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The Essential Importance of Due Diligence

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No matter what business you’re in, due diligence is absolutely critical. It’s boring, I’ll give you that. But it’s essential to ensure that what you think you are investing in is what you are actually investing in.

I work in the real estate industry and due diligence is one of the most important aspects of the business. It’s not as sexy as making offers and negotiating or even bringing a property back to life through renovation. But it is probably the area that new investors screw up on the most. 

First and foremost, it’s critical to start with a checklist. It’s amazing how even with routine matters, we often overlook essential steps when we don’t force ourselves to go through each and every one of them. Nothing better illustrates this than the myriad of examples Atul Gawande gives in his fantastic book The Checklist Manifesto. One hospital, for example, was able to cut down mistakes by over half just by instituting a checklist.

And in an industry with liability issues as large as the medical one (not to mention matters of life and death), that kind of turnaround is enormous.

What’s interesting about that example, though, is that the checklists these doctors and nurses put together all involved routine things they all knew they were supposed to do. The problem was that without the checklist, many of these routine tasks got skipped. That’s because many of them seem unnecessary or redundant. And all of them are rather boring and tedious.

But when it comes to people’s lives, being redundant in making sure you have everything just right is not a bad thing!

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Real estate may not be as important as healing the sick, but I’ve seen numerous investors get eaten alive when they missed essential repairs or wildly undershot their rehab budgets. And it’s not just new investors. For example, the Sydney Opera House was slated to cost $7 million and take four years to build. 14 years later they finally finished at a cool cost of $102 million.

In other words, it took 3.5 times longer than they thought and went over budget 1357 percent!

For real estate, I break the due diligence phases into the following checklist:

  1. “Pre-Offer Due Diligence
    1. Area Analysis
    2. Value and Financial Estimate
    3. Rehab Estimate
  2. Post-Acceptance Due Diligence
    1. Physical Due Diligence
    2. Financial Due Diligence
    3. Legal Due Diligence
    4. Inspections
  3. Retrading (if necessary)
  4. Final Decision and Walking Away (if necessary)”

During the first phase, before I have an accepted offer on the property, I try to evaluate the area by driving around, talking to locals and looking on various websites such as City-Data.com (for demographic information) and RentRange.com (for rental comparables). I also attempt to ascertain the ARV (After Repair Value) by looking at the MLS (or Zillow and Redfin if you don’t have access to the MLS) for comparable properties nearby that have recently sold.

When doing the walkthrough, I try to quickly evaluate the number of repairs that will be necessary. Early on, I can’t spend hours and hours on each property because I just don’t have enough time in the day to do so on the many properties we look at. I want to be “mostly” correct. If it’s an apartment or commercial building, I will look longer, of course. And I will also evaluate the financials.

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The biggest component with due diligence, however, comes into play after you get a property under contract. This is when I investigate every nook and cranny to make sure everything is as I expected. And for new investors especially (but really for every investor) I recommend having professional inspectors look at the property as well. If anything is amiss from my original expectations, I will retrade (lower my price or ask for more favorable terms) or walk away.

With apartments and commercial properties, I have to do a detailed financial analysis as well. This includes reviewing the operating statement, rent roll, accounts receivable and the like to put together a pro forma and evaluate the Cap Rate and Internal Rate of Return. (For more on those calculations; see here.)

Much of this is the same for investors analyzing other investments; such as stocks, bonds or acquiring businesses themselves. For example, two of the most common accounting “gimmicks” that can fool investors apply to real estate operating statements, small business operating statements and corporate 10K’s in the same way.

    1. Bad Debts that Haven’t Been Charged Off
    2. Misallocated Capital Expenses

With regards to bad debts, if a business or property uses accrual accounting, all the potential income is said to have been collected. Then, afterward any bad debts (tenants or customers who haven’t paid) are charged off. I’ve seen properties where the owners have waited almost an entire year to charge off those debts. If you don’t see this, you may think the property or business is doing substantially better than it is.

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Misallocated capital expenses can be a bit trickier, especially with real estate. This is because many items fall under “recurring CAPEX” or “replacement reserve.” Namely, items that will last for more than one year, but will still need to be routinely replaced throughout the life of the building. In other words, they aren’t upgrades. As I note regarding real estate,

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“Many owners will put operating expenses (i.e., maintenance, turnovers, etc.) under capital expenses so they don’t show up on the operating statement. This makes the property’s performance look a lot better than it actually is.

“For this reason, I plead with new investors to consider recurring capital expenses… as a line item on their pro formas. Yes, you only need to replace the roof once every 30 years or so, but you should understand such costs are an ongoing part of owning the property.”

The exact same thing can be said for businesses who may try to hide losses as capital improvements or equipment and put them on the balance sheet when they really belong on the operating statement. Don’t fall for it!

The moral of the story is that every investor needs to make due diligence an absolute priority. It may be boring, but it has saved my skin more times than I can count. And it will save yours too.

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