The importance of a diligence checklist

The diligence process for a multifamily building is complex.

In essence, you are buying a small business, often using a lot of debt.

And, if you’re buying the kind of beat-up buildings in which we specialize, often you’re doing the deal with missing / incorrect information from the seller.

To make sure you don’t miss any major issues, it’s critical to have a detailed checklist you go through for each deal.

In our case, the checklist has evolved over close to ten years, through something like 75 deals.

Every time we realize we missed something in diligence on a deal, we add that issue to the checklist to ensure we don’t miss it on the next one.

For example: One time we bought a deal next door to where a bunch of gangsters hung out all day. It took a lot of calls to the cops, etc. to get them to leave our tenant alone.

Over time, with experience, we’ve been able to use our checklist to see issues coming and either bail out or, more often, find a way to mitigate them.

No investment investment is without risk. There are always unknowns and things you can’t control.

But our job is to review each investment in minute detail, in order to absolutely minimize the chances of something unexpected surfacing and biting us (and, by extension, our investors) in the ass.

What a successful deal looks like

Just finished stabilizing a deal and thought you all would like to see some numbers.

Bought this large, non-rent control property in late 2015.

Renovated and re-tenanted it, with everything finishing up in the last week or so.

All in for about $3.6MM.

New rent roll is $369k (so, 9.8x GRM).

Looking like roughly a 7.8% unlevered yield.

Think it’s worth $5.2-5.5MM now.

Just beginning the refinance process, through which I think we’ll be able to pull out ~100% of the capital invested.

Then we’ll return the refinance proceeds to our investors and the partnership will collect cashflow from this building forever.

These deals are really hard to find, but when you do, the model really zings.

Competing with cowboys

We spend a lot of time looking at rental listings to ascertain market pricing for apartments of various types in different neighborhoods.

Recently, we’ve seen a lot of renovated product come onto the market.

Out of interest, I often check to see who owns the buildings and whether they’ve pulled the relevant permits for the renovations.

Very, very often, the answer is “no”.

This drives me crazy, because we are scrupulous about complying with city laws, even at great expense, and it’s ridiculous to have to compete with people who cut corners.

So far, I have refrained from doing anything about my frustration. But it’s getting harder and harder.

Why the zoning matters, even if you’re not building

Have been spending some time looking at new neighborhoods around LA for possible investments.

Many of the areas I’m reviewing were developed later than the areas in which we’ve traditionally done business.

Because they were developed later, when zoning codes were better established and enforced, the apartment buildings I’m reviewing tend to be grouped near other apartment buildings.

This is not great, from my perspective. Why?

Well, if you’re looking to turn around an apartment building, you want your prospective tenants to feel like your units are rare. That’s part of how you convince them to pay top dollar (along with making your units really nice and providing high quality service!).

If you’re in a mostly single family area, then your units are, by definition, unusual.

If, on the other hand, you’re surrounded by other apartment buildings, you will have lots of competition for tenants. Any time they come to see your units, they’ll also see your neighbors’. And, even if your neighbors’ units are not as nice as yours, their lower pricing is going to serve as a kind of “anchor”… one which holds down your potential rents.

The LAW has not been repealed

Was talking to someone yesterday regarding the frothy pricing in the LA market.

She made the reasonable observation that pricing in big city markets seems to be on a long, one way rise.

This is a version of an argument I hear a lot:

  • Millennials don’t want to move to the suburbs, because they prefer city amenities (bars, etc.), so demand is stacking up
  • Big cities don’t allow enough construction of for-sale and for-rent dwellings to absorb this demand
  • So, pricing in big cities will continue to rise forever

There’s a lot to be said for this argument… it’s been borne out over the past 7-8 years.

That said, I get suspicious when I hear arguments that posit a change in the fundamental law that the pendulum ALWAYS swings back.

I have no way of knowing when the steam will come out of LA asset prices. But I know, in my bones, that it will.

And, when that happens, and its raining money, we’ll follow Buffett’s famous dictum and be ready with our buckets.