With the changes in the real estate market in recent years, it seems like “deals” are all around us…and for the most part, they are. There is no doubt that this is a great time to invest in real estate. It is definitely true that we are seeing a much higher percentage of real estate opportunities that we have not seen in many, many years. However, this is not to say that we should feel overly comfortable investing in what “appears” to be good deals and skip the due diligence process altogether.
Some of you may already know there are several major categories which must be addressed in the due diligence process when deciding between your investment options. Some of those include environmental impact studies, building inspections, lease/contract agreements, etc.
Before you get overwhelmed by the long list of items to look for in the due diligence process, take a deep breath…You do not need to be the person doing the grunt work of the due diligence process! Actually, unless you are an expert in one of the above areas, I do not recommend that you perform the due diligence tasks yourself. Rather, there are professionals in these specialties areas that you can leverage to help you to perform the due diligence needed to make sound real estate investment decisions.
As a CPA and real estate investor, I have done quite a bit of due diligence on real estate properties for my own investments and for my clients. I have to tell you that for my personal investment properties that I have invested time and resources to the due diligence process, it has definitely saved me tons of money over the years. Due diligence has allowed me to weed out a lot of really bad investment “opportunities” that have come across my table.
There are varying levels of due diligence that are recommended depending on some of the following factors: the type of property that you are purchasing, how you will take ownership of the property, and how much money you want to invest, to name a few. Simply put, due diligence should be a cost/benefit analysis just as with anything you do in business. The cost/benefit analysis boils down into two simple questions:
- What is the cost in terms of time and money to perform the due diligence? and
- How much money do I stand to make or lose on this particular real estate deal?
The ultimate goal of performing due diligence on the investment under consideration is to be able to make an informed decision on the following question:
Is this really a good deal for me to invest in?
As you may know, the due diligence process can be a very simple and straightforward process, or it can be a very involved and complex process…depending on some underlying factors as mentioned earlier.. In this article, I want to share with you a few tips to help you save some time and money in performing financial due diligence for your investments.
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Understand the WHO Before the WHAT
Before analyzing the details of a specific investment, we encourage you to find out WHO are the individuals behind the investment deal. The founders’ experience, integrity, and long-term vision are often imperative to the success of your investment. Don’t Waste Your Time Not all information is created equal. As you review the financials, take a look at the one or two items that will either make or break the deal. If there is an 800-LB Gorilla in the room, address that issue first before moving on to the other items within the investment. If those key factors cannot work, then move on to the next investment!
Knowing the Difference
When doing financial due diligence, it is important to understand the difference between Actual vs. Projected performance. Actual activities can be verified accurately in the due diligence process. Projected activities often involve subjective forecasts which may not be currently verifiable. Much more weight should be put on actual rather than projected activities.
Does it Really Exist?
When confirming income items such as rents and lease amounts, we are typically looking to confirm the existence of these sources and the accuracy of the amounts. Comparing them to external sources such as bank statements, rent receipts, contracts, and agreements may provide that assurance in the due diligence process.
Do We Know All There is to Know?
In addition to knowing that all the income sources as reported actually exist, we also want to be aware of all the expenses and liabilities associated with a prospective investment. A review of financial statements, legal files, and correspondences may uncover any potential outstanding or pending liabilities associated with a particular investment. Also, a comparison of the financial statements against industry or market benchmarks often will reveal any understatement of expenses or liabilities.
As we discussed previously, due diligence can sometimes be an extensive process which may require the expertise of outside advisors and professionals. Qualified professionals can perform rigorous analysis and 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 sometimes even have the potential basis for a renegotiation of the final purchase price or terms of the transaction!
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