Due Diligence Is More Than Reading An Appraisal

"I am just a 40-year old civil engineer trying to make a sound investment for the future," a reader e-mailed me about a rental apartment property that he wants to acquire. "The property is being purchased for much less than the appraised value."

It is a buyers' market all over the United States and similar scenarios are playing out within driving distance from most of us. If you have cash to invest and credit to borrow the rest, opportunities abound.

"This is my very first time doing a commercial loan," the reader wrote. He asked for help obtaining an acquisition loan to purchase the eight-unit property. "The rents are below market because this property was tied up in probate for the past 12 years."

But instead of basing his purchase on the appraisal, he should be culling together documentation to determine whether the subject property is priced right. After doing the necessary grunt work, he will know much more about the property than the appraiser does.

Whether you are acquiring eight units or 800 units, there are no shortcuts. The process of gathering documents, verifying the information presented by the seller or broker and determining the investment worthiness of a potential acquisition, is called due diligence. It is specific to the type of investment. But the methodology is applicable for most income-producing properties and businesses. And it can enhance your chances of getting financing by showing lenders the documentation you used to justify your numbers.

First, get the rent roll. It shows the names of occupants, how much rent they are paying, when they made their last payment and what the market rent is for each unit. The document may include ancillary income such as late fees, non-refundable pet charges and sales of duplicate keys. It may also detail subjective information about each tenant and, sometimes, the readiness of vacant units.

To validate the information gleaned from the rent roll, request a report of the actual collections for the last several months. That way you can reconcile the rent roll with the operating statements to get a clearer picture of the revenues.

Independently verify every expense item on the operating statements. The fixed expenses are the easiest. The largest are property taxes, insurance, utilities and management fees.

Get a copy of the current tax bill and call the assessors office to find out if an increase is planned. Do the same for the property insurance. The utility company can provide you with a print out of the subject's history. Call property managers and ask what their management fee would be for the subject.

The subject's variable expenses should be compared to industry standards for similar properties. When I was in the business, I used data from the Institute of Real Estate Management, Urban Land Institute and the National Apartment Association for apartments. Other property types have their trade associations as well.

Average replacement reserves for items such as roofs, heating and air conditioning and exterior painting are also in the trade association data. However, individual properties will vary depending on the remaining economic life of each item.

Annalize all your numbers. Subtract the expenses from the income to get the net operating income. The NOI is the basis for the income approach to value. If you have done your homework, your NOI conclusion should be more accurate and more current than in a typical appraisal -- especially if the appraiser is using proforma rents and estimated operating expenses.

Subtract the mortgage payment and divide by the sum of your investment for the cash on cash return. The process gets more complicated to calculate an internal rate of return over a holding period. It tells you how well the property should do as a long-term investment.

Additionally, an engineer should inspect the property and an accountant is needed to pour over the financial statements.

The closing attorney and title company represent the lender. Sellers need to be represented by their own counsel. Hire the best acquisition lawyer you can afford to draw the contract and represent you at the closing.

Thorough diligence is not easy. It can also be costly to hire professionals. But to avoid a disaster, you must have them on your side.

Jerry Chautin
is SBA's 2006 national "Journalist of the Year" award winner and a volunteer business counselor with SCORE, "Counselors to America's Small Business," offering free business advice. He is a former entrepreneur, commercial mortgage banker, property acquisition dealmaker and business lender Follow him on Twitter, www.twitter.com/JerryChautin.