Last week, I shared with you some little known secrets in the financial due diligence process as well as how financial due diligence is done. This week, we will continue our discussion on Due Diligence Must Do’s by sharing real-life examples of how investors have sweetened their deals through the due diligence process as well as what key items investors should analyze.
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Learn by Example
Ron, a client of mine, was in the process of purchasing a 75-unit apartment in Oklahoma. The “pro forma” financial statements provided by the seller indicated great cash flow. To make the deal even more attractive, the seller was even willing to carry a significant portion of the note. The seller owned multiple apartment buildings in the same city and had been selling off the properties as he planned for retirement. So when Ron came to me, we were both really excited at the opportunity that he was now facing with the purchase.
As I began the financial due diligence process, I discovered an item in the financial statement that significantly effected Ron’s “sweet” deal. Upon initial review, I noticed the monthly insurance expense was significantly low for a 75-unit apartment building. After calling the insurance company currently used by the seller, I found out that the reason for this low insurance premium was because the seller was getting a huge discount from the insurance company for insuring all 6 of his apartment building with them. After calling several other insurance providers, I concluded that Ron’s insurance cost will increase by 80% from what the seller was currently receiving. That little piece of information alone significantly decreased the return on Ron’s prospective investment. Ron then went back to the seller and was able to re-negotiate the contract for $350k less than the original contract price.
Another client, Jason, engaged us to perform financial due diligence on a commercial property he had under contract in New Mexico. As we dug through the numbers provided by the seller, we noted that all of the lease contracts were coming up for renewal. After conversations with some of the existing tenants, we found out that ALL existing tenants were planning on moving. Actually, they were all planning on moving to a newer commercial center where the seller was going to be moving to. So essentially, Jason was looking to purchase a property which would be completely vacant just months after he took ownership. In this situation, the financial due diligence process un-covered a huge problem and protected Jason from loosing millions of dollars in a bad real estate deal.
Key Financial Due Diligence Checklist
So now that we have talked about the importance of due diligence in the acquisition process, here are some key items to analyze in financial due diligence:
1) Third Party Confirmations: For any financial information you receive from the seller or seller’s agent, make sure you corroborate these items with a third party to confirm its validity. Examples of third parties commonly involved include tenants, insurance companies, banks, vendors, and governmental agencies
2) Analysis of Information: For expense items which are not fixed, analyze the cost to determine its true cost to you as the new owner. Examples are insurance premiums, property taxes, management fees, etc.
3) Focus on the Big Stuff: As you are going through the financial due diligence process, keep in mind that Not All Numbers Are Created Equal. Having said that, spend the time to analyze and test the amounts that will impact your decision the most. Look for the 800-pound gorilla in the room and don’t sweat the small stuff.
Seek Guidance from an Expert
As we discussed before, due diligence is an expansive and extensive process and often times needs the expertise of outside advisors and professionals. Qualified professionals can perform rigorous financial testing procedures that provide you the investor with reliable information about the impending real estate transaction.
Armed with this knowledge, you can make well-informed decisions regarding your real estate transactions and have the potential basis for a renegotiation of the final purchase price or terms of the transaction.
Photo: Patrick Gage