Extreme Due Diligence – What is it and why is it so important?
Every real estate transaction starts at the same point: Due Diligence. It’s crucial and everyone does it. Due Diligence is the single most important aspect of protecting an investment by making sure it is actually an investment in the first place. While everyone does it, and lenders require some form of it, not everyone does it well or the same way! There are no universal standard requirements for Due Diligence. Most do the bare minimum to satisfy lenders. Candidly, few companies go above and beyond that minimum or really even know what they’re doing. For investors, selection of a manager that takes Acquisition Due Diligence as seriously as Allocation Due Diligence is critical.
What is Acquisition Due Diligence?
When acquiring a property, the buyer is allowed a Due Diligence or Inspection period. During this time the buyer may conduct any property inspections they find necessary. This often includes, but is not limited to, engineering reports, environmental reports, auditing leases, capital improvement plans, marketing plans, unit inspections, and general market research. This is the time to learn as much about the potential acquisition as possible. Once past the Due Diligence or Inspection period, deposits often increase and become non-refundable, which marks the point of no return: Either proceed to close or walk away from the many thousands of dollars and countless hours of human capital you’ve put in the transaction.
What’s the bare minimum Due Diligence required?
Most commercial or multifamily real estate properties are acquired using some form of financing and the lender will have specific due diligence requirements. These vary slightly from lender to lender, but generally the following are expected: Engineering Report/Property Condition Report (which typically require the inspection of only 10-25% of the units), Environmental Report, Title Inspection, Survey, Recent Financial Statement Analysis, and a Current Rent Roll Analysis. There are plenty of managers who comply with their lender’s bare minimum requirements and call it a day!
What other things can be done for a more thorough Due Diligence Process?
At Colony Hills Capital, Due Diligence is the bedrock of our ability to execute protecting capital and delivering performance. While we provide everything a lender may require, we have a proprietary Due Diligence process, which goes far beyond the lender’s cursory Due Diligence. We call it “Extreme Due Diligence”. Think about it like this, lenders seek only to protect THEIR interests; they want to protect the collateral and insure it does not drop in value more than 20-25%, at which point their investment is in jeopardy. As equity investors, we take on additional risk and therefore complete a higher level of Due Diligence on every potential acquisition, to protect both the collateral and our investors.
From an economic standpoint, instead of the basic review of financial statements and rent rolls required by most lenders, we look at all the seller’s bank statements from at least the previous 12 months to make sure the reported income actually made in their bank accounts. We carefully analyze every current tenant who had a delinquency during their current lease term to quantify potential evictions. We review capital improvement expenses, going as far back as ten years, to make sure the property is being properly maintained and that it is not hiding any problems below the surface; these expenses often times can be omitted from the property P&L statement. We conduct a detailed review of the security deposits and audit the accounts to make sure all funds are accounted for. We analyze rent rolls to gauge how well the lease expirations are timed. Some companies do not manage lease expirations, which can lead to significant drops in occupancy when an overwhelming number of leases expire in the same month Operationally, we do a deep dive into the details. We look at the occupancy history over the past several years to analyze seasonal trends so we can stay ahead of them. We look at turnover ratios to get an indication of tenant satisfaction and turnover costs. We review traffic reports from the property to identify areas of strengths, weaknesses, opportunities and threats. We conduct comprehensive market surveys to look at all the comps in the area to see who is doing what and what they are charging for rent. We look for nearby properties with proven value add stories. We meet with the local building department to analyze pulled and approved building permits; this lets us analyze future deliveries in the area and to gauge the impact on the market while accounting for job/population growth. We also meet with and establish solid rapport with the police/sheriff departments. Local law enforcement and the individuals who regularly patrol the area of the property can be one of the best resources in asset protection and enhancement. These agencies and people can provide insight on the property’s past that an owner will typically omit, such as break-ins, complaints, arrests, etc. They’re happy to talk to a new potential owner who is trying to focus on improving the property and tenant base (that makes their jobs easier!). Local police want the community to be safe as much as we do and as we develop a relationship with them, they attend property events and assist with any resident issues. The best single question to ask the patrolman, “would you let your family live at that property?” They’ll answer honestly and it will be an enormous endorsement should some even choose to live at the property, which provides additional peace of mind for tenants as well as us as owners.
The Nuances of Due Diligence: An Experienced Insider’s Tip
The ‘tricks of the trade’ used by distinguished professionals can make the difference between winning and losing. One of the little used “due diligence” nuances is talking to the property’s US Mail delivery person. The US Mail delivery person knows if tenants are getting collections letters, or notices from the IRS, or if they’re getting tax refund checks in the mail. This lets you know what your tenant profile really looks like, not what the owner represents it to be.
Why is Extreme Due Diligence so important?
The Due Diligence Process is THE first line of defense, and needs to function like a well-oiled machine. Basic Due Diligence catches the blatantly obvious, major deferred maintenance type items. However, “the devil is in the detail,” as the saying goes. An “Extreme Due Diligence” process uncovers critical information hidden from plain sight in the immense details that make up a commercial real estate transaction. By way of anecdotal example, Colony Hills has halted two acquisitions during the Due Diligence process. In one instance, our forensic team uncovered more than 7% of total reported revenue at a single property was actually missing and was never collected, and the seller could not account for the missing funds. The other instance is an example of how thorough our operations/construction management team is. We were potentially acquiring a property with a “down” building, meaning the units were in such poor condition they were not habitable. The seller claimed to have had the repairs bid out by their team, but our team determined that they had misrepresented the actual condition of the building. Far more work was actually needed, driving up the cost of the rehab and stripping considerable economic upside from our transaction.
Spending the extra time up front can add tremendous value down the line, confirm your investment thesis and, most importantly, identify deal-breaking information.
When conducting Due Diligence, get EXTREME!