5 Questions To Ask When Carrying Out Effective Due Diligence?

Due diligence might not be the most sexy topic but it's arguably one of the most important.

It therefore worries me the amount it is often misunderstood, overlooked and undervalued.

To me, the difference between a professional investor and an amateur is the ability to carry out effective due diligence and understand the risks behind something.

Finding a balance

There’s a fine line between analysis paralysis and diving into a deal, or project head first without a care in the World (that overused phrase ‘go hard or go home’ gives me shivers and should never be used).

Personally, when I invest, I want to know enough about an opportunity to give me comfort before making a decision, making sure that:

1. I know enough about the risks.

2. I know how to deal with risks should they occur.

3. There aren’t many (or any) risks I’m not aware of.

Comfort means something different to different people, but this blog aims to get you thinking more about risk and how to better protect yourself.

What is due diligence?

More importantly, what do you need to do before you make a start with due diligence?

You’ve already taken the first step: stopping to think about it. So, what else do you need to know?

‍It takes time.

Proper due diligence can be a lot of work, especially at the start. But the difference between investing and gambling is knowledge. If you want get-rich-quick, you might be more at home in a casino.

‍The more you know, the better you’ll be.

It’s impossible to know every risk, but each one is a step closer to control. That means understanding the market as well as the investment.

You’ve probably heard of ‘SWOT analysis’ before. It’s not a new term, and with good reason... it really works.

• Strengths

• Weaknesses

• Opportunities

• Threats

Don’t over complicate this process.

The point is to spend time thinking outside the box (a skill all good investors develop).

Make a spreadsheet or a handwritten list then build the details as you go. You could take a look at Mindmeister for a place to let the creative juices flow.

When this is completed, and we have significantly more clarity on the potential of this opportunity, we can ask ourselves a simple question.

Are there too many threats?

If so, we draw a line under it and look for another opportunity. If not, it’s time to move onto the next phase of assessment.

‍Start with one asset class

I’ve been investing for years, particularly in property, so my experience gives me insight into the types of risks and how to mitigate against them.

If I was approaching a new asset class, like art for example, I’d go back to basics to find out how money is made and lost in that market. It would take me a lot longer to compile that data than it would in property.

Early in my career I thought I could outperform the stock market by picking a few of my own stocks. “How hard can it be after all?” Let’s just say that didn’t end too well…

So by starting and specialising in just one or two asset classes, you’ll get quicker and more effective every time you do due diligence. Once you’ve built some wealth and a good initial portfolio, that’s the time to start diversifying into different classes.

Understand risk and return

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Investing is all about risk and returns. The goal is to ensure the chances of winning outweigh the chances of losing. With high quality due diligence comes secure wealth. Without it, you’re closer to speculating.

How do you carry out due diligence?

Here are 5 key questions to start your research.

1. How could I lose money?

The great Warren Buffet once said...

Try to make sure that the worst outcome for any of your investments is break even. That way, you can still say you gained experience as your return.

If you’re investing into a property and buying it yourself it’s hard to lose all of your money because – when purchased correctly – you will always have an asset with a value.

You can do this with research. Learn and ask as many questions as you can. Within the Property Entrepreneurs Club we cover these questions and issues, critiquing each investor's opportunities to spot and mitigate risk, finding ways to maximise their chances of success. It’s a powerful environment and if you’re a serious investor, one you have to be part of.

2. What are the exit strategies?

Not every investment will last forever. It’s crucial to know how and when to get out.

If you’re taking on debt to fund an investment, which is often the case with property, how are you going to pay that back?

If plan A fails, what are plans B and C? If you can see how plan A might fail, you’ll have even more understanding of your overall risk.

Recently, when assessing an investment into a block of seven flats...

Plan A was to split one flat into two, make improvements and tenant all eight flats, refinance some of my initial cash back out and generate a long-term income. Plan A could fail if I didn’t get planning permission.

Plan B was to keep the original seven flats, make improvements and tenant them. The return isn’t as good as plan A, but still meets my criteria. Plan B could fail if I have some voids, or the rental market changes and I can’t find tenants.

Plan C was to split the titles into individual leases, make improvements and sell each flat individually at slightly under market value.

And so on…

See how many times you can ask yourself “what if” and find an answer, research, ask around and gain guidance from other investors.

3. How does this investment diversity my portfolio?

Whether or not you choose to diversify with each investment, you should always ask this question.

As mentioned I'd recommend you start by focusing on just one or two asset classes, but you still want to be looking at ways you can spread your risk within them by adopting different strategies, tenant types or areas.

For example, if you own ten properties in a ¼ mile radius and the area floods then you're almost literally up sh*t creek.

So look at different areas, or different investment strategies.

One of the keys to long-term and secure wealth is to be diversified enough to protect against risk. If one engine fails, the others keep us flying.

4. Do I know enough about this investment?

Instinct plays a big part in investing, but it should never be the sole basis of your decisions. It has to be balanced out with information and knowledge.

When you have a strong gut feeling, ask yourself why you’re attracted to this investment. If you don't know enough, find someone who knows more than you. Ask questions. Don’t be afraid to talk details or monetary figures.

5. Do I know how to manage the risks?

Our job is twofold:

1. ‍The “investor” identifies and understands risks.

2. The “risk manager” mitigates and eliminates risks.

So ask yourself have you researched as far as you can? Have you identified every risk? Is there a plan to mitigate each one? Do the risks overlap with any other investments?

Are you ready for the next step?

If you can confidently reply to each of these five questions, you’ve done enough due diligence. If not, keep going.

Don’t be afraid to invest your time before you invest your money.

Investing is not quick and, no matter what you might hear, it never will be. But done correctly and patiently, time is our best friend and the returns will come.

Now let’s get building.

T