A lesson in due -diligence well several actually,
It’s been a fun week so far. I want to take a moment to thank God that I spend a good deal of time working on due diligence. For those who aren’t familiar with that term, due diligence is the legal term for the art and science of looking before you leap.
What I am going to talk to you about today are some case studies taken from my life in the past seven days. These are all real deals that I am/was working on.
Case Study #1– Raw Land for self-storage
This should be a simple transaction. The property in question is a gently sloped, mostly cleared parcel. More importantly the property is close to but not actually on the intersection of two major highways. In order for this project to move forward, we need some way of directing people to the proposed development.
So I made my offer contingent on being able to get signage that is acceptable to me. Rather than assuming that we could get the signs that we need to make this business a success, I added that little bit to our offer, and I proceeded to start my due-diligence. My first conversation was with the township manager. As he dashed my hopes that I would ever get the signs that I needed, I let out a big sigh. Then a big smile came across my face.
If I had not made my offer contingent on obtaining the ability to put up appropriate signage, then I would be closing on a purchase that would eventually end in disaster for me. It is not that I included that important detail in my offer that saved me. It is the fact that I followed up and drilled down on that one important detail. Because I was diligent in my investigation, I was able to avoid a financial catastrophe.
Case Study #2
Commercial Warehouse Condo Conversion.
In this case, me and my partners were looking at a proposed project that would convert an old warehouse into a bunch of condos or apartments. The seller of this project put together some really great pro-forma numbers for us. Pro-forma is another legal term that basically means, numbers that we made up.
So in this case, my focus was on the numbers that the seller so kindly provided for me. Here is where due-diligence separated from pro-forma. The cash flow numbers were darn good, and the project would have been very financeable with the pro forma numbers. The problem is that the pro forma numbers were a fairytale. A simple search of market rents indicated that the real expected rents in that part of Pennsylvania were about half of what the pro-forma claimed.
Again I let out a sigh, and then a smile came across my face. If I had trusted the seller’s rental projections then I could have been in for a very expensive learning experience.
As a point of reference, I determined the market rent by using rentometer.com and craigslist. Doing your own due diligence is not voodoo, it just takes a little effort on your part.
Case Study – the rehab that wasn’t
I was evaluating a property for its rehab potential. At a basic level, any sort of flip transaction can be boiled down to math. You need to understand a few numbers to construct your math. You need to know what the property will cost to acquire, you need to know what your rehab cost is going to be (plus or minus a few thousand dollars), and most importantly you need to understand what you after repaired value of ARV is going to be.
The numbers were good. The problem came up in the title search. This property came with a restrictive covenant that didn’t allow me to improve the front of the property. In learning about that restriction, I was able to avoid a disaster. There is no way that I could have exited that transaction profitably without being able to improve the front of the house. This stupid document required me to keep the original look of the property, and that original look was just plain ugly.