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Get More Out of Property Visits for DSTs and Other Real Estate Programs

by Brandon Raatikka

Physically inspecting the underlying real estate before making investment recommendations to clients is important for many reasons. Visits can allow you to verify sponsor disclosures about the property and location, identify risks relating to neighborhood trends, and observe the condition and operation of the property first hand. And then there are the compliance reasons. FINRA Regulatory Notice 10-22 cites “[v]isiting and inspecting a sample of the issuer’s assets and facilities” as what can constitute a reasonable due diligence investigation for broker dealer firms. Property and onsite visits to confirm sponsor disclosures about investments and strategies also fit within customary RIA due diligence practices observed by the SEC.

So how can DD personnel and advisors get the most out of property site visits?

To find out what makes for effective property onsite due diligence, we sat down with Jense Bowles, senior relationship manager at FactRight’s physical site inspection partner, Spectrum Field Services, Inc. Spectrum performs inspections for all of FactRight’s due diligence reviews on syndications of identified real estate, including DSTs. Spectrum has been in the commercial real estate inspection business for over 30 years, recently merging with Covius Real Estate Services to further expand its commercial service offerings. Spectrum’s 2,000 professionals nationwide perform between 23,000 to 25,000 specialty inspections per year. Spectrum serves a wide variety of clients including credit unions, mortgage servicers, and Wall Street investment banks. Clients have unique requirements, such as specialized forms or agency-mandated (FNMA or Freddie Mac) inspection scopes, but in our conversation, we drilled down on what can make any physical property and neighborhood inspection a success.

FactRight: What are the most common red flags you may encounter when visiting a property?

Jense Bowles of Spectrum: The biggest red flags are items that will materially affect the property or the market:

  • Roofs are always important because they require capital to replace, and when they fail, they can cause major damage, often requiring insurance claims and closure of units, impacting revenue while they are repaired. Roofs in poor condition can easily be a significant red flag.
  • Plumbing issues can lead to mold growth if not addressed quickly.
  • Electrical issues that could result in a fire.
  • The evaluation of the property contact can also be an important assessment. For example, If the property contact appears to be diverting you away from certain areas or units of the property, request to inspect those areas to see if there are issues the property contact may be trying to hide.

What are some onsite due diligence items that might not seem critical, but really are?

There are a number of small items that are easily overlooked but are really important. For example, as it relates to the condition of the property itself:

  • GFCI outlets and CO detectors in apartment buildings are important safety items. These can be expensive to get installed in older buildings that may be missing them.
  • Easy access to working fire extinguishers near the laundry and boiler rooms are vital. Recently, Spectrum inspected a property that had an electrical fire in the laundry room, but damage was minimal due to a fire extinguisher nearby.
  • Small stains in ceiling tiles are also important to trace back to the source of the leak. If there is a roof or plumbing leak it needs to be addressed so that it doesn’t become a major issue or cause mold.

Other important areas to consider or review include:

  • Obtaining a rent roll and looking at lease expiration dates (especially for retail properties in the current market) to see if there are several tenants who have leases expiring close together in the next year or two. This can prompt you to question the property management company about their efforts to extend these leases so that they aren’t scrambling to fill a large amount of vacant space at once – especially if the market trends indicate a rising vacancy rate.
  • Noting proximity to major highways, which are essential for most industrial properties for distribution purposes.
  • Recent or frequent name/branding changes for hotels can be a red flag. For example, if a hotel changes hands several times in a short timeframe, there may be a concern with the viability of the property within the market.

Do you have any particularly interesting (or horror) inspection stories? What were the lessons of these?  

Two horror stories in particular stick out. The first was, while completing an inspection, the inspector and property manager walked into a unit and found a dead body sitting in the recliner. Apparently, the tenant had passed away some time before and hadn’t been discovered yet. Authorities were called and it was determined that he had died of natural causes. There weren’t any particular lessons learned from this experience, but rather a demonstration of the fact that you never know what you will find while performing an inspection.

We also had an inspector who was inspecting a self-storage property and noticed a pungent smell coming from one of the large units. She spoke to the property contact and told them that she was suspicious that there might be a meth lab in the unit. They called the police, who got a warrant and did in fact find a meth lab. This is an example of where a good inspector was paying attention to small details that could be overlooked (and had been by the property manager). This created a huge safety and legal hazard for the property and may have impacted occupancy if potential tenants had also noticed the smell and utilized a different property.

For our readers who visit properties, what are your best tips for ensuring that an onsite inspection will be productive?

It is important to research a property before the visit is made.  If there are multiple buildings that need to be inspected, get an outline of the walk-through before going to the property.  We have seen instances where the property contacts have tried to steer the inspector away from buildings or units that are damaged, to portray a better overall picture of the property.

I also like to get to the property a little before my appointment time to walk around the exterior and common areas without the contact and get an idea of the property condition before I discuss anything with management. I prefer to suggest the units/tenant spaces we visit so that it is random and not picked by the contact. This leads to a more accurate picture of the property condition. Most of the time the property owners and management team aren’t trying to hide issues, but in the rare instances that they are, this system pays off and can uncover problems that affect the viability of the property. For apartment complexes I generally skim a sampling of online reviews before I go out so that I can see if there is a theme in the complaints and assess for myself when on site if there is really an issue with the property or management, rather than just a few tenants with a grudge. 

Last, as I previously mentioned, pay attention to management during the inspection. The management company’s preparation for and performance during the inspection can assess overall organizational skills, as can their interaction with tenants as they walk the property with the inspector. Maintenance staff can be evaluated on their attention to small items. Typically, if they are proactive in their care of the property, smaller items are addressed quickly before they become larger issues. Additionally, the smaller concerns can have an impact on the overall curb appeal of the property, which is very important for attracting customers or tenants. 

How do should you approach assessing location attributes and neighborhood trends?

Getting local perspectives is invaluable when assessing location attributes and neighborhood trends. For instance, while we also research each inspection in-office, our local inspectors have oftentimes heard rumors of new business or development that will impact the economy, as well as closures that could be detrimental. Sometimes, this information is available through an online search but is typically buried in the search results and can be difficult to find.  But, it if often well-known in the community, and thus, the local inspector. This can be especially true in smaller cities and rural areas but has also been the case in major metropolitan markets.

Speaking to a local real estate agent is an important step to perform additional due diligence to verify the findings from other methods. At Spectrum, we’ll perform a minimum of three broker interviews, and call several others if values are substantially different from what has been reported by the brokers. If there is a consensus between all three brokers that does not match our in-office research, we start over to sort out why our findings differ. It may be that our reports are from the quarter before, and there have been several changes in the market within the last month that have had a significant impact, but not enough time has passed for it to filter into our available research. Similar to our inspectors, it provides more in-depth local market knowledge that is vital to portray an accurate picture of market trends. Our goal is to provide information from as many sources as possible so that our clients can make an informed decision on an investment property or portfolio. So, due diligence officers should consider as many reputable sources of information on the market and neighborhood as possible.

What are the best ways to document a visit?

Taking a small note pad on site visits to document observations from the visit with the property manager and what is observed on site is very helpful.  But, the most important thing is to take a lot of pictures. Our inspectors will take up to 60 to 70.  While only 20 or so get sent to the client, it provides the inspector the opportunity to do another review of the site and determine if there are any issues that may be may be more significant than on first glance.  Sometimes a property manager who is not on site will even ask us about the location to verify deferred maintenance so that they can get it repaired!  Multiple angles showing backgrounds can help them identify where the damages are so that they can get them addressed quickly. Obviously, FactRight’s clients won’t need to take pictures for that purpose per se, but it goes to show how effectively pictures can help document the findings of a visit.

You can learn more about Spectrum Field Services at its website.

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Filed Under: Due Diligence, Real Estate, DSTs