When you’re considering any act with respect to your real estate investments, it’s important to carefully evaluate every aspect of the decision or transaction. Due diligence is a common term borrowed from the legal profession. It describes the process involved in fully researching any issue or decision. Due diligence is vital in real estate due to the personal and financial ramifications of the choices we make. Poor decisions lead to damaged credit, investment losses, poor cash flow, bad tenants, breaching buyers, defaulting borrowers, and a plethora of other problems.
Due Diligence Risk Factors in Evaluating Investments
There are numerous factors to consider in the process of conducting your due diligence when investigating a potential investment. Depending on the type of investments you’re pursuing, you need to consider factors related to the profitability of the project. Also, examine the solvency of the project sponsors and the condition of the market. Using common financial metrics including cap rate, IRR, debt-to-equity ratio, and more, you can objectively measure the suitability of the investment and develop a basis for comparing competing properties. Insist that the project sponsors provide accurate and comprehensive financial statements including:
- Balance Sheet
- Statement of Cash Flows
- Income Statement, Profit and Loss
- Statement of Retained Earnings
Carefully examine these documents, employing professional finance assistance where necessary. Identify the data needed to perform the various financial metric calculations. Ensure that the data is reliable by questioning the method and thoroughness of its preparation. The results of your calculation will indicate if the project has sufficient growth and profit potential to merit its selection over other projects. They will also indicate the solvency of the sponsors by considering the balance of debt leverage, equity financing, and liquid capital.
The other things to consider are the credit scores, liquid assets, and degree of experience that the sponsors represent. Even if the project itself is promising, weak project leaders can lead to missed milestones and eventual default. Also, thoroughly research market factors including labor supply, unemployment, housing starts, industry growth, regulatory influences, and population expansion.
Reviewing Property Manager, Tenant, and Buyer Credibility
If you’re managing your existing portfolio, you’ll also need to continuously monitor the financial performance of your investments. Ensure that your property managers are professional and experienced, and maintain complete and accurate records for every aspect of the operation of your property. Before you hire a property manager, interview a variety of firms. Be sure to call references and visit other properties they manage. Whether you do it yourself, or delegate to a professional property manager, devote extra due diligence to screening tenants and selecting only the most reliable and qualified.
Poor tenants can cause excessive maintenance costs, eviction proceedings, higher vacancy rates, and diminish demand for your property. It’s preferable to allow your unit to remain vacant until a qualified tenant is found, rather than enter into a contractual obligation with one that will likely cause issues. If you’re pursuing an exit strategy, it’s equally important to evaluate the qualifications of your prospective buyers. Much as you would with a seller, request complete financials for the entity making the offer.
Consider the credit scores, debt-to-asset ratio, and their prior experience in closing transactions of comparable class and magnitude. Protracted and failed escrows increase your holding costs, hinder your investment strategy, and lead to lost opportunity costs.
Ethical Finance Partners
Don’t forget to devote the same level of due diligence in evaluating the lenders and other financial partners you’re considering. Ask questions about their experience and success in funding projects such as yours. Do they have experience with your asset class? How long do their closings typically take? What rates do they offer, and what are their underwriting criteria? Forthright answers to these questions will help establish their credibility and level of interest in following through on funding your project. Don’t assume that a fancy website or extensive marketing equates to reliability. Demand proof and trust your best judgment.
Fortunately, recent legislation has helped regulate the finance industry. Congressional Acts such as Dodd-Frank and the close oversight of the SEC have helped improve transparency and accountability in the industry. While regulation has improved, it’s still important to conduct personal due diligence, read professional reviews, and get all your questions and concerns answered. Additionally, don’t accept the first financing approval you get, if the rate and terms don’t fit your investment objectives. Financing is a key component of your overall wealth-building strategy. Accordingly, only utilize the most appropriate and favorable funding products and sources.
Managing the Task
Due diligence is a critical aspect of real estate investment, and while time-consuming, can yield much greater results for the growth of your portfolio. It can also decrease your investment and borrowing risk and build your confidence in directing the future of your investments. If you’re looking for the benefits of a sound due diligence strategy, without the personal investment of time and energy, consider working with a financing and investment platform that can help you achieve your objectives with minimal risk and enable you to achieve the greatest results.