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REAL ESTATE Due Diligence Process

JScott

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Folks,

After months of reading, learning, creating spreadsheets, writing my business plan, and analyzing properties at home, I'm finally ready to start looking at actual properties. I plan to jump right into mid-sized apartment buildings (20-50 units), but I still have a fundamental lack of experience going through the evaluation and purchase process.

I realize that every negotiation is different, and anything can be negotiated, but since I have no idea what to expect, I'm just looking for some general guidelines.

Perhaps folks who have gone through this process with an apartment building can answer any/all of the following questions for me (these seem so basic that I'm almost embarrassed to ask):

- I don't currently have an buyers agent who I trust in the area where I'll be looking. But, I've found some properties that I'd like to get more information about. Is there any disadvantage to contacting the listing agent, and meeting with him/her directly? I presume I can find a buyers agent later in the process if/when I need one; but should I have one before contacting the seller's agent?

- While I know all the things I need to ask, look for, and investigate during the due diligence process, I'm not really sure what types of things I can/should ask at the various stages of the process. For example:

o What types of information should I be asking for upon first meeting the seller's agent? I presume he'll be able to provide me pro-forma income/expense data, information about the property and the seller, and other basic info, but is there other stuff I should be asking for before going to take a look at the property?

o Once I get the basic info from the seller's agent, and I'm satisfied that I want to look at the property, I presume that I'll go visit the property with the agent. During this visit, what is reasonable to ask? I presume I can see the outside of the property, and perhaps a vacant unit or two? What other things should I be asking for at this point?

- Let's say that after asking a lot of questions, seeing the property and reviewing the pro-forma financial data, I've gotten to the point where I'm serious about moving forward with more formal due diligence, what is the process from there? I presume at this point I should have both an attorney and a buyer's agent, and then I either sign a Letter of Intent or a contract?

o Do I sign a Letter of Intent or a contract? What is the difference at this point, if any? What do these documents generally obligate me to?

o Am I expected to put down earnest money at this point?

o Once I do put down earnest money, what is a typical amount or percentage?

o Under what circumstances should I expect to lose my earnest money should I not follow-through with the deal? Under what circumstances should I expect to get my earnest money back if the deal falls through?

o Is it typical to get a period of time to do formal due diligence (inspection, appraisal, reviewing financial docs, etc) without having to put any money down? How long is this period of time?

o If I'm expected to put earnest money down, how long is typical for the due diligence period to last?

- Can I ask to see actual financial data (receipts, expense/tax records, balance sheets, etc) prior to signing any formal documents? Or do I generally need to sign a Letter of Intent or a contract before getting all the financial data?

Anything I'm missing? Any other suggestions for getting me through this process the first time?

Thanks for any help!
 

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SteveO

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- I don't currently have an buyers agent who I trust in the area where I'll be looking. But, I've found some properties that I'd like to get more information about. Is there any disadvantage to contacting the listing agent, and meeting with him/her directly? I presume I can find a buyers agent later in the process if/when I need one; but should I have one before contacting the seller's agent?
You won't see all the good deals if you get a buyers agent. Most listings for properties this size do not get placed on the MLS. They get sent out on a network to potential buyers and eventually end up on Loopnet. In order to get a first shot, you want to be on the agents short list of active buyers. See this post for more information http://www.thefastlanetomillions.com/showthread.php?t=4321


o What types of information should I be asking for upon first meeting the seller's agent? I presume he'll be able to provide me pro-forma income/expense data, information about the property and the seller, and other basic info, but is there other stuff I should be asking for before going to take a look at the property?
The agents will usually have a package that includes the rent roll, actual expenses (unverified), proforma, area information, rent comps, sales comps, etc... No need to get too much information at this time unless you are in a time limit situation.

o Once I get the basic info from the seller's agent, and I'm satisfied that I want to look at the property, I presume that I'll go visit the property with the agent. During this visit, what is reasonable to ask? I presume I can see the outside of the property, and perhaps a vacant unit or two? What other things should I be asking for at this point?
If the manager of the property knows that the property is for sale and is willing to answer questions, you want to get a feel for as much as you can. If I know that the property is performing poorly, I ask a lot of questions around the problems to see if they recognize them. I also want to know what they have been doing to address the problems. You will usually get excuses and a song and dance. You want to see if they have implemented anything that you would try to do and get a feel for your plan to remedy the problems. If there are no visible problems, just ask about challenges that they have dealt with and things that they might see in the near future.

- Let's say that after asking a lot of questions, seeing the property and reviewing the pro-forma financial data, I've gotten to the point where I'm serious about moving forward with more formal due diligence, what is the process from there? I presume at this point I should have both an attorney and a buyer's agent, and then I either sign a Letter of Intent or a contract?
The selling agent will not want to share the commission. If you want a buyer's agent, be prepared to pay for one yourself. You should formulate a letter of intent now so you have the basic form ready when you offer. Most agencies will have a form LOI. Gather a few of them and make one for yourself. Then you can run it past your attorney to fine tune.

If you submit an LOI and it is accepted, then your attorney can help you draft a contract. The seller will usually want to draft the contract (if you want to do it, state so in the LOI). Send it to your attorney to review.


o Do I sign a Letter of Intent or a contract? What is the difference at this point, if any? What do these documents generally obligate me to?
It depends on what they say. I usually have this attached to all of my LOI's:

This letter of intent is not intended to create a binding agreement on the Seller to sell or the Buyer to buy the property. The purpose of this letter of intent is to set forth the primary terms and conditions upon which to execute a formal Purchase and Sale Agreement. All other terms and conditions shall be negotiated in the formal Purchase and Sale Agreement prepared by Buyer. This Letter of Intent is open for acceptance through (date)

If you go directly to a contract, it will obligate you to the terms of the contract.

o Am I expected to put down earnest money at this point?
The contract will usually dictate a time that the earnest money will need to be delivered by.

o Once I do put down earnest money, what is a typical amount or percentage?
I usually offer somewhere around 1%. Sometimes the seller wants more.

o Under what circumstances should I expect to lose my earnest money should I not follow-through with the deal? Under what circumstances should I expect to get my earnest money back if the deal falls through?
These terms will be outlined in the contract. Typically through a 30 day due diligence or inspection period is a safe bet. You can have a financing contingency as well but I try to get the financing wrapped up in the initial 30 days. You should not try this on your first few deals though.

Keep in mind that the fastest way to lose the ability to find deals is by tying up a property and then pulling out without a solid reason.

o Is it typical to get a period of time to do formal due diligence (inspection, appraisal, reviewing financial docs, etc) without having to put any money down? How long is this period of time?
No.

o If I'm expected to put earnest money down, how long is typical for the due diligence period to last?
30 days. In a seller's market, this time might be compressed a bit.

- Can I ask to see actual financial data (receipts, expense/tax records, balance sheets, etc) prior to signing any formal documents? Or do I generally need to sign a Letter of Intent or a contract before getting all the financial data?
You can ask but probably won't receive until there is a contract.

Anything I'm missing? Any other suggestions for getting me through this process the first time?
There are books out there that will outline this entire process. REad them and follow along. Find a good due diligence chelcklist to use.
 
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JScott

JScott

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Steve --

Thanks for taking the time to provide this feedback!

I have read a number of books (at least chapters in books) on the subject, but wasn't sure if "real life" played out the same way... :)

Thanks again!
 

Bilgefisher

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JScott your blog is threetypes.com correct? I would love to follow your progress on this. Please keep us updated. I plan on picking up my first multiplex (albeit only a 4-8 plex) in about a year and I want pick up any info I can.

Steve great response. ++
 
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JScott

JScott

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Will definitely keep everyone updated...

I had originally started a blog specifically to track my REI progress, but decided that there was too much personal info that I didn't want to post...

But yes, http://www.threetypes.com is another blog that I just started writing, and I'll continue adding information both there and here.
 

JesseO

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Jscott, thanks for coming up with all those questions. It's great to see someone in the same boat I'm in =) SteveO thanks for the great response! Speed to both of you ++
 

SteveO

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o Once I get the basic info from the seller's agent, and I'm satisfied that I want to look at the property, I presume that I'll go visit the property with the agent. During this visit, what is reasonable to ask? I presume I can see the outside of the property, and perhaps a vacant unit or two? What other things should I be asking for at this point?
I gave some information on this but want to add to it. This is a very important visit that should carry some weight in your decision to move forward or not.

You already have the marketing package that gives you information on the financials. This visit is going to give you a mental picture to reconcile the financials with what is happening at the property.

It also gives you an opportunity to see how functional the property is in general. You can take a good look at the floorplans to ensure adequate closet space, kitchen open to the living area, sound barriers between units (either listen or look at the type of construction), layout from parking to apartments, office accessibility and aesthetics, office hours, tenant profile (usually a small sample, try to visit late in the day), autos in the parking lot, etc... You should be very observant for things that can be changed and things that cannot, such as floorplans.

Sometimes I will shop a place just to get a feel. I tend to look like a tenant so I can get away with it. But, you can always say you are previewing for a friend, cousin, child, whatever will serve the purpose. In this situation, you are looking for the sales process and getting a quick look at the same time. Try to ask tenant like questions, such as, how is the sound barrier from the upstairs units, amenities, how quiet at night, crime, etc... Never let on that you are a potential buyer when you do this!!!

There will be a great opportunity to validate all that was said when you run numbers, rent comps, perform physical inspections, etc... I am always looking for issues that can be fixed or modified to improve operations. Bad onsite management is frequently the key to this.
 
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randallg99

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JScott, I have been looking at some apartment deals and some large commercial deals for myself and formulated the strategy that SteveO helped outline for you...

one thing I will add is this, and it's only because of some experiences I have had and it strengthens the bargaining position:

Tie the deal up and only then go for the nitty gritty details... have everyone lined up... make sure attorney isn't going on vacation (if so, get someone else)... contractors, inspectors, etc... Romancing the deal can kill it while having the DD contingency can do 2things: a) avoid losing the deal to someone else; and b) make sure the owner is honest with his numbers. (to me, this is #1 priority)

numbers are often construed to look better than they really are.
 
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JScott

JScott

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one thing I will add is this, and it's only because of some experiences I have had and it strengthens the bargaining position:

Tie the deal up and only then go for the nitty gritty details...
Good advice...

The only thing that I'm still confused about is the earnest money deposit. It's not clear to me the circumstances under which that money is gotten back or lost to the seller (I realize that it depends on the contract terms, but I'm not sure what a typical contract would look like)?

For example, if it turns out the seller didn't include some expense in his pro-forma numbers (that would ultimately make the return on the investment not nearly as attractive), would that entitle me to a refund of my deposit?

What if I did comps and found that the comps don't support the seller's pro-forma income numbers? Would that entitle me to my money back?

Or what if I had an inspection done, and the inspector told me that the roof would need replacing in a couple years (and that new expense changed my investment numbers)? Would that entitle me to my money back?

Understanding this certainly will help me understand what DD I need to do *before* I put down a deposit vs. what DD I do after I put down a deposit.

And just to be clear, putting down earnest money isn't a big deal to me, and I don't imagine I'd ever back out of a deal without a good reason, but even small discrepancies between the pro-forma numbers and actual numbers can make a big difference in the bottom-line.
 

SteveO

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The following is the section out of a contract that addresses this issue. The main point is that the allotted time was around 30 days. The physical and books and records needed to be completed in that time. The buyer could back out by sending in a notification stating so. The terms outlined came from the seller and most contracts state this much simpler than this one. This just happened to be one that I was able to find in a digital format.

------------------------------------------------------------------------

SECTION 3.
DELIVERIES, INSPECTION AND REPRESENTATIONS
3.1 Delivery Obligations.
(a) To the extent not therefore delivered to Purchaser, Seller shall deliver to Purchaser, promptly after the Effective Date, copies of the following items more particularly described on Schedule 1 hereto, to the extent, if any, in Seller’s Possession; as used in this Agreement, the term “Seller’s Possession†or “Possession of Seller†shall mean and include documents maintained in Seller’s files located at the Property or with Seller’s managing agent for the Property.
(b) Seller’s failure to deliver to Purchaser any of the above items within the period provided shall not result in the extension of the Inspection Period, and Purchaser’s sole remedy therefor shall be Purchaser’s right to terminate this Agreement by delivering written notice thereof to Seller on or prior to the expiration of the Inspection Period and to receive a return of the Deposit, in which event neither party shall have any obligation hereunder except for such obligations which are expressly stated herein to survive the Closing or the termination of this Agreement ( the “Surviving Obligationsâ€).
3.2 Inspection Period.
(a) Notwithstanding any provision of this Agreement to the contrary, this Agreement and the obligations of Purchaser hereunder are contingent upon Purchaser determining the suitability of the Property in Purchaser’s sole discretion. Purchaser shall have a period from the date hereof until 5:00 P.M. New York time on May 18, 2007 (the “Inspection Periodâ€) to examine the Property. The examinations shall be conducted during business hours, from time to time, and subject to the rights of tenants, and shall not under any circumstances compromise or affect the structural integrity of the Property. Purchaser must obtain Seller’s prior written approval of the scope and method of any physically intrusive inspection, testing or investigation of the Property (other than a Phase I environmental inspection) including, but without limitation, any inspection which would involve taking subsurface borings or related investigations, and any inspection which would alter the physical condition of the Property. Seller and its representatives, agents, and/or contractors shall have the right to be present during any testing, investigation, or inspection of the Property. In no event shall Purchaser or any of its agents, representatives or independent contractors contact any tenant at the Property, any governmental agencies having jurisdiction over the Property (except for a status of notices of violations, if any, and a confirmation of the zoning status of the Property and the existence of the certificates of occupancy or their equivalent), or Seller’s vendors directly without Seller’s prior written approval. If prior to the expiration of the Inspection Period, Purchaser determines that the Property is not suitable to Purchaser for any reason, then Purchaser shall give written notice thereof (the “Termination Noticeâ€) to Seller and the Escrow Agent prior to the close of business of the last day of the Inspection Period. If Purchaser timely advises Seller and the Escrow Agent that it elects not to proceed with this transaction, the Escrow Agent shall return to Purchaser the Deposit, and thereafter this Agreement shall be terminated and neither party shall have any further rights or obligations hereunder except for the Surviving Obligations. TIME SHALL BE OF THE ESSENCE with respect to this Section 3.2(a), and if the Termination Notice shall not be timely given to the Seller and the Escrow Agent by the expiration of the Inspection Period, this Agreement shall remain in full force and effect in accordance with its terms. Purchaser agrees to deliver to Seller copies of all Reports (hereinafter defined) at the time the Termination Notice is given by Purchaser. The obligations to deliver the Reports shall survive the termination of this Agreement.
On or before the expiration of the Inspection Period, Purchaser may deliver written notice to Seller (the “Service Contracts Noticeâ€) specifying any Service Contracts with respect to which Purchaser desires to have the Seller deliver notices of termination at the Closing (the “Terminated Contractsâ€); provided that (i) the effective date of such termination after Closing shall be subject to the express terms of such Terminated Contracts, (ii) if any such Service Contract cannot by its terms be terminated, it shall be assumed by Purchaser and not be a Terminated Contract, and (iii) to the extent that any such Terminated Contract requires payment of a penalty or premium for cancellation, Purchaser shall pay any cancellation fees or penalties. If Purchaser fails to deliver the Service Contracts Notice on or before the expiration of the Inspection Period, there shall be no Terminated Contracts and Purchaser shall assume all Service Contracts at the Closing.
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SteveO

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There are a number of escape clauses but most sellers will see through them quickly. Financing contingencies are fairly common in midsize apartments. When I sell, I try not to take a contract that has the ability to back out for financing. But the inspection period is the easiest time to get your free look and decide whether you eill move forward or not. It sometimes opens the door to renegotiation if discoveries are made. Let's say for example that your inspection determined that there are 13 carpets that need to be replaced and that the roof is in need of repair. You may not get money for all of the carpets or the cost of a new roof, but you can negotiate a settlement. If not, you can back out of the deal. Also, if they claim that the building has 30K per month of income and you find that this is not the case, you have more ammo for renegotiating.

This topic could easily take a full chapter to discuss as it is a very important part of a purchase.
 

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JScott

JScott

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Thanks Steve...I think this answers my question...

So, just to reiterate (in smaller words :)...

- Earnest money is provided at the time the contract is signed;

- The contract will lay out a total time period by which all phases of DD and preparation for closing must be completed (for example, 90 or 120 days);

- The contract will also lay out a shorter time period (the Inspection Period) where the buyer can back out for any reason whatsoever and recover the earnest money deposit (for example, the first 30 days of the 90 or 120 days). The Inspection Period could also be used to renegotiate if "surprises" are found;

- Assuming the buyer doesn't back out prior to the end of the Inspection Period, he will generally forfeit his earnest money if he doesn't close, unless there is a specific clause in the contract that covers a specific situation (like a financing contingency).

Thanks again!
 

SteveO

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Correct. An inspection period usually does not last more than 1 month. I have seen people on other transactions (not my own) that have gone past the dd period, backed out, and then fought over the money. That is a no win situation.
 

randallg99

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Correct. An inspection period usually does not last more than 1 month. I have seen people on other transactions (not my own) that have gone past the dd period, backed out, and then fought over the money. That is a no win situation.

another thing for JScott- Get all extensions in writing...

a property we were fishing for had major structural damages and the wait for the engineer's report went beyond the dd period allowed... this created super amount of havoc... after several months of lawyers and "phone fights," I finally received our deposit back.

A lot of the minor DD can be even be done while compiling the offer...
 

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