Physical Review

During the physical review, you and your team inspect the property to see if it falls in line with your business plan and your expectations. Let me expand a bit on this. As an example, let's say that you are planning to buy an apartment building and then do some slight renovations to the units that will allow you to increase the rents over the next couple of years. So how does the process start?

Before you make your offer to purchase the property, you will want to interview and select a property management company to help you prepare your operating and renovation budgets for the property. The key word here is before! This is not something you want to do after you make the offer. The results of this work will help you decide whether the property is worth making an offer at all.

TIP If you are going to be a professional real estate investor, have your team lined up before you make the offer!

A successful and competent property management company can go over your operating and renovation budgets to make sure they are realistic and give you credible feedback on all the previous assumptions you may have made on the property—assumptions such as operating expense savings, new income opportunities, and even cash flow projections. They can look at your business plan and give it a thumbs up or a thumbs down and help you adjust it so it is attainable and realistic. Remember, you will rely on a property management company to make your business plan work, so you had better make sure you are both on the same page from the beginning.

The property management company will have its own sub checklists for its own due diligence process. The people in the company will walk through every apartment and check the condition of the property in a multifamily project, for example, and bring in the sub-trades such as roofing companies, landscape companies, etc., that can provide detailed reports on the condition of the property.

In addition to spearheading the physical inspection, the property management company will also review all the rent-rolls, the operating statements, and tenant profiles, all in an effort to gain an understanding of the true, current operating income of the property. Usually it will present you with a summary of the findings.

TIP The property management company is a critical member of your team. Find the best one you can and work closely with it.

I cannot tell you how many times during my career that this work and the report that it generates has helped buyers make the right decision about a property. Let me give you an example from two perspectives. I was involved in a twenty-unit apartment community that I was going to buy and convert to forsale condominiums. When we did our walk-through, my property management company brought along several contractors who were going to do the work on the project once I closed.

To convert the apartments to condominiums, I planned to put about $20,000 of renovations—including adding a washer and dryer—into each unit. This was a non-negotiable expense since my market study indicated that other condo projects in the market all had washers and dryers. We needed to be competitive.

After the inspection, the owner of the property management company called me and said that everything checked out and there were no real surprises, except one. I asked, "What would that be?" He proceeded to tell me that his plumber and framer felt that because of the existing plumbing and stairwell configuration, putting in the washers and dryers would cost an additional five thousand dollars per unit. That added up to an additional $100,000. OUCH!

Well clearly, that unexpected expense was not in my budget, so I went back to the seller to renegotiate the terms of the deal. Specifically, I agreed to remove all contingencies after the completion of my due diligence, and in exchange I requested that the seller reduce the price by $100,000. He agreed. Having an expert in the room saved me $100,000! For as valuable as the property management company was in finding a potentially deal-breaking hidden cost, a property manager can also add strong value by reviewing the rent-roll and tenant profiles.

Here's my story: I was financing an acquisition of a large apartment building in Scottsdale, Arizona, that had been grossly undermanaged. My client was going to buy the asset and renovate the units and gradually raise rents. He thought the quoted street rents for this property were below market for the submarket and felt he could increase them once he renovated the exterior, improved the amenities, and did some minor interior work.

What the property management company reported after reviewing the rentroll was both startling and exciting. They discovered that more than 25 percent of the existing tenants had not received a rental increase since they signed their original leases! Two tenants were actually paying the same rent they had paid when they moved into the property the day it opened . . . fifteen years prior! This news meant that the property's net operating income would indeed increase significantly simply by raising the old rents to the current market rates and once the additional rent kicked in, based on the planned property improvements. The property management company earned its keep that day.

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