Investors make money either by increasing revenues or decreasing expenses.  The expense side of the ledger is very tricky.  At times, it will be important to spend money on regular maintenance items in order to avoid a much larger issue in the future.  Investors should keep this simple concept in mind as they tackle the due diligence of expenses.

When beginning the due diligence process, it is important to verify exactly what was spent.  Most property owners should have a list of major and minor repairs since they purchased the property or at least over the last five years.  Match these expenses with cancelled checks or bank withdrawals.  These should also be given to the property inspector so that they can verify that the work was done as well.  This should also be done with monthly expenses like utilities, taxes and standard repairs/maintenance items.

The next step in this process is to determine what work should have been done vs. what work was actually done.  Deferred Maintenance is a real estate term that describes necessary maintenance items that have been pushed out to save property owners cash today, typically at the expense of significantly more cash tomorrow.  Remember, the value of the property is equal to the net operating income divided by the capitalization rate.  If owners know they will sell their property this year or the next year, expect them to delay expenses to inflate their net operating income to increase the overall property value.

A traditional property inspector can spot deferred maintenance right away.  Small leaks that were never fixed can turn into significant water damage or worse, create conditions for mold to thrive.  Tour the property with the property inspector and ask them to point out any areas where deferred maintenance could exist.  This helps an investor in two ways.  First, it gives the ammunition to renegotiate the selling price.  Second, it helps the investor understand what kinds of items need regular preventative maintenance to avoid major headaches down the road.

The expense side of the equation also represents a hidden value in the property.  Hands off managers could be running expenses too high by paying outside property managers, who have no vested interest in keeping expenses in line.  Appraisals offer an easy check for expenses.  Most appraisals have a section that outlines market expenses.  Check these against the subject property’s expenses.  If the potential investment properties expenses seem too high, ask questions of the owner or the management company.  Older properties typically require more maintenance and have higher yearly expense costs.  Consider installing newer equipment to save money.  Refer back to the renovation section to figure out how to determine if an upgrade is really worth the money.

Expense should be monitored carefully and check against bills and cancelled check or bank statements.  Getting a handle around the expense side of the property could present an opportunity to significantly increase the value of the property.

Investor should be able to make money both buying and selling real estate.  Perfecting the due diligence process is a great way to save money when purchasing a property.  The first step in the due diligence process is to verify the revenue stream.  In order to verify the revenues an investor should request the following documents: Rent Roll, Operating Statement, Rent Receipts, Bank Statement to verify deposits and either the owner’s tax record (past 3-5 years) or the LLC’s tax records if the property is incorporated.

All of these documents work in conjunction with each other.  The rent roll represents the highest possible collected rent.  Assuming every tenant pays on time every month, the operating revenues should match the rent rolls exactly.  This is rarely the case.  Some times tenants receive rent concessions, they pay late, move out mid-month, etc.  The closer the total rent roll and the operating rent are, the better the collections and the higher quality the tenants.  It is a sign of a good operator.  On the other hand, huge disparities could mean an opportunity to increase value significantly through sound operational excellence.  The further the gap, the more important it is to verify all of the items listed above.

Rent receipts and bank statements should be used to verify the rent collected in the operating statement.  It’s very easy to falsify receipts.  While landlords typically will not do this to inflate the NOI, they will do this to give the perception that their tenants pay in a timely fashion, when in reality they do not.  Comparing monthly deposits is a way to ferret out this issue.  In this case, monthly deposits should match the operating statement exactly.

Tax records should be used as an additional check.  Some can be hard to navigate depending on how they were prepared and whether the entity is a stand alone LLC or tie to other properties, but sellers should be willing to provide this information to potential investors.

Remember, all sellers are not created equal.  Some sellers will be able to produce all of these items with no problem, while other sellers may not even have a current rent roll.  Be firm and adjust the offer price according to the data provided.  If there is no way to verify the last 12 months of Net Operating Income, the offer should be extremely conservative.  If bank records cannot be provided to prove when rent was collected, assume a higher than average bad debt collection and reduce the price accordingly.

The due diligence process is designed to mitigate risk.  Even if an investor chooses to purchase a property after receiving very little information, the investor knows the risk of that decision.  Failing to do proper due diligence leaves money on the table.