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Why careful due diligence is so incredibly critical to being a responsible, smart investor, explained by Wharton Emeritus Professor Peter Linneman.
BRUCE KIRSCH: Learn about due diligence analysis. And this is probably the least high-profile and the least sexy part of the real estate business. And this is probably the last reason why students would be attracted to working in commercial real estate.
Typically, they gravitate towards it because what they perceive is a lot of glamour, these huge transactions that are in the headlines, beautiful architecture that’s being pulled out of the ground, and the fancy cars that some people drive, and they know that they’re in the real estate business. And so due diligence is on the total opposite end of the spectrum, but is as important as it is unsexy. So how can we get students to value the significance of it?
PETER LINNEMAN: You know, it is the reason I put the chapter in the book. I think, as you know, if you looked at most books, you will not find anything on due diligence. And you go, really?
This is the process of proving out that the things that I’ve been told or things that have been represented to me are really true. What– I’m going to take at face value everything a broker tells me? I’m going to take at face value all my biases or vague remembrances or assertions by a seller, I’m going to take at face value? Of course not.
It is so important because you’re buying it in the belief that those things basically are true. And therefore, you better really spend time figuring out is it true? If they told you the leases last 10 years, you better check and make sure the lease lasts 10 years. They told you the lease was for $20 a foot. You better check it out. They told you that there’s no loan on it. You better check that out, and just on and on and on.
And it is absolutely critical. The most critical part of the acquisition process, bar none, is due diligence. Since it’s not mechanically numerate, and you can do it in your office at 2:00 in the morning on a spreadsheet, a lot of young people believe it’s not critical.
It is not necessarily creative, but it is essential. It’s careful work that has to be done. And quite frankly, it’s how you learn the business because you find out all the tricks. You find out the trick is, yes, there are no property taxes, but that’s because the building nine years ago was given a 10-year tax abatement. So it’s true what they told you. But the first year you own the building, you’re going to pay taxes.
And you just kind of learn all these tricks for– yes, you told me you replaced the elevators. I assumed you replaced them with modern system elevators. But they’re not modern systems elevator, and I assumed that I had a modern system elevator. You told me that the roof was repaired recently, but you didn’t tell me that it was just patched, as opposed to replaced, on and on and on and on.
I don’t know how you make it sexy, but it is critical, and it’s how you learn the business. You learn much more about the business doing due diligence than sitting at a spreadsheet. They’re both important in the process, but due diligence is far more important.
BRUCE KIRSCH: I like to think of it as a flight check. Let’s say you’re–
PETER LINNEMAN: That’s well said.
BRUCE KIRSCH: You’re a fighter pilot, and you’re on an aircraft carrier, probably worth your time and effort to do one last check, or have your specialist do that one last check down the entire list. OK, do we have the fuel that we need, and so on and so forth. And where are you guys going to be when I come back and I’m on fumes? Let’s just double-check things.
PETER LINNEMAN: Perfect analogy. Perfect analogy. And it doesn’t seem as sexy as flying, but nobody would fly without doing it.
