due diligence is the key - Posted by ray@lcorn
Posted by ray@lcorn on May 31, 2006 at 13:07:25:
I get resistance from sellers regarding a lot of what I do, especially in due diligence. But frankly, I couldn’t care less. I start from the assumption that everything they tell me is fiction until independently verified. More often than not the initial numbers don’t check out, in fact it’s rare when they do.
As you found with your deal, what the seller says and the reality can be two very different things. If you valued that property based on the $30T per month rent roll then you paid the seller for the effort it took to stabilize the property. Yours is not the first time I’ve heard of sellers filling a property with any warm body in order to get it sold. That’s the reason that we examine every tenant file during due diligence, looking not only for documentation but suspicious patterns such as a lot of recent move-ins with no references.
And sometimes the upside is good enough that it’s worth taking on some problems in order to get the deal done. I hope that was the case for you.
But if I’m going to take on problems I want to know about them up front. And the only way to go in with eyes wide open is to use the actual numbers, normalized for how I will operate the property.
If you’ve read my article about valuation (http://www.real-estate-online.com/articles/art-216.html) then you know how important the correct NOI is to determining the deal structure, the financing, and ultimately the overall return on investment. Mistakes in estimating total costs (e.g. deferred maintenance or expense increases) or unfounded income assumptions can have devastating effects on returns, especially in a competitive market when we’re looking for any edge we can find.
p.s. Thanks for the order, and the book has a great deal of detail regarding this very issue because it is so critical to valuation. You’ll also appreciate the extensive detail in the chapter on due diligence about how to avoid the type of problem you described.