Underwriting and Due Diligence Challenges in Commercial Real Estate
In the spirit of Murphy’s Law, most real estate investment firms would do well to anticipate challenges and risks when acquiring multifamily assets. The market for investment sales in 2016 was reportedly $150.3 billion, according to JLL’s research.
When buying older properties, just like buying an older car, you are unfortunately at the mercy of the previous owner.
How well did they maintain the physical asset?
Did they perform proactive maintenance and repairs or did they barely fix things only after they were broken?
Imagine a car owner who drives with their foot on the gas and the brake at the same time. Imagine that same car owner not changing the oil or following the manufacturer’s recommended schedule of maintenance. No matter how many miles or how great the car looks, it is definitely not going to last.
The same things happen with vintage (ie, older or legacy) multifamily properties.
Owners and operators, whether out of ignorance, inexperience, or unwillingness, pass risk onto unsuspecting buyers who have failed to investigate the property in a thorough and insightful manner. Fannie Mae even has a 7-page list of “known problematic building materials and property design issues.” Underwriting teams would do well to read and heed these warnings.
Here are a few ideas on where to narrow your focus during acquisitions:
- Balcony framing
- Building envelope/ waterproofing
- Electrical wiring
- Foundations
- Roof framing
- Grading and drainage
- Wood destroying pests (aka termites)
Other areas of potential concerns include plumbing, firewalls (aka draft stops), dryer vents (specifically code upgrades), as well as environmental issues (including mold, asbestos containing materials, lead-based paint, etc).
Balcony Framing
Issues
Multifamily design and construction is known for it’s speed of execution. Sometimes speed does not equal quality. Poor designs, inadequate detailing by architects and engineers can contribute to construction and maintenance risks on multifamily properties. The lack of quality control in the field (whether building today, 40 years ago, or even 400 years ago) will increase the risk of future damage and failure.
Why do some job sites look messy, while others appear clean?
Why do some contractors have daily safety meetings and others do not?
Why do some contractors have the most up-to-date drawings on site and others do not have a single piece of paper to be found anywhere?
Wood framed balconies and the long term exposure to the elements (especially moisture/ water) can lead to undetected structural damage, sagging framing, and sometimes, even worse, collapse.
Typical Observations
Moisture staining at balcony ceilings/ soffits, loose railing, soft spots in the wood framing are tell-tale signs that there could be a larger issue with the balcony framing. Some forensic engineers have estimated that undetected water damage occurs in up to 40% of conventional wood-framed balconies they have investigated
Mitigation Techniques
When acquiring vintage multifamily assets, it is usually too late to influence the design or construction. However, one can evaluate the need for emergency shoring, eliminating resident access to balconies, or developing effective repair designs.
Ultimately the damaged balconies will need to be removed and replaced with proper framing, flashing, and waterproofing. This effort is not cheap and could range in cost depending on the original design, construction, extent of damage, and number of balconies.
To avoid concealed deterioration at balconies, the following construction best practices are recommended:
- slope the framing and decking;
- flash all transitions, especially at the facade;
- protect corners with additional membrane waterproofing;
- provide a path for the water to drain from the membrane;
- slope the concrete topping and try to limit cracking with good workmanship and quality materials.
Building Envelope and Waterproofing
Issues
Stone, brick, stucco, and exterior insulation finish systems (EIFS) are not “waterproof.” In fact, Fannie Mae has singled out EIFS as a problem area despite it’s popularity as a cheap and fast construction material for building facades. Improperly flashed penetrations [think windows, doors, chimneys, vents, and material transitions such as balconies-walls] allow water to become trapped behind any facade material, whether it is EIFS or not.
Typical Observations
The smell of mildew, suspected fungal growth (aka mold), rotten sheathing, and wet drywall are signs that there could be issues with the building envelope (ie, the walls and roofs). “Patches” of paint at perimeter walls or ceilings near windows and doors could be an attempt to cover up previous damage. The sad truth is that if the deficiency allowing water into the envelope has not been addressed, water intrusion will continue at that location.
Transitions between facade materials [metal window frames to brick] are notorious for having deficiencies that allow moisture intrusion. Openings in joints (ie, no sealants), a lack of flashing [metal, membrane, or otherwise] and a lack of quality weather barriers can contribute to moisture intrusion.
Mitigation Techniques
Depending on the systematic and/or isolated nature of the water intrusion, re-painting and sealing joints (aka “caulking”) can greatly improve a building’s facade. Maybe you just need to re-roof the building. Either way, depending on the frequency of reported leaks, it might be best to “take an inventory” of known or previous leak locations using a site map and building floor plans.
Do they occur at the same balcony on the same unit type?
Does the same window-wall location leak at specific buildings on the property?
By identifying patterns, you may be able to develop effective (yet simple) solutions to prevent future water damage. The worst thing you can do (in our experience) is to fix the water damage without understanding where or how the water is infiltrating the building.
Electrical Wiring
Issues
It is no secret that older assets in the multifamily world are susceptible to electrical risks related to aluminum wiring, lower panel amperages, fused subpanels and the presence of Federal Pacific “Stab-Lok” Breakers.
These issues can increase the risk of fire and have been written about at length by the legal, insurance, and real estate industries. Aluminum branch wiring gets hot. Because of unequal expansion rates between aluminum and copper, connections can become loose and increase the risk for fire.
Stab-Lok panels manufactured by Federal Pacific are known to have a significant failure rate. By not tripping breakers when overloaded, these panels can overheat.
Typical Observations
Branch wiring at each building should be visually verified, observed, and photographed by a professional during the due diligence phase. Aluminum wiring is not the end of the world, but it does need to be addressed.
Apparently it was substituted as a building material back in the 60’s and 70’s due to the escalating costs of copper. One may even see the “aluminum” or “AL” on the plastic wire coating.
For unit level electrical meters, you should have a qualified (and skilled) person verify that the minimum panel amperage is 60 amps. During due diligence, you should request field verification that these panels are rated for the recommended minimum amperage.
Federal Pacific panels will have the words “Stab-Lok” on the face of the panel behind the door, or on the door itself. Easy enough.
Mitigation Techniques
After thorough investigation and observation of the aluminum wiring, a few methods for repairs include:
- Rewire the building
- Install COPALUM connectors
- Install AlumiConn connectors
More details can be found here in the U.S. Consumer Product Safety Commission Publication No. 516. If you are unclear on what an electrician’s scope should include, this document is a great place to start. Always be clear and concise when developing scopes of work for contractors.
The number and locations of the panels below 60 amps should be well documented for future evaluation related to the unit electrical systems. Talking to good electricians and even electrical engineers familiar with these issues is definitely a good idea.
When a unit draws more than 60 amps, the fuses will blow or the breaker will trip, in theory if everything works as intended.
Most 60 amp panel services are found on older systems which have a limited number of circuits [think branch lines running to the different rooms].
This configuration is a potentially hazardous situation, particularly if the system has fuses rather than breakers.
Some owners find that their overtaxed distribution system is constantly blowing 15 amp fuses. Their team may replace them with 20, 25 or 30 amp fuses to prevent the fuses from blowing so often. This repair can inadvertently lead to a branch circuit overheating and subsequently cause a fire.
The solution to the problem is not necessarily a larger service, but rather a larger distribution system. It is reportedly safer to have a building with a 60 amp service and 20 circuits than a building with a 100 amp service and 7 circuits.
Tamper-resistant fuses and/or the installation of “breakered” subpanels can help mitigate the risk related to fused panels.
Stab-Lok panel locations and quantities should be determined using a site map and building floor plans.
All Stab-Lok panels should be replaced by a licensed electrician. It’s simple, not cheap or easy.
Foundations
Issues
Foundation movement in some parts of the country can be related to seasonal moisture changes, the soil, and/or poor design and construction. A moving foundation is not the end of the world, nor is some cracking at interior or exterior finishes. Sometimes the foundation movement is so severe that doors and windows “stick,” preventing safe and easy egress. Other times, the window and door misalignments allow heating and cooling to escape from the interior.
Typical Observations
Drywall patches and repairs will typically be located at the corners above windows and doors. You might even noticed different color mortar in masonry facades or open cracks in the mortar joints.
Are windows or doors unable to open?
Are floor-ceiling-wall transitions visibly separated?
Does the floor noticeably “drop off” and/or slope in one direction?
2’-0” x 2’-0” square concrete patches on the sidewalks are good indications of previous foundation work at the property.
You might even see steel attachments along the foundation perimeter that could indicate pier locations.
The effectiveness of previous repairs depends on originally design, construction and on going maintenance.
Whether you are taking care of a boat, a fleet of jets, or a multifamily foundation, the process is the same. Good planning and execution go a long way.
Mitigation Techniques
While foundation investigations and repairs can be necessary, it can also be beneficial to simply do nothing. The best mitigation technique for foundation work is to consult a pro. Engineers and contractors all have varying methods of repairs.
If you complained of foot pain and the first doctor you went to said you needed to amputate immediately, would you want a second opinion?
What if the second doctor said try some new inserts in your shoes and stretch more?
There is a lot of “snake oil” sold every day in this country related to foundation repairs. Shop around. Ask tough questions. A new set of gutters, some extra soil to slope water away from the building, and drywall repairs can do wonders for a 40-year old property (and your capex budget).
Avoid pressed-pile foundation repair methods as much as possible. Think how your foundation would perform if it were broken into several smaller pieces instead of one big slab. What if the contractor who broke it said, “Yup, you need more piers to fix your ongoing foundation issues.”
Roof Coverings and Framing
Issues
Poor materials, long-term water damage, and bad workmanship can lead to rapid deterioration of roofing. Exposed OSB decking will fall apart after repeated exposure to moisture. Shoddy framing and sloppy construction can lead to sagging roof decking, causing even more concerns.
Typical Observations
When checking out roofs (usually from the ground level), you can take a very simple approach.
Ask yourself, “What like these is not like the others?”
Are there missing shingles?
Do the shingles look old and worn?
Can you see sagging between the rafters or trusses?
Are roof eaves and edges irregular or straight?
These signs can indicate potential trouble at the roof. Due to the depth of insulation typically found in attics, a building can leak for days, weeks, or even months before signs of water intrusion are visible.
Mitigation Techniques
Most 3-tab or architectural laminated shingles should last about 15 years. Depending on the roof slope, the climate, and the workmanship of the installation, roofing materials can deteriorate at a faster rate.
Re-roofing and repairing deteriorated decking can improve a roof’s overall performance. Depending on the original construction, additional purlins, bracing, and other framing could be needed to prevent further sagging of the roof.
Look, wood will stretch and sag over an extended period of time [think plastic not elastic]. It should not sag so much that your roof has a visible ripple or dip.
Grading and Drainage
Issues
Undersized or damaged gutters, negatively sloped landscape beds, tiny area drains, and horrible paving can lead to ponding water around the property. You may even have water intrusion at first-level buildings where the ponding is severe enough.
Typical Observations
If you are lucky enough to tour a property during or right after rainstorm, congrats! That is by far the best case scenario to discover potential drainage issues.
If you are not that lucky, some simple questions can help you determine if there are concerns with ponding water.
Are the gutters and downspouts connected with no signs of erosion or washout at the base of the buildings?
Do the landscape beds have mulch and slope away from the buildings [think “downhill”]?
Do you see several 12”x12” inch green yard drains throughout the property?
Does the pavement and parking have evidence of standing water (i.e., lots of dirt and debris in one place)?
Mitigation Techniques
A simple yet good tactic is to review the property on Google Earth’s desktop version to see if you are able to observe a pattern of drainage issues using available historical imagery.
New gutters, soil, mulch and concrete drainage blocks can all help push water away from your buildings. When trying to mitigate ponding water, avoid the use of 12”x12”‘area (or “yard”) drains if possible. These boxes and below-grade drain lines are great for contractors to sell you several $1,000 worth of work. However, their actual performance leaves a lot to be desired.
Instead, we typically find that re-working the natural drainage areas to carry water faster along the surface of the ground is more effective at moving water off the property. Some readers may know this technique as “sheet flow.” It’s simple. Have a landscaper or contractor dig a ditch deep enough that it creates a natural channel to funnel water during heavy rainstorms.
Pavement and parking drainage issues are usually a little more costly to take care of. Again, keep it simple and slope your asphalt or concrete surface down hill. Make sure your contractor is explicit with the quantities and locations of the work.
Wood Destroying Pests (aka termites)
Issues
Depending on the location of the property in the continental U.S., drywood and/or subterranean termites could be eating away at the wood framing. These little guys can quickly eat their way through 2x wood framing affecting sill plates, entire wall sections, rafters and more.Subterranean Termite
Drywood “Flying” Termite
Typical Observations
The easiest method to uncover the presence of active termites at a property is to hire a pro. If that is not feasible during your initial underwriting and due diligence, you can review documents for past treatments from pest control companies, as well as framing repairs and painting.
Does your property fall within any of these zones? If so, you should consider calling a pro for a quick inspection. Just like sports, business, government: some pros are all-stars, others are not.
Mitigation Techniques
For subterranean termites, you may want to invest in a treatment program and ongoing maintenance for the entire property. We have seen entire sections of walls missing from properties that were “spot-treated.”
It’s best to consult professional firms that are willing to stand by their work and provide a transferable warranty for their ongoing maintenance work after the initial treatment.
For drywood termites, get ready to vacate and fumigate your buildings. Not cheap, but it is the right way to eliminate these little pests from the property. Only after the “fume” would framing and painting repairs be recommended. Again talk to the pros if you want to clean up the property the right way.
What It All Means
While everyone’s underwriting standards and processes can vary, we just wanted to highlight some repeated “trouble areas” that we see in the acquisition of value-add multifamily assets.