Horror Story 2- Due Dilligence Lesson

What happens when you hire an unqualified crew to do due diligence?

Enjoy this story about what can happen to you Based on our experiences.

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Once upon a time, there was a woman named "Sarah", who had always dreamed of investing in real estate. She had saved up enough money and partnered with many investors to finally purchase a large 111-unit multifamily property in Amarillo Texas and was excited to start generating rental income.

She found a property that seemed perfect: it was in a growing location, had a VERY fair price, and the seller seemed trustworthy. However, Sarah was in a hurry to close the deal DUE TO a 1031 exchange partners time clock running out in their 180 day window to place their capital to avoid paying a LARGE capital gan tax bill, and didn't get her usual crew to conduct a thorough due diligence on the property, she found some local help.

First, Sarah didn't check the property's legal documents thoroughly. If she had, she would have discovered that the seller had not properly maintained the property and had several outstanding lawsuits from previous tenants.

The seller also had false leases, which usually can be discovered by lease audit when leases are being executed close to the same dates, with the same last name or contact person. In the lease Audit this needed to include commercial tenets (her first time) with background checks on the people occupying the space as well.

Second, Sarah didn't inspect the property herself or hire a professional inspector. She trusted the property manager, who left the management business right after closing, to hire a VERY expensive due diligence company. This company apparently did not include inspecting any part of the mechanical, electrical, elevator, plumbing roof, foundation as it was discussed. If she had been with them, she would have found that the property had several major repairs that needed to be done such as a leaking roof, mold, elevator on it's last repair, cracked cast iron, improper ventilation for the chiller, and much more. Also when she signed the contract for due diligence she did not notice the clause which make sure no action could be brought against the due diligence company for their negligence and she had to take the fall for each missed item which later failed.

Third, Sarah didn't research the seller's background or the property's financial records. If she had, she would have discovered that the seller had a history of not disclosing important information and the property had outstanding debts and liens upon closing and post-closing.

She also inherited elevator maintenance contracts and laundry contracts that made no sense to the properties needs. She needed to negotiate these away as a seller liability before closing and now knows to do so.

She wasn't clear in the building who had keys to what rooms or copies and dealt with an angry elevator maintenance man (due to his favorite staff members being let go of) engaging in criminal mischief, and criminal sabotage when she found that he had a key to EVERY area of the building, cut the rear gate wires we installed, cut two camera lines, cut the fire safety suppression lines to the elevator by breaking into the elevator control room. This is an interesting twist to traditional due diligence, but she needed to think of every possibility in making sure proper key turnover happened on takeover.

As a result of her lack of due diligence, Sarah soon found herself facing a multitude of issues with the property. The repairs were costly and time-consuming, the lawsuits were draining her finances, and the liens and debts made it difficult for her to refinance or sell the property. She finally solved each and every issue one by one and cost the investors a lot of their returns due to the delays of attending to all of the issues.

In the end, Sarah learned a valuable lesson about the importance of thorough due diligence when buying commercial multifamily properties. She realized that taking the time to do her research and being vigilant could have saved her a lot of time, money, and headaches.

The moral of the story is that investing in commercial multifamily properties can be a great way to generate income and build wealth, but it's important to conduct a thorough due diligence to avoid costly mistakes.

What should have been done?

When purchasing commercial property, it's important to conduct a comprehensive due diligence to ensure you are aware of any damages, liabilities, false leases, lawsuits, liens, debts, and other issues that could affect the property's value or your ability to use it as intended. Unfortunately, some sellers may try to hide these issues in order to sell the property at a higher price. Here are some tips on how to do a thorough due diligence and how to spot potential red flags that indicate the seller may be hiding something.

1. Review all legal documents: This includes the purchase contract, lease agreements, title reports, and any other legal documents related to the property. Look for any inconsistencies or discrepancies that may indicate the seller is hiding something.
2. Inspect the property: Conduct a thorough physical inspection of the property, paying attention to any signs of damage or neglect. If the seller is aware of any issues, they may try to hide them by covering them up or making superficial repairs.
3. Check for liens and lawsuits: Look for any liens or lawsuits filed against the property or the seller. These can indicate that there are outstanding debts or legal issues that may affect your ability to use the property.
4. Review financial records: Review the property's financial records, including the income and expenses, to ensure they are accurate and that there are no hidden debts or liabilities.
5. Research the seller: Research the seller's background and reputation to see if they have a history of hiding issues or engaging in shady business practices.
6. Hire a professional: Consider hiring a professional inspector, attorney, or accountant to assist with your due diligence. They can help you identify any red flags and provide expert analysis of the property's condition and financials. Make sure the pros carry full liability. Mechanical, electrical, plumbing, foundation, CONTRACTS, professional lease audit- with full liability from the auditor all need to be thoroughly looked through.

By following these tips and being vigilant, you can increase your chances of identifying any hidden issues that may affect the value or usability of the commercial property. However, it is important to note that even with the most thorough due diligence, there may be issues that are not immediately apparent. Therefore, it's always a good idea to proceed with caution and consult with professionals before making a purchase.

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