March 17, 2024

JF3482: Skipping These 5 Due Diligence Steps Could Cost You BIG — the Due Diligence Show ft. Charles Seamen




Welcome to the Due Diligence Show, a new Best Ever series featuring deep dives into every aspect of the due diligence process. In this series, our host, Slocomb Reed, will interview expert guests to uncover their stories, tips, and strategies to give you the information you need to master the due diligence process.

Charles Seamen, a real estate syndicator focused on multifamily, joins host Slocomb Reed on the Best Ever Show for another installment of the Due Diligence Show. In this episode, Charles highlights five crucial steps in financial due diligence — steps that could cost you BIG if you skip them or don’t execute them properly. These include reviewing lease audits (and evaluating them properly), reviewing service contracts, what’s actually included in the sale (tools, equipment, inventory, etc.) and more. 

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Slocomb Reed (01:45.834)
Best ever listeners. Welcome to the best real estate investing advice ever show. I'm Slocomb Reed and today we are bringing you our best ever due diligence show. One day a week, we bring you an expert in the field of commercial real estate due diligence to deep dive into a component of this piece of commercial acquisitions. Experts who share their stories, tell us about their skills, the mistakes they've made, and the things that they've learned in, so that we have the opportunity to learn from the best.

Today we have Charlie Seamen. Charlie is joining us from Charlotte, North Carolina. He's a real estate syndicator who focuses on multifamily assets. His company is called Cash Flow Champs LLC, and his current portfolio consists of seven multifamily assets, totaling 775 units.

Our topic for today is five is our topic for today is five crucial steps to financial due diligence that will cost you big. If you skip them, Charlie, let's go ahead and dive into this list. No, sorry. Let me, let, I want to do that a little bit differently and sorry for the delay.

Charles Seamen (03:21.24)
Slocomb, thanks for having me on for the introduction.

Slocomb Reed (03:29.474)
Charlie's a long time friend of the best ever podcast. He actually knew Joe Fairless before he got into apartment syndication. He's been interviewed on the show a couple of times. If you, if you search Charles Seamen or Charlie Seamen, uh, best ever podcast, his episodes should show up and you can get a little more information on his background there. So let's go ahead and dive into your list of, uh,  of the five most crucial steps of financial due diligence. And we'll see where the conversation goes from there.

Charles Seamen (04:00.96)
Absolutely, so the list I have the first is going to be the lease order We'll talk about that one a bit more because that's going to be a pretty important one Second one is going to be your service contracts and agreements Third one is going to be the survey The fourth is going to be the list of equipment and personal property that's included in the sale And then the fifth is going to be your payroll and also utility bills. So really six in there, but we'll lump those last two together.

Slocomb Reed (04:37.558)
We, uh, we actually just recorded the premiere episode for the due diligence series, uh, with Dax Ferguson, if you know him and, uh, one of his top five mistakes across the board in due diligence was not taking the lease audit seriously enough. So, uh, makes a lot of sense that would end up on this list as well. Let's start there.

Charles Seamen (04:59.112)
Yes, absolutely. So, you know the lease order is definitely an important piece of the puzzle and you're going to see a lot of things that can be discovered as you do that. So What is a lease order? Let's start with that So what you're doing is you're taking the rent roll that the seller provides you and you're comparing it to the actual leases Why do we do this? Well you you want to see what's actually in the leases because if you have a dispute with the tenant and you need to take them to court for any reason, what's in the lease is what's actually going to prevail.

So what are we looking for with the lease? Well, there's a few things. First thing is you're looking for the names of the applicants that are actually on the lease because those should be the occupants in the unit. You're also looking for any additional occupants that may be on the lease even if they're not a leaseholder. 

And that could be, it could be adult child, it could be a minor, it could be any other person that for whatever reason is living in the unit legally, but they're not considered a leaseholder. You're also looking for the amount of the monthly rent, the start and end date of the lease agreement, whether or not any pets are included, and also if there's any fees that are charged for those pets, the amount of any security if you're just starting out, if you have security deposits, those security deposits are technically a liability because if the unit gets returned to you in good condition, then you need to return that deposit to the tenant.

So just make sure that you're clear on how much the tenant is actually provided and that you have that accounted for. And also you want to make sure of any additional rent charges. So aside from pet rent, there's many other things you could charge for.

There could be a water sewer feeding, a lot of properties charge that, that's a pretty common one. You may have properties where you wind up selling renter's insurance or something with bulk cable and internet service. So there's all different charges and the lease agreement's gonna dictate what you're legally able to charge and what you're not. So make sure you're clear on that because that could impact your financial projections going forward.

Slocomb Reed (07:21.083)
That makes a lot of sense.

Charlie, in your experience, where do acquisitions people and real estate investors, where are they making the biggest mistakes or the most common mistakes within the lease audit?

Charles Seamen (07:38.22)
Good question. So a lot of times what I find, most times you'll see that the occupants on the rent roll and the rents are usually pretty accurate. It might be minor discrepancies, but not major things. The biggest thing that I tend to find is on the pet rent and the other income and the late fees. So you really need to understand what the leases say so you can build out your financial projections accordingly. And if you're assuming that you could build back a certain amount of other income and you're not able to until that lease expires, then you need to adjust your projections to reflect that accurately.

Charles Seamen (08:19.16)
Sometimes even at the same property, you'll see more than one form of lease used. So what happens is you can't assume that every tenant is going to have the same lease and because of that you really need to do a check through each of them and make sure that you have each of the details for every lease accounted for.

Slocomb Reed (08:42.178)
That makes a lot of sense. Let's move on to number two service contracts. Tell us, tell us where you've seen investors make mistakes on receiving and analyzing service contracts of the properties they're buying.

Charles Seamen (08:58.072)
Sure, good question. Probably the biggest mistake is assuming that they can all be terminated upon a sale. Sometimes that's not the case. And there are certain agreements that may carry over even after the sale, so you as the buyer are going to have to inherit those agreements and make sure you build that price into your underwriting. So probably the more common contracts that you can't cancel, things like laundry rooms, usually bulk cable and internet contracts, those are usually not terminable upon a sale.

And those usually are big ones. So there are ones that usually can be terminated upon a sale and those are more common agreements like landscaping and pest control, security, many times those can be terminable upon sale, but go through the agreements and just understand which ones you're not going to be able to terminate and which ones may have a long-term impact so you know to account for them in your underwriting.

Slocomb Reed (09:58.934)
Yeah, the biggest I'm based in Cincinnati, Ohio. The biggest example here is with a company formerly known as Cincinnati coin laundry, now jets services. They signed multi-year leases with landlords to put their court operated laundry machines and laundry rooms and basements all over the city. And a lot of, uh, landlords don't realize that is a full long lease agreement.

And when they remove those machines, Jets, Cincinnati coin has litigated to get them put back in and they almost always win when they have to do that. So that makes a lot of sense. It's certainly something that you need to look into and there's language that needs to be in your purchase contract. And it needs to be a part of your due diligence process to be looking into these kinds of things. Have you seen coin laundry?

Coin laundry, laundry rooms, bulk cable and internet. Those are two very obvious examples. Have you ever seen other service contracts that are not terminatable, cancelable upon sale?

Charles Seamen (11:13.76)
Yes, but they're a lot less common. But to that point, you do have to read every agreement because sometimes it's the ones that you don't check because you assume they're terminable that wind up not being, and they wind up costing you money.

Slocomb Reed (11:30.066)
I know an example that I have come across in my own experience is landscapers and gutter cleaners who had contracts set up with previous owners that were terminatable but were not brought up during due diligence. And then they come out and they start cutting the grass and they send them a new bill. Or they come out and they clean out the gutters in the fall and they send a bill and the bill goes to the new owner who didn't hire them for the service, but there was a service contract in place. And those, and according to the in place contract, those contractors are owed the money for their services.

Charles Seamen (12:11.488)
Right, and you know, another example I've seen, and this is probably more common, I'm sure I've only had it happen once thankfully, but we had a property we bought where the owner or one of their relatives actually owned the trash removal company, so they were getting a more favorable rate than they probably would have gotten otherwise. And unfortunately, that was one that, you know, wasn't terminable upon sale. So those are things you need to build into your underwriting and carry them through until the end of the term.

So things you have to watch out for. Somebody has a relative or an interest in a different business, you know, maybe they're giving themselves a better rate than they may otherwise get. So just make sure you're clear on that and that you have that built into your underwriting, your pricing model.

Slocomb Reed (12:53.45)
Rare example of a time when you want a service contract to survive the, yeah, you lock yourself into that for as many years as you can.

Charles Seamen (13:03.208)
Yes, if you get a favorable rate, you hope that's these. Ha ha ha.

Slocomb Reed (13:07.542)
For sure. Number three on your list is the survey. Why did you include the survey in this list of financial duty, diligence steps?

Charles Seamen (13:18.54)
So the survey is an important piece because it tells you what you're legally buying and it shows you where the meets and bounds of the property are and ultimately, you know, it says okay this is the actual land and the parcels and all the improvements that you're buying and One from a legal standpoint or from a title standpoint, that's gonna be a big thing but two you also want to know what you're getting and especially if you're buying a property that might have vacant parcels or vacant land attached to it.

You know, if there's something additional you can build on, you want to know what the parameters of the land that you own are, so you can accurately account for that. Another thing is also just seeing if the title is up to date and if it's complying with current standards, because if it's not, you'll need to go out there and get a new survey, and oftentimes that's going to take many weeks, especially in the post-pandemic world. It's become increasingly tough and increasingly more expensive to find surveyors.

So if you do need an updated survey, you want to make sure you figure that out as early in the process as possible and order that so you don't have any issue with your closing time.

Slocomb Reed (14:29.154)
Charlie, is all of your multifamily investing experience in Charlotte or are you also invested or have you invested in other markets?

Charles Seamen (14:38.924)
Primarily Southeast. So I've been in Florida, Georgia, and both of the Carolinas. Originally I'm from New York, and I worked for a guy who did some multifamily investing, commercial real estate investing in general, up there, so I'm familiar with that a bit too, but mostly the Southeast.

Slocomb Reed (14:58.75)
In your experience investing in the Southeast is the need for a survey market dependent?

Charles Seamen (15:10.12)
Say it's more property dependent. So it can really vary based from property to property and oftentimes how long ago the most recent survey was done. So in the last five to six years there have been some updated survey requirements that weren't necessarily required by most standards prior to that. So usually if you have a survey older than that most times you're going to need to update it and that's because the lender and the title company are both going to want it to be compliant with the most current standards.

So you'll need to have that produced the way they want in order to satisfy their closing requirements. If it's something that's done within the last three, four, five years, a lot of times you can get away without needing to change it. Most times it will be just as simple as signing an affidavit, but the goal is to identify that as really in the process as possible so there's no delay as you get ready to close.

Slocomb Reed (16:08.27)
That makes a lot of sense.

Fourth on your list is equipment and personal property included in the sale. Tell us more about that.

Charles Seamen (16:19.48)
Sure. So one thing that's always good to look for, now let me preface this and say, most times this isn't going to be a deal breaker, at least in most cases, but it's at least good to know what you're getting. So aside from the real estate itself, a lot of times in the sale, you will get office equipment, you will get tools, you'll get machinery.

So you want to understand what you're getting. And if you're going in there and you're expecting to get a good quality set of tools and a good quality set of machinery and that can be everything from an office computer to a copy machine to a set of wrenches and tools. If you're getting a higher quality, you want to make sure you know what's included because many times what can happen is while a deal is in the contract, all of a sudden the high quality tools disappear and low quality ones replace them closer to closing.

So just understand what it is you're buying and if you're getting tools or equipment that has a certain value to it. Oftentimes it's good to go through and make a list of the makes and models and sometimes even serial numbers just to see what it is that you're actually buying and making sure that you get that on the day of closing. Aside from just tools, sometimes it could be access inventory.

So you may have on the property, somebody who's keeping doors and HVAC units and certain things in stock so that way you don't have to go to a supplier every single time you need to replace one and you have things in stock. So all of a sudden if you were getting a high quality HVAC unit that cost you $5,000 and then closer to closing you wanted to get one that cost you $2,000, that could be a substantial difference in inventory so you want to understand what you're getting and make sure that you're actually receiving those products after the sale occurs.

Slocomb Reed (18:07.07)
And whether or not that inventory is gonna be there at all. I know an example, yeah, an example I've experienced personally and thankfully I've always had it, the language very clear in the contract and I've had a clear understanding with my buyers and sellers across the table. The other example is,

Charles Seamen (18:10.448)
Right. He's a past relate by using.

Slocomb Reed (18:29.99)
Down to units or units pending renovation when the materials have already been purchased but haven't been installed, cabinets, countertops, carpet, paint, things like that, there, we oftentimes find ourselves as value added distress investors buying properties where the seller had plans to do some renovating that they didn't get done. And that's part of our business plan. Part of the, part of our model.

And part of our budget, if we're expecting that, you know, five apartments worth of kitchen cabinets and countertops and sinks and faucets are already in place in storage.

Charles Seamen (19:10.272)
Right. Yep, that's for sure.

Slocomb Reed (19:17.394)
Last on your list of five is payroll and utilities.

Charles Seamen (19:22.504)
Right. So what are you looking for there? Well, those are two of the largest expenses you're going to have at any property. If you're buying a property that's large enough to have staff, you should assume that's probably one of your big ticket expenses. So you want to know the names of the staff, you want to know their salaries, you want to know how long they've been at the property, and you want to understand what it's going to cost you if you decide to keep that staff on. Now let me give a little tip.

If the staff is doing a good job and you're satisfied with the way they're performing, generally it does make more sense to keep the staff on than to go out there and replace them. Why? Because they have a lot of intellectual knowledge about the property and as the old saying goes, they know where all the skeletons are buried. Where if you bring new staff in, it's going to take them a while to get acclimated.

So make sure you have an understanding of who these employees are what their qualifications are and what it's really going to cost you so you can build that into the underwriting. And then with the utilities, you know, a lot of times, especially with older properties, 60s, 70s, 80s vintage, none of those properties were built with energy efficiency in mind. If you're buying a 2010 property, it's still relevant, but probably a lot less relevant because it costs you a lot less.

But you want to understand what the utility history's been like for the last two years and really analyze the bills to see how much usage there is and what that's gonna cost you because with, especially with older properties, utilities are a major expense and you wanna make sure you really have them dialed in. And they also fluctuate very much from market to market. A lot of other things are more consistent but utilities tend to really vary widely. So having a good understanding of them is gonna go a long way.

Charles Seamen (21:19.768)
An example I would give, one property we had bought, this was a property actually in Charlotte, and the seller was a pretty sharp guy. He was managing the property himself, and he really didn't have any payroll expense. Now it's a 64 unit property, so you can look at it and say, okay, maybe it's believable, maybe he's managing it offsite. And that was kind of what we thought on the front end.

you know, as we got the deal on the contract. But then as we started doing our due diligence, what we realized is he actually did have staff, but he wasn't paying them at the property level. He was paying them through a separate entity, and he was dispersing the labor amongst all of his different properties, so it never truly hit the property. So why is that important? Well, it's important because all of a sudden, you think your NLY is one number, and that's what it actually shows on the financials.

And keep in mind, he's not misrepresenting it necessarily because he's not paying them through that entity. But unless you're going to run the property that same way, that's probably not going to be the way you want to underwrite it. So now all of a sudden you have to build that payroll expansion into your underwriting, see if your numbers still make sense, and if it doesn't, then you need to go back and ask for a reduction in price and say, Mr. Sellers, this wasn't disclosed on the front end. We didn't know about this. So now we have all this additional expense. And we can't afford to pay you X, so we need to pay you Y.

Slocomb Reed (22:51.278)
That makes a lot of sense. Another thing that I see fairly often is especially a properties in that like 68 unit and smaller range where full time staff on site may not be justified based on the needs of the property, the revenue being generated based on the market that you're in. There's often a tenant who's receiving free rent in exchange for doing some things around the place, whether or not that agreement is in writing.

You know, this is a conversation about the financial audit, but another thing that I will say is that during your due diligence process, if you're inheriting staff, you also want to vet the quality of that staff and the work that they're doing. It may be the case that you have someone who is that a property has a part-time employee who just isn't getting the job done and isn't really trying. Uh, and that's why they're able to get everything done on a part-time basis because they're not getting properties, uh, they're not getting apartments ready or apartments, uh, rent ready or leased in a timely manner. And you may discover that what you really need is a full-time person on site or you have one tenant

Slocomb Reed (24:14.986)
Who's been handling apartment showings and turns and cleaning common areas and things like that in exchange for some sort of payment under the table or a free apartment.

Charles Seamen (24:26.784)
You know, it's funny you mention that so one suggestion I would actually make and this is for anybody out there Especially if you buy properties in rougher areas C minus D type properties If you and especially if they're smaller in nature like less than 100 units, you know a Lot of times what you'll see is the staff at those properties tend to have their own deals with the tenants.

Most times with properties like that, you have less oversight from like a regional manager, from a property management company. So because of that, there's a little more wiggle room with what the on-site staff can do. From experience, I would say they get very creative. We had one property which we decided to keep the on-site staff on, another 64 unit property. And it took us a few months, but we realized after a while the staff was robbing us blind. And at that point, we fired them and replace them.

So the lesson I kind of came out from there was, okay, you need to do this with all properties, but with the smaller the property and the rougher the area, you really want to vet the existing staff and just make sure that you want to keep them because what you'll find is when you get in there, a lot of times they do have deals with the, side deals with the tenants that aren't on paper and that you can't see. So just make sure you do a good job vetting them.

But we found that they were you know, taking evicted tenants and putting them in vacant units and, you know, charging them to keep the utilities on, even though the utilities are in the property's name. So there are all sorts of things that we discovered. I was like, okay, well, that's, that's the last time we do this.

Slocomb Reed (26:10.678)
Yeah, that makes sense. I think my, my point here is that when it comes to vetting your payroll expense, it's really too, they're two components of that. One of them is vetting the actual people that you're inheriting, but also vetting, uh, to, to your point about the, um, the investor who is paying his payroll, 
at a portfolio level instead of a property level make sure that you are, yeah, make sure that you're qualifying the level of payroll or the payroll expense that will be required for the successful operation of the property according to your business plan. So our five, give me just a second here.

Charles Seamen (26:44.144)
I just recommend you use different.

Slocomb Reed (27:04.402)
Our five critical steps to financial due diligence coverage today. The first is the lease audit. Second is reviewing service contracts, especially making sure you know whether or not they can be terminated upon the sale of the contract, prioritize the survey, especially if the property is going to require it, if there are potential boundary issues.

Slocomb Reed (27:37.282)
Fourth is making sure you know what equipment and personal property is and is not included in the sale. And fifth is verifying payroll and utilities.

Charlie, any final thoughts here before we wrap up?

Charles Seamen (28:00.388)
No, I think that was a great recap and hopefully these are valuable to the listeners.

Slocomb Reed (28:05.794)
I am certain that they are Charlie. Thank you best ever listeners. Thank you as well for tuning in. If you have gained value from this conversation in our best ever due diligence show on financial due diligence, please do subscribe to our show. Leave us a five star review and share this episode with a friend. You know, we can't buy to through our conversation today. Thank you and have a best ever day.

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