Counseling as Part of the Due Diligence Process

This is an excerpt from 5 Things That Should Be on Your Due Diligence Check List, a course taught by John Brennan, an S.E.C. member and past president, and Vicki Yeomans, an S.E.C. member.

During the due diligence period we rush to check certificates of occupancy, surveys, utility availability, and myriad items that appear on due diligence check lists.  One of the most important questions we should ask does not appear on any of these boiler plate forms: “Is this property right for this ownership?”  Does this property serve the purchaser’s goals and align with his skills, assets, and capabilities?

To best answer these questions, the due diligence process needs to begin prior to putting a property under contract.  We need to begin counseling the client so both broker and client understand the goals, capabilities, and needs.

Defining the benefits sought:

When discussing real estate investments with clients, I like to carefully define their time frame expectations and quantify the benefits sought.  One client plans to retire in 10 years and will need an annual income of $150,000 in today’s dollars.  Another client wants to create a portfolio value of $250,000 to ensure that her granddaughter will have adequate funds to attend college in 8 years.  One client is seeking income, the other wants appreciation.  Few people think about their future needs in specific terms and the types of return that will be necessary to achieve their goals.  Beginning by defining the end benefit is a big step toward creating a realistic, goal-driven decision process.

Once you and the client have defined the purchase goals, part of the due diligence challenge becomes determining if this property meets those needs.  Is it a necessary interim step toward a longer term objective, or does it provide the benefits he is seeking?  I always like to ask a client his or her long term expectations for the property.  What will be the value of this property to him or her in 5 years, 10 years, and so on?

A well-counseled client who manufactures electronic components was going into contract on a 23,000-square-foot metal office warehouse.  When we discussed his expectations for the building, he stated all the benefits listed in the sales brochure.  Because the purchase was to house one of his businesses, we discussed the near- and long-term projections he had for that business.  He quickly abandoned the first “wonderful opportunity” and began looking at larger, more substantial properties.  He ultimately purchased a 50,000-square-foot tilt wall building in one of the most prestigious industrial parks in the Houston area.  This property better served the vision he held for his company.

Assessing assets and capabilities:

After establishing the goals for investment, learn the client’s assets and capabilities.  Assets not only include current properties and cash but also the ability to borrow and support negative cash flow. Defining current assets and borrowing capabilities early in the counseling process is critical. Borrowing capacity and borrowing comfort may be dramatically different.  Never make assumptions about borrowing; a client’s tolerance can be affected by the terms of a loan and limits of liability.  When discussing negative cash flow, always ask how carrying a negative will affect the client’s lifestyle.  Divorces have been created by signing for liabilities.

Assets can also include skills that add value.  Some skills are obvious, and some are not immediately evident.  One client is a contractor whose assets include the work force and organization of her employees.  Another has a brother who retired from the upper management of a major hotel chain.  The two siblings have formed a partnership and are currently developing and owning hotels under that flag.

Purchaser temperament:

Finally, does the purchaser have the right temperament and personality for the requirements of the subject property?  Not everyone can handle the realities of apartment ownership and the damages done regularly by tenants.  Each real estate type has its own set of ownership challenges.  Looking at any business or investment from the sidelines is very different than actual ownership.  Making the determination if the buyer and the property are a good match needs to be explored during the due diligence process.

A favorite mantra of the Society of Exchange Counselors is, “there is no bad property, just inappropriate ownership.”  Inappropriate ownership occurs when the owner’s goals, skills, assets, and capabilities do not align with the requirements of the property.  Counseling a client to determining the appropriateness of the union of property and buyer should be a big part of everyone’s due diligence process.

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