500 word Forum Post Response to another person's post.
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At the core of every investment decision is the goal of maximizing profit while minimizing risk. When making investment decisions, most real estate professionals examine a variety of financial figures, ratios, and purchase and exit scenarios to determine the prudence and profitability of a particular investment. However, just as important as identifying all areas of profitability is identifying all areas of investment risk.
Risk represents any obvious or hidden potential for loss. Realized risk that has not been planned for or mitigated can instantly transform a seemingly lucrative investment into a financial, environmental, or even legal burden to the investor. In addition to examining areas of revenue, investors should also engage in due diligence.
Due diligence involves executing thorough research for the purpose of identifying any and all potential investment risks. Completing proper due diligence is an essential step in making an informed decision of whether to pursue a particular project as planned, engage in an investment with a different strategy, or forgo the project altogether.
The importance of proper due diligence is outlined in an example given by DCMI Mid-Atlantic, a real estate consulting and construction management firm based in Warrenton, Virginia. The firm recently worked with a borrower who purchased what many investors would consider a promising acquisition. The property was a vacant 12-unit apartment in the heart of Washington, D.C.
The Capitol Hill property was in good shape. Capital for acquisition and renovation costs was easily approved by lenders; and financial projections predicted positive cash flow after six months. However, soon after the purchase, the borrower was faced with several costly and time consuming hurdles; which may have been avoided or prepared for had the investor taken adequate due diligence measures.
The first hurdle involved the city zoning board’s decision not to approve the addition of two new lower level apartment units. As a result, the investor’s income projections for the project and the property appraiser’s initial valuation for the complex became inaccurate. The investor was placed in a position of reduced revenue potential and the lender was locked into a reduced leverage position. Moreover, the investor had to procure expensive, newly revised architectural drawings and restart the city permitting approval process. The investor lost money through both additional expenses and as a result of prolonged tenant vacancy.
Once demolition was underway, the construction firm discovered asbestos in the property units. In this case the construction firm acted appropriated and properly removed the asbestos. This resulted in further time delays and a tremendous increase in the investors planned renovation costs. Had the owner or the construction firm decided to act improperly and conceal the discovery of asbestos, the owner may have found themselves in the significantly worse position of legal and environmental misconduct.
In the end, the investor missed the ideal timeline to offer their units in the market, missed lender payments, and was forced to pursue an expensive loan modification. The increased costs and loan modification dramatically altered the long-term profitability for the entire acquisition.
The investor failed to pursue even basic due diligence actions. “Due diligence independently verifies all representations made by a prospective client and uncovers pertinent facts that may not have been disclosed but are important to the success of the project,” explained Val Riccardi, a principal with real estate consultancy DCMI Mid-Atlantic, Inc (DCMI, 2012)
In a major city full of bureaucrats, it is not unlikely that city planning boards may offer more scrutiny and roadblocks. The new owner may have avoided this situation by taking additional time to seek tentative construction approval prior to procuring the property. Moreover, the investor could have noted the age of the building and chosen to initiate a more thorough inspection for potential environmental dangers. They may have also chosen to develop a contingency plan for such issues; taking into account alternative income and borrowing scenarios.
DCMI Mid Atlantic (April 2012) Capitol Hill renovation project gone awry underscores importance of real estate due diligence. Business Wire. Retreived from: http://web.b.ebscohost.com.marylhurst.idm.oclc.org/ehost/delivery?sid=282c36da-c199-457f-a66d-303ba06dfda5%40sessionmgr113&vid=38&hid=124&ReturnUrl=http%3a%2f%2fweb.b.ebscohost.com%2fehost%2fdetail%2fdetail%3fsid%3d282c36da-c199-457f-a66d-303ba06dfda5%2540sessionmgr113%26vid%3d37%26hid%3d124%26bdata%3dJnNjb3BlPXNpdGU%253d
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||07/02/2015 06:00 pm