Investor's Corner - What does due diligence mean and what is the best way of doing it?
Wednesday Jan 19th, 2022
So you are considering buying real estate and are just unsure about all those nitty-gritty details that you want to double and triple check to make sure it's to your liking?
Guess what? So does everyone else!
The good news is that you must not necessarily verify everything before your place an offer on a property. Imagine having to go through financial statements for the last 12-36 months, checking each and every entry, reading every single lease agreement, creating estimates and analyses based on your findings and everything else that comes with "auditing" the building's financials and physical well-being to see if there are any skeletons left somewhere in a closet!
This is when the due diligence (DD) period comes to the rescue.
The due diligence period, essentially, is a time period (normally 30 days but might vary from a few days to a few months depending on the complexity of the deal) that is set aside for the buyer to do a building condition assessment and make sure it's a sound investment. During the due diligence period, financials are checked, inspections are made, your financing will be confirmed as well as many other tasks that would be taking place (e.g. environmental reports, checking for liens/liabilities, etc.).
Here's a quick overall glimpse at what to do during the due diligence period to protect your investment in the best possible way:
1- Put together an acquisition task force
Although this must be done at an earlier stage and even before starting to look at properties, the team of "consultants" that you put together would basically determine how successful you'd be in this journey. This is one part that paying some extra to hire the best would actually pay off. Hire seasoned people who have been doing this for quite some time. An acquisition task force would include but is not limited to Commercial Realtor, accountant, tax advisor, real estate lawyer, mortgage broker/advisor, admin, general contractor (to estimate accurately the costs associated with repairs, replacements, renovations). There are scenarios where you could need more or fewer people but these are usually the essentials.
2- Assign tasks to each member
Once you are certain about fees and timelines, you can start assigning tasks to each member to save as much time as possible. The more you get accomplished during the first few days the less the overall stress level would be! Get that inspection done ASAP as it will reveal most of the improvement capital that needs to be deployed. Sometimes it's not even worth pursuing the DD further if it turns out that the HVAC has to be replaced, the basement is leaking, the roof is decades old and so on. It's best to break down the steps as much as possible and track everyone's progress somewhere (like Trello, Asana, Monday.com) so nothing is left out.
3- Make adjustments as necessary
It is during this time that all the sweet and bitter surprises happen; you'd find a hidden gem after reviewing the zoning, the repair costs are more than anticipated, your bank won't finance more than a certain LTV for this one, there is that one nightmare tenant that is actually the reason the buyer is dumping this whole property, etc. Be prepared mentally and emotionally for these and much more. After all, everything is a negotiation here and as long as you keep looking at the deal as an investment and steer away from emotional decisions, you should be OK. If it comes down to asking for a price reduction based on the discovered facts and adjusted figures, then who cares?
4- Be mindful of deadlines
Sometimes the way DD is set up is through a step-by-step verification method meaning that you have a few days to do the inspection and waive the condition, another few for financing, another few for checking the financials and so on. It is absolutely crucial for you to make sure all these deadlines are met and actions take place preferably a day before as many of these clauses have a wording that -for your protection- makes the agreement "null and void" if you do not take any action. Now imagine finding that gem that we talked about and forgetting to waive a condition before the deadline!
5- Tenants are key
One thing that cannot be emphasized enough is the tenant profile of the building. These folks would eventually become a part of the "family" so do as much DD as possible to make sure they're a good fit. Ask your Realtor to put in a clause where it allows you to meet the tenants during the DD period and take the time and do just that. Not only does it give them a good first impression of their future landlord but also it provides you with an opportunity to see who they are, what they do and if there are any "bad apples" there that you should be concerned about.
6- There is always risk
Just like any other investment that is made, no matter how much DD is done, there is still some risk there that you would have to bear. Following the right steps, having a clear vision and goal as well as a team of veterans on your side would always help you dodge as many bullets as possible. Don't forget that commercial real estate is always a great asset to own in your portfolio especially if you have had a few simple investments already.