The art of asking the right questions in due diligence

Back in 2021, we invested in a relatively small development out in Dallas, Texas, which we planned on subdividing into 15 one-acre plots of land. To me, it seemed like a fairly straightforward project and business model, ideal for getting to know our team, which included a new engineer.

With our due diligence complete and the development underway, we realized we’d missed a crucial detail: the creek on this land had significantly more water running through it than first thought.

We soon understood that, because of this, the cost of building a bridge to cross this creek was five times higher than we anticipated. Our prospects for profitability were now highly unlikely.

So how did this happen? Where did we go wrong in our due diligence? And most importantly, what lessons can be learned to ensure it doesn’t happen again?

Hidden Creek Village: A lesson in taking things at face value

First, let me finish the story of Hidden Creek Village, the investment that seemed like a simple development with a sound business model but suddenly became borderline disastrous.

Thankfully, through a combination of luck and ingenuity, we salvaged it.

Needing to find a way to increase the density of the development to offset the unexpected cost of the bridge, we stumbled upon what’s known as a ‘package plant’ in Texas, in essence, an on-site water waste removal system incentivized by the state.

By building this system into the development, we learned we could get a significant subsidy from the local city authorities. Without this, the project would never have been profitable.

Listen to the full story on the Deal Makers podcast:

One elementary mistake, almost disastrous consequences

Having had time to reflect on this episode, it’s clear where we went wrong in the due diligence process.

The number one mistake we made was failing to probe our engineer’s assumptions.

He gave us an estimate for the cost of the bridge, and we simply accepted it without thinking twice. After all, who were we to question an experienced engineer? We lacked expertise in bridges and were happy to take his estimations at face value. However, that was a huge mistake.

Had we stopped to ask him how exactly he got to that number and drilled down with questions like “What if there’s more water than you thought there?” or “What might cause a change/pose a risk to the cost you estimated?”, perhaps we’d have prompted him to rethink his initial estimate, and we’d have avoided the nasty surprise that almost jeopardized our development.

It sounds so simple – don’t be afraid to ask questions and never take information at face value – but you’d be amazed by how many real estate developers trip up in this regard.

Lesson learned: Digging deeper and asking the right questions

By sharing this story, I want to equip you with some practical takeaways for real estate due diligence.

Avoid confirmation bias

If there’s one thing I know now that I wish I had known before the Hidden Creek project, it’s the importance of avoiding confirmation bias – a problem all investors should be wary of.

We wanted the Creek development to go ahead, and so when our engineer gave us a cost estimate for the bridge that seemed reasonable, we were happy to accept it. It validated our business model and gave us confidence in our assumptions, such as the project’s profitability.

Now I know that our mindset should be the opposite: look for a reason to say no during your due diligence. Scrutinize assumptions. When you start doing this, your due diligence takes on a whole new dimension – and far fewer red flags will fall through the creek, so to speak.

Always consider hiring a second engineer

The financial risk of your engineer being wrong is huge.

When in doubt – in fact, even when not in doubt – I’d advise real estate investors to hire a second professional opinion during the due diligence process.

While I admit we could have asked more questions ourselves to have potentially avoided the unexpected bridge cost, ultimately, we lacked the engineering knowledge to thoroughly scrutinize the original estimates.

In our case, hiring a second engineer to analyze the assumptions of the first engineer could well have identified the water issue ahead of time and saved us a huge headache.

While hiring a second opinion poses an extra investment, it could be the difference between a successful or disastrous real estate development – so it’s worth considering.

Nurture your network to learn from collective experience

I said earlier in this article that our Hidden Creek development was saved by a lucky or serendipitous discovery, but you make your own luck and engineer your own serendipity. In my case, nurturing a strong network was what laid the foundation.

Working to find a solution to offset the bridge’s cost, I began reaching out to my connections in the industry, asking for ideas.

Lo and behold, one person got back to me and gave me the idea of building a water plant in order to receive a healthy subsidy from the state. In addition, another contact recommended a bridge-building technology that could reduce the cost.

Sending these emails to connections I’d maintained over time saved our project and should have been part of our due diligence from the start.

Make sure you nurture a list of your associates – which could involve sharing articles they’d find interesting a couple times a year, or simply wishing them well over the holidays – and be sure to offer value yourself when possible.

Leverage your network in two ways: first, reach out to relevant contacts as part of your due diligence.

If there’s a specific area you’re unsure about – let’s say the ESG value of a project or the nuances of local regulation in the project’s location – ask connections for advice or valuable introductions to others who could help. Don’t be afraid to ask for help – in my experience, people are often flattered when you reach out to them and are happy to assist.

Also, bear in mind that whatever deal you’re working on, it’s likely someone else has already done something similar. You just need to find them and ask for their perspective.

Your network can also serve as a safety net in case you miss a critical detail during your due diligence. As was the case for us, if you miss a red flag or issue during your due diligence, the power of your personal network could be what saves you from significant financial loss.

Due diligence: Final takeaways

To conclude, I’d recommend to all those reading this to internalize the fact that you’re often going to be wrong, and that you’re a biased creature. Don’t make the mistake of jumping into a project due to emotion. Be humble, avoid ego, and be wary of confirmation bias – shrewd business decisions derive from this approach.

Modified Date & Time : 27 Mar 2024, 03:45 pm

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Author

Paul Thompson

Paul Thompson is a real estate fund manager, consultant, and coach based in Arkansas. He has vast experience in wholesaling, land deals, fix and flip, buy and hold, mid-term rentals, and fund management. For more information, visit his website.

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