Never Skimp on Due Diligence

​I work in the real estate industry and it’s not a well-kept secret that due diligence is rather tedious and boing. I don’t know a single investor who relishes it, yet every good one knows it’s absolutely essential.
 
On one of our first deals, the property looked all well and good after we got it under contract. What I took for “thorough” due diligence at the time was painfully inadequate, however. And I learned this the hard way as a week after the tenant had moved in, raw sewage started backing up into their bathroom.
 
And let me tell you, there’s no way to endear a landlord to a tenant’s heart better than raw sewage spewing out into their home!
 
Unbenownst to me, the sewer line had collapsed when long before we bought the property. Not only did we have to dig it up and replace it (at the cost of about $5000), we also had to put the tenants up in a motel for a few days and offer them a rental discount.
 
An expensive lesson, but sometimes such lessons are necessary.
 
Later on, we came across a similar situation with a fourplex which I wrote about in more detail here. This time we had the sewer line scoped (at the cost of about $250) and found it had collapsed. We went back to the seller and got the price reduced $10,000! Not too shabby.
 
And this is by no means isolated to investors who specialize in single family houses and small multifamily properties. Missing essential items and going wildly over budget is a national pastime in real estate from big to small. For example, the amazing Sydney Opera House was supposed to be built in four years for $7 million. 14 years later and over $100 million down the tubes, it was finally finished. As beautiful as that building is, it represents what is perhaps the all-time biggest failure in budgeting and due diligence.
 
Due diligence is, of course, not something that only applies to real estate. As I’ve put it elsewhere,

​“…The purpose of performing due diligence in real estate is to confirm what you believed to be true about a property when you got it under contract.
 
“While it can be arduous… [it] will help you avoid any unwanted surprises and greatly increase your confidence in the investment. And what do new investors need more than confidence?”

​This applies just as well to stocks, bonds and acquiring businesses, brands or technologies as well as a myriad of other investments just as well as it applies to real estate.
 
Indeed, it’s not just important for new investors, as there is a tendency amongst seasoned investors to become more and more complacent as they start to believe they “know everything.” They get cocky and then they start making mistakes. We’ve seen this at the highest levels of the corporate world over and over again. Indeed, it doesn’t take long to realize Time Warner failed spectacularly when performing sufficient due diligence before its ill-fated merger with AOL.
 
Regarding due diligence on stocks, there’s no better place to turn than Benjamin Graham’s classic book The Intelligent Investor. For investing in startups, Rayyan Islam puts it well, noting that it involves interviews, web research and talking to “friends and enemies” alike.
 
Throughout his article, Islam’s most important point is that “most meetings you should be going into prepared to say ‘no.’” While lots of ideas sound good on paper, in the real world, most of them don’t work out; especially regarding startups. Good ideas can often be ruined by poor leadership (remember, you’re evaluating not just the business, but the team). Strong underlying fundamentals might be doomed because of competition (say an online sales platform with the specter of Amazon hovering above it). And on and on it goes. Jumping at every new shiny object is bound to lead to failure.
 
Islam notes the four key areas to investigate for investing in startups as follows,

• “Figuring out Four Key Areas
  • - People
  • - Product
  • - Market/Traction

- Deal Terms”

​It’s interesting to note that when performing due diligence on a piece of property, the vast majority of your time should be spent on evaluating that property itself and its financials. With regards to a startup, it comes down to the product, financials and most importantly the people running the company. Due diligence differs widely based on the type of investment you are investigating. But the one consistent theme is that it must be done thoroughly and objectively.
 
For this reason, I highly recommend putting together a checklist of all the key steps you will take when evaluating whatever type of investment you are looking into. Those doubting this would be well served to read Atul Gawande’s classic book The Checklist Manifesto and the numerous examples he cites of the improved performance a checklist brings about. We all have the tendency to skip things, especially boring and routine things we feel like we have down by the back of our hands. This can spell certain doom when buying a stock, property or investing in a startup.
 
Due diligence may be tedious and even boring. It’s the unsexy side of business big shots don’t like to talk about. Nevertheless, due diligence is absolutely essential.