Real Estate Investing Basics

Real Estate Investing Due Diligence Must-Do’s

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Due Dilliegence

One of the most important steps in the real estate investing process is due diligence.  Please take note when I tell you that I have seen a lot of investors get burned in deals where they fail to take all the appropriate steps in performing a thorough due diligence analysis of their investment property. 

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So this week, I want to share with you some little known secrets in the due diligence process as well as opportunities that can be identified.  In addition, I will also share with you some stories of pitfalls that could have been easily been avoided with proper planning and implementation of the due diligence process.

For those of you who have some experience with this process, you already know there are several major categories which must be addressed in doing due diligence for multi-family and commercial investments. Some of those can include environmental impact studies, building inspections, lease/contract agreements, etc. Today, I want to share with you the some of the secrets of financial due diligence.

Financial Due Diligence Secrets

How many of you have been presented with a great cash flowing property only to find out later that the picture painted is not at all what it seemed? When we buy income properties, one of the most important things to understand is the financial status of the property. Very often, we are provided with “pro forma” financial information of the property which is used in our calculation of items such as the cash on cash return, cash flow, and return on investment. 

One of the most important things that you should remember from this article is that you should NEVER buy a property based on "pro forma" financial information that you receive from the seller. The reason is because "pro forma" financial information, by definition, is only estimates of how the property "may" perform. These numbers are only estimates that have been generated by the seller/agent.

When we buy an investment property, we want to purchase the property based on its “actual” performance. So it doesn’t matter how high of a return or cash flow the “pro forma” financial information indicates, we need to know how the property has actually been performing. Here are the top 2 reasons why we don’t rely on “pro forma” financials:

1) I personally have never come across a property where the actual performance was better than as indicated by the “pro forma” financial statements. Rather, in most instances it’s the other way around with the actual being significantly lower than the “pro forma” numbers.

2) Since “pro forma” financials are only estimated amounts; it is extremely difficult to do the due diligence testing of these projected numbers.

Financial Due Diligence Process Details

Once you receive the actual financial information from the seller, now its time to begin the financial due diligence process. So what exactly does this entail and how is it done? I always explain it to clients this way: Think of financial due diligence as an audit.

You, the investor,  are the auditor. 

You want to take a look at all the numbers as presented and make sure that they are accurate, reasonable, and comprehensive.  The rent, other income, expense, and loans need to be verified with third parties (ex, banks, and tenants, contractors) to ensure that they are accurate and comprehensive. Here are three tips to performing your financial due diligence:

1) Aside from obtaining bank statements, rent rolls, and credit card statements, one of the most powerful tools that I utilize in financial due diligence is the seller’s tax returns. A quick way to test for the validity of their financial information is to look at the tax returns filed by the seller. Look for any discrepancies between tax returns filed and financial information provided by the seller. Any inconsistency that you find may be areas that you would want to dig further into.

Why is this such a good tool to utilize?

Well, it’s extremely rare for someone to over-report income on their tax returns, so the income numbers you see on the tax returns are often a good indicator of the actual performance of the property.

2) For all income and revenue items, you want to verify its “existence”. This is where you would review rental/lease agreements and review bank accounts to ensure that the rental revenue as provided by seller actually “exists” and the money is collectible.

3) For all items of liability such as loans, deferred maintenance, and debt to outside contractors, you want to test for “completeness”. Since these are items that will likely be expense items once you take over the property, you want to make sure that you are aware of all these future liabilities. It is possible that there are liabilities relating to the property that have not been disclosed to you by the seller. So the financial due diligence process of testing for completeness is aimed at detecting any items missing from the information as provided by the seller.

Make Sense of it All

Due diligence is an expansive and extensive process and often times need the expertise of outside advisors and professionals.  Next week, we will continue our discussion on Due Diligence Must Do’s by sharing what key items to analyze, as well as by sharing real-life examples of how investors have sweetened their deals through the due diligence process.

Photo: theloushe

Amanda is a CPA specializing in tax strategies for real estate, self-directed investing, and individual tax planning with over 18 years’ experience. She is also a real estate investor of over 10 years with a focus on long-term hold residential and multi-family assets across multiple states. Formerly a tax advisor at the prestigious accounting firm Deloitte in the Lead Tax Group, focusing on tax strategies for the real estate industry and high net worth individuals, and at an international Fortune 500 Company in the high-tech industry in the Corporate Tax department, Amanda’s goal is to help investors with strategies designed to supercharge their wealth building. Amanda’s highly rated book Tax Strategies for the Savvy Real Estate Investor is amongst Amazon’s best seller list. A frequent contributor, speaker, and educator to some of the nation’s top investment and self-directed IRA companies, Amanda has been featured in prominent publications including Money Magazine, Realtor.com, and AllBusiness.com. Amanda was a speaker at Talks at Google and is a 40 under 40 honoree by CPA Practice Advisor, showcased amongst the best and brightest talent in the accounting profession. Her firm Keystone CPA, Inc. was awarded a two-time winner of the Top CPA of Orange County Award by OC Metro Magazine. She is certified by the CA State Board of Accountancy and is a member of the prestigious American Institute of Certified Public Accountants (AICPA) with clients across the nation.

    Becky Zienkowicz from Madisonville, KY
    Replied 10 months ago
    thanks for the details info in this article.
    Andrew Syrios from Kansas City, Missouri
    Replied 10 months ago
    Absolutely Becky! I’m glad you found it helpful.
    Nick Roberts
    Replied 10 months ago
    Great article Andrew thanks for all the detail references.
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    Thank you Nick, I’m glad you found it helpful!
    Eva Mackowski rental_property_investor from Granbury, TX
    Replied 10 months ago
    Great article. I just need to figure out how to set up my business to protect my assets… thanks
    Andrew Syrios from Kansas City, Missouri
    Replied 10 months ago
    Thanks Eva! And here’s a good article for asset protection: https://www.biggerpockets.com/renewsblog/2015/12/04/protect-real-estate-investments/
    Bryon Andrews from Stillwater, MN
    Replied 10 months ago
    Great article, thank you Andrew!
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    Thanks Bryon! I’m glad you got something out of it.
    Victoria Seale from Santa Fe, New Mexico
    Replied 10 months ago
    Andrew, your in-depth article, photos, and explanations are well done and greatly appreciated! thanks Victoria
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    Thank you for the kind words Victoria, I’m glad it helped!
    Fay Holt
    Replied 10 months ago
    GREAT INFORMATION THAT WAS NEEDED AND HELPFUL IN HAVING A GREAT LOOK OUT IN GETTING OFF IN THE RIGHT DIRECTION
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    Absolutely Fay, I’m glad you found it helpful and good luck!
    Bill Syrios rental_property_investor from Eugene, OR
    Replied 10 months ago
    If you know about the personality test Kolbe (kolbe.com), you know the term Quick Start. Many RE investors and entrepreneurs, in general, score high on the Quick Start scale…including me. That makes us, as the name suggests, fast, by-the-gut decision-makers: “Yes, that seems to make sense. Let’s buy it!” Such inclinations can serve us well in investment decisions, until it doesn’t. Quick Starts–and you know who you are–especially need to slow down and take Andrew’s advice by applying careful, patient attention to his lists of due diligence items. One thing I would add that has helped me is to surround myself (in our team) with Fact Finder types (see Kolbe again). Fact Finders more naturally follow due diligence procedures in life which will normally come through in how they approach RE purchase decisions. In just one example, “a Fact Finder” saved me and partner a cool $100,000. We were in contract to purchase an apartment complex in Dallas for $950,000. We knew the property needed lots of work but felt like we were getting a solid price. What we didn’t take seriously, until our Fact Finder friend dug it up by her careful attention, was how inconsistent the rents were over the year before sale. As we dug more deeply we found out the seller was padding the occupancy through his property manager by dropping rental application criteria and inflating rents by giving concessions. Just a couple of days before closing the sale we confronted the property manager and the seller about what was going on. In the end the seller dropped his price from 950,000 to 850,000 and believe me, we needed those extra concession dollars as we subsequently tackled the rehab job that was still more expensive than we anticipated. For you Quick Starts out there…you can take a friend of mine’s approach: double what you think it will cost you for rehab and then add another 10% on top of that. Or, maybe better yet, heed Andrew’s (Fact Finder) advice and put in the time to do quality due diligence. It will help you avoid making bad and really bad decisions not to mention, sleep better at night!
    Bill Syrios rental_property_investor from Eugene, OR
    Replied 10 months ago
    Correction. Our own “basic due diligence” saved us $55,000, from $1,000,000 to $950,000. Our friend (Amanda’s) “in depth due diligence” saved us another $120,000 on that deal! Getting a RE investment minded Fact Finder to help you or transforming yourself into such a Fact Finder for purposes of quality due diligence can make all the difference.
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    $55,000 is still a lot to save!
    Miles Lacy from Kansas City, Missouri
    Replied 8 months ago
    Andrew, I cant express enough how much I appreciate your attention to detail, process flow, and completeness in this article. As a new investor in the KC area, this is a very refreshing view in what I perceive so far to be a world of Quick Starts (as your dad calls them). I prefer to be very analytical in every aspect of my investments but of course lack the experience and always feel like I’m missing something during D.D. and spend way too much time in the process. I was very excited to see your upcoming BRRRR workshop on March 16th, and plan to see you there!
    Andrew Syrios from Kansas City, Missouri
    Replied 10 months ago
    Good comment dad and thank you! Perhaps you should considering writing for BiggerPockets too?
    Julie Fullmer
    Replied 10 months ago
    Thank you very much for the article! We are looking at our first investment property. It’s an ugly duckling but after using this information hope to figure out if it can be a swan. Wish I didn’t have to do this long distance though. Any forms I can use would be a great blessing. Thank you, Julie
    Andrew Syrios from Kansas City, Missouri
    Replied 10 months ago
    I would be happy to share the forms with you Julie, but we need to be colleagues to share documents. So please accept my request and I will send them right over.
    Jenn Keeney from Louisville Kentucky
    Replied 10 months ago
    I’d love a copy of your forms! Great article with details and depth! Normally articles just barely touch on topics.
    Andrew Syrios from Kansas City, Missouri
    Replied 10 months ago
    Sure thing Jenn, but we have to be colleagues to share documents so please accept my request and I will send them right over.
    Ryan Dossey real_estate_broker from Indianapolis, IN
    Replied 10 months ago
    I LOVE that you get into confirmation bias. It’s hard for investors to admit that they’re wrong or that the deal no longer makes sense. Kind of reminds me of sales guys cashing the checks in their head before the deal closes.
    Andrew Syrios from Kansas City, Missouri
    Replied 10 months ago
    Thanks Ryan and yeah, confirmation bias can be an absolute killer as can entrepreneurial optimism (or over-optimism). Major things to be aware of when investing in real estate.
    Kevin Kern wholesaler from Louisville, Kentucky
    Replied 10 months ago
    Great article, something that every investor should read. Did a nice job of explaining everything in thorough detail. With there being so many different moving pieces in a real estate deal, it is very easy to feel intimidated (if new) or let something fall thru the cracks (experienced). Due diligence is key!
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    Thanks Kevin! And yeah, I think that “overwhelmed feeling” can be alleviated by having a checklist and simply following it step by step instead of trying to think of everything that you need to do all at once.
    Steve Hiltabiddle from Philadelphia and suburbs
    Replied 10 months ago
    Andrew, I enjoyed listening the Syrios Brother’s Podcast #121. There was so much information so I’m glad to read your post as this captures much of what you shared about evaluating a property. Many thanks.
    Andrew Syrios from Kansas City, Missouri
    Replied 10 months ago
    Thank you Steve, I’m glad you found this and the podcast helpful. Good luck investing!
    Andrew Syrios from Kansas City, Missouri
    Replied 10 months ago
    Por supuesto Kory y tenga un fantastico fin de semana!
    Ben Leybovich rental_property_investor from Lima/Chandler, Ohio/Arizona
    Replied 9 months ago
    Andrew, I am commenting more out of respect for your accomplishments, and respect for your desire to educate, both of which are second to none in my opinion. I’d like to add a few points, which I hope will help a few folkjs. 1. Rentometer.com is not particularly accurate. I tend to avoid platforms such as this in my rent-setting. 2. In this way you and I are very different, but your CF pro-forma indicated $0 for payroll. I understand that you run your own PM, but in my world if the property doesn’t absorb management and payroll it is immediately out. At $1000 rents you’re generally taking 90+ units. 3. Property taxes in your example of $19,000 is more than $1,000/door. This is extremely high burden inside of the OpEx, and tells me something about the general market that I don’t like. Rents of much in excess of $1000 are needed to begin to underwrite such a load. Same could be said about insurance in this case. 4. I am not seeing the IRR calculation. I know this is a re-positioning project, but what does the exit look like? I mean, you will do the work, but eventually, be it in 5 years, 7, or 10 years, you’ll need to get out, and I want to know how much equity you are getting for the work you are doing. What does this look like…? To give you an example, the property we’ll close on in about 3 weeks looks like $13M all in and $19M-$20M out. This is a necessary component of the DD – underwriting the exit. Hoping this commentary helps someone a little bit. Thanks for a great article. It’s obvious you put a lot of thought into this piece!
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    I always appreciate some constructive criticism, especially from someone as successful as yourself Ben. A few notes on your points: 1. I generally agree, I would only start there to get a vague idea before directly comping it. 2. Most of what we buy are houses and small multi’s, so payroll is hard to allocate, so we charge an internal management fee. We are looking to get into multi’s and syndications more and I’ll be making sure to review your posts on those matters. 3. This was a portfolio of houses (which I should have mentioned, even after editing twice I still miss stuff… the joys of writing amirite?). So the taxes are usually (in KC) about $1000/unit. But the rents are higher which compensates. 4. I do run an IRR analysis on apartments and portfolios (although not on individual houses). I only link to my discussion in that piece, but would be interested to get your thoughts: https://www.biggerpockets.com/renewsblog/a-guide-to-internal-rate-of-return-and-other-financial-metrics/ Thanks again Ben!
    Phillip Syrios investor from Kansas City, Missouri
    Replied 9 months ago
    Stop giving away all our secrets! Haha, just kidding. Great article man! You’ve only had to do this on 500 or so houses…
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    Do you honestly believe I didn’t sabotage this piece with all sorts disastrous advice???
    Greg Whiteley
    Replied 9 months ago
    This is great ! You explanation of each step is thorough and complete with helpful examples. I also like the list of websites that can assist me in the process. Thank you !!
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    Thanks Greg, I really appreciate the kind words!
    Jessica Morelock from Emporia, Kansas
    Replied 9 months ago
    I always learn so much after reading and listening to your articles. Great job Andrew!
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    Thank you Jessica, I really appreciate that!
    Luis Ortega rental_property_investor from Fontana, CA
    Replied 9 months ago
    Andrew Very good information and perfect timing. I’m a newbie and will be performing due diligence on a property very soon, I’m nervous about the whole process, I will definitely be using this article as a guide. Please share copies of forms/docs Thank you
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    Thanks Luis, knowing what to do and doing it thoroughly can really calm those nerves.
    Octavian Goncalves from Providence, Rhode Island
    Replied 9 months ago
    Please share all the forms and document resources you have when you have the time on due diligence.
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    I think we already communicated, but if not, send me a colleague request and I will shoot them right over.
    Tammie D Jordan from Waynesboro, Virginia
    Replied 9 months ago
    Thanks for this very informative article.
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    Thank you Tammie, I’m glad you found it helpful!
    Devin Moeser
    Replied 9 months ago
    Andrew, Thank you very much for the article. I read it last week and came back to read a second time. I have been struggling to adopt some of the D.D. approaches that I have learned working for larger construction and development companies but sometimes they are overly burdensome for smaller operations. If the offer still stands I would be interested in the docs that you reference in the article. It sounds like they would be great assets. Thank you again for the article.
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    Hey Devin, thank you for the kind words. It’s definitely a lot to digest, but it’s worth spending some time with it. I sent you a colleagues request, please accept and I will send you the documents. (We have to be colleagues to share docs.)
    Ronnie Fielder rental_property_investor from Kailua, HI
    Replied 9 months ago
    Andrew, really good article on due diligence. I love the practical tips and the notion of taking emotion out of the equation.
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    Thank you Ronnie, I really appreciate it!
    Joe Steinheiser from Lansdale, Pennsylvania
    Replied 9 months ago
    Great article and very thorough. Thanks.
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    Thanks Joe!
    Jonathan Jaffe from Lewisville, NC
    Replied 9 months ago
    Dear Andrew, Very informative and the format is exactly what I think many people will find very useful, obviously given the comments already here. If I could also ask to be a colleague so that I can take you up on your offer to share those documents. I’m about to go under contract with my first, and your expert format will no doubt prove very useful. Thank you for your generous offer!
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    Thanks Jonathan and I just sent them.
    Lisa Priestley rental_property_investor
    Replied 9 months ago
    Thanks Andrew for all the great information. Is it possible to get the forms mentioned? Cheers. Lisa
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    Hi Lisa, I would be happy to share the docs. Please just accept my colleague request and I will send them right over.
    Michael Johnson rental_property_investor from Columbus, GA
    Replied 9 months ago
    Thanks for this article!! Considering purchasing my first commercial rental property (13 units) and desperately needed this info! Definitely going to read this thrice over before I offer!! Mike
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    Absolutely Michael, and I hope things go well with that property!
    Benjamin Hammond from Rosharon, Texas
    Replied 9 months ago
    Thanks for the valuable info. I would also like a “colleague” sharing of the docs mentioned. I tend to look big picture and need tools that will help me also consider the critical seemingly small items. What suggestions do you have for due diligence on long distance properties? I’m new to investing but looking at a long distance market. Thanks in advance.
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    I just shot you a colleague request. Go ahead and accept and I will shoot you over the docs. As far as out of state investing, I would check out my article on it for a quick rundown: https://www.biggerpockets.com/renewsblog/2014/12/23/investing-out-of-state-essential-items-to-vet/ and David Green’s book for a more extensive look: https://www.biggerpockets.com/store/long-distance-real-estate-investing-ultimate
    Jacob Dixon from Phoenix, AZ
    Replied 9 months ago
    I would love to have the documents you posted here in regards to due diligence!
    Andrew Syrios from Kansas City, Missouri
    Replied 9 months ago
    Hey Jacob, I just sent you a colleague request. Go ahead and accept it and I will shoot them right over.
    Jacob Dixon from Phoenix, AZ
    Replied 9 months ago
    Thank you sir!
    Timothy Bell
    Replied 8 months ago
    Great article Andrew!
    Andrew Syrios from Kansas City, Missouri
    Replied 8 months ago
    Thank you Tim!
    Preston Hall
    Replied 8 months ago
    There’s a lot of great information there. Good article!
    Andrew Syrios from Kansas City, Missouri
    Replied 8 months ago
    Thanks Preston!
    Angelique Dodaro from Eugene, Oregon
    Replied 8 months ago
    Thank you for a useful guide with very valuable and concise information. I specifically appreciate the rehab estimation sheet.
    Andrew Syrios from Kansas City, Missouri
    Replied 8 months ago
    Thank you Angelique, I really appreciate that!
    Jane J. from Los Angeles, California
    Replied 8 months ago
    Fantastic article and certainly highlighted what I need to know! I would also love a copy of your forms if you don’t mind please Andrew. Thank you so much, I will be sure to follow you.
    Andrew Syrios from Kansas City, Missouri
    Replied 8 months ago
    Thank you Jane! We have to colleagues to share documents so please accept my request.
    Yolanda Boateng
    Replied 7 months ago
    Hello Andrew, Really great information! Could I please get copies of your forms?
    Andrew Syrios from Kansas City, Missouri
    Replied 7 months ago
    Thank you Yolanda and sure thing. We just need to be colleagues to share docs, so please accept my request.
    Ilir Lako
    Replied 6 months ago
    Great article Andrew. I also watched the video that you and Ryan Dossey did on the topic. I am new to the real estate world and I am trying to learn as much as possible in order to acquire a property for additional income. I would love to get a copy of the forms and templates you showed.
    Andrew Syrios from Kansas City, Missouri
    Replied 6 months ago
    Sure thing Ilir. But we have to be colleagues to share docs, so please accept my request. Thanks
    Ilir Lako
    Replied 6 months ago
    Thank you. Accepted.
    Charles Salter Iii from San Diego
    Replied 6 months ago
    Andrew thanks a million for this post and the video you made back in december on this topic. I have a property under contract and estimating the rehab has been difficult without knowing exactly what to look for. The book by J. Scott on estimating rehab costs will be my next purchase. Can I get a copy of the forms you use in this article?
    Andrew Syrios from Kansas City, Missouri
    Replied 6 months ago
    Sure thing Charles, I shoot them right over to you.
    Scott T. from Florida
    Replied 4 months ago
    Andrew…… OMG!!! Wow, So much important information my head is spinning… I will definitely have to reread this a few times to digest. If you could send me over these forms I would appreciate it greatly… We’re already connected, and anything I could do for you in the future please don’t hesitate.. Regards, Scott