Due Diligence

Due diligence is an essential step in real estate investment. After selecting the property type and geographic location, the investor needs to ascertain he has accurate information regarding the physical asset, financial performance, tenant base and future prospects for the subject property. Due diligence helps the investor accomplish those tasks. Due diligence can provide in-depth data and insights for these areas and mitigate the risk of a real estate investment. The costs associated with due diligence are minimal compared to the costs of making an imprudent investment decision.

In addition to investors avoiding unfavorable investments, due diligence can:

Enable investors to quickly pass on potential investments which do not merit a complete analysis;

Save money and reduce the time an investor spends evaluating a possible investment by more quickly declining an investment which does not fit the investor’s criteria or that is not consistent with what was presented; and

Provide the investor with a better understanding of the benefits, costs, risks and opportunities related to an investment.

The financial costs and time expended by the investor and the opportunity cost (of not pursuing other more attractive investments) related to fully analyzing a real estate investment are substantial. Due diligence helps to reduce these costs. In most due diligence cases, the business person leading the investment effort has developed an “investment hypothesis”. Potential “investment hypotheses” include the following:

This property will generate a 7% unleveraged yield without any upgrading.

This property is 30% occupied due to poor management. By focusing on leasing, the purchaser can achieve stabilized occupancy of 90% within 12 months while leasing at $18 per square foot.

The subject class A apartment complex was built 15 years ago when the level of finish was at a lower level. The subject property currently has both a good resident profile and is in good physical condition. By spending $8,000 per unit to upgrade the level of finish with items such as granite countertops, better appliances, upgraded cabinets, the rental rates can be increased from $.90 per square foot per month to $1.05 per square foot per month.

Investors cannot save both time and money by performing an initial review of the investment hypothesis. In many cases, the investor has too many other time consuming commitments and responsibilities to personally perform an in-depth analysis or to visit the property to confirm the investment hypothesis before proceeding with an acquisition. If it is possible to eliminate investments which do not meet the investor’s criteria before negotiating the contract to purchase the property, the investor can save legal fees related to the contract, time involved in negotiating the contract, time working with the lender, the cost of third-party lender – related records and any additional due diligence the investor would perform.
Depending on the investment hypothesis, the investor’s familiarity with the submarket where the property is located and the subject property itself, the following due diligence tasks merit consideration:

Market rent analysis;
Market analysis (occupancy, absorption, construction and rental rate trends);
Financial analysis/financial modeling;
Construction cost analysis (upgrading and curing deferred maintenance);
Code compliance;
Organize procurement of third-party reports;
Evaluate options regarding the level of renovation or upgrading;
Highest and best use analysis;
Market study;
Feasibility study;
Lease audit;
Lease abstraction;
Detailed examination of the seller's financial statements;
Comparison of seller’s financial statements with bank statements;
Obtain survey;
Interview management companies;
Interview leasing companies;
Property tax analysis and forecast.

The list of due diligence tasks which should at least be considered is daunting. However, the time and cost related to properly performing due diligence is insignificant compared to the time and cost to remedy a poor investment.