The Cost of Ignorance
By Justin Meyer
Nobody likes surprises. This is especially true when those surprises can cost you. That’s why the first thing that they teach trial lawyers is to never ask a question to which you don’t already know the answer. Real estate is the same way.
I am struck by the different ways that a real estate deal can fall through. If the buyer can’t get the funding for the property – if it appraises for too low a value relative to the cost, then the deal is dead. If the buyer, in doing his due diligence uncovers something negative about the property – then the deal can die. With new EPA regulations, due diligence is becoming more and more important, and with that becoming more and more complex. And sometimes, it’s the smallest detail that can be the straw that breaks the camel’s back.
For want of a nail, the kingdom fell.
But what if the king, in doing research into his own kingdom had found that he was missing one nail. Well, then he would have been able to save everything. Real estate sellers, as they plan to put their properties on the market, can do themselves a great service by conducting their own due diligence into the property. Look through your files, and check to see what is missing. Did you do a Phase 1 survey when you made the purchase? If not, do one now. Do you know how long all of the leases run? Double-check it and get everything squared away. Ask your broker to run through the list of things that he would caution a potential buyer to look for and look for them yourself. When is the last time you had an engineer check your building? The answer should be right before you put it on the market. Otherwise, a nasty surprise might be waiting for you when the buyer’s engineer discovers mold in your ventilation system, rusted pipes, and an elevator that’s about to snap its cables. And if you don’t think that will affect the purchase price, then you need to rethink your place in the real estate business.
Any due diligence needs to start with financial statements and tax records. Sit down with your CPA and review the property tax bills for the past ten years, as well as site-generated taxes, such as income or sales taxes. If the property houses renters, examine the balance sheet and tenant rolls, ensuring that the listed rents and lease terms are accurate. Knowing when the leases are to expire is also important. The price fetched for a property with all of its leases about to expire will likely be lower than one where the tenants are all still locked in for fifteen more years.
Next, review all structural engineering reports. Look at when the last report was completed. If it has been longer than a year, it is time to complete a new one. Have someone come in and check everything – because the buyer will. Get estimates on having everything repaired as well. Some repairs will be cost-effective, and some will not. Discuss them with your broker, to determine how important they are. But for each item that you do not repair, expect to have to bring your asking price down a little.
Finally, make sure that you review the title status. A sale can be held up, or even fall through, if the buyer needs to wait for title issues to be straightened out. Title problems might seem rare, and this seems like a wasteful expense, but if you are that one exception to the rule, then your lack of preparedness could prevent the sale from being made.
An ounce of prevention is worth a pound of cure, or so the axiom says. By preventing problems from arising, you can prevent retrading (the buyer requesting a price decrease during, or immediately before, the closing). By being prepared for any issues that the buyer might raise, you can be prepared to counter any request made that would cut into your bottom line.
All this work might end up costing you more than you wanted to lay out on the sale of the property, but in the end, it will be worth it. By protecting your investment until the end, you are guaranteeing yourself the maximum return. How many nails do you need?
This article originally appeared in Due Diligence Digest. © 2006. Reprinted by permission.