Due Diligence—An Essential Component of Your Management Plan
"Get in,” I said to my younger brother Kevin (who was just 5 or 6 years old at the time) after we pulled his red wagon to the top of a long, steep road that ended in front of our house. “Use the handle to steer. Jason and I will push you down the hill until we can’t keep up. Just stay in the middle of the road and don’t hit the sidewalk.”
It seemed like a good idea at the time. But I didn’t think about how to stop. I didn’t check the wheels to make sure they were secure. Nobody looked at the handle or the bolts that fastened the axle to the frame. I didn’t think about cars, rocks, or the trouble I’d be in after he crashed either. I didn’t have a plan. Instead, like any other kid, I focused on the initial activity to accomplish our goal: to have fun.
Unfortunately, more often than not, this is true for real estate investors as well. Although we may define it differently, our goal is to still “have fun.” We’re all pursuing financial independence, working to acquire greater wealth for ourselves and our families. As investors, the plan is not as simple as checking the handlebar and wheels on a wagon. There are many moving pieces to consider.
Effective Due Diligence
Jim Rohn said, “We can no more afford to spend major time on minor things than we can to spend minor time on major things.” Many real estate investors enjoy the thrill of hunting down and negotiating their next investment. I’m one of them. At least to me, that’s the most exciting part of investing.
Good negotiations require thorough due diligence. Most investors do very little due diligence. Many simply verify the rent roll, do a physical inspection, make a few adjustments to an operating report and call it good. Then they close on the property and wonder why they struggle with it for the first six months.
Due diligence is so much more than that. Investors who understand it are the envy of those who don’t. If you do an effective due diligence before you buy you’ll make better investment decisions. Makes sense, right? And, if you do an effective due diligence before you sell, you’ll sell at a higher price too. If that’s true, why do so many investors struggle with due diligence today?
There are two main reasons. First, nobody showed them what to look for. Nobody gave them a list of questions. Nobody explained why to ask questions. Due diligence is not all that difficult if you have a plan covering “all” aspects of investing. (No single checklist covers everything.) However, due diligence should cover these nine specific categories:
1. Books and records
3. Physical inspection
5. Management team
6. Operations and system management
9. Legal issues
The second reason many investors struggle with due diligence is time. It can be difficult to cover these issues when the seller or their agent pushes you to make a decision in seven to fourteen days on smaller properties and 30 days on larger acquisitions. Let’s be honest, that’s not a lot of time. Why do they do that?
It’s simple: time kills transactions. Nobody wants to wait for you to make your decision. That means they’ll press you to make it sooner than you probably should. Sellers and agents know that without a sense of urgency, your depleted desire to own the property will show in the price. They know that our excitement and enthusiasm for an investment is at its highest level early in the game. That emotion can spell disaster for investors, usually to the tune of tens of thousands of dollars or more. Can it be done in seven days? Sometimes, if you have all your ducks in a row and you spend the time necessary to get the answers you need. But more often than not, investors make premature decisions that result in more operational issues than they care to deal with when they finally close and take over the property.
- Role, responsibilities and authority of the management company
- Personnel policy and staffing structure
- Marketing plans and procedures
- Leasing, rent collection, and occupancy standards
- Lease termination and eviction process
- Operating budget and forecast
- Income analysis
- Physical appearance analysis
- Expense analysis
- Accounting and reporting procedures/expectations
- Management training programs
- Management compensation
Steve Steadele, author of the book Multifamily Millionaire, is a successful Real Estate Investor, Broker, Entrepreneur and self-made millionaire. Steve specializes in the acquisition and disposition of investment real estate throughout the United States. To learn more about his products and services, visit his Web site at http://www.SteveSteadele.com.
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