June 12, 2019

JF1744: How To Perform Due Diligence On An Apartment Syndication Deal

In the first two parts of this series, Theo broke down 10 financial documents you’ll need to be familiar with for you apartment syndication due diligence. Today Theo will be explaining how to analyze the first five of those 10 documents. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!


Best Ever Tweet:

“Depending on what type of loan you’re getting, you may have to address some things before you close”


If you’re a passive investor wanting to learn more about questions to ask sponsors in order to qualify the opportunities, sponsors, and the markets opportunities are in, visit BestEverPassiveInvestor.com.

We created this site just for passive investors to have a free resource providing the questions to ask and things to think through. BestEverPassiveInvestor.com


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 am your host, Theo Hicks.

Each week we air two podcast episodes that are typically a part of a larger podcast series that’s focused on a specific aspect of the apartment syndication investment strategy. For the majority of these series we will offer a document, spreadsheet, some sort of resource for you to download for free, that accompanies that series. All of these free documents, as well as past Syndication School series can be found at SyndicationSchool.com.

This episode is a continuation of a series we started last week. This is part three of the series entitled “How to perform due diligence on an apartment syndication deal.” At this point you have a deal under contract, and you are beginning the three things that you need to do before closing, which is 1) secure financing, which was the topic of discussion in the previous series. This series is number two, which is to perform due diligence on the apartment community, and then number three, which will be the series we begin next week, is to actually secure the commitments from your investors.

So 1) fund the majority of the deal with that, 2) make sure all of your assumptions are actually accurate, and that there aren’t any disqualifiers of the deal, and then 3) fund that debt with equity from your investors.

If you haven’t done so already, I recommend listening to parts one and two, where we introduced the ten due diligence reports that you’re going to need to get during this due diligence period. In those two parts, first we described what each report was, we talked about how to obtain these reports, so who you need to get them from, we talked about the estimated costs based off of it being a 150+ unit deal, and then I opened up some example reports from an actual deal that Joe has done, and kind of just walked you through how the report flows.

And as I mentioned last week, parts three and four we’re gonna go back over those ten reports, but this time we’re going to discuss how to actually analyze those results. In this episodes we’re gonna get through as many as we can, just because the six through ten are more of disqualifiers; so if the report comes back clean, you’re good to go. If it doesn’t, then you need to renegotiate with the owner a new price. They need to complete whatever needs to be done, or you back out of the deal.

I recommend when you are — just taking it back high-level, when you’re going through these due diligence reports, you’re gonna wanna have your cashflow calculator open and then if you did your rental comps on a different document, I would have that open as well. That’s how we’re gonna talk about the due diligence reports in this episode; I’m gonna go through and say how you should analyze the results, and then we’re actually gonna look at the simplified cashflow calculator that you can download for free at SyndicationSchool.com. It’s under series number 14, where we’ve talked about how to underwrite a value-add apartment deal… So I’m gonna tell you exactly where in that model you would need to change things based on the due diligence report.

Let’s jump right in, starting with number one, which is the financial document audit. So you use the results of the financial document audit, which as a reminder is the audit of all of the financials, bank statements of the owner, and then a contractor will create their proforma and what they believe the income and expenses will be based off of that. So you’re gonna use that report to confirm or adjust our income and expense assumptions.

When you underwrote the deal, if you remember, these were the assumptions that you based off of the Trailing 12 months of profit and loss and the rent roll that was provided to you by the seller. Then you also based these assumptions on the market cost per unit, per year raise for the expenses. Or you had a conversation with your property management company and they helped you determine what those stabilized expense and stabilized income assumptions should be.

As I mentioned with this report, you’re gonna go ahead and open up your model and go through each of the stabilized income and expense line items, and you’re gonna want to compare those with your results of the financial audit. Or what’s also likely or possible, depending on the contractor who performs the audit, they might even have created a summary tab that has one column that’s all their income and expense assumptions, in this column it’s your income and expense assumptions, the next column is any deviations, so a positive or negative number, and then they might put a little comment there saying “Hey, I know you had $1,000 per unit for payroll, but based on our evaluation it’s actually gonna be $1,100/unit/year for the payroll.”

So if you need to make any adjustments, or if any discrepancies were found, then before you go ahead and just make those changes in your model, you’re gonna go ahead and discuss those with your property management company first, just to confirm that you need to change those income and expense figures in your model. So run the audit via your property management company.

Depending on the number of discrepancies or the size of the discrepancy, there might be a change in your projected returns. If you are telling your investors that you’re gonna find deals that result in a 15% IRR and a 10% annualized cash-on-cash return, when you first underwrite the deal and put it under contract maybe you’re at 11% cash-on-cash return annualized and a 16% IRR… But then you get your financial document audit back and you realize that the maintenance and repairs are gonna be way higher than you first expected, and those returns dip below at 15% IRR and 10% cash-on-cash. Well, then you might need to actually go back and renegotiate a different purchase price, or you might need to back out of the deal entirely… Because again, you don’t wanna buy a deal just because; it needs to make sense.

On the actual cashflow calculator, the things that might change as a result of the financial document audit are gonna be those revenue and expense line items under the stabilized column, so vacancy loss rate, loss to lease, concessions… In this cashflow calculator they’re labeled as [unintelligible [00:08:38].19] discounts given to employees living on site; those are units being used as a model unit, so it’s technically a zero rent… Maybe a maintenance room…

You’ve got bad debt and other income, so those are the revenues that might change based on this financial document audit. And then all of your expenses: payroll, maintenance and repairs, contract services, turn make-ready costs, advertising, administration costs, utilities… The management fee probably won’t change, just because that’s something you negotiate with your property management company. Taxes probably won’t change, unless you did the calculation incorrectly… Insurance – that might change. And then lender reserves and asset management fee should stay the same. The lender reserves is something you negotiate with the lender, and the asset management fee is something you negotiate with your property management company.

Again, if you change those, you’re gonna wanna go ahead up to — on this cashflow calculator it’s the projections data table, and it starts in row 7, column K. You’ve got your projected cash ROI, your project cash 5-year IRR, your LP cash ROI and your LP 5-year IRR. You wanna make sure that those are still above that threshold that your investors want.

Number two is that internal property condition assessment. The internal PCA is something that is also created by a contractor, and essentially they will provide you with a document that has different priority levels of repairs that need to be made – immediate repairs, recommended repairs, and then ongoing repairs. You’ve got your immediate repairs, your immediate replacements, which are things that need to be addressed immediately after closing, and depending on the type of loan you’re getting, they might even need to be addressed before you close on the deal.

Then you’ve got your recommended replacements, which indicate maintenance issues that were identified, that aren’t necessarily required to be replaced, but the things that are kind of like “Hey, you should replace these, but you don’t have to replace these for the property to be in working order.” Then the third category, as I said, was the continued replacement, ongoing replacement.

Those are things that don’t need to be replaced right now, but they will need to be replaced at some point during the business plan. For example, let’s say the roof has about five years of life remaining, and your business plan is to hold on to the property for ten years… Then the roof is not gonna be an immediate replacement, because it still has some life left, but at some point during the business plan you’re gonna have to replace that roof.

Now, in addition to just listing off these three different categories of repairs, this report will also list out the preliminary costs, because this is gonna be provided by a contractor of your choice, ideally your contractor… So they’re gonna review the costs of the interior items and maybe even the exterior items that require repair.

If you remember, during the underwriting process you created your renovation and upgrade plan for the interior and exteriors of the apartment community, and then you also put in some projected costs. Maybe you yourself have a background in construction, so you just came up with those costs yourself, maybe you based them off of another deal you had done, maybe you based them off of a deal your mentor or consultant has done, or maybe you just had a conversation with your management company and they gave you some ballpark numbers. But again, these are assumptions, so you want to confirm that these are actually accurate with this report.

Once you receive this internal PCA, you’re gonna want to go ahead and compare 1) the costs, and 2) the actual items that need to be repaired, and make sure that they align with your assumptions. For the exteriors, how do the contractor’s findings compare with your budget for the exterior renovation?

You’re gonna wanna look at those immediate repair(s) that need to be done in the future and see “Okay, what did I think needed to be repaired immediately, and what did I think needed to be repaired at some point in the business plan, and how do those compare to what my contractor said.” If you didn’t include something in there that your contractor did, then you’re probably gonna have to adjust your number. Then do the same thing for the interiors as well. If there was some deferred maintenance that they were able to identify that this contractor didn’t identify, you’re gonna  wanna know that.

Keep in mind that these are gonna be preliminary costs, so they’re not gonna be the exact costs. These aren’t quotes; these are just contractors saying “Hey, based on our experience and what we saw, we’re thinking this is gonna cost about this much.” However, these are preliminary costs that are created by a contractor, so depending on how you did your assumptions, unless you did a full inspection of the property, these assumptions are likely going to be better than the assumptions that you made during the underwriting process.

So if there are discrepancies between the contractor’s estimated repair costs and your budgeted costs, then you’re gonna have to change the renovation figures on your model, so that they reflect the results of the PCA.

Now, hopefully, I guess best case scenario is that your assumptions were right on the point; all the deferred maintenance, immediate repairs, continued replacements that were found by the contractor are all included in your cap ex budget, and the costs are the same. And ideally, since you should be conservative in the first place, they might even go down. You might discover that you thought it would cost $25,000 to repair the parking lot, whereas the contractor said “Oh, this is only gonna cost you $15,000 to do.” That’s the ideal situation.

However, if something comes up that wasn’t accounted for, or if your expenses are too low, then you’re gonna have to make adjustments in your cashflow calculator, and just like the adjustments you made based on the financial audit report, this might push your returns below that threshold, and outside the range of your investors’ goals, at which point you either need to renegotiate the purchase price, renegotiate some other expense on your cashflow calculator, or you’re gonna have to back out of the deal.

Moving to our cashflow calculator, since this is a simplified cashflow calculator, you are just going to have one little cell where you can input your capital improvement budget. That’s gonna be cell C14. It says Capital Improvements. It’s under the Uses category, along with Purchase Price, Operating Account Funding, Acquisition Fee, Closing Costs and Financing Fees.

I believe I’ve mentioned this in the series about underwriting, but since this is a simplified cashflow calculator, you’re gonna want to utilize the comments function on Excel. For example, in that cell C14 about capital improvements don’t just put in a number. You’re gonna want to create a comment and say “Okay, for the interiors [unintelligible [00:15:44].05] cashflow calculator is about 1.5 million dollars.” Let’s say we plan on spending $750,000 on the interiors. Then you wanna say below that “Here’s exactly how much money we’re spending per unit on the countertops, the kitchen, the bathrooms”, and then same thing for exteriors.

Spending the remaining $750,000 on the exteriors – “I have to restripe the parking lot, we’re gonna renovate the clubhouse, we’re going to go ahead and buy new pool furniture, we’re gonna revamp the fitness center…” That way you can send that budget to your contractor, so they can go ahead and give you preliminary costs for those upgrades, but also you can have a clear picture in your mind of what the costs actually are, because this report – you’re probably not gonna get it for a few weeks, or maybe a month or two after you initially underwrite the deal; so if you just plugged in a number based on a calculation you did on your notebook and you’ve lost that notebook, then you’re not gonna know how that number was calculated.

Overall, number two is the internal PCA. You’re gonna wanna review that and make any adjustments to your cashflow calculator based on those results, and those adjustments will be made in cell C14, next to Capital Improvements.

Number three is the Market Survey Report. The Market Survey Report is created by your management company, and they’re gonna go ahead and compare the subject apartment community, the apartment community that you’re buying, with the direct competitors in your market, and we discussed how to find good rental comps in that series on how to underwrite a value-add deal.

Ultimately, they’re gonna provide you with the market rents, or in the cashflow calculator they’re labeled as renovated rents… That you’ll be able to achieve after you’ve completed your business plan. So your property management company knows the upgrades you’re planning on implementing at the property, they’ll take the information, they’ll find other properties with those upgrades already completed, determine a rent per square foot, and then based on your square footage of your units or the same unit type they’ll go ahead and give you an estimated renovated rent. Obviously, to determine the accuracy of your renovated rent assumptions you’re gonna wanna compare the average rents for each unit type from this market survey report with the renovated rents you have in your financial model.

Now, this report is created by your management company, as I said, so you can trust that these are the rental premiums you should be comfortable with, because since they are going to be managing the property and they’re telling you “Hey, based on what we can do, these are the rents that we can get”, you can go ahead and trust those. Maybe just review and make sure that the amenities line up; maybe you changed your upgrade program based on the results of the PCA that came in, so that might have some adjustments… But overall, you can trust the numbers sent to you by your management company.

Again, like all these reports, if there is a discrepancy between the results of this market survey report and the assumptions that you made on your financial model, then you’re going to want to make those necessary adjustments. And then again, review those projected returns to make sure that they are still above that threshold.

Going to the cashflow calculator – any changes made from the Market Survey Report are gonna happen under that Unit Mix data table. Specifically, you’re gonna wanna make the changes to cells G10 through cells G15. Or if there’s more than five unit types or six unit types, then obviously you’re gonna have to expand that data table and you’ll have to change more renovated rents… But right now we’ve got six unit types – A1, A2, B1, B2, B3 and C1. And we’ve got our renovated rent assumptions based on our rent comp analysis, and then we’ve got our rent premiums compared to the current rents at the property.

Maybe you have to change all six of these, maybe you have to change one or five of them, or maybe you don’t have to change any of them. Again, depending on how good your initial rent comp analysis was… And if you wanna know how to perform your own rent comp analysis, rather than just trusting the numbers listed in the offering memorandum, we also discuss that in this series on how to underwrite a value-add apartment deal, and we also gave away a free rent comp template that allows you to perform a rent comp on the phone, by calling these actual properties that  are comps.

We’ve got the Rent Comp Detailed, which is what you discover from your online investigations, and then we have that amenities checklist that you wanna use first, just to determine that the comps you’ve found are actually truly comp properties.

Next is the Lease Audit Report. That’s number four. The Lease Audit Report compares the data obtained from the actual leases with the information provided in the rent roll. When you’re underwriting a deal, the owner is not gonna send you – for this particular deal it’s 256 units – 256 leases. What they will send you is the rent roll, which is a summary of those leases. Each unit has its own row, or maybe a couple of rows, and then you can take that and determine, “Okay, so for all 48 A1 units the market rent on average is $973. For the A2 unit type, the current rents on average are $978.” And then maybe there’s some vacant units, so the vacancy loss for this property is $150,000 per year.

Mostly what you get from the rent roll is gonna be that economic vacancy loss, as well as — well, I guess technically you’ll get the units from there as well; any units that are being used as models, office units, things like that. And obviously, as all the information you had, those are what you used as your underwriting assumptions. Once you get the Lease Audit Report, your property management company is actually gonna look at all 256 leases. They’re gonna look at the rents on those leases, they’re gonna look at the terms, they’re gonna look at the actual lease start and end date, and things like that.

Then in that report, any discrepancies found between that rent roll and the actual leases will be highlighted. So unless the current property management companies are completely incompetent and aren’t tracking things properly, there shouldn’t be any discrepancies at all. If there are, they should be minor… But even if there are minor discrepancies, you need to make sure that you update your model. More specifically, in the cashflow calculator the cells that might change are gonna be those current rents under the unit mix, so H10 through H15.

Then you’re also gonna wanna take a look at that vacancy. Maybe the rent roll was from six months ago, and the current market rents have gone up  or they’ve gone down, or there’s more vacancies than you initially thought, which is why it’s important to look at the historical 12-month vacancy, as well as the current vacancy, to see “Okay, did they just fill this property up to sell it, or is this indeed the actual average vacancy that they’ve had for the past 12 months?” So those changes will be made to those current rents and those vacancies.

Now, you maybe ask yourself “Why do I care how the property is currently operating? What really matters is how it WILL operate.” Well, the appraiser is gonna base the value of the property on the current net operating income, as well as other methods – the replacement approach, as well as the sales comparison approach… But any changes to those rents, up or down, is gonna affect the value of the property; and the value of the property is gonna impact the type of loan you can get.

If you underwrote at current rents that were incorrect, and when you put the new rents the NOI goes (let’s say) way down, then you’re not gonna be able to get as high an LTV loan. Of course, it’d be better if the rents were actually up. That way the value of the property will be higher than hopefully the purchase price, and you’ll have some free built-in equity at purchase. That’s number four, the Lease Audit Report.

I think we’re gonna stop there for today, and we’re gonna go through five through ten on tomorrow’s episode.

In this episode we went through how to review the results of the first four due diligence reports. One was the Financial Document Audit, two was the Internal PCA, three was the Market Survey Report, and four was the Lease Audit Report. And then again, I  actually had the cashflow calculator open, the simplified cashflow calculator which you can download for free at SyndicationSchool.com, under series number 14, “How to underwrite a value-add apartment deal.” I went through exactly where in that model the adjustments will need to be made for each of those reports.

Until tomorrow, I recommend listening to parts one and two of this series, “How to perform due diligence on an apartment deal.” I recommend listening to the previous other 13 Syndication School series about the how-to’s of — sorry, not 13; we’ve got more than 13. We’re in series number 17 right now, so I recommend listening to the 16 other free Syndication School series about the how-to’s of apartment syndication… And go ahead and download that simplified cashflow calculator if you haven’t done so already. All that can be done at SyndicationSchool.com.

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

    Get More CRE Investing Tips Right to Your Inbox

    Get exclusive commercial real estate investing tips from industry experts, tailored for you CRE news, the latest videos, and more - right to your inbox weekly.