Often Overlooked Due Diligence

by 01 Aug 2012

Due Diligence is near and dear to my heart. In a nutshell, due diligence is 70% of an agent/brokers/investor’s job. Some are good, but most I run across are really bad at performing due diligence for their clients. We as agents owe our clients the "F" word – the Fiduciary duty to protect our client in a transaction.

At the heart of due diligence is asking for information to provide a clear picture of the transaction. In my opinion, it's not unreasonable to ask for information no matter who you represent. If providing relevant information regarding the transaction is a problem for either party (Buyer/Seller), then it's time to re-evaluate your position.

As an aside, due diligence is more important for the Buyer/Seller who is not represented by an agent or advisor.

To my point, I am currently representing a Seller of multiple income-producing properties. Since there are multiple buildings, the transaction becomes a Commercial one. Please note, this concept of due diligence bleeds over into all realms of real estate transactions.

I have three – that's correct, three pages of documents and information requests. This list fits Buyer or Seller, Commercial Sale or Lease, Residential Sale or Lease. Before I accept a listing, I request all the documents that are germane to the type of listing. This accomplishes two objectives – a clear picture of the deal and speed of the deal flow.

Here are some overlooked questions to add to your list, whether Commercial or Residential Income-Producing Sale/Purchase:

Is the property under third-party management? If so, do you have a management contract in place? Please provide a copy of the management contract. Why is this important to a buyer? I have seen management contracts that survive a sale. I may not want to be compelled to use XYZ Management Company.  Key – this point may be a contingency written into the purchase contract. No surprises after closing.

What type of lease document do you use when you lease a property? I want to inspect the document.  You need to know what you are committed to after the purchase of the property. Any free rent? Any repair deductibles? Promised future repairs during the lease terms?

I take this further and request an Estoppel Certificate from each tenant.  Black's Law Dictionary provides a good description of an Estoppel Certificate. Key – it can affect cash flow.

Do you have any tenants that are month-to-month? If yes, why?  Has their rent increased after the lease expired? If no, why?  How long have they been tenants? Is it possible to get them to sign a new lease?  Key – again this can affect cash flow.

Physical Inventory of Fixtures, Equipment and Furniture

If you want a simple way to check the validity of Income Numbers, request the last twelve months' bank deposits. If the Seller balks, see this as a RED FLAG. While on the subject, I personally place no stock in PROFORMA Numbers. Try and get a bank to lend you money on proforma numbers. They've been down that road. Besides, we’ve all seen where “Real Estate Always Appreciates” got us. Proforma = Throwing Darts at the Wall. I want Real Numbers. I need to be able to figure the upside or downside to a property.  If you don't have them, then you should pass.

If the property has employees, request a Payroll Register: employee names, positions, pay rates, benefits. Key – cash flow.

Request all service and advertising contracts. Trash, HVAC, etc… Key – cash flow.

Request a copy of the property insurance policy. For all you know the property is under-insured. Your expenses just rose. Key – cash flow.

To summarize, these are just a few of the important questions a buyer should ask. I see them missed at every turn. Some of these questions are real deal breakers. As a buyer you have every right to ask for this information. Heck, you're the one taking the risk. If the Seller balks at any of these requests you should walk away. There is never a good reason to withhold information in a transaction. Hence, we have the Greater Fool Theory. There is always a fool who will purchase blind or overpay for a property.

Sellers, think how much faster the transaction will go if you have this information ready to go for a solid buyer. I want to see all of the deal, warts and all. Buying & Selling Income Property is all about CASH FLOW.

 Mike Morrison, CNE, Will & Will Real Estate, in The Woodlands, TX, specializes in small multi-family property sales & purchase. He works mainly with investors. For comments or questions, email him at mmorrison@willandwill.com .

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