Due Diligence is the process of taking a close look at the details of a potential investment, to verify material facts and evaluate the property’s investment potential. While there are numerous factors involved, due diligence is the foundation upon which successful, profitable commercial real estate investing is based.
Anything worth doing is worth doing as well as it can be done, especially where hundreds of thousands, if not millions of dollars, are involved. Your ability to separate fact from fiction determines return on investment.
Note that Due Diligence is MUCH more than just 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.
For the sake of this article we will not go into an analysis of these four key areas, but will focus rather on rooting out the hidden profit uncovered when we Do the four key area Diligence with the following objectives in mind :
The REALITY of a Return On Investment based on our trademarked Do the Diligence analysis.
The stand alone value of the property in the market.
The current property features that produce income versus the hidden profit features we uncover.
The bottom-line price we are willing to pay based on our Do the Diligence analysis. Keep these objectives in mind to determine the actual return on investment.
Maintain a disciplined objective approach when you examine financial information provided by the seller. Your financial statements assessment must uncover concrete benefits in revenue, cost and earnings, and, ultimately, cash flow. Simultaneously, your analysis does not only verify reported numbers and assumptions but should determine a true value as a stand-alone investment income producer. The majority of the price you offer reflects the ability of the property to produce income in the here and now, not as it might be once you have made added value improvements. Never buy a property on Proforma projections of income.
Determining an investment’s true value is an acquired skill that improves with experience. A seller will present the property paper assets as much more appealing than they really are. That is their job. Your job is to uncover accounting tricks to reveal real numbers. Here are some common examples of financial slight of hand:
Distorted tenancy rent payments. A building can be occupied with tenants that have been allowed to consistently pay late or not at all, without contingencies that are immediately carried out by soft management.
Overoptimistic projections of expected returns. A property might advertise its market proximity to an area that has a higher return on investment than it is currently experiencing.
Disguising cost centers that cloak the real picture. Marketing, maintenance, management fees that are in reality excessive for the property or poorly allocated for the market
Treating recurring items as extraordinary costs to get them off the Profit & Loss statement. Inflated or delayed maintenance fees disguised as one time costs.
Failing to reveal capital expenditures or general and administrative costs in the periods leading up to a sale to inflate cash flow. For example, a property may decide to postpone its on site Laundromat contract renewals so those new figures won’t be immediately visible on the books thereby misleading the investor about contract renegotiation and increased costs.
Careful examination of the historical and prospective cash flows reveals the real stand-alone value of the proposed acquisition. Look beyond the reported numbers–and rely on your on site team visit when you Do the Diligence to verify costs versus reported income.
Getting to real numbers usually requires the close cooperation of the seller. Any adversarial posturing by the seller is almost always a signal to dig deeper.
Of course, no matter how deep you dig, many facts can remain hidden if you do not know where to look or how to find hidden profit potential. Uncovering as many discrepancies in represented value versus stand alone value will improve your position when you make your offer and is crucial for your acquisition and return on investment.
A complete Do the Diligence analysis system is available at the Investor Tours University.
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