207: Best Tips For Due Diligence the Right Way

SHOW NOTES FOR EPISODE 205: BEST TIPS FOR DUE DILIGENCE THE RIGHT WAY

There’s a huge problem in the real estate investing business that nobody is talking about – DUE DILIGENCE.  Investors are leaving big money on the table by not learning key essential principles.  Most investors, real estate brokers and real estate professionals barely scratch the surface when conducting their due diligence.  In this podcast, due diligence expert Brian Hennesey shares 10 effective tips on how to do your due diligence the right way.

What You Will Learn

• How taking and keeping good notes on your mistakes, challenges and solutions can help make you into an expert in your field
• Ten of the most common due diligence mistakes made by investors
• How to save time and money in purchasing real estate investments?
• Why you need to conduct due diligence for property purchases
• Learn the right way to conduct due diligence and avoid making mistakes the will cost you tons of money
• How to prepare your own due diligence checklist
• Learn a proven system to allow you conduct due diligence faster and with more confidence as an investor
• Secret tricks sellers use to “gloss over” items that should be disclosed

About Our Guest

Brian Hennessey

Brian Hennessey is the author of The Due Diligence Handbook for Commercial Real Estate.  He has been in the commercial real estate industry for over 30 years as: a commercial broker; Senior Vice President of Acquisitions/Dispositions and also ran his own real estate syndication/asset management company. He has represented a number of Fortune 500 Tenants including: Bank of America, The Walt Disney Company and Baxter Healthcare.  The Due Diligence Handbook was written originally as a personal reference tool/checklist to make sure he included the many facets and volume of information that is needed for commercial real estate transactions.  Brian conducts seminars where he teaches the principles presented in the book in greater detail.  He shares his experiences; strategies; tactics and the many lessons learned over the years as an acquisition executive, investor and commercial real estate broker.  He believes his book helps to raise the bar and standards for those professionals involved in purchasing commercial properties.

More About Brian

• Brian was a commercial broker for about 18 years where he came up with Due Diligence Handbook
• He was invited to be the Vice President of Acquisition/Disposition by one of his clients who is starting a real estate investment company
• Brian was wanting to be on the “buy side,” so the invitation came at the right time
• He started working and found out that buying is, in fact, a very different role
• The first couple of transactions involved a couple of large office buildings in Dallas that were being sold by a Canadian investment firm
• He dealt with the Vice President with the Canadian firm who quickly figured out that he was a neophyte as a buyer and quickly took him to school
• He learned a whole lot from the those transactions
• It was very stressful and he was constantly taking notes to better understand what was required in these types of transactions
• As the “due diligence” period went on, the pressure started being turned up on him through questions from the real estate attorney, the investor, accountant, the banker
• The transaction was very stressful that he couldn’t wait for the transaction to end
• He was losing sleep thinking about if he asked the right questions, did he ever get the answer to this or that, having 4 or 5 legal pads in front of him trying to keep of tract of different questions, and things that he’s asking from certain people and who wrote him asking for what information
• A week after the transaction was completed, one of the investors in the deal pulled him aside and asked Brian, “How could you have missed all of the information required in this deal?”
• Humiliated and embarrassed, all he can do is say sorry.  The investor expressed how he made a huge mistake hiring him as his acquisition guy
• That night, he couldn’t get to sleep, he asked himself, “How can I done that differently?   What can I do to make that happen more smoothly?”
• He finally decided to make a reference manual for himself and wrote down all the issues, questions, create checklist, so he won’t need to reinvent the wheel every time he buys a piece of property
• Over the next 6 years, buying 9 million square feet worth of office space all over the country, he kept track of every transaction
• Every time he learned a new lesson, he wrote it down and the list kept growing and eventually became a comprehensive reference manual
• He had developed a complete due diligence system
• At one point, he formed his own syndication company
• After the recession hit, he decided to get back into the brokerage business
• Being out of the business for awhile, he wasn’t sure how to get started
• He decided to pull all his notes together into a the reference manual and call it an “Investor Handbook” to use as a marketing tool
• He decided to put it up on Amazon, not really expecting to sell very many
• Unexpectedly, it started taking off on Amazon
• So he took it more seriously, had it professionally formatted and put it back on Amazon
• This time, it took off and became #1 best selling commercial real estate book
• Brian thinks that the reason for it becoming #1 best seller is because a lot of people aren’t  aware of what some of the things are that you can do, how deep you can dive into due diligence, and how people can minimize risk as much as possible.   As Warren Buffet says, “Risk comes from not knowing what you’re doing”
• The Due Diligence Handbook is also a list of all the mistakes Brain made when he dove into purchasing properties
• Brian says, “It is cheaper and easier to learn from other’s mistakes.”
• This makes you to be a better investor in the long run.
• Having and hearing a proven system allows you to conduct due diligence faster, easier, and more efficiently.  Thus you become more confident and self-assured as an investor going up against any seller
• People gain from learning from other’s mistakes. They will save themselves from having to do that.  This could be the reasons why his books are so successful
• The information and system is adaptable for investors in single family homes, shopping centers or sky scrapers

Most Common Due Diligence Mistakes

Mistake #1: Not Valuing the Property Correctly

A lot of people will do a cursory investigation, when they find a property they like, and make an offer and negotiate a purchase price with the seller.

What due diligence does for an investor is it allows them to figure out what is the property that he/she is purchasing is really worth.  What are its pluses and minuses, strengths and weakness, and ultimately, what is its true and potential value.  You do that during your investigative process.  When you’re underwriting or figuring out the financial analysis of the property, you’re constantly adjusting value

• Go through the leases (make sure you’re not locked into a long term lease)
• Sellers can try to hide things from you
• Was buying a 150 plus unit in Golden, CO
  • Class C property in B area
  • Great potential
  • Negotiated an acceptable price with seller
  • Brian was in the area and wanted to start the inspection process but owner was reluctant because Purchase and Sale Agreement had not been signed, but he later agreed
  • 2 hours into inspection, one of the contractors pulled Brian aside and said it looked like the owners are trying to cover-up some structural damage with some boards and mud
  • Contractor said to repair the damage it could cost $1.5-3 million
  • He pulled out
• Physical inspection (together with your team – contractors, property managers) should be done prior to signing the contract
• Be straightforward, continue to negotiate as long as you are moving forward but do not spend a bunch of money negotiating the contract if you find something unsolvable

Mistake #2: Not Understanding your Lender’s Underwriting Requirements

Property should qualify under the lender requirements before you begin.

• Someone finds a property and feels they can get a 70% loan
• You find that a major tenant has 2 years left – lender won’t count lease because there’s less than 3 years left and reduces ratio to 60%
• Now need money for reserves
• Not the return you had hoped

Before you get started, call up a lender, give them general parameters – what kind of property, if it is in a decent area, price, share what you know about the tenants and leases, and get an idea on what kind of a kind of loan they can put on it. Common example of what can happen:

Mistake #3: Not Checking with the Local or Municipal Building Department on the Property’s Compliance on Certain Codes

• Find out if there are some violations or pending compliance that needs to be fixed
• When you need to renovate, your repairs (when they reach a certain dollar amount) might trigger a bunch of new compliance issues (i.e. handicap requirements for the bathrooms, access, etc.)

Mistake #4: Assuming There Are No issues Within Existing Tenant Leases

• Read through the existing leases, if possible, with a real estate attorney.  Be aware of what is on those leases and make careful notes.  Examples of things you might find include:
  • fixed rent options below market rents
  • For example, 5-year fixed rent option, prior to lease expiration, these can potentially devalue the property and affect your numbers
  • Refurbishment allowances
  • Free rent inter-dispersed throughout the lease
• When you negotiate your Purchase and Sale Agreement, make sure:
  • Any concessions given to tenants prior to the end of the due diligence period, you, as the buyer, should be credited for
• Example:
  • He found a building in Phoenix (lender owned property)
  • Lender flew their attorney out to negotiate their Purchase and Sale Agreement
  • When it came time for closing, Brian found a debit of $427,000 for tenant improvement, leasing provisions, capital improvements, etc.
  • Brian told the owner that that amount was THEIR expense and it should be a credit for him and the owner changed it

Mistake #5: Assuming Lenders Will Accept All Third Party Reports

• Ask for a Lenders Approved Vendors list of all third party reports to avoid ending up paying for a report that is not approved
• Third party reports are environmental, property condition assessment, and make sure that these reports were produced by “approved vendors” from the lender’s approved list
• If you don’t do this, you may have to pay for two reports of the same thing

Mistake #6: Trusting that the Seller and Their Representative Have Disclosed All Issues

• Seller is not going to come to you in the beginning of sales process and give you a list of everything wrong with the property
• They’re hoping you won’t find anything wrong
• Don’t take things for granted.
• They may disclose some things but there are also gray areas that they may think they do not need to disclose.
• Don’t assume anything. If you want to assume anything, assume nothing.   If you want to assume anything, assume that there are some problems you need to find and your job is to look for them

Mistake #7: Not Walking Each and Every Unit

• Tell seller you want to walk each and every unit
• If seller says “no,” ask “What are you trying to hide?”
• Find out ahead of time (before you sign contract) if you need to redo some units and if possible, talk to the tenants, interview the vendors, and try to find problems e.g. smoke damaged units, if appliances were taken out, mold issues, etc.
• Example:
  • Brian was buying a large hotel
  • 377 room full-service hotel from very well-known international hospitality/hotel firm
  • He asked to walk all rooms and they refused because it was too disruptive to guests
  • They said he could walk only 25% of rooms
  • Brian was also interviewing vendors at the time and one disclosed that a number of rooms were shut down because of mold issues
  • He called owner and said, “If I can’t walk every room, I’m cancelling escrow.”
  • They said OK.  When he walked the rooms, they found out that 55 rooms were shut down due to mold issues
  • He ended up getting a $2.5 million discount off the price
• Other example
  • Owner did not want buyer to walk units because they were afraid that the buyer would talk with large tenant who was going bankrupt who was planning to leave before lease was due
• Make sure that the seller allows you to walk each unit even it means disrupting the tenants, you can always cancel the escrow anytime.
• If you want to pursue with the purchase, you can always get a discount off the price for all the problems that you may find and avoid cost of large litigation fees later.

Mistake #8: Verify Building Measurement

• Get ALTA survey ($1,800 – $2,000)
• An ALTA Survey is a detailed survey performed by a registered licensed surveyor, prepared in accordance with the standards specified by the American Land Title Association (ALTA) and the American Congress of Surveying and Mapping (ACSM)
• Get property field measured by architect or space planner to make sure the numbers match square footage listed on other data

Mistake #9: Expecting The Closing Statement To Be Without Issues

• Many investors miss this because they are pressed for time (work full-time job, wrap up in doing the loan, due diligence, appraisals, other responsibilities)
• By the time that you get to the point that the property is ready to close escrow, you could be probably exhausted – drained mentally, emotionally, physically from doing due diligence, getting a loan, getting through the appraisal process, etc. and you just drop the ball, stop scrutinizing things, because you just want to get over with it.  The result is you could be leaving a lot of money on the table
• Things start slipping though the crack
• Some savvy investors know this and can take advantage of the owner at this stage of the deal
• This is the time that you need to be tapping on the breaks, scrutinizing your preliminary closing statements, especially the extra amounts that the seller suddenly puts in there. It is not because it is on there, you will just accept it as fact, which is not the case.
• Need to keep asking questions:
  • What is this amount?
  • Why is the lender charging $6,000 to review leases?
  • Negotiate fees
  • Have someone on your team that knows better review the fees, etc: CPA, real estate attorney, property manager, experienced investor friend
  • Don’t just count on one person
  • Because, 4th or 5th time you may review it, it all starts to look the same
• Show it to some experts who can go through it methodically, don’t count on one person – CPA, Real Estate Attorney, Property Management Person, another investor friend, especially when you have been looking at it for several times, it will look the same for you.

Mistake #10: Not Spending Time at the Property

• The property is a living, breathing breathing mechanism and you need to see how it operates at all different times
• Sometimes you may be very surprised
• Go there at different times of the day, different days of the week to see:
  • In the morning – Are they going to work?
  • What kind of tenants are coming and going?
  • Mid-day – Who’s coming and going?
  • How is the parking working?  If it’s an office building, are homeless people living there at night?
  • In the Evening –  How is security, if there are vagrants coming in and out, or any shady looking characters hanging out in the area
  • Weekends – What kind of cars parked are parked in the area?  Is the parking lot a hang-out for the teens?

Few Summary Comments on Common Mistakes

One thing about learning conducting due diligence properly – once you learn how to do the due diligence properly, you get better and better at it.  It’s just like anything else, like riding a bike, the more you do it the better you get at it

Biggest Success

• Brian considered his biggest mistake was his biggest success.  Learn a ton of lessons at that time
• This is when he ended up buying 350,000 square ft. of office buildings in March 2007
• 5 office buildings in Houston
• His first large acquisition
• Ended up adding $700,000 worth of net operating income for the 16 months owning it
• Was hit by recession
• He put it back on the market
• Went into escrow 2 different times where he would double his money but couldn’t get a lender because of the sub-prime loan crisis
• So he ended up paying up for the property for 3 years.
• It was cash flowing and GE Capital ended up buying the loan
• GE Capital was also buying up properties at the time and because this property was cash flowing and had a short-term loan on it
• It had a short term loan on it and GE required $1 million to extend the loan at the the end of 3 years
• He didn’t have the $3 million but said, “because it’s cash flowing, they must know something, want this property and this is why they’re making the move to take the property from him”
• GE Capital took the property
• Brian asked his attorney what would be his chances if he sued GE capital.  They said it’s a very “lender friendly” state and that there would likely be 50/50 chance of winning
• Brian took the chance, sued them and won the Stay of Foreclosure
• He ended up talking to a bankruptcy attorney and he asked if he went into foreclosure, would it buy him more time.  He said, “It may, but, if GE Capital says ultimately, you’re right, and it’s worth less, are you prepared to get a new loan and pay them what it IS worth?  Brain said “no” because it might cost him $6-7 million dollars.  Brian handed back the keys
• Lesson learned: “You learn more from your failures than you do from your successes.”
• The bottom line: failure and success are interrelated.  You can’t be worried about failing because that’s how people learn.  People can gain from learning about other people’s mistakes- This is why his books are a success!

Advice to Old Dawgs Interested in Getting Into Real Estate Investing

• If you want to jump into commercial real estate, it is not for the faint at heart
• Keep it simple.  Don’t get yourself too far over your skills.
• That’s why multifamily is so appealing.  There’s lots of it. People always need a place to live.  It’s a good place to get your feet wet in commercial
• You can also buy a small retail store, industrial building
  • Smaller properties (under 20,000 sq feet) you can divide it up
  • Industrial property – smaller units
  • Retail in small town
• If you buy it right you can hardly go wrong. Learn what you need about it and prepare for the times that it might not be leased.
• Start small and work your way up
• Once you learned the fundamentals, especially the due diligence part
• You make your money on the buy and you realize the value on the sale
• What your learning on due diligence, is not only just adjusting your financial underwriting as you’re going through the process, but you may find out you are not buying what you thought you were buying, do your homework and you can go back to the seller, give them an itemized list and outline what you will need (needs new roof, etc.) and ask for discount
• Triple Net can also be a good place to start – Tenant generally pays all expenses

Rap-It-Up

• Favorite Real Estate book: What Every Real Estate Investor Needs to Know About Cash Flow by Frank Gallineli
• Favorite business book: The Success Principles by Jack Canfield
• Most valuable web site for success (other than your own): Loopnet.com, Mike Lipsey, and other real estate investors website
• Favorite app: Hp 12c Financial Calculator App – Financial Calculator
• Favorite quote: “Meet everybody and every circumstance on the battlefield of life with the courage of a hero and the smile of a conqueror.”
• If you had to start all over, knowing what you know, and you only had $1,000 cash, what would you do to launch your real estate investing business?  Give $500 to charity and take the other $500 and use it for the efforts locating opportunities and to co-invest with others and use expertise as sweat equity.

The Due Diligence Video Courses

• Brian has developed a special video course that he wants to make available to the Old Dawg’s listeners
• This video courses goes into deep dive principles
  • Strategies and tips
  • What you need to look for
  • Things to be aware of
  • How to approach objections from seller
  • What to look for in physical inspections
  • A mock tenant interview (one of your best sources of information on a leased investment)
  • And other valuable information
  • Belt and suspender investing
• Free trial!
• 25% discount off the course for Old Dawg audience — Go to impactcoachingsystems.com/courses, to the courses, put in the discount code – olddawgs25 – and you will automatically get a 25% discount off the course price.

How to Reach Brian

• ImpactCoachingSystems.com
• Brian’s website also has tons of great free resources at: ImpactCoachingSystems.com/Resources
• brian@impactcoachingsystems.com
• Phone: 818-371-0311

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