Don’t sweat the small stuff, or should you?
Investing in a significant renovation or new development deal is risky business. You’ve probably heard the adage, “don’t sweat the small stuff,” or maybe you’ve even read the book by that name. But, when it comes to investing money in real estate, that’s exactly what smart financiers do. While it is exciting to look at the upsides of your pursuit and potential rewards, making decisions based on sound knowledge should be equally important. Once a purchase agreement is lined up, there is usually a tight window of time to inspect existing conditions and evaluate whether the deal makes sense to consummate. The process of investigating an opportunity is commonly referred to as “due diligence.” While there is no one-size-fits-all checklist as every deal is unique, you should consider the following best practices to identify and quantify related risks.
Learn the market
Economics 101 requires thorough understanding of the market the project will serve. What is the existing and future demand? Define who will be attracted to rent or buy and what they are willing to pay. Understand not only their financial profile, but also their emotional profile (psychographics). What supply is current competition? What similar projects are in permit or planning by others and how will yours be different? Write your strategy down so that you can measure results against expectations later.
Know who you’re dealing with
Every real estate transaction, whether it involves a large apartment building or a single convenience store, is different and has unique relationships. Get to know the history as well as the personality of key deal members. Through real estate brokers, attorneys and lenders you can learn about the seller, property manager, developer, designer, contractor, leasing and other parties involved. Research and evaluate the capabilities, experience and realism of each team member to assess how likely they’ll be able to consummate closing the deal and executing on their promises. Don’t skip the face to face interactions, because informal conversations often reveal more about the transaction than paperwork alone.
Research the land
Most buyers will obtain a survey to describe the physical extent of the property, a title commitment to verify ownership, and an environmental study (Phase I ESA) to make sure prior owners didn’t leave a mess — all because a lender requires them. However, it is important to really understand the context of the site and look deeper. Have experts clarify what is legally allowed and how much can be built on the site (zoning, easements, covenants, etc.). Do any of these limit what you are planning for the project or the time it may take to get there? The last thing you need is to invest in a property you can’t use the way you want when you want to. And, don’t forget to look ahead to pending or potential changes and when they might occur. These can be reasons for investing or translate into a big mistake.
Visit the site
The online information and the paperwork may look impressive, but nothing beats seeing a property in person. You should visit the site and walk through the building to inspect it. Assess its condition. How well does it fit your intended needs? If you are significantly renovating or constructing new, how compatible is the site to getting labor, materials, electricity and water to the property, and then staging and storing materials until needed. Generally, doing projects in cities is much more challenging than doing them in the middle of a field. But, it’s still worth studying as it can have big impacts to your budget and schedule.
Evaluate the infrastructure
Piggybacking on the site visit, where is the nearest connection to water, sewer, electric, gas, telephone / internet, etc.? Will the current infrastructure be able to support the planned project? If not, what will it take to extend or expand? Find out the status of current and planned roads and other means of transportation to the property. Don’t forget to understand how storm water will be managed, as that’s a growing area of concern in most places. And, find out if there are opportunities to add on-site solar or wind methods to provide power.
Study the design
Next to selecting a good site (that can’t be moved), good design is very important. There should be a clear program of requirements (overall square feet, number of floors, types of units, level of quality, etc.) written and compared against your strategy expectations. Design is usually represented in the form of drawings (graphic plans) and specifications (narrative details). Review them thoroughly for fit, completeness, coordination and quality. Not only do those documents describe the outcomes, they also serve as the basis for estimating and budgeting costs. A bad design is hard to fix later without real impact to cost and schedule.
Real estate projects are also complex and require that team of people mentioned earlier. The parties should have responsibilities, tasks and costs defined within various contracts and agreements. Have your attorney and insurance advisors review those documents for appropriate form and content. For contractors, pay particular attention to both what they have included and assumed, as well as what they have excluded or indicated to be determined by others or subject to adjustment in the future.
Through this process, you’ll begin to identify potential risks and maybe even some serious concerns. Take your time and ask lots of questions. Uncover hidden details and key information that may not be apparent at first. Time spent now can help limit any post-transaction surprises. Once you’ve listed the risks, outline potential mitigation options including what requires others or more money to cure. Then make sure you plug in appropriate time and cost contingencies because few things go exactly as planned.
Engage trustworthy advisors
Don’t try to perform diligence alone as there are too many facets to cover in a short amount of time. You’ll at least need market, legal, financial and technical experts. Make sure that each advisor you partner with for your income-producing real estate transaction is an expert in this field. Ask each consultant for information on past projects and his or her role. Did the advisor support a similar client from deal conception, then closing and all the way through implementation of construction or development? A relevant advisor should be able to comment on the proposed project program, schedule and budget. Then, perform due diligence by supporting the acquisition team through the purchase or venture closing. An advisor well-versed in real estate investments can manage and guide you along the entire journey.
Keep in mind that every real estate transaction is unique and requires a due diligence plan. So, my advice is do sweat the small stuff before making any important investment — your financial future depends on it.
Real Projectives® has advised dozens of investors on hundreds of different deals throughout the United States. For more information on how the professionals at Real Projectives® can support you through each stage of the diligence process, give us a call at 888.357.7342 or contact us.