The financial aspect of due diligence focuses on why you're buying the property. It helps ensure that you make money by verifying the seller records of the property's financial performance. To perform thorough financial due diligence, be sure to obtain the following from the seller:
1 Income and expense statements: These statements show what the seller has collected in income from the tenants as well as what the owner spent in operating the property. You should at least obtain annual income and expense statements for the past three years. Also, get all of last year's monthly profit and loss statements and review the balance sheet for the past three years. These documents can be obtained from the seller. After you have all this information, complete your financial evaluation on the property to ensure that it produces the type of returns that you expect or desire.
i Rent rolls: A rent roll is essentially an attendance sheet for all the tenants. It displays the tenant name, unit space or square footage, amount of rent paid, move-in date, lease expiration date, and security deposit. When you have the rent roll, verify the rent amounts with those given on the lease agreements. Also, add the total income of the rent rolls and compare that with the income and expense statements amount. If you notice any discrepancy here, put up a red flag and investigate further.
i Tax returns: Obtain the property's tax returns for the past three years. If there's a single owner, you only need to review that return. If the property is operating under a partnership agreement, you need to get every partner's tax return for the property. Add up all the income and expenses shown on the tax returns. These numbers should match those from the property's income and expense statements. If they don't, ask yourself a question: "Which would you believe? The IRS tax returns or documents that the seller produced?" Crunch your numbers again and see if the property still produces an acceptable return for you. If the discrepancy is in your favor, that's okay, but if it's not, you may have to renegotiate the terms of the deal to meet your objectives.
i Lease agreements: A lease agreement can be a complex legal document. We suggest allowing someone who has expertise with that type of lease do the auditing for you. If all the leases are the same, such as in an apartment building, have an attorney review the first few to make sure that they're valid. For every other category of commercial real estate, we suggest verifying the leases by using an estoppel letter. This letter confirms that the lease is true and accurate and is the only agreement that's made between the tenant and the owner.
Pay strict attention to the expiration of the leases of each tenant. What if a good portion of the tenant leases expire next year? Do you have the financial strength to carry the property while it's being filled up again (which can take several months)? For the tenants that have upcoming expirations, do you have the right to renegotiate the leases even if you aren't the owner yet?
i Utility bills: Obtain the past two years' worth of actual utility bills for the property. These bills include electricity, gas, water, sewer, trash, telephone, cable, and Internet service bills. Compare the totals of each utility category to the seller's total given on the expense statements. If the numbers don't match, put up a red flag. Reevaluate the numbers and see if the deal is still worth making.
i Property tax bills: Obtain the past two years' worth of property tax bills. Verify the amounts with those given on the seller's expense statements. Again, if the numbers don't match, put up a red flag and investigate the discrepancy. Reevaluate to see if it's still a good deal. Also, call the tax assessor's office and find out how the property will be reassessed and how often after you become the owner. It's a good idea to figure this property tax increase into your expense calculations as the new owner. It also varies from state to state. For example, in California the tax rate is roughly 1 percent of the sales price, but in Texas, the tax rate is about 3 percent of 80 percent of the purchase price.
Getting assistance for the financial portion of your due diligence is critical if you're just starting out. As mentioned in the checklist, leases can be complex and they're extremely important. So, you can't be lax. Until your skill level increases at deciphering income and expense statements, we recommend having a more experienced investor or mentor review them along with you. And as for hiring an accountant to review any of the financial documents and tax plan for you, make sure he or she has relevant real estate work experience. A lot of times we discover that being book smart in crunching numbers and tax planning just doesn't cut it. Pay for good experienced help. You owe it to yourself and to your future with this property.
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