A Work in Process: Let’s Talk About Due Diligence…
This week we are switching things up and discussing what happens after we have an opportunity under contract. At CF Capital we consider due diligence to be of utmost importance, and how thorough we are in this stage of the process sets us up on our path to success prior to making an investment. This phase of the investment process is all about identifying, verifying, refining, and triple-checking the critical characteristics that make up a property.
Our philosophy is that the only way we can be successful in due diligence is if we create a repeatable process while remaining adaptable. We also believe that this requires a thorough approach.
What do we mean by thorough? The common latin phrase, “Nullius in verba,” means “take nobody’s word for it. We think this reflects our exact mentality when we approach due diligence.
“No research is ever quite complete. It is the glory of a good bit of work that it opens the way for something still better, and this repeatedly leads to its own eclipse.” - Mervin Gordon
We want to leverage our team and best-in-class partners to turn over every stone on our own. We do this because we want the true perspective of what we are getting ourselves into, and not automatically assume that every bit of information we have collected from the current ownership group is 100% accurate and up to date. In fact, it is very rare to find a property where everything matches up.
Ultimately, we want our method of due diligence to gain additional trust in ourselves and the numerous variables in an investment (or at least as much as we can). After all, we are fiduciaries for other people’s hard earned capital as well as the diligent directors of our own participating capital, and we want to be able to sleep at night knowing that we consistently put our best foot forward as an investment manager.
With that said, let’s dive into some of the nuances of our due diligence process.
At this point, we have received information from the seller, and make assumptions and decisions on the deal based on that information. We overlay this provided data on top of our market knowledge and have discussions with our best-in-class 3rd party providers like property management companies and service providers. Now we must verify.
Before we dig into the areas that we verify, we believe it is worth mentioning the importance of doing so. First, verification allows us to identify any problems. Second, it serves as a means to protect ourselves and any potential downside from a potential investment. Lastly, it enables us to capture any opportunities when we look to verify every bit of information.
With flexibility in the order of verifying information, we begin by collecting and referencing as many documents as possible -- financial, legal, and operational.
On the financial side, we verify capital improvements and capital expenditure. In order to protect ourselves, we also verify income and expenses. Typically, we look at the past 3 years, but will consider longer historical periods.
To gain further clarity on the finances, we examine delinquency reports, lease audits, security deposit audits, property tax bills, tax appeals, and historical utility usage to cross-reference with anything we have gathered already.
Payment history is also reviewed. No one wants to find out that a majority of the tenants are regularly late on payments!
Finally, on the financial side, we verify forward-looking income and expense projections. We do this through rent comp surveys, submarket reporting , and required third-party reports. All in all, our goal here is to make our own projections as precise as possible by validating our assumptions from operational and capital improvement standpoints.
With regard to the legal due diligence, our legal team reviews piles and piles of documents.
You might have a mental picture in your head of us working late into the night with our desk lamps, reading through the large stack of property files. Basically, we are doing just that.
With one property in a target market, we have verified any document from legal audits and service contracts to something as simple as the title. We also made sure zoning is appropriate, and made sure that there are no encumbrances to the property. In this case there were no encumbrances, but if there were, we would need to sort it out before closing.
We continue our document review when we go through operational due diligence. We dig into building plans, floor plans, phase-specific third party reports, and other market reports.
Operational review also takes things one step further: we do hands-on inspections and investigations. In the physical inspections, we walk through every unit onsite at the property with our property management team and look at heating, cooling, plumbing, electrical, roofs, and windows just to name a few parts of a long list.
Furthermore, we will seek out and identify any other property intangibles. Is the site easy to access? How visible is the property? How does the property present itself to future tenants? There are many things that could determine the outcome of a property investment.
We even do a higher level investigation of the staff and tenants to get a feel for the past and current status. A similar investigation is done with nearby properties.
Perhaps you can tell from our tendency to include the “little things” in our articles, but we believe our due diligence process is a direct reflection of our detail-orientation. From all of this, we hope that you were able to take away some of the main points. We want to identify and be fully aware of the risks and how we can mitigate them, as well as the opportunities and how we might capture them. We go through due diligence to solidify our business plan and nail our execution so that we are set up to outperform for our investors.
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