Due Diligence is the process of looking closely at the details of a potential investment, to verify material facts, and to assess the investment potential of the property. While there are numerous factors involved, due diligence is the foundation on which successful and profitable commercial real estate investing is built.
Anything worth doing is worth doing as well as it can be done, especially when hundreds of thousands, if not millions of dollars are involved. Your ability to separate fact from fiction determines your return on investment.
Keep in mind that due diligence is MUCH more than looking at the numbers. Let’s use a commercial apartment property as an example. There are actually four critical areas that determine the value of a multi-family investment.
Financial analysis
Market analysis
Tenant Analysis
property analysis
For the sake of this article, we will not go into an analysis of these four key areas, but rather focus on rooting out the hidden benefit discovered when we do the Diligence of the four key areas with the following goals in mind:
The REALITY of a Return on Investment based on our trademark Do the Diligence analysis.
The independent value of the property in the market.
The current income-producing features of the property vs. the hidden earnings features we uncover.
The final price we are willing to pay based on our Do the Diligence analysis. Consider these goals to determine your actual return on investment.
Maintain a disciplined objective approach when examining the financial information provided by the seller. The evaluation of your financial statements should uncover concrete benefits in revenue, cost and profit, and ultimately cash flow. Simultaneously, your analysis not only verifies reported numbers and assumptions, but must also determine actual value as an independent investment income producer. Most of the price you offer reflects the ability of the property to produce income in the here and now, not how it could be once you have made value-added improvements. Never buy a property on Proforma income projections.
Determining the true value of an investment is an acquired skill that improves with experience. A seller will present the paper assets of the property much more attractive than they actually are. That is his job. Your job is to discover accounting tricks to reveal real numbers. Here are some common examples of financial tarnishment:
Distorted lease rent payments. A building can be occupied with tenants who have been allowed to pay late or not pay, without contingencies that are carried out immediately through soft management.
Overly optimistic projections of expected returns. A property could advertise its proximity to the market with an area that has a higher return on investment than it is currently experiencing.
Disguise the cost centers that hide the real image. Marketing, maintenance, management expenses that are actually excessive for the property or misallocated to the market
Treat recurring items as one-off costs to take them off the profit and loss statement. Inflated or delayed maintenance fees disguised as one-time costs.
Not disclosing capital expenditures or general and administrative costs in the lead up to a sale to inflate cash flow. For example, a property may decide to postpone its on-site laundry contract renewals so those new figures are not immediately visible on the books, misleading the investor about contract renegotiation and increased costs.
A careful examination of the historical and prospective cash flows reveals the actual and independent value of the proposed acquisition. Look beyond the reported numbers and trust your on-site team visit when you do the due diligence to verify costs versus reported revenue.
Getting to actual numbers usually requires the close cooperation of the seller. Any contradictory position on the part of the seller is almost always a signal to go deeper.
Of course, no matter how deep you dig, many facts it can remain hidden if you don’t know where to look or how to find hidden profit potential. Discovering as many discrepancies in represented value versus standalone value will improve your position when you make your offer and is crucial to your acquisition and return on investment.
A complete Do the Diligence analysis system is available from Investor Tours University.
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Investor Tours University is a dedicated resource that helps investors build wealth and achieve their defined level of success. We offer state-of-the-art commercial real estate investment education designed to meet the needs of investors with various backgrounds and experience levels. Our faculty consists of a network of national experts in legal, tax, investment strategy, property management, acquisition, and sales professionals who practice what they teach investors, which is how to achieve generational wealth using commercial real estate.