You want to invest $3 million into a real estate project. Time is tight because it’s closing in 12 days. The developer (51 years old) seems to have a decent track record and takes credit for billions of dollars of projects, but this project doesn’t yet have zoning approval and the previous owner dumped the property because his plans to develop it got tied up in court by angry neighbors.
- Scenario one: You find the developer has no criminal record and no bad press. Your lawyer looks over the contract and you send the developer your $3 million because the return looks attractive. Four years go by and the project is mired in delays, cost overruns, and your guy gets the project into expensive litigation with another partner (something it turns out has happened in a prior project of his). In the end, as he considers selling the land, you are happy to have him buy you out at a loss.
Cost: $1.25 million. But you saved $3,500 by not paying for good due diligence.
- Scenario two: You find the developer has a history of litigation against close associates, plus got into a loopy lawsuit over a $5,000 dispute that he says knocked down his credit rating. He has billions in past projects but he’s taking time to litigate over $5K. You see that the project doesn’t have approval and that he’s been unable to refinance his large mortgage even though rates have fallen. Maybe he’s too highly leveraged in his other projects. Maybe he hasn’t done those billions he claims he has. You pass on the project.
Cost: $3,500. And you have $3 million in dry powder to invest somewhere else.
$3,500 buys back your $1.25 million mistake, not to mention any excess returns a different project could earn.
0.28 percent seems like a fair price to have paid.
Think of due diligence the way you think about car insurance above the minimum amount your state requires. In New York, you could get insured for just $50,000 in case the other person in an accident should die. But what happens if they die and you get sued for $2 million? Inadequate insurance could result in a lien on your house.
You will try your best to drive defensively, but if you make a mistake you’ve prepurchased the cost of the mistake with a higher premium.
There is no state law anywhere in this country that says you have to spend a minimum amount of money in due diligence on a proposed business transaction. You are fee to lose millions on a bad deal.
But if you are insured for more than the minimum coverage allowed for a car accident, why are you risking big money with your investment by foregoing good due diligence?
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