Financial due diligence tells you what a building has been earning. Physical due diligence tells you what it will cost to keep it earning. A roof near the end of its life, original galvanized plumbing or an aging boiler will not show up in last year’s net operating income, but each one will show up in your bank account. This guide explains what to inspect in an apartment building, how to turn the findings into a capital plan and how to set aside reserves.
Inspect the building, not just a sample of units
In a small building, walk every unit if the leases and local notice rules allow it. In larger buildings, many buyers inspect a sample plus all vacant units, but the building systems should be seen in full: roof, structure, foundation, exterior envelope, windows, plumbing, electrical service and panels, heating and hot water, ventilation, fire safety systems, elevators if any, parking and drainage. A professional property condition assessment, or separate inspections by qualified trades, is the usual way to do this.
What to ask the inspector to report
- The age and condition of each major system and its expected remaining life.
- Items that need attention now, and items likely to need replacement in the next several years.
- Rough cost ranges for the major items, so you can build a capital plan.
- Anything that could affect safety, insurability or code compliance.
- Signs of water intrusion, which in the Pacific Northwest climate deserve particular attention.
Seattle-specific checks
Seattle rental properties must be registered with the city and can be selected for inspection against minimum housing and safety standards. Ask the seller for the current registration and any past inspection results. City rules also allow tenants to delay a rent increase when a unit fails to meet minimum standards, so deferred maintenance can affect income as well as expenses. The rules are covered in Seattle Landlord Rules to Price In Before You Buy.
Older buildings may also raise questions about seismic performance, especially unreinforced masonry. If the building is older brick construction, find out whether it appears on any city list relevant to seismic risk and what that could mean for future work and insurance.
From findings to a capital plan
Group the inspection findings into three buckets: work needed at or soon after closing, work likely within the next five years, and longer-term replacements. For each item, write down the expected timing and a cost range. Immediate work is usually funded at closing from your own cash or negotiated as a price reduction or seller credit. Near-term items go into your projections year by year. Long-term items are covered by an ongoing reserve.
Setting a reserve
A replacement reserve is money set aside each year for capital items. Lenders often require a minimum amount per unit per year and may hold it in an account. Your own reserve should reflect the building’s actual condition: a recently renovated building needs less than one with original systems. Include the reserve in your cash flow below NOI, because it is cash you cannot spend even if it does not appear as an operating expense.
A short case
Imagine a buyer whose T12 shows healthy NOI on a building from the 1960s. The inspection finds a roof with only a few years left and a boiler that has been repaired several times. Neither item appears in the seller’s expenses because neither has failed yet. The buyer adds the roof to year three of the capital plan, sets aside an immediate amount for the boiler and raises the annual reserve. The building’s NOI does not change, but the cash flow after reserves drops, and so does the price the buyer is willing to pay. That is due diligence doing its job.
Negotiating after the inspection
Inspection results are often the basis for renegotiating before the contingency period ends. The usual options are a price reduction, a credit at closing, or the seller completing specific repairs before closing. A credit or reduction is often simpler for the buyer because it lets you choose the contractor and the scope. Whatever you agree, put it in writing and make sure the amount matches the cost estimates in your capital plan rather than a round number.
If the findings are serious enough to change the deal fundamentally, such as major structural or water problems, walking away during the contingency period may be the right decision. That is the purpose of the contingency.
Summary
Inspect every major system, get cost ranges, sort the work by timing and fund it through closing funds, projections and a reserve. Then test whether the deal still works if costs come in higher, as described in Stress-Testing an Apartment Deal: Rates, Rents, Expenses and Exit. The financial side of due diligence is in How to Review a T12 Before You Buy an Apartment Building.