You are about to acquire a property and the clock is ticking. This is the timeframe after which you’ve analyzed the offering memorandum, obtained an accepted letter of intent (LOI), and signed a contract to purchase the property. Now, as the contract specifies, you have just thirty days to perform all your due diligence.
That doesn’t allow much time, but performing due diligence is the most important step you’ll take before you close and take title to the property. After you close, there’s no turning back and the property will be yours — along with any warts you didn’t uncover.
Too often I’ve heard sellers, brokers and others say, “There’s no time to perform such detailed due diligence. You’ll lose the deal.” I say, “So I’ll lose the deal!” It’s a giant mistake to believe that you must have a hairline trigger or you’ll lose a deal.
Your four main activities in performing due diligence include the following.
Undertaking Analytical Due Diligence
Verifying the information contained in the offering memorandum through an in-depth investigation of the property’s books and records.
Carrying out Psychological Due Diligence
Uncovering the inside story of both the property and the property owner to uncover both hidden value and potential problems.
Uncovering the Seller’s Motivation to Sell
Gaining as much leverage as possible to be in the best negotiating position to purchase the property.
Discovering Whether it’s a Sound Investment
Understanding fully whether the prospective investment fits your personal economic objectives and risk tolerance requirements.
Performing analytical due diligence is just the beginning. Equally important is performing psychological due diligence. Every property has not one, but two, separate and distinct personalities — one for the property and one for its owner. This means you need to perform an in-depth investigation of not just the property, but also the seller.
Performing psychological due diligence is an extremely effective way to uncover hidden value and existing and/or potential problems overlooked by others. This is where golden opportunities lie and where riches can be found.
Performing psychological due diligence requires the mindset of a detective. In real estate your suspect is the seller. Examine the seller’s “rap sheet.” What are the seller’s tendencies and behavior patterns? Why is the property for sale? Is the owner in financial trouble? How flexible was the seller in past dealings? Was the seller a pro? Does the seller drain all the potential out of the building before selling?
Just as a detective creates a profile of a suspect, your seller profile should include detailed information about the owner’s personal situation, financial situation and professional reputation. It should provide a treasure trove of insider information.
A great way of getting information about a seller is to establish a network of contacts that include brokers, attorneys, bankers, construction workers, title companies and more. My favorite source are employees that were recently fired by the owner. Ask them questions and, believe me, they have a lot to share.
Real-Life Example
In the early 1990’s we purchased several properties that were in a state of foreclosure. In performing my psychological due diligence, I discovered that many property owners attempted to convince their bank that the property wasn’t even worth the principal amount of the mortgage. To achieve this deception, the property owners would enter into fictitious leases at below-market rents with family members, friends and acquaintances. While negotiating with the bank to restructure the debt on more favorable terms, the property owners would submit to the bank a very low rent roll to support their claim that the net operating income generated by the property couldn’t possibly support the existing debt service.
Rather than foreclose, the banks would often cut a deal with the property owners for both a lower interest rate and forgiveness of part of the debt. As soon as the ink was dry on the restructured documents, the property owners would have their buddies vacate the apartments and re-rent them at much higher rates.
Through our network of contacts, we became aware of the game the property owners were playing. I’d asked a property owner how his office building was doing. He said with a laugh, “The first or second time around?”
With this insider knowledge, we gained a tremendous advantage while negotiating the purchase of certain properties with the bank. Because we’d done our psychological due diligence of the sellers, we had the insider information, not the bank. As soon as we closed, we immediately started eviction proceedings, successfully evicting more than 50 illegal tenants and dramatically increasing the cash flow and market value of the property. We were able to purchase fifteen properties for a fraction of their market value.
Nine out of ten purchasers fail to perform an in-depth investigation of the seller. Big mistake! If you neglect learning what makes a seller tick, you’re at a tremendous disadvantage in the process of purchasing real estate.
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