How to NOT Buy a Lemon: Investment Risk Mitigation with Due Diligence Funnel
“If it so good – then why are you selling it?”
This is a question that was raised by a very astute investor when visiting investment property in an urban market. I was so intrigued by the question that I considered how economists defined this idea. The idea has been named the Lemon Dilemma.
What is the Lemon Dilemma?
The Lemon Dilemma deals with the issue of information asymmetry that exists when the seller knows more about an item than the buyer. For example, let’s look at “The Lemon Dilemma” as it exists in the context of used car marketplace. To help illustrate this concept, I am citing the example from 2001 Economist article titled The Lemon Dilemma.
“Consider a car buying market place where used cars come in two types: those that are in good repair, and duds (or “lemons” as Americans and most economists call them). Suppose further that used-car shoppers would be prepared to pay $20,000 for a good one and $10,000 for a lemon. As for the sellers, lemon-owners require $8,000 to part with their old banger, while the one-owner, careful-driver old lady with the well-maintained estate won’t part with hers for less than $17,000.If buyers cannot spot the quality difference, though, as is often the case in the real world, there will be only one market for all used cars, and buyers will be ready to pay only the average price of a good car and a lemon, or $15,000. This is below the $17,000 that good-car owners require; so they will exit the market, leaving only bad cars.”
This example got me thinking of whether this happens in the world of real estate as well. I started to realize that this information asymmetry exists within the real estate world as sellers know more about both the asset and tenant than we do as the buyers. So how can we as real estate investors even out the information asymmetry?
Leveling the Playing Field
In real estate, unlike in the car market place, we can request a due diligence period through our purchase and sale contract. It is my recommendation to always have a due diligence clause present within your contract so that you can pursue a three prong due diligence research. The due diligence period is when you can level out the information asymmetry through a three-pong due diligence sequence:
- Income Potential
- Expense Validation
- Asset Condition
Due Diligence Funnel for income producing assets is as follows in my opinion:
What to Request
Reason for Review
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|Tenant Leases||A lease is a contractual arrangement calling for the lessee (user) to pay the lessor (owner) for use of an asset. Asset’s existing leases produce the income, so it is critical to review every lease, and read every word. Make a note of any discrepancies, concessions, or required improvements. If the improvement or concession has not been met, you will inherit the obligation and must factor it into your operating projections|
|Rent Roll Chart||The Rent Roll Chart is a great indicator to identify turnover and vacancy potential problems. A basic rent roll report should show the unit number, the tenant name, the rent amount, any past due balance, and the lease expiration date. Request the previous 3 year of rent roll charts to help analyze tenant turnover, collection problems, and note anomalies from current performance.|
|Tenant Files||Tenant files are the most critical review item and the most difficult one to get from the seller at times. You may have to go the tenant office to review them as they will contain tenant sensitive/private information. Tenant files can reveal the most critical information. Examine each for completeness and compliance with appropriate regulations prior to closing. Major concerns are tenant credit reports, complete applications, any personal guarantees, and for residential properties the required waivers for lead paint and mold. Files with poor or non-existent credit reports and lack of landlord references are a red flag.|
There are three key items to verify when it comes to expense validation:
Utility bills are typically the highest line-item expense in multi-family properties and will typically range from 10-20% of Gross Rental Income. With this expense line item it is necessary to understand both the cost and consumption of the item. To understand the cost, you should request at least two years of the actual monthly utility bills that show both the cost and the usage. If the property owner has not preserved the bills, they are readily available from the service provider. You may need an authorization to release in order for the service company to send you the bills of the requested time period. Annual costs only are not enough to determine if the usage is in line. An annualized statement tends to smooth the seasonality of use, and evaluating by cost only can mask over-consumption.
In order to understand if the utility are being over or under-consumed, it is necessary to understand the consumption pattern. Each utility company has a norm of usage that the company can often supply if you request average uses for your area. Compare this norm to the utility consumption of your asset through the units of use (gallons, watts, etc.) to see whether the expense numbers are over or understated.
Property taxes make up the second biggest chunk of your expense costs against your gross rental income. It is important to analyze this expense as a trend over time since it will help build in the proper expense growth assumption within your Discount Cash Flow (DCF) Model. It takes only a few minutes to verify the information straight from the source, you can get the information online for free or you can get the information from the city tax collector. So what information should you ascertain:
- Assessed Value: A property card or record will include a total assessed value. This value is usually irrelevant to valuation, but it is wise to compare the assessed value of the subject property to others of the same type in the market. If it seems out of line, a reduction may be possible.
- Sale Implication on Value: Be sure to inquire whether the sale transaction will change the tax assessed value and when. Whenever you purchase the “Hot Prospect”, the purchase price/sale price will represent the new market value as the price will define what you and the seller thought the asset was worth. This update in market value can be a double-edged sword. If the property was assessed below the new sale price then you can expect your property taxes to increase but if the property was assessed above the new sale price then you can expect your property taxes to decrease. Hence it is important to understand whether the sale transaction will change the tax-assessed value.
Insurance is the third largest expense percentage within the expense statement. Insurance premiums can be verified by requesting a copy of the insurance policy binder. Compare the cost listed on the operating statement to the actual premium. Also get a quote from your own insurance carrier to ensure that the stated insurance expense is adequate and accurate.
Capital Expenses can become a major drag on your cash reserves if the asset will need a lot of work due to deteriorating physical condition. Hence it is important to dig in and research the condition of the asset:
- Get seller disclosures statement. In some states, sellers are required to disclose considerable information about the condition of the house itself and potential hazards to the property. The disclosures are useful to hand to your inspector for follow-up on known issues as seller are required by law to be truth and can be held liable if they did not reveal a hidden known defect.
- Get Risk Assessment Report. Insurance Company typically after placing insurance on an asset will get an inspector out to the asset. The insurer prepares this report to notify the owner of any problems in the property that must be corrected to maintain coverage. It is an objective third-party look at the property from the perspective of identifying liability for negligence, poor workmanship, deferred maintenance and latent defects, basically a preliminary due diligence report on physical conditions.
- Get out a professional. Hire a home inspector to inspect all major house systems, from top to bottom, including the roof, plumbing, electrical and heating systems, foundation, and drainage. This will take two or three hours and cost you from $200 to $500, depending on the location, size, age, and type of home.
Buying a lemon asset is no fun. Utilize the above three prong due diligence funnel to avoid getting into a lemon.
Do you have any other tips or tricks on how we can avoid buying a potential lemon. Share your thoughts in the comments below.