obtained from experts such as engineers, appraisers and lawyers.

In order to compare a specific property with others on the market, surveys and Internet research techniques are also useful. “Through discussions with the occupying folks, discussions with the local property management firm we are dealing with, we come to an understanding of what the competing properties are in our area. We want to understand not only what they are asking for rent, but we want to understand the quality of that property compared to the quality of our property,” Claspell explains.

Impact of technology

While the due diligence process itself hasn’t changed much over the years, technology has helped facilitate the process. Thanks to input from Google Earth and Google Maps, for instance, a manager can get an idea about a property before visiting its physical location. It is much easier to access various research reports.

All this has helped speed things up a bit, Passco finds. However, Maushardt says, “It’s nice to go in and look at a Google map and see an aerial of the property, but I don’t think it has a major impact on the process or results of a due diligence effort.” However, she does find that it helps in putting together presentations.

Due diligence can make a difference

With multifamily acquisition activity continuing to be strong this year, there is heavy competition for properties, with a lot of capital chasing multifamily properties.  This means that investors’ expected rates of return, or cap rates, remain low. Edmiston notes, “We’re at that part of the cycle now where pricing is heated in most major markets as well as secondaries.”

In this sort of competitive environment, behind-the-scenes due diligence activity can serve to ward off bad deals and give investors a competitive advantage. It is not unheard of for a deal to fall apart after the due diligence process. Maushardt says that deals have been scuttled, for instance, because two parties couldn’t agree on the cost or scope of a physical issue.