Due diligence in a property investment offer

Jun 14, 2023 | Property Investors

The importance of due diligence when presented with a property investment offer

A businessman reviewing property investment offer.

A businessman carefully analyzes a property investment offer.

 

 

 

 

 

 

 

This is what you’ll learn after reading this article:

  • Understanding the concept of “due diligence”
  • Defining due diligence in the Context of property investments
  • Comparing Due Diligence in Property Investments to Other Purchases
  • The Scarcity Mindset and Blind Trust in Property Deals
  • Balancing Risk and Action: The Role of Due Diligence
  • Common Property Investment Advertisements and Due Diligence
  • Summarizing the importance of due diligence in property investments

 

The importance of due diligence when presented with a property investment offer

First, let’s grasp the true meaning of “due diligence” and its importance.

Tips on what due diligence is and the impact on property investment

According to one dictionary meaning “due diligence” means “the reasonable action that a person takes on a proposition to keep him safe from potential harm”

Investing in property can result in financial losses, which corresponds to the mentioned dictionary definition’s concept of “potential harm.” Don’t get me wrong. There is not one investment that can give you guarantees. If someone guarantees you an investment return, run as far as possible. We do our best to ensure that we minimize potential risk or loss when it comes to investment, but there are no guarantees.

This is where due diligence comes in when we invest in property; “…doing our best to ensure that we minimize potential risk or loss…”.

Comparing Due Diligence in Property Investments to Other Purchases

When people buy a car, they first read up all about the car. They speak to friends and family who may have had experiences with the particular car. When they get to the dealership, they ask the salesperson a long list of questions. They will test drive the car only when they are satisfied with the presented information. And only then will they make an offer on the car, if at all.

The same applies to taking out a cell phone contract. We compare the contract benefits to similar offerings from other service providers. Then we weigh up whether the cell phone package will meet our needs in terms of talk, SMSs, and data. And also explore the features of the actual cell phone.

It’s known as due diligence. We “take reasonable action” to “keep us safe from possible harm”. In both instances, the “possible harm” refers to financial loss or tying us into a contract or agreement that we cannot get out of. We do our due diligence on the car and the cell phone to minimize the risk of a bad investment.

Here is my question… If we do so much due diligence on a car and a cell phone purchase, then why do we not exercise the same amount of due diligence on the acquisition of an investment property? After all, a property may be the most expensive acquisition that we may ever make in our lives. The intention is also to keep the property for much longer than the car or the cell phone. We are ultimately looking for a solid investment.

The Scarcity Mindset and Blind Trust in Property Deals

Here is a possible answer. Contrary to what many experts may tell you, great property investment deals are not around any corner. If they were, everyone would be investing in property and there would be no need for feasibility studies and due diligence tick boxes on a deal. So, the next time someone tells you that property investment deals are everywhere, challenge the person and ask him to bring you a deal within seven days.

People often overlook the scarcity of deals and blindly trust sellers, neglecting their own due diligence on seemingly “good deals”. They want to trust blindly, and then they go for it, hoping for the best.

Why do we want to trust blindly? Well, there is the promise of making money; lots of money. This blind trust stems from a place of scarcity. We want to believe the person so very much that they will give us a great return on our investment which will hopefully be the end to all our money problems. You often get deceived and taken advantage of. So, what should we do instead? Approach any property investment deal from a place of abundance. Know that if this deal doesn’t work out after you’ve done your due diligence, there will always be more deals to consider.

Blind trust arises when people grow impatient waiting for the perfect deal, leading them to trust without hesitation. There is the thing; the right deal will make its appearance. Just keep going at it. You never want to commit to a deal from a place of desperation. You become clouded by what is actually in front of you when this occurs.

Balancing Risk and Action: The Role of Due Diligence

Having said all of the above, I’m not saying over-analyse a deal and never take action. Far from. We have to take risks in life, and this is also true when it comes to property investment. However, let us not make uninformed investment decisions. Let us not take uncalculated risks. The potential loss can be too tremendous. I’m saying do due diligence on a deal. Minimize the risk. Know what you are getting yourself into.

 

Common Property Investment Advertisements and Due Diligence

Here are a few examples of property investment adverts where you need to exercise due diligence before going into that specific property investment deal:

“This property will cashflow from day one”

That is quite a bold statement to make. When you enquire about the deal, ask “What do you mean by cash flow from day one?”. It is important to know how someone else has quantified a deal standard. They might have left very important information out of the calculation. For a property to be cash flow positive from day one, your calculation should be:

  • The gross monthly rental income
  • MINUS:
  • The bond repayment
  • The rates and taxes
  • The levies (if it is in a sectional title scheme. However, if it is a freestanding property, you calculate your own levy amount as you would have to pay building insurance and security)
    Property management
  • EQUALS: A positive cash flow. After paying these costs, you need to ensure a monthly surplus in your bank account. Your net operating income, after settling all net operating expenses, is also known as the preferred term.
  • The above costs are the bare minimum that you need to have a positive cash flow each month. There are other expenses that I have not even taken into account, like an amount for maintenance and a vacancy rate.

“Rental income of up to R7000 per month”

You are given the best-case scenario when using the words “up to”. “Up to” also refers to “the best that you can get”. We don’t perform feasibility studies and due diligence based on best-case scenarios They are done in worst-case scenarios. You want it to still be a good investment even in the worst-case scenario.

Let’s assume you have done your calculation on the best-case scenario of R7000, and when you take occupation of the property, you cannot secure a tenant for R7000 per month, or even at R6500 per month. You now have to drop your price to R6000 per month just to get a tenant in the property. You are now less than R1000 below your initial calculation. On a two-bedroom, one-bathroom apartment, this is a huge amount and can cause you to go into a negative cash flow, which means you will have to pay every month on the property.

“Guaranteed rental income of R7000”

The word “guaranteed” is a sales technique to make you trust what they are saying. When it comes to investments, we don’t just trust, blindly. We do our due diligence.

Get the exact street name and suburb of the property with the “guaranteed R7000 rental income”. To find rental prices for two-bedroom, one-bathroom apartments in Ferndale, Randburg, visit www.property24.com and search for listings in that area. You want to get the average rental income. For instance, take at least six properties with the same specs, add up the total rental income, and divide it by the number of properties. This will give you the average. In this instance, we are looking at six properties.

In order to compare apples with apples, you need to take it one step further. Calculate the average square meterage of the unit you want to buy and apply the same calculation to the advertised units. For instance, if an 84m2 two-bedroom, one-bathroom apartment in Ferndale fetches R7000 in gross rental income per month, and the unit that you are hoping to purchase is 48m2, the chances are zero that your unit will also fetch R7000. The square meterage/size of the unit influences rental prices, along with its location and features.

“No bond and transfer cost”

No bond and transfer cost does not mean you are buying a bargain. It means there are no bond and transfer costs payable. Sometimes we have to see something for what it is. Be cautious with the packaging of information, even though it is accurate. Ensure it is presented correctly. Great, there is no bond and transfer cost. I get to save a few rands on this purchase, but is it a good investment? You could be paying a monthly shortfall on a property in an area where there is no growth, but hey, you saved on bond and transfer fees. If the investment is wrong, the “no bond and transfer cost” should not make any sense. Please be aware. A few rands saved upfront, does not equal a good investment.

“A great 5000m2 land for development for only R300 000”

Wow, it does sound like a great deal, doesn’t it? You may have R300 000, or the bank will definitely give you a loan for R300 000. Let’s buy it. A deal like this might not come around soon. I can build twenty units and rent them out and make lots of money. This is what goes through our heads, right? Be very careful about such thinking. Don’t accept any investment deal without analyzing it thoroughly.

The Importance of Verification and Independent Analysis

Anything to be checked before you buy this “great piece of land”?

  • What is the current zoning? And the zoning requirements must be met to build the desired twenty units on this land?
  • Does the soil in the area allow me to build a four-storey development or can I only develop single-storeys?
  • Are there bulk services and even if there are no bulk services, will the municipality approve additional water and sewerage for an additional twenty households on this piece of land?

Before you buy any piece of land because it looks like a good investment, first decide what you would like to do on this land, and then find out if it is possible. Beware of land sellers trying to deceive you with worthless properties, banking on your inability to recognize the scam.

“Invest R500 000 towards this development and your investment is immediately worth R1 500 000.”

Great. Thank you for your offer. Please send me the breakdown. How do you get to this calculation? Where is this development based? How many units are in this development? What are your development costs? What is the per unit cost of the development? How will my R500 000 investment immediately be worth R1 500 000?

After you have received all the information, you now need to go and verify everything. Once you have done so, your reply to the person who sold you the investment opportunity will probably look something like this:

Thank you for presenting this opportunity. However, if you are building X number of units in Sunnyside, Pretoria, where the market value of similar units currently is R500 000, I’m not sure how it will go up to R1 500 000 in value. Your offer does not have a cash flow component to it. However, if I take my R500 000 and I buy five units in Sunnyside through making use of home loans, and I put R100 000 towards each of these units, I will be cash flow positive on each of these units from day one. I will thus not be looking into your opportunity.

Very often this developer will try and sway you with a feasibility model that makes no sense to you. Remember, Warren Buffet’s number one rule when it comes to investment is, only invest in something if it makes sense to you. If not, stay away, and save yourself hundreds of thousands of rands.

Conclusion

There are still hundreds of examples that I could give of how you need to exercise caution before you “invest” in a property. You must do your own homework when presented with an investment property. These examples will help you understand why. Do not ever trust blindly that whatever is presented to you, is actually 100% accurate. I always say, “When you want to know about the benefits of ice cream, you don’t ask the guy who is selling the ice cream”. He has got one objective, and that is to sell his ice cream.

Happy investing and be safe.

Updated 19 March 2023

 

 

 

 

 

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