Due diligence. This term cannot be repeated enough to carry its significance in real estate investing. Without due diligence (like getting home inspections and analyzing future market values) you run the risk of getting “burned” for your investment. For most real estate investors, we try to correctly judge the home and future possibilities. We might turn the property into a rental or completely overhaul the home in renovations. But not everyone carries out their dream appropriately, so I’ve compiled a couple of personal secrets to real estate investing must-do’s.
The Limits Of Pro Forma Financials
First, never ever rely merely on “pro forma” financial information about a given investment property. By definition, a pro forma statement only estimates expected future cash flow and return on investment. What’s more, these estimates are generated by the seller and/or seller’s agent. These numbers may be unrealistic or overly optimistic. Therefore, ascertaining “actual” historic performance is key for the potential buyer.
Realize that actual performance will almost never be better than the pro forma estimates. In fact, the actual historic performance of a property is often much worse than what the pro forma financials indicate. Finally, projected numbers on pro forma statements hinder due diligence testing since the numbers they use are unreliable at best and disastrous at worst.
Essentially An Audit
Once in possession of actual financial data from the seller, the analysis of those numbers can begin. In many ways, such analysis essentially represents an audit of the information presented.
One credo here is simple: verify, verify, verify! Rents, other income, loans, and expenses need to be meticulously verified with third parties. These entities will include banks, contractors, and tenants. It’s obviously vital to make sure that the numbers are accurate. However, it is also crucial that they be comprehensive as well. For example, is every expense being properly accounted for?
A review of rent records, credit card statements, and bank statements is a good start, but it is not enough. The validity of the financial information needs to be further verified by matching these financial records with the information the seller included on his/her tax returns. It is very unusual for anyone to over-report income on returns, so these documents are typically a clear indicator of the actual performance of the property. If inconsistencies do appear, the need to explore even more thoroughly is merited.
Financial due diligence also includes the verification of the actual existence of revenue streams. Are reported rent levels both real and collectible?
Completeness of Liabilities
Assuring that the property does not actually generate higher expenses than reported is obviously important. For example, deferred maintenance is a future liability that cannot be overlooked. If the seller didn’t perform certain work in a timely way, that expense is invariably going to fall on you. Loans and interest also represent liability that can be accurately accounted for. Any outstanding debt to outside contractors must also be fully accounted for. An accurate financial picture is impossible to develop without these items fully included in the analysis.
A singular goal always remains — test for completeness to ascertain what, if anything, is missing from the seller’s financial disclosures.
Investing in the Temecula Area
Financial due diligence can oftentimes require the expertise of trained professionals. “Going it alone” could saddle you with a problem investment for some time to come. At the same time, discovering pertinent, undisclosed information about the property won’t necessarily be a deal breaker. Used wisely, such information can still result in the conveyance of the property to the buyer, but under more favorable terms.