June 7, 2019

JF1737: How To Perform Due Diligence On An Apartment Syndication Deal Part 1 of 4 | Syndication School with Theo Hicks


Last week Theo covered financing options for apartment syndication deals. For this week’s series, he’ll be covering the due diligence process as it pertains to large apartment communities. Today we’ll hear details about five documents you’ll be reviewing, tomorrow we’ll cover five more documents. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!


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Joe Fairless: There needed to be a resource on apartment syndication that not only talked about each aspect of the syndication process, but how to actually do each of the things, and go into it in detail… And we thought “Hey, why not make it free, too?” That’s why we launched Syndication School.

Theo Hicks will go through a particular aspect of apartment syndication on today’s episode, and get into the details of how to do that particular thing. Enjoy this episode, and for more on apartment syndication and how to do things, go to apartmentsyndication.com, or to learn more about the Apartment Syndication School, go to syndicationschool.com, so you can listen to all the previous episodes.


Theo Hicks: Hi, Best Ever listeners. Welcome back to another episode of the Syndication School series, a free resource focused on the how-to’s of apartment syndication. As always, I’m your host, Theo Hicks. As you know, each week we air two podcast episodes – every Wednesday and Thursday – that are part of a larger podcast series, where we discuss and focus on a specific aspect of the apartment syndication investment strategy.

For the majority of these series we offer some sort of document, spreadsheet, resource for you to download for free, that accompanies that overall series. All of these free documents, as well as the free Syndication School podcast series can be found at SyndicationSchool.com.

This episode is going to be part one of a series entitled “How to perform due diligence on an apartment syndication deal.”

As I mentioned in  last week’s episode, once you place a deal under contract, there are three things that you’re doing concurrently. Number one is you start the process of securing your financing, and that was the focus of a previous series, so if you haven’t done so already, I highly recommend listening to that series. Again, that’s at SyndicationSchool.com. We discussed the overall process for securing financing for your deal.

The second thing you’ll be doing during the contract to close period is you’ll be performing due diligence, and that’s going to be the focus of this series. Then, of course, in order to fund the debt, you’re gonna need to raise capital from your passive investors, so that’s the third thing you’re doing – securing those commitments – and that will be the focus of the next series.

In this episode, part one, we are going to discuss the due diligence reports you need to obtain during the due diligence period. It’s actually ten documents, and the goal is to review documents one through five in this episode, and review documents six through ten in tomorrow’s episode.

Now, when I mean review, what I’m going to do is I’m going to describe what the report actually is, and I’m actually going to pull up an example and I will walk you through and discuss what the document looks like. These are reports from an actual deal that we did, so unfortunately we can’t share those, but hopefully I do the description justice; I’m sure if you googled it, you could find examples of each of these reports.

I’m also gonna discuss how to obtain each of these reports, and then I’m gonna discuss generally how much these reports cost. Now, what I’m not gonna talk about is what you actually do with these reports once you get them. That’s going to be the focus of next week. Next week we’re gonna go through (in part three) due diligence documents one through five, in part four due diligence documents six through ten, and discuss what you need to look for when reviewing these documents, and how that could potentially impact either your underwriting model, or your ability to even take down the deal in the first place.

As I mentioned, there are ten due diligence reports you need to obtain. Due diligence reports one through five are the financial document audit, the internal property condition assessment, the market survey report, the lease audit report, and the unit walk report.

As I said, we’re gonna walk through and describe what each of these documents are, I’m going to describe what they look like with an example, how to obtain the report, and then also how much the report costs.

Starting out, the financial document audit. This is going to be an analysis of the apartment’s historical operations, and then the actual report will compare the historical operations to your projected income and expense figures. If you remember in the episode about the LOI, one of the things that you’re going to want to collect are the current owner bank statements, their rent rolls, their three years income and expenses, and these are going to be used to conduct this audit.

For this audit, typically they’ll provide the consultant with detailed historical financial reports, the leases, the last three years of income and expense data, bank statements, rent rolls… Essentially, anything they need in order to perform this audit. And they’re going to do their thing in the end and at the end they’re going to provide you with a report in the form of a detailed spreadsheet that essentially is where they logged all the information that you sent them. That includes historical income, operating expenses, non-operating expenses, and then net cashflow. Then they’re gonna compare this with the budgeted figures that you provided, that you created during the underwriting phase. Then there’s also gonna be a lot more tabs that actually has the raw data that was used to create the summary tab.

The summary is gonna take a similar form to a proforma. It’s gonna look similar to the five-year, seven-year, ten-year proforma that you created during your underwriting process. So you’re gonna have the individual income and expense line items broken down for easy comparison purposes on your end… And also it’s ideal that the consultant will also provide you with a second document which is an executive summary, which will essentially explain to you how to interpret the audit that they’ve performed, as well as what data was used to create the spreadsheets. They’ll say “Hey, I used the rent rolls you sent me, the leases you sent me, the historical expenses and incomes you sent me, the bank statements you sent me…” And then they’ll also ideally have a written explanation of any figures that deviate from your budget. Essentially, anything that they believe you are budgeting incorrectly – they will mention that in that summary.

Now, to obtain this document, you are going to need to hire a commercial real estate consulting firm that specializes in creating these financial document audits. So either through your mentor, your consultant, your property management company, or a quick Google search, or even your broker, you should be able to find a consultant that can perform this analysis for you… And the approximate costs for this is going to be around $6,000. Now, keep in mind that all of these costs are gonna be for, say, a 200+ unit building, so if you’re looking at a 20-unit building, it might not be $6,000, it might just be a couple thousand dollars less.

It’s also possible that your property management company can perform this audit for you, so that’s something that you can ask them and see if they will do it and what the cost will be. But we use a third-party outside group to perform these analyses.

So just quickly going through the actual example – there are 10+ different tabs. The first tab is entitled Input, so it says “This is how to actually read the document”, and then they’ve got the Summary tab, which again, looks very similar to a proforma, so it’s got the previous three years ago summary, two years ago summary, and then the previous year, and then the budget, and then any adjustments that the analyst made that was actually performing this analysis. Then it has any adjustments that we would make on our end. Then it explains in the comment section why the analyst made that adjustment, and then why we as a client made that adjustment.

And then essentially every other tab is just the raw data that was used for the summary. For example, it’s got the T-12 monthly breakdown, it’s got the prior year monthly breakdown, the prior two year monthly breakdown, it’s got the scheduled base rents, which is just the market rents, and all the other income losses – loss to lease, delinquent rent, rental concessions, vacancy loss… It’s got any non-commercial rental revenue, it’s got a list of a rent roll for non-commercial revenue, it’s got a bank statement analysis, so it goes through each of the deposits for the bank statements that were provided… There’s another income tab that breaks down all of the other income… It’s essentially got over 20 tabs. It’s got a payroll tab, it’s got a management fee tab… Essentially, every single category that’s on that summary page has its own tab.

On the summary page, for example, for payroll it just says Payroll, or Other Expense, so on these other tabs it’ll have a breakdown of “Okay, so under Utilities, here are what the actual costs were. Here’s water, here’s sewer, here’s trash.” So again, very detail.

Of course, this is something that you can make yourself pretty easily, except obviously you’d have trouble with the adjustment aspect of this. So that’s number one, the financial documents audit.

Number two is the internal property condition report, or the internal PCA. The internal PCA is a detailed inspection report on the overall condition of the apartment  community. A licensed contractor will inspect the property from top to bottom, so they’ll look at all the interiors, all the exteriors, and then based on this inspection, this contractor will prepare a report with not only their recommended repairs, but also they will break that down into immediate repairs, recommended repairs, and continued replacements. So they’re not just saying “Hey, you need to repair these things”, they say “Here are the things you need to repair right now, here’s some things that you don’t necessarily need to repair, but you probably should, and then here are some things that you need to repair now, but you’ll definitely need to repair in the future.”

For all of these different priorities of repair items they’re also going to provide you with some recommended or preliminary costs for these repairs, as well as accompanying pictures of the interiors or exteriors or whatever else they deem to be an immediate repair, a recommended repair, or a continued replacement.

Now, since this is the internal property condition assessment, you are also going to need to find a third-party licensed contractor to perform this assessment on your behalf, and the approximate cost is $2,500. Now, the PCA report could be anywhere from 10 to 15 pages, up to 100 pages, depending on how many repairs were identified, and it’ll start off most of these documents with a summary, so you can technically just read that and they’ll summarize the information that’s in the actual body of the report… And then they’ll do an introduction just explaining themselves and their methodologies.

Then you’re gonna have the property photos and descriptions, preliminary costs for the repairs, and then some closing comments. For example — I’ll just do the summary; for example, it’ll say “The balconies and private patios are found to be in fair condition. Common areas are in good condition. The swimming pool is in fair condition”, and it goes through all the different line items – fences, pavement, landscaping, foundations, things like that. Then below that it says “Okay, based off what we saw, here’s what we think you need to do, and here are the costs. Exterior paints will cost $93,000. Carpentry for the siding and the trim, $160,000. Parking lot restriping, $8,500.” And this particular PCA is focused strictly on the actual exteriors for the costs, so they’re not providing you with the costs for the interior on this one, but that’s obviously something you can request.

Then below the summary it just goes into details on where they got that information from. “The balconies and private patios are in fair condition, so here’s some pictures of the patios.” Same with the parking lot, the fences, HVAC, things like that. So that is the internal property condition assessment, and in fact, the reason why we put that “internal” name upfront is because the lender is actually going to perform their own property condition assessment as well, so it’s nice to have two separate ones just for comparison purposes.

Now, the reports three through five are actually going to most likely — again, really depending on your property management company, it should be all in one document that your property management company creates. That’s the market survey report, the lease audit report, and the unit walk report. So I’m gonna go through each of those and then I’ll go through the actual report and walk you through what the report looks like and what you should expect to see. But of course, since this is created by your property management company, it’s likely going to vary based on their design and how they approach the actual reports.

Number three is the market survey report, and this is a more formal and comprehensive rental comparison analysis than the one you performed during the underwriting phase. If you remember, during the underwriting phase – this is also a Syndication School series we’ve done – we discussed the detailed rent comp analysis that you perform online, which is essentially you looking up properties on apartments.com, collecting those rents, creating your amenities spreadsheet to make sure they’re actually like properties, and then ultimately getting an average dollar per square foot in the market for your stabilized property, so that’s how your property will be after it’s renovated. And then using the square footage and unit types at your subject property, you’re able to determine what the new rents will be. Then you confirmed all that by actually visiting these properties in person.

This one’s a little bit different, because your property management company is going to do that, and they’ve got access to better softwares than we do. Your property management company is going to locate direct competitors of your apartment community, and then they’re gonna compare your apartment community with each of the direct competitors over all the factors we discussed during the rental comp analysis, and they’re gonna use those to determine the market rents on an overall and a unit type basis.

Number four is the lease audit report. The lease audit is the process of examining the individual leases at the apartment community. Essentially, your property management company will collect all of the leases of the current residents at the apartment community and perform an audit. During this audit, they’re gonna analyze each lease and they’re gonna record things like the rents, the security deposits, any concessions that are being offered and the overall terms, and then they’re gonna compare that information gathered from those leases with the rent roll. So they’re gonna make sure that all of the rents are aligned, all of the security deposits, all of the concessions are aligned, all of the lease starts and lease end dates are aligned. Then they’re also gonna look at some of the legal terminology to make sure that the leases were created properly.

Now, just because once you take over that property you’re going to be inheriting all those existing leases, you can’t change those leases until that lease ends. So if there’s something wrong with those leases, and if it’s something that would be risky to you, from a legal standpoint, or if just the numbers aren’t aligned, then obviously that’s something that you need to know.

And then number five is the unit walk report. The unit walk report is the inspection of each individual unit at the apartment community. The internal PCA is for the exteriors, the unit walk report is for the interiors. During this unit walk, your property manager or a representative from your property management company will inspect each individual unit. I’ve actually done one of these before, and it’s an all-day affair where you literally go to every single unit and have a pre-made checklist – and of course, everyone’s checklist is different, and they approach it differently. Maybe it’s very detailed, or they write down a sentence or two about the kitchen, the bathroom, or it could be a checklist of appliances, one through five, one being in terrible condition and needs to be replaced, and five being we can leave them alone.

The purpose of the unit walk is to determine the current condition of each unit. While they’re doing the unit walk, they will, as I mentioned, take notes, and they’ll wanna look at this like the condition of each individual room – kitchen, bathroom, living room, dining room, any other rooms that there are in the house. They’re gonna want to look at the type and the condition of the appliances… Because again, a unit that has white appliances won’t rent as much as a unit that has stainless steel appliances. So you need to know not only what type of appliances are in there, but also what is the condition of those appliances, a.k.a. do they actually function, and are they dented up, are they really dirty…?

They’re also gonna look at things like the presence or absence of washer/dryer hookups, because maybe some of the units have washer/dryer hookups, others don’t… They’re gonna look at the condition of light fixtures, they’re gonna look at missing GFCI outlets… Anything else that really stands out as a potential maintenance issue or a potential resident issue. So maybe it’s a very messy unit, or the unit is completely destroyed compared to other units because of the resident – well, that’s something you’re gonna wanna know if you have a problem resident at the property. You’re gonna wanna know how long their lease is.

As I mentioned, these three reports – the market survey report, the lease audit report and the unit walk report – will likely be all consolidated into one long due diligence report sent to you by your property management company… And ideally, the property management company will do these three reports for you for free, as long as you close. So a question you’re gonna wanna ask is “Will you perform the market survey report, the lease audit and the unit walk as long as I close on the deal, and if I don’t close on the deal and you perform these, how much money will that cost?” Of course, you could also hire a third-party to perform this analysis and create these three reports, and the cost of that will be approximately $4,000.

Again, this report is gonna vary from property management company to property management company, but just running through the one that I have right now – it’s actually 88 pages long, and it starts with a lease audit, and then it goes to the unit walk, then it goes to the market survey. For the actual audit, literally it’s a screenshot of all the rent rolls, and then any discrepancy is gonna be highlighted. For example, on this it’s a lot of security deposit discrepancies that are highlighted, which means that the security deposit listed on the rent roll is not the security deposit that was listed on the actual lease.

Then it’s gonna do the same thing where it’s gonna take a screenshot of the rent roll, and then it’s going to have an additional column with comment sections. So the highlighting is kind of a quick “Okay, what’s wrong”, and the next section or the comments are saying “Okay, well what exactly is wrong.”

For example, one of the comments says “Rent roll lists $150 security deposit, whereas the lease is actually $100.” Or this one right here it says that the credit results for this lease says a guarantor is required for this person, but the comment is there’s no guarantor on file.

Another example, the rent roll lists a rent of $975, when in reality the leased rent is $960.

All of these things are very important information for you to know, and it’s impossible for you to know going into the deal, because you don’t have your hands on all the leases, which is why it’s really important for you to make sure you’re requesting all of these things upfront. So that is essentially what the lease audit is.

The unit walk, again, will vary, but typically there’ll be some sort of summary tab. It will have a summary data table of all the different factors you’re looking at. For example, on this report we were looking at the living room flooring condition, the appliance type, the washer/dryer connections, the number of GFCI outlets, and then the light fixture condition.

For each of those data tables there’s all the unit types. For this particular property there are four unit types. Then there is a Good, Replace or Updated column header for each of those. For the first unit type there’s a total of 42 units, 24 of those units – the living room flooring is in good condition, in 12 of those units it needs to be replaced, and in 6 of those units it needs to be updated.

Now, obviously they have the same thing for appliances, washer/dryer, and then below that they actually have the raw data, where each unit has a row. If it has multiple things going on, it could have a total of five rows. If the living room, the appliance color, the washer/dryer, the GFCI and the living room are all out of whack… And then it just has a description of what we’re talking about, and then comments.

For example, unit 1, in the kitchen, the description is “Dishwasher condition”, and it says “The dishwasher in this unit is white, whereas all the other ones are black.” For unit 10 the description is “Pets” and it says that there’s dogs there. Another example is unit 94. It says “The master bathroom”, description “Bath light fixture condition” and the comment is “It needs to be reattached to the wall.”

Essentially, what the property management company did is they went to every single unit and they marked down for the living room and the flooring, whether it was good, needs to be replaced, or needs to be updated. For the appliance color – were the appliances all black, were the appliances a mixture of black and white, or were the appliances white. For the washer/dryer connection a simple yes or not. For the GFCI it was “How many are in the bath/ How many are in both the kitchen and the bath/ How many have GFCI in the kitchen only/ How many don’t have any GFCI at all.” Then for the living room – light fixture condition. Was the condition good, does it need to be replaced, or does it need to be updated.

Now, of course, you can do this for anything. You can say “I wanna know something about the bathroom, I wanna know about the kitchen flooring, I wanna know about the living room flooring. I wanna know about all of the light fixtures in the entire property. I wanna know about the windows, I wanna know about the front door.” It can really be anything. The data table below that actually isn’t the raw data for those summary data tables; I actually misspoke… It’s just overall comments on the units. So when they walk through a unit, if anything stood out, if it needs to be rehabbed, if there’s water leaks, if there’s pets, we’ll record it there. We’ll discuss how you use this information next week.

And then lastly is the market survey. Again, this is very similar to the market survey you see in an offering memorandum, but this time it’s actually done by your management company.

That concludes this episode, where we went over due diligence documents one through five. Tomorrow we’re going to discuss six through ten, before we go through all ten documents again and discuss exactly how you need to analyze these documents once they are received.

In the meantime, to listen to other Syndication School series about the how-to’s of apartment syndications and to download the free documents for the previous Syndication School episodes, visit SyndicationSchool.com.

Thank you for listening, and I will talk to you tomorrow.

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