Conduct Due Diligence
How to Conduct Due Diligence on a Multifamily Asset
Due diligence: it’s the practice of minimizing risk and uncovering rewards.
Let’s say you’ve identified a multifamily property that you would like to acquire. You’ve reviewed the basic information regarding the property — the date of construction, the number and type of units, the rent roll — and now you’re wondering: what comes next? Perhaps this is the first multifamily property that you’ve ever purchased; or maybe it’s the 10th, but you’re still seeking ways to enhance your due diligence procedures.
To assist you in this endeavor, LoopNet spoke with Jack Brundige, chief of portfolio management with Waypoint Real Estate Investments. Waypoint owns and operates more than 28,000 multifamily units across the United States, and Brundige personally reviews every property they acquire. Unsurprisingly, he knows a thing or two about assessing a prospective multifamily acquisition.
Based on LoopNet’s conversations with Brundige, he identified the following top 10 components of the due diligence process for multifamily assets:
Assessing the competitive set.
In-person property tour.
Know your residents.
In-person tour of competitive properties.
“North, south, east, west analysis.”
Conducting inspections and determining capital costs.
Building a budget.
Opportunities for revenue growth.
Evaluating supply threats.
Market stability versus volatility.
“I think a lot of people look past some of those subtle features [of the due diligence process] and it either bites them, or sometimes it’s a missed opportunity,” said Brundige.
Assessing the Competitive Set
Brundige explained that, for Waypoint, the process always begins with establishing a foundational understanding of the geography where the property resides, i.e. your submarket. You’ll want to identify assets within your prospective property’s submarket that were constructed around the same time period and offer a similar unit profile and amenity package. These properties comprise your building’s competitive set — keep that term in mind, because we’ll be returning to it on numerous occasions throughout this process. “Before going to even visit a property that we think is a good investment, I’ll have the team do an analysis of all the information they can find on properties that are comparable to the one that we’re buying,” commented Brundige.
Once you’ve compiled your competitive set, you’ll want to analyze all of the data you can collect about these comparable properties. According to Brundige, information sharing among property owners and managers within the competitive set is generally common, so the management or existing ownership team at the property you are assessing should be able to provide data regarding rental and occupancy rates, as well as concession packages. Brundige added that concessions — e.g., free rent or other incentives such as gift cards — are particularly important to consider in a market where leasing demand is slow.
Brundige referred to this phase of due diligence as the “desktop analysis,” as it’s conducted remotely. But don’t get too comfortable, because for the next stage of the process, we’ll be heading into the field.
In-Person Property Tour
Once you’ve completed your desktop analysis, it’s time to tour the property in person. Your review of the building should be focused on three primary elements: common areas, such as the lobby and hallways; amenities, like fitness centers and pools; and the units. For the common areas, you’ll want to consider their general condition, functionality and cleanliness. Regarding amenities, Brundige advised that you should analyze how they are laid out and organized within the property, and consider the advantages and disadvantages of that structure.
While surveying the units, Brundige advocates evaluating them from the perspective of a potential renter. “How [do the] the units profile? How spacious are they? Do they have nice appliances? What do the countertop finishes look like? Do they have any deck [or outdoor] space?” These are the aspects of a unit that a renter experiences intimately each day and will determine how much they are willing to pay for that unit.
Know Your Residents
After considering the property from a renter’s point of view, Brundige counseled that you park yourself in the lobby or leasing office and see who the residents are and how they use the space. “It gives you a sense of who your resident base is,” Brundige said. He added that this qualitative review should be, “followed-up with some more data-driven analysis based on information that the on-site teams have on the income profile of your residents.” Existing ownership or management should also provide intelligence about the residents’ employment background, as well as local employment drivers in the submarket.
In-Person Tour of Competitive Properties
Once you’ve completed a thorough tour of the property that you’re considering purchasing, Brundige posited that the next step is to conduct an in-person review of your competitive set. Ideally, you want to analyze these properties in the same manner that you inspected your prospective asset, by assessing the amenities, common areas and various unit types. Brundige said that, in his experience, the management personnel at competing properties are amenable to granting access to their buildings. He suggested that the best approach is to be honest, and tell them that you’re looking to invest in a property in the area, and you’d like to briefly tour their amenities and any open or model units. Once you’ve analyzed your competitive set in person, compare and contrast each building’s attributes and challenges to those of your property.
A two-bedroom unit at Volaris West Kernan in Jacksonville, Florida, which is owned and was developed by Waypoint (Courtesy of Waypoint).
“North, South, East, West Analysis”
For the final phase of the in-person assessment, Brundige advised that you return to your prospective property and undertake a process that he refers to as the “north, south, east, west analysis.” This, essentially, is an attempt to put yourself in the proverbial shoes of a resident at the property. Brundige said, “Start at your property and drive in all directions, walk in all directions; really try to experience what it would be like to be a resident at this property and what is attractive about it and what may be a detraction. Does it feel too far away from the grocery store? Is it cool that the park is across the street? Is it noisy?” Endeavoring to understand the resident experience at the property in this manner can give you a unique appreciation for the qualitative virtues and weaknesses of the property.
Conducting Inspections and Determining Capital Costs
Once the in-person tour of the property has occurred and the local market and competitive set assessments are complete, it’s time to bring in the experts. You’ll need third-party professionals to conduct thorough inspections of the property. They’ll look at elements such as the age of the roof and the condition of mechanical components, and also focus on potential tripping hazards and flood and drainage issues. You’ll also want to have an environmental report prepared to uncover any potential contamination issues either on site or adjacent to the property.
Based on these expert assessments and your own analysis of the property, you’ll be able to identify any anticipated capital costs in the near-term, as well as over a five- to 10-year period. Some of these capital costs may pertain to necessary repairs, while others could involve optional improvements that can add value to the property and enhance revenue. Brundige said that this process requires determining if there are upgrades that can be made either in the units or to the amenities that will enhance the overall resident experience and drive rental rate growth.
Building a Budget
In addition to the capital costs and improvements, you’ll need to understand the ongoing operating expenses for the property. Brundige said that is where a nascent investor can easily make a crucial error. “A lot of people that are just getting into the business make the mistake of relying too heavily on the in-place operating expenses, and it’s really important, if this is one of your first couple of deals, to look to that existing information, but [also] do as much homework as you can, asking questions of as many friends that you know in the business or local people that are actual service providers.”
In fact, when Waypoint acquires a property, they begin this process without even reviewing the existing operating expenses. Brundige explained, “We like to start out by not looking at the information that’s available on the historic performance of the property.” Instead, Brundige and his team build a budget from scratch to generate, “what we think is an appropriate budget for the property from all operating perspectives, including staff.”
This approach may seem daunting for a new investor, but Brundige said that it’s actually simpler than you may anticipate. In terms of service contracts, for landscaping or cleaning for instance, Brundige advised investors to, “go out and get the bids. Tell them what you have, and a lot of people would be happy to provide the information to you, with the hope of getting the business” after you acquire the property. It will also be important to review local labor costs for any in-house staff that the property requires, as well as utility expenses in the submarket.
Once you’ve constructed your own version of the operating budget, you should then compare it to the existing, in-place budget for the property. Brundige said that based on this review, “we’ll make adjustments sometimes, as we look through the existing information and maybe learn something that’s unique about the property that either costs more or sometimes costs less.”
He added that you should also closely peruse existing service contracts, as that can reveal the reason for discrepancies between the budget you have developed and the property’s current operating budget. “Look at the actual contracts that are in place with those providers to see the scope of service that they are providing. If they’re only cutting the grass once every two weeks and that’s why it costs less, maybe that’s not the right thing to do,” Brundige said. It’s also important to understand the parameters of the existing service contracts, to ensure that you have the ability to terminate any current providers, should you elect to make a change.
At the end of this process, you should have a final budget, inclusive of both operating expenses and anticipated capital costs, that represents your vision for the property. Take this budget, line it up with the property’s revenue, and you’ve now determined the asset’s net operating income.
Fifty02 West Over Hills in San Antonio, Texas, which is owned by Waypoint (Courtesy of Waypoint).
Opportunities for Revenue Growth
Once you have determined the property’s anticipated net operating income, based on its existing revenue and your proposed budget, Brundige advised that the next step is to “decide whether or not you think there’s some additional growth associated with that [revenue] in future years.” In order to do that, you’ll need to analyze the rents at your property relative to your competitive set. “Are the rents priced where they should be? Or is there an opportunity to elevate those rents?” He queried. Brundige noted that sometimes enhancing rents will require improvements — either to the property, the units or both — but that on other occasions, “there’s just a dislocation on where those rents are relative to the market.”
Determining what your rent growth will look like going forward — whether you can anticipate 3% inflationary increases or something more robust — will be largely dictated by the dynamics of your local market and, in particular, the prospect of new supply within that market. Speaking of which …
Evaluating Supply Threats
At this stage in the process, based on your review of comparable properties, you should have a well-developed understanding of your existing competitors within the submarket. However, you also need to be cognizant of multifamily buildings that are planned or currently under construction that could add new units to the market that may compete directly with yours. This additional supply could significantly impact your property and its ability to grow revenue in the future. Brundige advised that, for Waypoint, the first step in determining the supply pipeline is to look at CoStar data (CoStar Group is the owner of LoopNet), which tracks new development activity in markets throughout the country. This will serve as a strong foundation for understanding the supply pipeline and, if you’re in a larger market, it may provide sufficient supply intelligence. But if you’re in a smaller submarket, where one or two new projects could have an outsized impact on your property, Brundige cautioned that you’ll want to dig deeper.
In such instances, Brundige and his team will venture to the local city hall and review requests for construction permits, variances, etc. in order to uncover additional development activity. He also advised that during the “north, south, east, west analysis” it can be beneficial to “pretend you’re a developer yourself,” and consider, “where would you want to put the next one?”
It’s also prudent to appraise the general municipal attitude towards development in the submarket. “If there’s a lot of available property in the market and the municipality allows construction to commence easily, that could be dangerous, because you could wind up in a situation where rents could fall rapidly in the future, if all of the sudden there’s too much supply.”
Market Stability Versus Volatility
When asked if there was any particular attribute that Waypoint looked for in a property or a market, Brundige was quick to identify the benefits of a “stabilizing factor.” For instance, is the city a state capital? Perhaps there’s an industry that tends to congregate in that market — like tech companies in Austin, or insurance firms in Hartford, for example. Brundige added that, “In many cases it can be a university. That’s one of the best, not for student housing purposes, but because universities don’t usually pick up and go someplace else.” Moreover, they don’t often seek to reduce their student enrollment or corresponding number of staff.
In terms of a cautionary factor that would make him wary of a property or market, Brundige mentioned volatility. He advised that prospective purchasers should review historical market data and consider, “not just what’s going on today, but what happened over the last several years. Did rents go up dramatically and then drop? Did occupancy, similarly, go up and then drop? If it wasn’t because of some identifiable factor, that’s really concerning if there’s movement like that. It means it’s difficult to predict, potentially, what’s going to happen in the future.”
Brundige also noted that it’s important to scrutinize all of the property’s historical financial records closely, particularly with regard to rental income. “It’s really important, both for protecting yourself, but also for identifying potential value-[add] opportunities to really dissect [the data] and look at the revenue that’s generated in each month and see if there’s a pattern.” For instance, if you’re just reviewing the 12-month average revenue for the property across all unit types, you might not notice that there was a decline in revenue during the past two months, or that your two-bedroom units are underpriced relative to the market.
COVID and Other Considerations
It may seem that some of Brundige’s advice — in-person tours, the importance of shared amenities — doesn’t entirely align with the current pandemic era. When asked about this, Brundige acknowledged that Waypoint, like most large multifamily owners and investors, had not altered its investment criteria in light of COVID-19. He said that, “[COVID] hasn’t changed our review of the properties yet,” and that he still views the closure of certain amenities as a temporary issue that needn’t impact their long-term value. He did note, however, that one crucial area that COVID-19 has affected in terms of due diligence, “is your cleaning protocols and making sure you understand the expense and the manpower necessary to wipe down the common areas.”
Further, while he was sympathetic to investors who might be hesitant to tour a potential purchase, let alone numerous competing properties, in person, he felt that it was an essential facet of the process. “I am going to see every property that we’re buying still,” Brundige said. “It’s just so important to go out there and experience it in person and make the effort, even in these times.”
Ultimately, Brundige distilled his due diligence philosophy down to a single sentence. “Make sure we understand how to maintain that property in as good a condition as we buy it, and [how to] elevate it, to the extent that we can, while we own it.”
By, DANIEL SCHMERGELCOMMERCIAL REAL ESTATE EDITOR