What Ever Happened to Due Diligence?

By Frank Forte

The end of 2022 has taken professional investing’s reputation on a rough ride. Hardly a week goes by without prominent headlines that highlight the epic implosion of yet another high-flying, over-hyped company. Theranos is one example. Investors such as Oracle founder Larry Ellison and media mogul Rupert Murdoch failed to see the blood-testing company was actually a scheme — in November, founder Elizabeth Holmes was sentenced to 11 years in federal prison for defrauding investors.

FTX proved to be another glaring blind spot for professional investors. Valued at $32 billion in early 2022, the cryptocurrency exchange collapsed in November. Among those who lost millions on FTX was “Shark Tank” investor Kevin O’Leary.

Why do so many highly-experienced investors fall for the hype? How can these smart people get duped by “visionaries”? The answer rests with two words that too many investors overlook: due diligence. It’s worth noting that O’Leary, who also served as a spokesperson for FTX, has said publicly that he failed to conduct enough due diligence on the company. Let’s learn from these cautionary investment tales and consider the vital role of due diligence. 

What Is Due Diligence?

Due diligence is a rigorous process that seeks to answer a vital question: Will this investment live up to its promise? Although the specific approach to this deep-dive analysis will vary by industry, it generally involves evaluating the financials, conducting onsite visits, and speaking to customers. The recent investment schemes mentioned above were made possible because due diligence was not a priority. Instead, investors used groupthink as a lazy shortcut: “If X and Y are funding this one, it must be a good opportunity.” The current disregard for due diligence was on full display when Sequoia Capital chose to invest more than $200 million in FTX, despite the founder Sam Bankman-Fried playing video games during his pitch.

Although early investment rounds can produce attractive returns for investors, that sense of urgency creates problems when the due diligence process gets rushed. Decisions should be governed by a detailed, informed analysis, not by FOMO (fear of missing out). It’s true that thorough due diligence is painstaking work— but not nearly as painful as the feeling you’ll get after losing millions on a poorly-vetted investment.

The Essential Role of Due Diligence in Real Estate Investing

Fraudulent schemes are less common in real estate investing because the due diligence or underwriting process is much more stringent and regularly followed compared to other investment areas. For real estate, the main steps in this process typically include:

  • Examining financials
  • Onsite property due diligence visits
  • Evaluating the market fundamentals, including visiting similar properties in the area
  • Analyzing tax implications on the individual property and the overall investment portfolio
  • Meeting the tenants
  • Meeting with property management
  • Evaluating insurance needs and comparing provider quotes

At Lucern, the underwriting process is integral to our investment strategy. That’s not the case with all real estate investors because some rely on macroeconomic factors to drive value. When investors only seek the next “hot location,” they’re taking a short-sighted, risky approach. Instead, our priority is long-term sustainable cash flow. Before we invest, we spend an enormous amount of time getting to know a market, the community, and the market players. Our evaluation of assets includes speaking to tenants and property management teams, as well as studying similar assets. Our commitment to due diligence doesn’t end once a deal is complete, because we conduct ongoing due diligence on the markets where we invest.

Let a Detailed Process Be Your Guide

When experienced investors are duped by lofty claims, it’s a stark reminder of what happens when “great opportunities” lack a proper audit. Recent investment debacles underscore the need to restore standards around deal evaluation. To determine if an investment is too good to be true, investors need a detailed view of company operations and potential cash flow anomalies. It’s time for professional investors to get back to basics and conduct due diligence before investing. Instead of getting caught up in FOMO around a much-hyped deal, proper due diligence allows investors to savor JOMO— the joy of missing out— on bad investments. 

Contact us to learn more about multifamily real estate investing with Lucern Capital Partners.