Making Offers and Closing The Deal
Once you have properties that fit your buying criteria being sent to you by commercial brokers, or you have calls coming in from your direct mail campaign, it won’t be long before you find a property that looks like it is a deal and you want to check out.
Once everything looks good on paper you want to drive by the the property to 1) eyeball it, get a general sense of the property, but mainly 2) to check out the neighborhood.
Whatever condition the property is in, you want (ideally) the neighborhood to be higher quality than the property. So if you are buying a Class C property that is 30% vacant, with deferred maintenance and below market rents, you want it to be located in a Class B area, an area where the other apartment buildings are higher quality that yours.
You do not want the property, in it’s current underperforming state, to be the best property in the area. Class C property in a Class D area. Leave these properties for others.
A Class C property in a Class C area is OK, but when you have a higher quality neighbohood you are bringing the property up to, you have higher quality tenants, fewer management hassles, the ability to charge higher rents, and greater upside after you have executed your value plays and turned the property around.
The best scenario is a Class C property in a Class B area. When you find this deal, it’s time to make an offer and start looking at it more closely.
Letter Of Intent
The first step in making an offer on the property is not a purchase and sale agreement, but a Letter Of Intent. This is a non-binding agreement that is used between you and the seller basically for both of you to thrash out what you will agree to before going to the timeand expense of an actual binding contract.
On it you outline the price you are willing to pay, the terms, the closing period, and any special terms you want in the actual contract.
For you, it’s also an opportunity to go on the property, posing as a prospective tenant, to look at the property, and the units more closely. When you do this, you can get a sense of nature of the repairs that are needed, both inside and outside the property, find out what the rents are, get a sense of the tenant quality, and anything else that would tell you what the value plays are on this property.
If something jumps out at you, like repairs being greater than represented, this is the time to adjust the price, or the terms. Or to back out completely if your find something (like, no parking) that kills the deal for you.
If everything looks goods after your incognito walk around the property, you and the seller can sign off on the Letter Of Intent. Also, start talking to property management companies about managing this particular property.
Going To Contract
Once you have a signed LOI it’s time to go to contract and create a formal binding agreement for you to buy and the seller to sell the property.
If you are buying the property through a commercial broker they will probably insist on using a state realtor contract. This is not necessarily a bad thing, just bear in mind, any realtor form is slanted in the interests of the realtor, and their client.
If you are using a realtor contract for your deal, READ IT, from start to finish and make sure you understand everything it says. If there is anything at all you don’t agree with, change it, and make it say what you want.
Remember, everything is negotiable and now is the time to haggle. Don’t worry about marking up the agreement, just make sure it represents what you agree to do, in every small detail. After you sign, you have to deliver on it, so make sure it says what you want it to say.
The important elements to nail down in your contract are,
1) earnest money, how much and when it is paid in by,
2) financing contingency, how long it is, any extensions, and how long they are,
3) due diligence, detailing the documentation you want to
see and how long you have approve it.
4) inspection period
5) the closing date
The first element you have to deal with on your contract, and the first actual commitment, apart from your signature, is earnest money.
On any apartment deal earnest money will need to be about 1% of the purchase price if you are going to be taken seriously.
I know, you learned how to buy houses writing a $10 earnest money check. Not here. Being cheap on earnest money, or trying to get out of paying it, tags you as an amateur and not to be taken seriously. You will lose all your credibility at this point, not to mention the deal, if you push the issue.
Earnest money, in a meaningful amount, needs to accompany the contract and paid into escrow (or the title company) for the contract to be binding and the deal to go forward.
How meaningful is meaningful?
On a $7M deal, 1% is $70,000. Let’s bring that down to $50,000 to make it a round (yet still meaningful) mumber.
I know, you are saying to yourself, “where in all god am I going to get $50,000?”
You know the answer … private lenders.
Look, I know you’ve got all kinds of “what!!”, “no way!!”, “they would never do that!!!” chatter going on in your head right now. Just, withold judgement about that for a while and accept the idea that this is indeed where your earnest money is going to come from.
A few things to understand about this:
1) earnest money is protected by the financing contingency, and the inspection contingency. If the deal doesn’t close because of anything to do with the property, or with the bank not approving you for financing, earnest money is refunded.
2) earnest money is part of the purchase price, just like the rest of the down payment that is funded by private lenders. The only difference is it is paid a few months in advance of the rest of the private lender money being used for the deal.
3) you should be calling, networking for private lenders from the very first day you begin looking for deals. The returns and security provided by apartments are a very straightforward value proposition. If you present your deal to at least two people every day, after a month you will have developed your core group of private lenders. These are people who now know you, trust you, and are waiting to invest their money with you.
As far as timing goes, when you are going back and forth with the letter of intent, you are talking to your private lenders then to find the one or two who you are going to use for earnest money when the time comes. (n.b. earnest money private lenders receive extra returns to compensate for the extra time their money is in the deal.)
By the time you are executing the contract, your earnest money private lenders are standing by, ready to wire funds at your request.
When you have a signed agreement and earnest money paid into escrow, the clock begins ticking on the timelines in the contract.
There are four timelines you need to be concerned with.
1) Due diligence
3) Private money
4) Turnaround plan
These timelines run side by side, and all converge at the closing.
In the purchase contract there will be a contingency period for you to perform your due diligence. This is the timeframe in which the seller send you copies of all the documentation on the the building so you can verify that what has been represented to you about the building is, in fact the case.
There are two main categories of due diligence. Physical due diligence, and financial due diligence.
Physical due diligence is everything to do with the physical condition of the property. Repair estimates that have been done, disclosure about specific deficiencies or damage to the property, any environmental reports that have been done. Work orders and receipts for repairs that have been made in the last 12 months. Anything and everything the seller has related to the physical condition of the property, so you can be fully aware of what you are buying.
Financial due diligence is checking all leases of the property so you can be fully aware of what the actual, current income of the property is “today”. Not what is was, or projections of what it could be, but what it is right now. You want to see leases for all of the current tenants, and leases for laundromat machinery, vending machines, and anything else that generates income on the property.
Your contract specifies the time the seller has for getting this documentation to you. Five days is reasonable, ten days at the most.
Once you have received all of the documentation and checked through it all, you then perform your physical inspection of the property. If you are using a broker, he/she and the onsite manager will accompany you on your tour of the property.
Your objective on the physical inspection of the property is to verify all the documentation you received. Were the repairs mentioned really made? Is there anything not working that wasn’t mentioned? Are all of the units represented as vacant, actually vacant? Make sure you inspect every single unit.
You will have got a general sense of the property when you issued your LOI (Letter Of Intent) and walked around it a bit, but this is where you get down to brass tacks and see everything.
Don’t be shy about asking questions. This is where you find out what you are buying, you want to know everything.
The time you specify on your contract for due diligence is totally negotiable, the longer the better. 45 days is a reasonable period, 60 days is better if your seller will accept it.
There will also be a financing contingency in your contract that covers you going to a commercial lender or bank to get a purchase money mortgage.
The financing itself will take every but of 60 days so you want to make the contingency period at least this long, with the option to extend for another 30 days if necessary.
You loan application process is very straight forward and essentially comes down to providing the documentation the bank requires. The key to this is though, speed. Always gather your documentation quickly and put the ball back in the lender’s court. This keeps your file open on the underwriter’s desk and your deal the top priority.
Additionally, problems always crop up. Dealing with them quickly takes them off the table and keeps the process moving.
One place the commercial loan application differs from a residential application is the lender is less concerned about your personal credit, and more concerned about the income the property produces. And seeing the income the property produces is dependent on how well it is managed, the lender will want to know what your management experience is.
It’s OK if you have zero experience in managing apartment buildings, you are not going to manage the property. Your property management company is.
To satisfy this concern of the lender you will need to include a business plan for how you intend to manage the property. You don’t have to write this yourself. Ask the property management company you selected to provide that you, and then include it in your loan application.
Although your use of private money to cover the cash requirements of the deal won’t be mentioned anywhere in the contract, you use the entirety of the contingency periods to make sue you raise all the private money you need.
Whether you are raising your private money by networking, or by using a securities attorney and doing a private placement, a 90 day financing contingency is plenty of time to raise all the money you need.
The key to successfully raising all of your private money before closing though is preparation. Whichever route you take, make sure you have made all of your contacts and have all of your presentations and documentation ready, so once the contract is signed you go straight into promoting the deal and lining up your investors.
Start the day the contract is signed and keep going daily until you hit your target.
While doing your due diligence you will be getting a much closer look at all of the physical and financial aspects of the property, and now you know the reality of the situation you can put together a coherent plan to remedy those areas that need attention.
Turning the property around is where you create value, so the more organized you are about planning and implementing the sooner you get the building back to top performance and start benefitting from increased cashflow and value.
As you encounter deferred maintenance items, note them all down and categorize them, for each individual unit, for building exteriors, and landscaping.
Likewise for onsite management. Take note of any lax bookkeeping or management practices that will need to be changed, any bills that seem to high, supplier contracts that could be renegotiated, property taxes that can be challenged.
By closing you will have a detailed outline of all areas needing improvement. From here you can construct a series action plans for each area of work, which taken together, become your Turnaround Plan.
When all the inspections have been completed and approved, your loan application approved, your private money raised, clear title delivered, your closing agent will schedule a closing date.
On the day of closing, the hard work has been done, and all there is left to do is show up at the appointed hour and sign documents.
That’s it. Now you own your apartment house.
Though it’s not a profit machine just yet.
You have execute your Turnaround Plan and extract the upside value currently lying dormant in the property. Only then can you hand off management duties to your property management company and celebrate your financial freedom.