July 17, 2020

By Charles Sells

Vice chairman of Berkshire Hathaway Charlie Munger might be best known for his position on Warren Buffett’s hugely successful conglomerate or as “Warren Buffett’s business partner,” but he is also hugely successful in his own right. Munger is an American investor, businessman, former real estate attorney, and philanthropist worth nearly $2 billion. He is the author of Poor Charlie’s Almanac, which is go-to reading material for many real estate investors, and also the originator of a saying about due diligence that pretty much sums up its importance in the real estate investing space in about two dozen words.

Munger famously observed on the topic of hell (yes, we are getting to the due diligence part!), “The definition of hell in the legal system is endless due process and no justice; in the corporate world it would be endless due diligence and no horse sense.” Essentially, Munger is stating that due diligence is only useful and effective if you know when enough is enough! This is a very accurate statement, but some investors twist the sentiment around until they can use it as an excuse to let their due diligence lapse rather than as a guide for knowing when enough is enough.

The key to doing successful, effective due diligence is to know when you know everything you need to know. If that sounds a little bit circuitous or vague, that’s because it is! It has to be. Since every deal is different, you will not always be able to apply the exact same set of rules to every due diligence process. However, there are three key due diligence actions that will make or break your passive real estate investments and that will enable you to determine if an investment firm or agency truly has your best interests in mind when they leverage your capital.

1: Evaluate the Property in Light of the Strategy.

Too many times passive investors get involved with service providers whose biggest claim to expertise and experience lies in their ability to “get good deals” from off-market sources. These providers brag about the discounts they get or their access to “exclusive deals” from motivated sellers. Unfortunately, a big discount does not immediately translate to a good deal. Beware of investors and providers who are so focused on the discount they forget about the rest of the deal.

Do Due Diligence the Right Way: Apply your planned investing strategy to every great deal individually instead of assuming a big discount will automatically equate to a big return on investment.

2: Don’t Forget the Neighbors!

You probably know that finding good comps for a potential deal is important, but most investors believe having two or three “good comps” is enough reason to move forward with a deal. While this may be solid ground for investigating further, make sure your comps are in close proximity to the property you are considering and, furthermore, that there are not extremely negative or completely off-the-wall comps in close proximity to your deal.

For example, if you have the opportunity to acquire a property that the comps seem to indicate will generate great returns but, upon closer inspection, you realize that property is located next door to a local artist who has painted their property purple and attracts a lot of drive-by traffic to that location, then the good comps from farther away will likely be outweighed by the close proximity of a house that will negate a lot of your hard work and improvements when it comes to your ability to rent or sell the property. If you fail to look at the neighborhood as well as the comps, you could easily miss this issue until you already are committed to the deal.

Do Due Diligence the Right Way: Do not miss the forest for the trees! Both local comps and the neighborhood itself will directly impact your deal, so evaluate both the big and the little things. Do not be satisfied with just a couple of comps alone and no additional big-picture perspective.

#3: Take the Temperature of the Local Housing Market.

One of the most important aspects of due diligence involves taking a look at the broader real estate market in which you are investing. No matter how great a deal you find, if no one wants to live in the property once you have finished your project you will be out of luck when it comes to those great returns you were hoping for! When it comes to passive real estate investments, it will be your responsibility to make sure your service provider has evaluated the market in which they are investing your capital thoroughly. Look for three key components in a market:

  • Desirable location in which to live
  • Expanding jobs market with incomes that will support living in your properties
  • Expanding local economy

If the market in question meets these three requirements, then you can feel good about making a passive investment in the area. Investors should note there are exceptions to this rule because even in awful markets, there are desirable locations where most locals want to live. However, if you are investing in such a market you must be very sure you understand how to identify these neighborhoods and verify that the neighborhood is not at risk of blight or stagnation as a result of the broader marketplace.

Do Due Diligence Right: See for yourself that the market in which you are investing is an attractive one with room to grow and that your potential deals will have either buyers or renters in the area who are qualified to live in your properties. For example, if you are building high-end condos in a working-class neighborhood where most people rent, unless you have extremely sound evidence that the market will support these condos you probably should think twice about your investment.

Last but Not Least: Research Your Provider

So far, we have mainly talked about doing due diligence on the properties and markets in which you plan to make passive investments. However, that is only part of the equation when it comes to successful due diligence as a passive investor. Remember, being a passive real estate investor means that you leverage your capital and another party, usually an investment firm or agency, does the active work on your deals. You are placing a lot of trust and faith in that active party, so it is your job to make sure that person or business deserves that trust and faith.

Here is a list of ways you might do due diligence on your investment provider:

  • Ask for (and follow up on) personal and professional references
  • Do a background check
  • Request details on other deals – both good and bad
  • Do your own due diligence on a few deals to see if the provider’s requirements for a deal are similar to your own
  • Find out when the provider gets paid for services. If they are paid up front instead of being performance-based, find out why and ask what type of “skin in the game” keeps them accountable
  • Inquire about your options for viewing the property before, during, and after any repairs and renovations
  • Ask about their lead generation strategies for finding good deals and verify these strategies make sense in the market

When you are investing passively in real estate, most of your due diligence will occur on the front end of the relationship with your investment provider. As a result, the burden of determining if a relationship will work must happen up front before you sink your capital into a property with your active partner. If you would not partner up with a provider in business outside of real estate investing, then think twice before entrusting them with your capital. Be sure you can be proud to tell people who is handling your passive real estate investments, or maybe your due diligence is telling you to rethink your decision.

Charles Sells is the founder and president of Platinum Investment Properties (PIP) Group, the only agency that offers clients extraordinary returns on their investments while allowing them to retain 100 percent control and ownership of their investments. Learn more about PIP Group’s extensive due diligence process and why they are paid on performance instead of up front by their investors by emailing Charles directly at Charles@PIPGroup.com or by visiting PIPGroup.com.

 

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