From Wikipedia – “Due diligence is a term used for a number of concepts involving either an investigation of a business or person prior to signing a contract, or an act with a certain standard of care. It can be a legal obligation, but the term will more commonly apply to voluntary investigations. A common example of due diligence in various industries is the process through which a potential acquirer evaluates a target company or its assets for acquisition.”
Due diligence has been common practice in many areas where a potential buyer is looking to buy an asset of some description. In the field of property, carrying out due diligence is and has been common practice in the commercial property world but this has not been the case with residential property, perhaps with the exception of some professional landlords.
The concept of buy to let was launched by ARLA, the Association of Residential Letting Agents, in 1996 and quickly generated substantial public interest across the UK, both in respect of buying to let in the UK and overseas. Concurrently a whole host of training organisations sprang up to “educate” the public in the “dark” arts of making millions in property without risking their own money using ever more “creative” concepts, whilst not really explaining the dynamics of property investment. Greed was the driver and the ever rising values of property, almost regardless of location, were the food that fed the greed.
I have been one of those educators, since 1996, although I would like to think that the seminars and workshops I have presented have been ethical and have fully explained the dynamics of property investment and the inherent risks. For example, way back when valuations were being inflated on new build and loan to values were based on the inflated valuations, I was pointing out that a property had to sell at the inflated value for this to become an Open Market Value on which the LTV of a mortgage could be based and I was often rubbished for my protestations. I could give you a number of other examples but I am digressing from due diligence.
One thing that is certain is that had I tried to teach due diligence then as I do today, I would probably have had a number of my students walking out because they were there to learn how to become a millionaire overnight and easily and “don’t bother me with the detail”.
Today though, the whole environment has changed, and I think it is unlikely that we will ever return to the market conditions that existed through the 10 years from 1996-2007. For a considerable time to come everyone will be far more cautious about getting involved in property investment and this includes the lenders without whom, as we have already learned, there isn’t any property business.
Whilst there are still some investors who are prepared to take what I would regard as a “cavalier” attitude, most are looking to act responsibly, gain a real understanding of the dynamics of the market and develop and operate a relatively risk-free strategy rather than the high-risk strategies which were prevalent in the past 10 years, to the substantial cost of investors.
The results of these high-risk strategies are most obvious in the auction rooms today where properties are being offered at auction at 50% or less of their 2006 – 2007 “value”. Even at 50% – I deliberately haven’t used the word discount here – a number of these properties, particularly apartments, are still not selling and so the lenders are reluctant to lend against them.
This brings me to due diligence. I firmly believe that, as the dust starts to settles on the recent excesses in the residential property investment industry, the suppliers who investors depend on as well as the lenders will look to make sure that the borrower has both a viable business plan which allows for changes in market conditions and is able to show that he has carried out due diligence on each individual investment.
The lenders will do this for 2 reasons: 1. to protect their investment, the money they have lent the investor and 2. to protect themselves from being attacked and possibly sued for irresponsible lending.
In my view Due diligence splits into 2 parts.
Part 1: Research on the location in which the property is sited.
I use the word location, as it is a common term in the property world though I would prefer to use the word neighbourhood since we don’t really live in a “location” but we certainly live in neighbourhoods with neighbours who we may or may not enjoy.
Also, it is difficult to conceive, without any preset parameters, the size of a location. I don’t think a large city can be a location but a small one certainly can be. Personally I am based in the ‘small’ city of Oxford. A town or village can be a location but in terms of due diligence on where a property is sited, we’re still talking about too large an area. Within a city or town a suburb is possibly the right size.
In my view, a location for the purpose of Due Diligence is an electoral ward, which can be broken down into a number of neighbourhoods, dependent on the physical structure of the Ward. I live in North Oxford and have carried out due diligence on the electoral ward I live in. I have broken down the Ward into 5 separate neighbourhoods, each of which has very different criteria from a property investment point of view.
By carrying out this in depth due diligence, I learnt a lot about the Ward I live in that I was unaware of before, even though I have lived in and around this area for close on 30 years. For instance, even though North Oxford is supposedly the most expensive property area in Oxford, within my Ward there are 3 or 4 streets which feature in the top 10 cheapest streets in the city according to mouseprice.com.
So, due diligence on the neighbourhood in which you are going to invest is vitally important and should enable you to demonstrate to those interested why your investment will be viable both in the short and long-term. I would advise including in your due diligence the neighbourhood, which should be quite a small area, the electoral ward in which the property is located and the suburb in which the electoral ward is located if the two are not the same.
How you carry out this due diligence will be the subject of another article.
Part 2. Research on the property.
This should be associated with your customer, your tenant (buy to let) or buyer (buy to flip) as the two are effectively joined at the hip and either, from an investment perspective, does not exist without the other.
Now before I expand on carrying out due diligence on the property, the question that arises is: Which comes 1st, the location in general terms, and by that I mean the town or small city, or the property.
This should depend on your strategy and as there is no single right strategy, your strategy should reflect what you want to do because at the end of the day there is no point in trying to develop a strategy which really doesn’t excite you.
To be successful you need to be excited about developing your strategy and that excitement must be generated by more than just making money. I don’t propose to expand further on strategies in this article, except to say that in settling your strategy, you will have decided on the type of property you intend to buy and who your customer is.
In carrying out due diligence on the customer and the property you need to be able to prove that the first fits the second, both today, tomorrow and, if the strategy is buy to let, for the next 10 years.
The principle driver in due diligence is ultimately the customer. Your “choice” customer determines what type of property you should buy, the standard and facilities that are included in the property and the neighbourhood in which it is located.
Your customer will also dictate the rent that you can charge (buy to let) or the actual sale price as against the asking price (buy to flip). By default, your customer therefore dictates the price that you can afford to pay for the property, after deducting acquisition and renovation/refit costs.
So in preparing your due diligence on your investment proposal you need to demonstrate that your customer exists as well as the source of said customer.
Let’s use students for the purposes of this example.
In carrying out your due diligence, there are a number of questions that you should answer about who your customer is.
- What is the source of students, which university or college?
- Do the students need rented housing outside of the University or College. Remember, many universities and colleges house their students.
- Assuming the answer to the second point is yes, does the University have any plans to increase their in-house accommodation within the next 10 years.
- Does the University intend to relocate within the next 10 years.
- Does the University intend to expand over the next 10 years.
Assuming you have proven you have a customer, you must go on to define what that customer wants.
Something I have preached for many years is that your property should always be “1st choice” for your chosen customer. In achieving 1st choice, you need to be able to marry up the neighbourhood with the property, with the standard, with the cost (rent/sell price) and with the local facilities.
Quite possibly the 1st criterion from our students’ point of view is the neighbourhood. What facilities and amenities are available nearby and are they student oriented? Neighbourhood is also often the 1st criterion for other customers although they will likely be looking for slightly different amenities and facilities.
The next criterion is standard: What is the customer getting for his money? This, in the case of students, may be determined or influenced by the university or college that they are attending as many universities inspect the housing they list for the students.
The third criterion will likely be cost which will be driven by what your customers can afford coupled with Neighbourhood/Ward comparisons. Most of your customers will already have researched where your property is located to decide whether or not they can afford it and whether it is worth progressing any further. If they can afford it, they will contact you.
So to summarise, I believe that demonstrable due diligence on an investor’s project will become increasingly important to the lenders in future. As a result it should be top of the list for any investor, if they are concerned with mitigating the risks inherent in any property investment.