PHASE III DUE DILIGENCE: PHYSICAL INSPECTION
I’ve used an image of a stereo microscope to represent this post…it’s important to have both eyes open when conducting Due Diligence.
I typically prefer to have the Books and Records Due Diligence research well underway before I set up a date for Physical Inspections. Physical Inspection almost always involves out-of-pocket expenses that I prefer not to commit to until my B & R work shows its worth proceeding.
The Physical Inspection Process varies widely based on the age, current usage, previous usage, type of asset, size, type of investor, and more. I’ve seen professional contractors that will waive the physical inspection on a small asset if they are convinced that the offering price is low enough. On the other end of the spectrum, a church I helped an investor acquire had a stream of inspectors from roofing, oil tank location, radon, basketball floor evaluators, electrical, plumbing, boilers, and more.
The zenith of the professional inspection spectrum was clearly demonstrated by Marx Okubo recently. Their on-site team included an Architect, an Engineer, and a Contractor. The inspection cost over $8,000, but the out-of-state buyer wanted an exceptionally thorough review of the physical plant. In addition to the on-site inspection, they performed interviews and did a significant amount of online research. The client ended up with a 90+ page report with cost to cure estimates for deferred maintenance. There was also a schedule of estimated repairs over the next 10 years of ownership. I also gave the Buyer the option of using a service that bid only $1,500. After the Buyer read the report she concluded that the additional expense was well worth it.
Two additional thoughts on Marx-Okubo:
- I first ran into M-O on a lawsuit on a condo conversion project. The thoroughness of M-O’s report proved that the developer had fully researched, documented, and disclosed information about the condition of the asset. Yep. That’s it. That’s the kind of attention to detail my clients want.
- One of the things Rose City Commercial Real Estate salutes is excellence in its many forms. I have previously lauded restaurants, a property management company, a short sale advisor, and manufacturing entrepreneur, and more. In no case do I solicit or accept compensation. There is no quid quo pro. The same applies to Marx Okubo. I honor them because I just think they do a better job.
MY RULES: If I’m involved in Due Diligence:
- Every room of every building gets checked.
- Look underneath every sink for leaks and mold.
- Inspect around every hot water heater.
- Check the condition of the toilet floor area.
- Check wood decks for rot.
- Every roof gets checked, visually at a minimum.
- Problems get photographed at a minimum, but I prefer video documentation. Not at inspectors have that equipment…I bring my own.
- If the buyer says that they are looking at the project as a condo conversion, I always recommend thermal imaging with an infrared camera. This is even more important in Oregon, where condo conversion developers are subject to being sued for defects for 10 years after the last unit is sold.
I know of an investor that bought a large multifamily asset a few years ago. He was in a huge hurry because he was running out of time on the second leg of a 1031 Exchange, and needed to identify properties quickly. Over 300 of the 350 units needed new hot water heaters. The roofs were in bad shape. A properly conducted inspection would have alerted him to the problem and saved him over $1,000,000. In another case, a buyer discovered a hole in the floor of a second-story unit the size of a basketball. The unit below had huge quantities of black mold in the carpet and several walls.
ENVIRONMENTAL RESEARCH typically starts out as a written survey attempting to catalog hazards that are suspected and known to have been present on or near the subject property in the past. This is called a “Phase I Environmental Study”, or colloquially as a P1. Should the buyer have concerns after reviewing the P1 they may ask for additional testing. A note about Radon Gas Build-Up: Several people have asked me if this was just a way to give a few Radon Mitigation Contractors a way to make a living. One of the best friends I’ve had in my life, Bob McEwan never smoked a cigarette in his life, yet died of lung cancer. His beautiful Lake Oswego, OR home tested very high for Radon. Count me in as one of the believers in testing for Radon Gas, and mitigation when indicated by high levels. MOLD is greatly feared today, almost as if it were radioactive. The truth is that most mold spores, even ugly ones, are not fatal or even dangerous. The problem of course is that even one fatality is not acceptable.
Be aware that environmental issues tend to be expensive and time-consuming to resolve. I recently finished a deal that went under contract in 6 days from listing. It didn’t close for an additional 14 months due to working through environmental issues.
ALTA SURVEYS (American Land Title Association) are often required by lenders of commercial properties. It protects the value of the loan’s security (the land and improvements) being reduced by lawsuits from encroachments on neighboring properties, etc. And yes, these more extensive surveys do uncover challenges. The owner of a 30 unit apartment I listed had built a fence but on the neighbor’s property. We negotiated a resolution, but that was a roadblock to closing before it was resolved.
CONTACT RICK BEAN:
Call me at 503.577.1034 or e-mail me at rick@rosecitycre.com if you would like additional information about Due Diligence procedures or other investment real estate inquiries.
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