Time to get into more details about the remaining five documents of the 10 that you will need to be familiar with in your apartment syndication due diligence. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!

 

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TRANSCRIPTION

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 – every Wednesday and Thursday – that are a part of  a larger podcast series that’s focused on a specific aspect of the apartment syndication investment strategy. And for the majority of these series we offer a document, spreadsheet, some sort of resource for you to download for free.

All these free documents and free Syndication School series podcasts can be found at SyndicationSchool.com. This episode is going to conclude a four-part series entitled “How to perform due diligence on an apartment deal.”

As I mentioned in yesterday’s episode, the three things you’re going to be doing concurrently after you’ve put a deal under contract – that is you signed the purchase and sales agreement – is 1) you’re going to secure financing from your lender or mortgage broker. Two is what we’re talking about today, which is due diligence, and the financing was the previous Syndication School series; I believe it was series 16. Then the third thing, which we’ll talk about next week, or at least the series will start next week, is securing the equity from your investors.

So far, in parts in one and two, we introduced the ten due diligence reports that you’re going to need to obtain during the contract to close period. We described what each of these reports are, we described how to actually obtain these reports, so who actually does these reports and how to find those individuals, we talked about the estimated costs of each of these reports, and then I walked you through example reports from actual deals that Joe has done, just to give you an idea of the flow and the size of these reports.

Then yesterday, or if you’re listening to this in the future, the episode preceding this one, we began to discuss how to actually analyze the results of these due diligence reports, and we got through the first four. We got through 1) the financial document audit and the adjustments that will be made from that are any of your income and expense assumptions; 2) was the internal property condition assessment, which the adjustments would be made to your capital improvement budget, specifically the exteriors; 3) we went over the market survey report, and these adjustments that might be made as a result of that report would be your renovated rent assumptions, so the rents that you believe you’ll be able to get after you’ve implemented your value-add business plan and your capital improvements. And then number four was that lease audit report, which really depending on the current management company and how they created their leases, you shouldn’t have any issues with this; but if there are any issues, the adjustments would be made to the current rents, or maybe some of the revenue items, like vacancy or concessions or the units that are being used for other purposes.

Something that I didn’t mention is that if there are crazy issues with the leases – maybe the terms aren’t up to the legal standard – then that’s something that you’re gonna have to address before taking over the property, because you don’t wanna inherit a bunch of (in this case) 256 leases that are technically void, because they weren’t initially created properly.

In this episode we’re gonna go over those remaining documents before we move into discussing step three, which is securing commitments from your investors.

The fifth report you’re going to obtain is that units walk report. As a reminder, the unit walk report will summarize the current interior conditions of each unit. It’s going to outline the exact number of units that require upgrades, they’re gonna outline what type of upgrade they need, as well as any maintenance or replacement of certain items that needs to be addressed, and they’re also going to look at any resident issues as well.

Literally, you and/or your property management company are gonna walk through every single unit, you’re gonna have an iPad out with some sort of unit walk software, or you’re just gonna have a notebook, or maybe you’ll have a printed out Excel template, and you’re gonna say “Based on my upgrade my plan, maybe (just to keep it simple) one of the things we plan on doing is to upgrade the appliances to stainless steel.” You’re gonna walk through every single unit and you’re gonna say “Okay, which units have stainless steel and which ones don’t?” Because before, when you’ve made your assumptions, maybe you thought that none of the units has stainless steel appliances, and you assumed it would cost $1,000 per unit to put into stainless steel appliances, 256 units, that’s $256,000.

Well, let’s say you do your unit walk report and that’s not the case. This is one example of one thing that could be discovered during the unit walk report. So once you receive the unit walk report, you’re gonna wanna go ahead and compare that data with your interior renovations assumptions to determine the accuracy of your business plan.

The first thing that you’re gonna look at is does the number of units that require interior upgrades from this unit walk report match your business plan? Again, if you think you need to upgrade the appliances in all 256 units, but in reality 50 of those units already have stainless steel, then that’s a $50,000 decrease in your budget. So you wanna do that for all your upgrades. Any flooring, countertops, cabinets, anything in the bathroom, any lights you’re installing.

Next you’re gonna wanna see if there were any unexpected deferred maintenance that wasn’t accounted for in your budget. Maybe your entire budget was focused on everything being in perfect condition, but maybe during the unit walk report you realized that 10% of the units have peeling paint, or have holes in the walls, or water damage in the bathroom… Maybe you didn’t think that  you need to replace the cabinets, but once you actually got into all the units — maybe you only toured the model unit, and you assumed every unit was like that, but then you realized that half the cabinets need to be torn out completely and you can’t just replace the cabinet doors, and things like that.

Then you’re gonna wanna go ahead and see if your property management company made any notes about residents. For example, maybe the current lease states that they can’t have pets in the units, but you find 10% of the units have dogs, and you can tell that there’s animals in there, and because of that, all the carpets need to be replaced. This is at the discretion of you and your property management company, but maybe there’s some tenants that you believe will need to be evicted once you’ve taken over operations.

Those are the three main categories you wanna look at. One, do the actual number of upgrades match the number of upgrades in my business plan? Two, are there any extra deferred maintenance items that I missed? And then three, what is the tenant situation?

Using that data, you can 1) no matter what, create a much more detailed unit-by-unit interior renovation plan, which will allow you to create a more accurate budget. So instead of just continuing with the example from the last episode, where I said that of that 1.5 million dollar capital improvement budget on that simplified cashflow calculator, let’s say half of that is going to the interiors… And you said, “Okay, this much is gonna go to the kitchens, this much is gonna go to the bathrooms, this much is gonna go to the rest of the house”, whereas now you can literally have an Excel document with 256 rows for each unit, and you can say “Okay, in this unit, what do I need to do in the kitchen? What do I need to do in the bathroom? What do I need to do in the rest of the house?”, whereas before you might assume that you needed to do everything to all units, whereas after the unit walk report maybe you only need to do everything to half the units, and the other half of the units only need appliances, or new cabinets.

For the deferred maintenance, hopefully you put in a contingency, which we highly recommend 15% of your budget should be contingency. Ideally, they did not identify deferred maintenance that would cost you more than 15% of your cap ex budget. Ideally, they didn’t find any at all, so that 15% is just built-in equity… Or you need to just raise less money.

And then for the unruly residents, you will want to have a conversation with your property management company on how to move forward with that.

Now, going to our simplified cashflow calculator, which again, you can download for free at SyndicationSchool.com under series 14… The adjustments to this we made in that cap ex improvements. So the internal PCA is where you make your exterior adjustments, the unit walk report is where you make your interior adjustments.

Number six is the site survey. The site survey report is basically a map, and it will list any boundary, any easement, any utility, any zoning issues for the apartment community. Typically, if a problem is found during the site survey, then the bank is just not going to provide a loan on the property. So if there’s some easement unaccounted for, if there’s some boundary issue, some utility issue, some zoning issue, then that is going to need to be resolved before new debt can be secured on the property.

So if you’re assuming the loan, not necessarily a disqualifier, but definitley something that you’re gonna have to worry about when you sell the property, if your loan isn’t gonna be assumable. So if something does come up, unless again you had that assumable loan but there’s still issues with that, then your options are really limited, and they need to be addressed on a case by case basis, depending on the severity of the issue. But ultimately, if the problem cannot be resolved, then you’re gonna have to go ahead and cancel the contract, which is why when we talked about submitting your LOI, you wanna make sure that you have the proper contingencies in place. So you wanna have your inspection contingency, your title, survey, loan contingency, things like that.

Number seven is the other property condition assessment. This is the PCA that is performed by a third-party that your lender selects. Essentially, this is going to be the exact same as the internal PCA you performed. The goal is the same, which is to determine the quality of the exteriors, and then go ahead and give you the immediate repairs, recommended repairs, and then the contingency replacement items. And you’re gonna wanna go ahead and approach that the same way you approached your internal PCA. You’re gonna wanna look at all of the different immediate repairs that the lender requires, because in this case the lender might require you to make those immediate repairs… So your general contractor might have categorized a certain repair as recommended, whereas your lender might have categorized the repair as immediate, which means you’re gonna have to adjust your budget because you’re gonna have to those right away in order to qualify for that loan.

Then for recommended and continued, you’re gonna wanna see if the lender included anything in addition to the things included by your general contractor. So essentially, you’ve got two PCA’s, and you’re gonna wanna combine those together and make any adjustments to your cap ex budget.

Going back to the simplified cashflow calculator, that adjustment will be made at C14, Capital Improvements.

Number eight is the environmental site assessment. The environmental assessment report will list out any potential or existing environmental issues at the property. Similar to the site survey, if the person that performs this environmental site assessment identifies an environmental problem, then you’re gonna wanna get with your lender to make sure that that is something that won’t disqualify you from financing. Because if it does, then you’re not gonna be able to secure a loan on that property.

Maybe even find a different lender, who will overlook that issue, but again, like the site survey, these issues should be addressed on a case by case basis, and if there’s major issues found, you might have to cancel the contract. Because again, even if you were able to qualify for financing somehow, the rules might change, or another lender might not provide financing to someone who wants to buy that property at the end of your business plan.

Number nine is the appraisal report. The appraisal report will provide you with an as-is value of the apartment community. Once you receive the appraisal, obviously you should compare the appraised value of the property to the purchase price. Now, as I mentioned in part two (I believe), there are a few different ways the appraisal will determine that as-is value. Number one, they will calculate the value using the income approach, which is dividing the net operating income by the market cap rate.

Second, they will determine the value using the sales comparison approach, which compares this property with comparable properties that were sold within the last 6-12 months, or even longer, depending on the market; if you’re in a really small market, then they might have to find a property thta was sold more than 12 months ago, or if you have some very unique property that’s one of a kind in that market, they might need to expand out into another market.

The example that I was giving in my real estate agent classes was if there’s some waterfront property in Cincinnati that’s very unique, then they might have to go to some place like Pittsburgh to find a similar comp for the sales comparison approach.

And then the third way they calculate value is by determining the replacement cost of the property, so literally how much will it cost to replace this property – that’s the value of the property.

Now, the lender is going to use this appraisal to determine how much money they’re willing to provide you with, how much debt they’re willing to put on the property. They’re not gonna base it off of the contract price. So just because you have the property under contract for a certain price and the lender told you they’re gonna give you 80% LTV does not mean that, for example, for a ten million dollar property they’re gonna loan you eight million dollars. They’re only gonna loan you eight million dollars on that ten million dollar purchase price if the property value determined by the appraiser is indeed ten million dollars.

So if the appraisal comes back at that ten million dollar mark, good on you. What’s even better is if the appraisal comes back at a higher number. Let’s say you have a property under contract for ten million dollars, and the appraisal comes back at 12 million dollars. Well, if you’re still getting that 80% LTV loan, essentially if you’re getting an 80% LTV loan or the same LTV loan at a higher value, then you’re gonna have built-in equity from the front. For example, following the 12 million dollar appraised value, since you’re under contract at 10 million dollars, you’re putting down 2 million dollars, the bank is putting down 8 million dollars, that extra 2 million dollars is essentially equity that you have for free. So if you were to refinance it in a year, you’ve got 2 million dollars of equity built in without even implementing your value-add business plan in the first place. That is fantastic.

But if the appraised value is lower than the contract price, then you will either need to make up for that difference by raising additional capital, or you’re going to have to renegotiate the purchase price.

For example, if the property is under contract at 10 million dollars and you’ve got that 80% LTV loan, but the appraised value comes back at 8 million dollars, then 80% of 8 million dollars is 6.4 million dollars, which means rather than putting down that 2 million dollars initially, you’re gonna have to put down an additional 1.6 million dollars. Obviously, that’s going to throw off your returns, so if you are unable to renegotiate the purchase price, or if you didn’t have amazing returns at that initial purchase price, then you’re gonna have to go ahead and cancel that contract.

Now, the only exception to that is if you are implementing a very strong value-add program, so you’re raising the rents a lot, raising the income a lot, or decreasing the expenses a lot, and the appraisal comes back a little low, then you might be okay. The lender might say “Okay, I know the as-is value now is 8 million dollars; however, based on your business plan, the value is gonna increase to 15 million dollars by the end of year one, so we’ll go ahead and loan based on that 10 million dollar purchase price, or we’ll go ahead and increase the loan-to-value that we’ll give you.” That means that your down payment for that loan might not necessarily change, it might not be a reflection of that lower appraised value.

So on your cashflow calculator the appraisal might change your purchase price, which is C13, but it also might change the terms of your loan, which are all the way down in rows 61 through 64. That’s your LTV. Maybe they might give you a different interest rate, amortization, and the loan term might not change unless you’re getting a completely new loan based off of that lower appraisal value.

Let’s say for example you’re wanting to get just your standard agency Fannie Mae loan, and they have a minimum loan amount, and that appraised value drops to below minimum loan amount, then you’re gonna have to go and change to that small balance loan instead, and those terms are a little bit different.

Number ten, which is the optional report, is that green report. The green report, which is really the only report that is not going to disqualify a deal, unless you made the assumption that you were gonna be able to decrease some expense because of what you expected the green report to come back as, it shouldn’t disqualify the deal.

The green report outlines all of the potential energy and water conservation opportunities. So it’s gonna list out all of the opportunities that were identified – among other things, but these are the things that are important to you – the estimated costs upfront to implement that opportunity, and then the associated cost savings, as well as an ROI.

Deciding which opportunities to move forward with will be based off of the payback period and your projected hold period. For this cashflow calculator, it automatically assumes you’re holding on to the deal for five years. If you want to change that, you’re gonna have to go in there and do some manual manipulations… Because again, this is simplified, it’s not super-detailed. We just wanted to give you a base model to start with, and customize it from there. For this model, if you get a green report back and the payback period is greater than five years, then you probably don’t wanna do it, unless it’s some safety issue… And if it’s under five years, the obviously, you’re gonna wanna move forward with that.

So here’s an example of the energy-efficient opportunities, the energy water conservation opportunities that were identified on a 216-unit apartment community that Joe had assessed a few years back. They identified about seven different things. Number one was installing dual pane windows. Number two was installing a wall insulation and leakage ceiling. Three was installing roof insulation. Four was installing programmable thermostats. Five was installing low-flow shower heads and toilets. Six was installing LED lighting on the interiors and the exteriors, and then seven was the energy star rated refrigerators and dishwashers.

After looking at the initial investment amount and the cost-savings with all seven of those, Ashcroft decided to move forward with three of those seven. Number one was the low-flow shower heads, which had a one-year payback, and after that it was annual savings of about $16,000. They also went ahead and moved forward with the exterior LED lights, which actually had a 14.4-year payback, and then after that about $3,200.

As I mentioned before, you wanna base your decision of off 1) the ROI and 2) the safety. This was a safety issue, and the LED lighting was better for safety and security, so they went ahead and decided to install those, even though it didn’t technically make financial sense. And then three, which I guess I didn’t mention in my list of seven, so there’s actually eight… They went ahead and put a cover on the pool, which had a 1.5 year payback period. After that, $400/month in savings. It’s small, but it’s still $400/month.

As I mentioned, the reason behind implementing the low-flow shower heads and the pool cover was because of the five-year plus hold period, so they were able to pay that back; for the shower heads it was one year, for the pool cover it was 1.5 years, which means they had about 3-4 years of extra capital coming in due to the fact that they don’t have that capital going out. So that was purely for profit, whereas technically they ended up losing money on the exterior LED project, but the lights were installed, again, for the safety.

So in the green report they’re literally gonna list out everything. Anything that could potentially save you energy, no matter how long the payback period is, it’ll be listed out. Going back to those seven from the 216-unit example, if they were to implement all of those opportunities, the overall payback period would have been 92 years, and the longest payback period would have been 165 years, for the energy star rated dishwashers.

So unless they decided to hold on to the building until they were dead, or some sort of immortality serum was created, then stick to the opportunities that result in a payback period that is lower than your projected hold period, or if it is going to address a safety concern. The really only other exception I can think of is if you’re trying to position your property as a green, environmentally-friendly property. In that case, you might be able to get higher rents by saying that all of our appliances, our energy star rated, we’ve got dual pane windows, we’re doing all these different things to be eco-friendly. That might help, but again, it’s gonna be depending on your renter demographic.

Those are all ten reports for the green program going to the cashflow calculator. The reduction will be in your utilities, so that is the stabilized utilities in cell F48. That is where you will see those reductions. So if you are having, for example, a reduction of $16,000 per year after the payback period, you can go ahead and reduce that.

And of course, since you are going to be putting up extra equity to complete these projects, you might also have to change the capital improvement budget in cell C14.

At this point you should have made all the updates to your cashflow calculator based on these ten reports, and either made a decision to move forward at the same purchase price, to renegotiate the purchase price, or to cancel the contract in general. If you stay at the same purchase price or you’re able to renegotiate a new purchase price, then the next step is going to be to start raising money for the deal, which we will begin to talk about next week.

This concludes this series about how to perform due diligence on an apartment community. I recommend listening to parts 1-3, as well as the other Syndication School series about the how-to’s of apartment syndications, as well as make sure you download that free simplified cashflow calculator under series 14 about how to underwrite a value-add apartment deal. All those can be found at SyndicationSchool.com.

Thank you for listening, and I will talk to you next week.