the reparations and some of the consequences of having an adverse environmental reaction on the property. You know, you get that phase water face to back and says, yeah, it's riddled with contaminants. Your master. Hey guys, welcome back to how to invest in commercial real estate. This is episode 12. We're going to dive deep into underwriting. My name is breeding cheek with the criterion fund and I'm joined by my co host, Brian Joel, What's up? What's going on? Welcome back. So um you know, we've we've gone over um you know how we're finding our property, how we're gonna make the offer on it. We got a free letter of intent from um invest, how to invest in sierra dot com. We downloaded it, we know how to use it. We watched last video and and now we're in contract on that property and we need to figure out what's next. So you know, we probably read some package or om that said, you know all the details and and now we need to go into underwriting or due diligence or whatever you wanna call it, started taking him. Yeah, the biggest pitfalls, right? You know, there's a lot of traps you can fall in um into and due diligence and we've fallen in quite a bit.
So we'll go over, you know where the traps are and where you can save some money. Yeah. So um you know, we were not going to go into an exhaustive list of everything you need to do during due diligence because that's kind of boring and that will be in our course later on. but today we thought we'd go over some things, some areas uh that will, that have cost us money. So it can save you guys money. Absolutely. The two biggest areas of underwriting or due diligence, you know, the two biggest things are the physical condition of the property, which may not be as relevant to the cash flow, but you know, if it's deteriorating, you may have to pay to fix it. And then the second and most important one is the financial underwriting the property. So when we refer to financial underwriting, that's more of how much money is the property making, What's the top line revenue? What are the expenses, How are we verifying that? How much money is it making at the end of the day and then um you know, that's, that's really financial modeling, right? Because we're most likely buying this piece of commercial property because it makes us money, right, that we're buying a stream of income, we're paying a certain amount of money for hopefully a stream of income that we can count on.
Were financial buyers basically exactly the real estates like this sidekick? Er, you know what I mean? Same thing with the physical condition of of it, right? Like a new roof isn't going to make you make more money? It's not going to substantiate the income on that property, but if you don't have it and you need to replace it, the financial cost of replacing the roof would would affect it. So just kind of getting into the biggest one? Um not the biggest one as far as financial versus physical, but when you're looking at the physical condition of the property, what are things you're looking for? You know, the physical condition of the property underwriting well, and and we talk about pitfalls, uh we want to talk about the the things that aren't so obvious and and in the maintenance world, there's gonna be certain maintenance problems that could be hidden that you may not see. Uh just at first glance, and those are, those are the important ones to figure out, right? So this is deeper than what you, you know, if you're pulling up in the parking lot and just taking a glance, it's probably what you don't see is what we're trying to say. One of the biggest ones um is a roof.
You know, roofs are really expensive, There can be um a lot of problems to a roof. You know, it could be the shingles, it could be the wood rotting underneath that and that, you know, that's a big one to find. So um a really common one is to make sure whoever is inspecting the roof is doing a roof boring test, right? Because that's, that's important, they're gonna dig a hole in that roof and it's going to tell you how many layers of roofing are there? It's gonna tell you if the last roof was a tear off? Like did they tear off the complete roof and do it right and take it down to the metal or the plywood or whatever it was? Or did they just put a new roof over the last roof? Right? Which you can't do forever and could cause problems just like your home? Yeah. And roofs are really expensive. So when you're going in the underwriting and you're saying, hey, you know, Um we agreed to this purchase price on this property, you know, it was a $5 million 20 years old. Um you know, you need to pay a portion of that. You need to be asking the seller for a portion of that roof cost. Right? Yeah, absolutely. That that could be a big, big cost.
Um like I said, they can put shingles over shingles or an overlay on a flat roof, there could be water damage underneath and the decking, we've bought in properties that had really bad roofs and and we at the, in the very beginning we didn't hire the right professionals to make sure that we have a full understanding of the situation. So uh that's that's one of the first ones on on the main decision is the roof. Get a professional up there and get a full roof report. Have you ever run into a problem where your roof? Inspector didn't know what he's doing? I mean, do you need to most people that advertises roof inspectors, are they going to be all right? Or have you ever run into that where maybe a roof inspector didn't do his job and you need to get some commercial Rufer uh You shouldn't have a problem maybe on a residential fly by night guy or girl you might have an issue but commercial rumors are gonna are gonna do a good job. I like to use that somebody who's not selling me a roof too. You know that the guy who's inspecting my roof is not the guy I would buy a roof from.
So he's not just trying to like sell me the moon of like hey this roof is garbage needs to replace. I I appreciate that. You know, I appreciate that. But I just don't want to fancy sales pitch. All right, let me talk about a couple more the maintenance problems and we'll go on to the next 11 that we ran into that. I knew very little about when I first started investing his slab leaks. Uh You know, a lot of properties especially older ones have will have a boiler or even a boiler trailer. The lines run underneath the parking lot. And if the property is old they may be completely rusted out falling apart and you'll you'll below a slab leak under there and you'll your water but you'll just know because your water bill will be thousands of dollars too much. Uh and you'll lose the pressure. And so that's, that's a, that's a huge one is to, is to get somebody to inspect and understand what your risks are there. They're really expensive to fix hard to find and really inconvenient for the tenants. Yeah, the big one is um, you know, in that market, you know, let's just say if it's the city of Dallas, right? The city of Dallas, you should be able to pull a report or gather some data that says, hey, for apartment complexes in the city of data or the city of Dallas, the city of Dallas builds this much for water on average.
The utilities for this apartment should be this per month. And if it's not, there's something wrong and maybe a slab leak and there's water just being dumped into the ground that nobody's found it. Maybe, you know, inefficiencies and toilets and something like that. But utilities generally speaking, multi family are massive cost savers. You can make a ton of money by saving utilities a couple more. I have that we ran into when we bought was, we bought something with aluminum wiring and, and you know, lenders might have a problem with that. Your insurance carrier might charge more or have a problem with that. Uh, it creates a fire hazard. Uh, it can burn the installation, the plate covers can get hot. There is a cheap way to deal with that by pig tailing the ends of the wire. But that's something you can easily find out about. Let's see uh, working components are another big one. Um, you know, H. V. A. C. Equipment, you can get burned on that really, really easy boiler chiller systems, especially just because uh, you know, traditional H. V. A. C. Unit for your home is one, you know, you have 1 to 4 units on your house.
Right, Well an apartment complex has a boiler chiller or like a hospital has one massive massive unit in charge of heating and cooling that that entire hospital or that entire apartment complex. Right? So it's an expensive item. It's a piece of equipment and there's only one. So when one unit breaks down, they all break down, They all break down, right? If that unit is serving every apartment in that apartment complex and it goes down because it's 40 years old. Those units can cost hundreds of thousands, if not millions of dollars, depending on how big, how old, what the system is, what the condition of the piping looks like. So, I mean, you need to be paying paying attention to HPC tenants aren't happy well and multi family families aren't happy if It's 105° out and they don't have air conditioning or the other way around, they'll complain. Beginning investors, I would say be careful buying a common boiler chiller Because once again, if it goes out, it's a 200 unit deal, you have 210ants, all without hot water. Uh, that, that's going to be a big problem for someone that's just getting in in the game. Uh, let's see.
Another thing I want to tell people is walk the property during a rainstorm. Oh yeah, because everything looks great in the sun, but we, we bought in properties, Uh, thinking it hadn't rained the whole time. We were in due diligence. It didn't rain for 20 days, 30 days. And now we're non refundable or we own the asset in a downpour comes in and now you see all the drainage problems the, where it's, uh, flooding, there's runoff there, the water is collecting, uh, in a foot deep area on the side of the building. So that's one I would, I would suggest that's not cheap necessarily to fix either. It's not as easy as just changing the slow because sometimes you can't, you can't drain onto somebody else's property and that can be expensive. Yeah, yeah. I mean, water water can be a big one walking in the rain is big just because you can look up, see if anything's leaking if its retail property can go and say, hey, you know, you have any leaks. Right now it's raining. Um, you know, walking in the rain or walking in different, different physical condition will definitely help. So that's good. What's next? Um, all right here we got, um, excessive structural damage, structural damage can be a really big one.
Right. Because it's not something you can typically see unless you're trained, you you may know what to look for. Um cracking brick or you know, um the structure, you know, leaning or or falling off or um detaching itself from other parts of the structure. Could be a big one sense of settling. So we we were dealing with that right now on a on a deal we have here in Tulsa where um they have these these brick facades on on the sides of the building that kind of help with the siding and the look of it. And those started to pull away from the building and became a hazard. And so now we're having to pay to replace those and now we we got that in a short sale kind of foreclosure situation. Uh it was a good deal, but I don't believe we did a structure on it. So uh it always helps. Absolutely. Here's one that's uh that's hidden that you can never tell and that and that can be really expensive and that's uh environmental contamination. Right. Oh yeah. And so how do you, what do you, how do you check for that? Yeah, you have to hire professional, you have to hire people that do an environmental report.
And what that report called Phase one is typically is a typical terms called Phase one. And basically companies go in and they look to see if there's any uh or ever was any potential for contamination. So they're gonna look in the background of the property and see, okay, has anybody any tenants ever used chemicals? Was this ever a landfill site, a gas station with underground tanks, dry cleaners that, that may have dumped chemicals, you know, out in the drain. Uh So those, you know, and so they'll do that and they'll say, hey, the phase one says it's clean. There's never been any risk Or it says, yeah, there were some companies here 10 years ago or 20 years ago that may have had chemicals on site. Then they send you to do a phase two. And so that's a more extensive test um, to confirm that there's no uh, no contamination. So what are they testing, You know, Phase 1? What are they? Are they testing the ground of the water, the air? Uh Yeah, they'll, they'll, well, I'm not an expert at this, but I do know they will test uh, I think the phase one is is not a no impact testing.
So that is really just to confirm whether there could be presence of contaminants. And so if you get a clean phase one, there's no history of any chemical or any type of business like that. Then then you're clear. So it's a real, it's a basic test. It maybe a couple $1000. Uh Not a big deal. It's when they find that there used to be a gas station here 20 years ago and that was raised. And then they built this apartment complex on it or this retail center now they'll they'll have a phase two and phase two is uh they actually do soil testing, water testing and even air testing. Gotcha. That seems like it could be expensive. I mean I know you hear these horror stories on the news of you know just you know flint michigan and contaminated water. I mean the reparations and some of the consequences of having um you know an adverse environmental reaction on the property. You know that you get that phase one or phase two back and says yeah this it's riddled with contaminants. Um that that can be mandated by the government where you have to report it to them because it's you know, the environment.
And then they could mandate a lot of heavy clean up and repairs can't they? Yeah you don't want the E. P. A. Anywhere near uh this. And so I would say for beginners that if you get anything but a clean phase one uh without a lot of legal advice, I would move on to the next deal. We have a deal in las Vegas that had a dry cleaner that was using a banned chemical. And we found out about it through the Phase one and Phase two before closing. We went ahead and closed because everyone told us that it's not a big deal. But we did make the seller put up several $100,000 in escrow until the problem was fixed. Well once we, we close now it is this sort of collateral or something. Not only did they commit to clean too cleaning it, But they put up, you know, $3-$500,000 just in case it costs a lot. Well here we are, two years later, uh, they ended up finding, uh, ended up finding contamination all the way down at the water table like 75 ft deep. They have to install these well monitors.
Uh, and it's become a fiasco, luckily this, the seller is still paying uh, and it hasn't impacted us, but it can get really ugly and really expensive. So, um, well I think one of the next ones, which is always one of my favorite is just walking the property right? You've got to be walking physically walking and looking at the majority, if not all of the square footage of the property. It's absolutely crucial because you're gonna see stuff, you know, you're gonna talk to if it's retail, you're gonna talk to the tenants if it's multi family. I mean you're gonna talk to the tenants no matter what. And in multi family, are you gonna walk in and look at every single, Every single every single at least 75, at least. Um, and you walk in, I mean people have lied about down units. Hey, there's no down units, there's 500 rental units and every single one is rented and then you walk in a dozen that are on fire. Hey what happened to these 12 units? Are they rentable? You know you said there wasn't any down units? How many how many times does that happen? Well that has happened and let's let's just say they're trying to hide it down unit and you say that you're only going to walk the vacants.
Uh But then they just they just list uh they just list a vacant is occupied and then that person moves out after your due diligence or after right before you close. So there's a lot of tricks, especially in multi family it's important to to walk all the units. So you don't get surprised. Yeah and and and in retail and industrial you want to see how those tenants are operating in their business. You want to see if there's leaky ceiling tiles. You want to I mean you want to see what the traffic feels like inside the space you want to. Is it clean as everyone packing up to leave does as soon as you enter every single apartment that you're walking, they tell you about all of the maintenance problems that the H. V. A. C. Doesn't work. That happens all the time, right because they find out somebody was walking their apartment, it probably has to do with management. You know they're going to tell you everything, they're gonna tell you stuff that's going to make the selling broker cringe because they want to fix its where they live. There gonna be like, yeah, this drips all the time. Every time it rained. I mean this place is adopt. Don't buy it. That happens all the time. You walk properties all the time. Yeah. And and we'll get into it later. But a good property management company uh Sorry, a good property condition report company will make sure they go into every unit.
They'll test every light socket, every appliance uh And all of that and they'll give you a full report. Which which will be helpful. So absolutely. Um All right, real estate taxes can really bite you in the tail. Yeah. We won't take a ton of time on this because it's pretty simple is that if someone's owned a property for a long time. Uh The taxes may not have adjusted because there's a certain amount that they can adjust per year. And so you're going to pay this new price. And if it's, let's say its double uh you know, this guy bought a 10 15 years ago for three million. And now the going price is six million. Uh Well, the taxes are gonna just so I'm like a multi family, that burden is going to be yours. Uh So that can be a huge hit to the n y if the taxes are going to double and you're on the hook for it. Yeah. So taxes are paid based on the market value of the property and the market value of the property is whatever you bought the property yet. So it's public record, you bought the property for five million bucks, right? So like you on this apartment complex for two million bucks, I bought it from you for $5 million. My taxes are going to be more than double than yours, more than double.
And you need to be putting that in the piano. And so the pitfall you're talking about there is someone might look at the taxes and say, okay, well, I'm gonna budget that as my tax bill. It's super easy. Yeah, they're going to give you their N. O. I. Or their Proforma income. And so a beginner just may not understand how much those taxes are going to impact his cash flow and multi family that's called a real estate tax adjusted Ny. Which is super common selling a good multi family selling broker is going to put in there. The N. Y. With the new adjusted sales tax already built in, right? They should do that, they should do that. And then on retail. Uh if you just have to evaluate how much of that real estate tax increase are the tenants going to absorb if they're paying triple net charges. So a lot of that could be on more assets than than retail. That could be, you know, office in some cases uh industrial, in a lot of cases. And so it's not a huge deal if all that increase can be passed on to the tenants, although if it's a large increase it is going to burden your tenants and it may prevent you from increasing rent as fast as you want to uh increase it.
Yeah. Yeah, that's a big one. All right. So um when you're looking at properties and you come across, you know, let's let's use an example of maybe a smaller deal or maybe a Starbucks, Starbucks is a really good example. Let's use that one. So Starbucks is known for having very high rent. Why do they have higher and Joel Well, I I think because they probably get the developer to build out the space to their specification and so in order to do that, they they want to hire rental return boom. But it's not really rent, is it? It's like semi quasi like tenant improvement, build out dollars. You know, it's it's not really just rent. I mean, as long as Starbucks is on the hook to pay it, it's guaranteed their their quality credit company. The problem you have to be careful of is when these tenants have artificially inflated rent for the sub market. Uh And if you lose that tenant, that's a problem. Now Starbucks, okay, you're going to get them to pay. But let's say and we've run into this uh you buy a property and I'll give an example we have a property that's got a dance studio and they got a bunch of t money when they built out their space.
And so their rent is higher than market. So I had to I had to make sure that we underwrote that risk because for that space, if I didn't have that dance studio there and I was just gonna rent it to a new tenant, either have to give them T. I or I'm gonna have to get slightly lower rent, buying A property with the Starbucks, so it's single 10ant. And so if they have a 10 or 15 year lease and you buy it and all of a sudden lease is up and they decided to move, then you're trying to to retain at that. And you've all of a sudden you've you've bought it based on an artificially high lease. Is that what you're saying? Absolutely, You may rent it for $25 versus $40. Yeah, a foot per year. Right. Yeah. Another really common thing is is gas stations like how many, how many times have you seen a gas station or Starbucks pick up and move across the street and you're like, well that really doesn't make sense, does it? I mean they they have determined this location is a good location, obviously sell a lot of coffee here, but you know, somebody offered them cheaper rent for the same build out and they were like, man, I keep the same location cheaper rent, let's Do it. And so I just want to make sure people understand what we're talking about here.
So let's say I'm gonna rent a unit and the tenant says I'll pay $14 a foot. And then then he says well I'd like I'd like all this money to build out my store And I say great I'll give you you know that that money but I want $18 a foot rent. Now uh now if I go to sell before that lease is up let's say the next year. Well now I gave him maybe I gave him the difference between 14 and 18 for a year or two. But whoever's underwriting that deal, if it's on an eight cap They're going to pay 12 times uh that difference in rent. So you see how some some people, some sellers might want or think about pumping those numbers up by giving T. I. And then try to sell and get that 12 multiple on that rent increase when he only had to give one or one or two times that that increase. So that's that's the T. I. Part. And then the market part is just understanding uh a pitfall is oh this is a good cap rate, I've run into this where I think oh that's a nice property and that cap rates high, but then when I look at the rents their their way high and so that's why they're offering at a better cap rate.
And I better be be careful that those tenants stay or or how am I going to retain that? That that that high high dollar. Yeah, I think that's the perfect segue into the next one is looking at what types of income you have, right? Because there's going to be good income, which is, you know, let's just say the market is $14 to put for that same space, will use that same example and they're paying $14 a square foot. That's great income. It's contractually obligated. It's Annalise they're paying market rent Bad income that you want to make sure you're looking at is the tenant improvement dollars they got in the beginning of at least that's making them pay 17 or 18 instead of 14. That's bad income because that's going to disappear one day. That dance studio that that you mentioned, you know, they could say, well, you know, I thought I had this high rent because of, you know, you built out the space. Well they are paying back. So do I get a rent decrease now. So you've got to look out for things that may be extra extraordinary. You know, it's it's not a normal recurrence. Yeah. You want to when your underwriting income you want to make sure that that they're the income that your underwriting and paying a multiple on that's because that's what we talked about on the campaign is paying a multiple on a stream of income is that you're not paying on rent that may or may not be there every month.
That's not contractually uh there. And so I'll give you an example like late fees, let's say someone is a bad operator. They they don't, no one pays on time, they can't collect the rent, but they like getting those late fees and then you go to buy it And they've built those late fees into the NY. So now you're gonna pay 12 times the value of those late fees. Uh and then you you take it over and now you're you're getting the tennis to pay on time that now that income isn't there, but you pay, you pay 12 times that income in the purchase price at an a cap. But then if you operate the property differently or if the tenant changes their behavior now that that income isn't there. And so those are the that's a pitfall when you're looking at uh underwriting a deal is what income is contractually obligated to be paid by the tenant. And what is fluff. That is a one time charge for a special circumstance that you should not pay a multiple on good information. You know, people miss that. They're they're just getting punished for ignorance, man. Like it's all it is. You should you should just be able to listen to this podcast, watch the show and be like, man, I I need to watch out for this kind of stuff and it's all it's all mistakes we've made.
Uh you know, I would love it if people wouldn't go through the decade of mistakes and and costly errors that we went through. Hopefully they're learning from this podcast, they won't make those mistakes. Yeah. And underwrite. It's great too because you just you just go to the seller, hey, Mr seller, I've I've got a problem, you know, I'm researching your great property and you do have a great property. I'm excited by it. But man, I was looking into some of these things you told me and it looks like your income is, you know, 5 10% artificially higher because of all your late fees. Now, you know, I'm not gonna run those late fees, I make my tenants pay on time mr seller. Now, how can I in good conscience pay 12 times a dollar you earn when I'm not going to turn that same dollar because I just run the property better. One more example of that. That's a great point is uh let's say someone and we we've done this from time to time, depending on the property IS 1. 1 Seller has got security deposits on all of their tenants, so that then when they go to do a make ready, when the tenant moves out, they have some money to help pay for any damage that the tenant did.
Let's say you have another operator that takes that security deposit and doesn't call the security positive, calls it a one time non refundable lease app deposit or lease fee. Sophie is probably going on PML deposits probably going on. Yes. And so if he's taking that $200 security deposit but not calling it a deposit because it's non refundable and he's putting it in the income column. Now you're paying $12 or 12 times. I'm just using that as an example of an eight cap. If it's a seven cap, it's even higher you're paying that and you shouldn't be because that's money that should be there to to both incentivized the tenant not to tear up your space and to help you put it back together when they move out. So that's that's a costly one. Yeah. And if you look at the other side of that coin right? Like you could almost celebrate the seller. Like man, I got I sold this in, I built this in, you know, there's all this income and you know, I don't know if they can earn that income but I earned it while I was there. So I I should put it on there. You know, so you could kind of celebrated as a celebrate at the same time. You want to be listing your stuff in a way to where people can build faith in it, it becomes reliable.
You know what I mean? You don't want to be the guy who pitches and sells all your deals and then come to find out everyone is like, oh you better be careful about one of his deals. He's you know, he's going to sell you a crappy old used car man because that stuff will come back to bite you. The world's small enough. People find out the brokers will know and I'm going to say we have done some of those things never being dishonest. It's just on, let's say an older property or C class. Probably that's how we chose to operate it and you're just gonna operate it different. It just it just is we're just telling you as a buyer is, it's the buyer needs to understand how to evaluate that income. And so that's why we're telling you, Yeah, you touched on the next one briefly with as it relates to income, but it's an equally important point as it relates to expenses. Right? There's things that go on the P. And L. And these are expenses as much as we want to write off everything. Uh help offset that tax. We owe Uncle Sam our accountants and Cps make us put things in the balance sheet. You know, things that you have to depreciate like carpet, appliances, um roofs and parking lots and H.
V. A. C. Equipment. You know, if it's got a usable life of more than a year. You're really supposed to put it on the balance sheet and appreciate it. Well you may not get a copy of that. A seller may not be so eager to disclose the cash flow statement month over month because it has more to do with, you know, their debt and liabilities that aren't necessarily related to the property. So if you're just looking at A P. And L. And and multi family would be a good one. Um You know, the cost of those make readies, the seller could be capitalizing all of the costs. So when you're looking at the P. And L. It's like, oh somebody moves out and costs virtually nothing to get somebody new in there. Well, yeah on the P. And L. But if you look at the balance sheet, there was all, there was new carpet that was capitalized. There was no appliances that were capitalized. There was all of these repairs. And if you're not finding that when you know the panel is one thing. But cash flow is very different. Well and and it is subjective, so it's not that a seller or buyer are doing anything wrong. Um There's just as an objective. I mean it's a very subjective opinion of what is a capital cost that goes on the balance sheet and off of the PML, which would increase the N.
O. I make you pay more for the the asset and what is what should be considered an expense a month to month expense and should go on the P. And L. Reducing that. Ny and making the property cheaper. And so what the pitfall is not really understanding that game, not understanding what the expenses like. We're talking mainly multi family here, but You're not familiar with the expenses that should go along with a 70s style vintage deal in in your market. And so there may be putting too much on the balance sheet and capitalizing. And so when you get in there, you're like, man, I they didn't my maintenance costs are double or my maintenance costs are increased by 50%. And it's because you're having to spend a lot of money that they were they were calling capital expenses. Right? And so you've got to understand that difference and you got to make sure that you either no, in general what those costs should be or ask the seller. Hey, tell me all of the capital dollars you spent at this property of the last two years. Okay. I love it. All right. So hopefully pitfalls guys, all of these things have cost me money.
Uh and and they've all been things that I didn't know how to mitigate. And so now no one about them. You guys can hopefully avoid them. All right. Well, if you haven't downloaded your free letter of intent, make sure to go to invest, how to invest in Syria dot com. Um We're giving away a letter of intent and we even teach you how to use it. There's a video there. So you can go through that. Um I think we're gonna help a ton of people today with underwriting. There's there's so much you can go into and like Joel said, we're gonna do a deep dive on underwriting in our course. But for now here is the biggest pitfalls to avoid. It's going to save you a ton of money, Watch this, send it to somebody. Send us questions. Absolutely. If you are looking for a property condition report person, I mean they're everywhere. There's one of your market. There's every in every market there's somebody who can inspect all of these things physically and financially, if you can't find one, Reach out to us, I'll be fined one. and that's it'll be back in a few days for another episode. Thanks. Yeah.