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Media Contact:
Christine Ziomek
chris@caryl.com
(201) 796-7788
June 7, 2011

Giving Due Diligence Its Due In The Process Of Buying Multi-Family Real Estate

By David I. Tesler, Esq., CEO of Real Diligence, LLC

Multi-family investments are currently dominating market activity. Young people are preferring to rent while families losing their homes to foreclosure have no option but to rent. Already there has been a sharp decline in the rental vacancy rate to 6.2% in first quarter of 2011 and a double-digit rent hike is being anticipated by economists over the next two years in the hottest markets. This has investors flocking to buy rental apartment buildings.

Buying commercial real estate may be glamorous, but the financial due diligence needed to do it wisely is not. Still, financial due diligence is essential for basically any commercial real estate acquisition today. There is no such thing as a “small” acquisition that can afford to forgo a rigorous financial due diligence review, and there is no commercial distressed asset acquisition that is “simple” or risk-free. The current commercial real estate market involves assets typically ranging from $10 to $50 million, but can fluctuate from $5 million to $500 million. This is especially true of the multi-family investments. Analyzing past operations in order to project future property performance is never a black or white endeavor – it’s very grey. Evaluating the true value of a garden apartment building or multi-family midrise is a complex, multi-phase undertaking that often eludes complete clarity. A wide array of variables conceal the true value of a property.

How can a buyer be sure that they are getting the benefit of their bargain and avoid the financial and legal pitfalls that lie at every stage of the process? Although risk is an unavoidable element in any commercial real estate purchase, the stakes are even higher when buying distressed assets in today’s erratic market. The only way to limit risk is by conducting adequate financial due diligence on the asset.

Whether purchased through short sale or by buying notes or bank-owned (REO) properties, every distressed asset is unique and requires a multi-step process of examination, including valuing the note, valuing the real estate and conducting due diligence on the loan, property and seller.  Rushing to purchase troubled assets before conducting thorough and comprehensive due diligence can all too often lead investors to pay inflated prices and eventually lose money. Cash-rich funds have been especially susceptible to this mistake.  

The market has changed drastically. Assumptions utilized in the past are no longer accurate (and possibly never were.) Instead of accepting underwriting based on past expectations, it is important to find the “true value” of the asset. The primary task, then, is to gain a clear financial picture of the asset today and uncover any current or potential trouble spots. This is accomplished through a comprehensive financial due diligence review and an honest and conservative market analysis. It is a process that few companies are qualified and staffed to conduct in-house.

Many investors are turning to financial due diligence specialists for help. In addition to a market analysis, financial due diligence specialists conduct comprehensive financial audits, compiling and interpreting many layers of documentation within sharply restricted time frames. This process includes:

  • validating and verifying all rents, as well as any income from additional sources, such as parking, vending machines and the like;
  • validating and verifying all expenses; these are generally more numerous and variable than income items and can include outlays for anything from snow removal to elevator replacement;
  • establishing the historical record of income and expenses in order to verify the accuracy of the sellers’ projections for future budget and cash flow; and
  • reviewing bank statements to confirm that income is reflected in statements.

The data is then compiled and presented in a comprehensive report with a clear and concise executive summary.

When specifically conducting due diligence on a distressed note, it becomes necessary to conduct multi-layered due diligence. The first step is to organize and abstract the loan documents to ensure a clear understanding of the rights, obligations and responsibilities of all parties. Next, a financial review of the underlying property is needed, to the extent that access to available documentation allows. There is simply no other way to properly evaluate the value of what is being acquired.

Proper and accurate due diligence can also be helpful post acquisition with the complex organizational and logistical issues that arise should the investor need to take ownership of a foreclosed property.  The purchase of notes on distressed properties also has many legal pitfalls to avoid. Investors need to hire qualified counsel to ensure the enforceability of the loan documents and protect against any potential lender liability claims brought by a borrower in connection with an acquisition.  

For any individual investor or fund targeting the acquisition of distressed real estate, the goal is always to minimize risk and maximize return. In today’s market, upfront financial due diligence of the asset will go a long way to achieving that goal for distressed properties and notes.

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David I. Tesler, Esq., is the CEO of Real Diligence, LLC , a company that specializes in financial due diligence of real estate and notes. Real Diligence is a part of the Madison Commercial Real Estate Services family of companies.

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