Real Estate Investing Due Diligence Must-Do’s

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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.

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About Author

Amanda Han

Amanda Han of Keystone CPA is a tax strategist who specializes in creating cutting-edge tax saving strategies for real estate investors. As real estate investors herself, Amanda has an in-depth understanding of the various aspects of investing including taxation, self-directed investing, entity structuring, and money-raising.

11 Comments

  1. Amanda, in regards to Item 3 under Process Details, are most of the items you are talking about here uncovered with a title search and property inspection? Can you give some examples of what might be lurking in this area, and how we go about uncovering? Thanks!

    • Sharon:

      A title search is certainly a great place to start to uncover what types of liability may be on a property. There are certain types of debt that may need other due diligence research. Some good suggestions would be to speak with their property management company to see if any money is owed to the property managers. Sometimes there are private notes on a property as well which are not recorded. A good way to uncover this could be to look at their tax return and analyze the interest expense deductions to identify interest paid and see whether there are debt not yet disclosed.

  2. Jeff Brown

    Whenever I speak of spreadsheets — including my own — I tell folks to look at the pretty numbers and understand much work went into ensuring they are reliable.

    I then tell them to print it out and burn it. Then, take the GSI, divide by 2, and be happy Man plans, God laughs. Some superb thoughts, Amanda.

  3. Great intro Amanda, looking forward to your follow up posts. One of the things we invest time and/or money in on every deal we look at is what average expenses are for the type of building, age of building in the particular market the property is located in. A great source for this information is the local landlords association. I can’t tell you how many owners, particularly individual owners understate their expenses. If you’re dealing in a market where the expenses for the subject property are $4,000 per unit and the owner is claiming only $2,800 you can be sure that either they’re under reporting their expenses or there is a large amount of deferred maintenance building up. We try to secure the average expenses before we ever make an offer so that if one is accepted we know beforehand what the negotiating issues will be. Once we’re in due diligence we do exactly as you suggest, studying the tax returns since no one would under-report their true expenses. If the seller’s reported expenses are well below average we know we’ll have to pay extra attention to possible deferred maintenance.

    Keep up the great posts-

  4. Amanda,

    Do you have difficulty obtaining a persons tax statements, and if so what is your course of action? Do you move on, or have you already gotten a release to receive this info to begin with before you even start the process?

    Thanks

    • Hi Kent:

      Thanks for your email. The tax return should be part of the package of financial documents that is requested as part of the due diligence process. We have not seen sellers refuse to provide that. Unfortunately, there is no way to force the seller to provide you with documents. However, if they do refuse to provide tax returns or any other financial items you request, it may be a sign to move on from the property as you may be dealing with someone who is not candid about the transaction.

  5. Great and important post, thank you.

    We deal mainly in condos, so a few specific tips on those –

    1. The sink fund pool (known in different names in different countries – basically the reno/repair funds collected over the years from owners) should correspond with the block’s renovation history. If it’s been depleted – it had better be evident in some serious work. If it’s untouched, it should be sufficient to cover (as a rule of thumb) app. 33% of the price of the unit PER EACH AND EVERY UNIT (the logic being that your insurance policy and government compensations in case of natural disasters should hopefully cover the rest, and also that, on average, statistics say that disaster will normally not strike until 2/3 ROI has been achieved).

    2. Don’t just look at the current tenant’s history – check 4-5 years back at the very least. Also compare the holding company’s (known in the US as the HOA, I believe) fees at least 4-5 years back. Again, this should correspond with the building’s renovation history. Did they raise in anticipation of a big reno, or just after one? If not, why DID they raise the fees? Was it in accordance with inflation, or just on a seeming whim?

    3. Comps, comps and more comps – if your tenant moved in when the economy was swell and is still paying the same rent, but comparable units are renting out at 50-75% of the current rent, DO NOT assume you will continue to make the same income – assume, rather, that he’ll move out next month and you’ll be down to THAT.

    4. Land portions – included? not included? be aware that a condo with no associated land portion essentially only loses value, regardless of landed property trends. Also realize that, if you’re paying land lease, these may rise when land prices rise – when inflation hits – or when the holding company needs more money. Last but not least, realize that, if there’s no land portion associated, the holding company has very little reason to compensate you, will try to wiggle their way out of it if disaster strikes, and will most likely succeed. This is not to say you shouldn’t purchase if the cashflow is great – but you should sure as hell negotiate the hell out of the thing.

    5. Last but not least – read the holding company’s “rulebook” – are their rules easonable? Does it look like you may be hit with fines left, right and centre for anything your tenant may or may not do? If it does – resat assured, it’ll happen – and they’ll get away with it. Don’t assume you’ll be living there – assume it’ll be an old lady who may be suddenly hospitalized for months on end, or a low income earner who’s never home – do you see them getting into trouble that YOU may end up paying for?

    Great post, thanks! Looking forward to the next instalment!

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