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.
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.
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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.