You’ve identified your acquisition target. It’s passed the sniff test. Financials pencil out and the bones of the deal meet your initial criteria. Your investment committee has bitten off – hook, line, and sinker. You’ve negotiated acceptable terms. You’ve got your trophy on the line but now what must be done to dot your Is and cross your Ts and maximize your chances of success?
This is a comprehensive approach to due diligence that will ensure you are doing everything in your control to verify the veracity of your investment projections before you commit your capital.
Fundamentally, the due diligence period is a formalized discovery window to confirm assumptions, identify potential hiccups, uncover unforeseen issues, and ultimately, determine the feasibility of a project. It’s the active mitigation of physical, financial and legal uncertainties and you get one chance to get it right. This finite window is paramount to your fund’s sustained success. Below we highlight the items essential to the due diligence process while providing a handful of potential “deal killers” that often result in an impasse.
So, How do investment professionals approach due diligence for real estate deals?
A comprehensive real estate deal due diligence process will include the following elements: establishing a deal team of experts, financial due diligence, physical due diligence and the operation due diligence. This last item aggregates all your findings to fine-tune your operations plan.
Establishing a deal team
Assemble a team that is trustworthy, reliable, and qualified. This team can be made up of in-house staff and/or third-party professionals. These are the real estate deal experts you can repeatedly lean on to give you accurate, deal and market-specific feedback. The first step in establishing an effective due diligence process is rather holistic and can be applied on an asset or portfolio-level. Once established, should result in a more efficient process for current and future real estate deals.
This team is far-reaching, specialized, and will not only assist in getting the deal across the finish line but also execute on your investment strategy once ownership is transferred. We are talking about your property manager, your leasing team, analyst, facility staff, attorney, accountant, title company, physical inspectors, contractors, and especially your lender.
Each member has an important role to play and should truly be viewed as a partner on the deal while contributing to a common goal. The size of your firm’s staff will dictate which of these individuals will be in-house or retained as outside counsel. Regardless, having an established deal team can create valuable scalability as you avoid scrambling to fill these roles for each acquisition.
Let’s take a deeper look at a handful of these “deal partners” to better understand their importance.
- Property Management/Leasing:
You’ll probably already have a leasing strategy in mind prior to getting to the formal due diligence period but this is your opportunity to interview the management and leasing teams already in place. Determine whether or not you wish to retain them, use in-house resources, or find the best-suited market experts to execute your strategy. This decision may vary deal-to-deal or market-to-market, as market and deal size variables play a deciding factor.
Having the right attorney can make or break a deal on its own. Experience, reliability, personality, and available resources are all essential components to consider. What benefit does experience provide if unwarranted conflict kills a deal before it gets started? What benefit is there to having an attorney you trust but can’t dedicate the time required to keep your deal moving forward? An effective attorney will help guide you through the process, step-by-step, from initial contract negotiations, to title issues, to the closing table. It is essential to retain someone who has your interests in mind but is ultimately, also a dealmaker.
Unless you are looking to take down deals with zero financing, the lender relationship will prove essential in successfully closing and holding any property. Not just a figurative partner, a lender is quite literally your majority “partner” and thus, as important as rates, terms and fees are, mutual comfort is equally as important. A reciprocal level of comfort and confidence only increases the probability of repeat business, favorable terms, and flexibility with debt options further along in the hold cycle. The lender is putting their capital on the line, and they are well versed in due diligence. Often times, the “list” your lender will want to check off in their due diligence process is similar or even more robust than your own. This list can be an invaluable guide to your own due diligence.
Financial due diligence
It is common to dedicate considerable time and effort into researching, underwriting, or determining market assumptions for any potential real estate acquisition before submitting any formal bid on an asset. Assuming the numbers pencil out and adhere to your investment strategy, this period serves as a time to scrutinize the information provided and discern the credibility of the represented cash flow.
Below is a list of items you will want to audit to verify the financial information and market assumptions you are basing your investment on are as reliable as possible:
- Rent Roll:
Ultimately, for the majority of investment properties, the durability of the rent roll is the foundation of your investment. Therefore, you will want to ensure all rental rates, escalations, expense reimbursements, concessions, expirations, renewals, terminations, options, rollover exposure, and any additional provisions are accurately accounted for. It is vitally important to read through each and every lease and amendment to get a clear understanding of the landlords responsibility to each tenant, and vice versa. By doing so, you may uncover errors in prior operations that may prove difficult to correct. Additionally, it would be important to verify that tenants are already complying with the contracts at hand, otherwise you may be looking at tenant responsibility that becomes difficult to enforce if the tenant(s) is not accustomed to adhering to them.
- Vendor Contracts:
These are typically not provided until you are under contract. It is important for your team to quickly review all in-place service contracts and determine if existing contracts shall be retained or if new relationships/vendors would be better suited. This decision may boil down to your business plan and whether or not you plan on seeking best-in-class services or cost savings.
- Historical Analysis:
You may feel your team has a pretty good idea of how the property is currently operating, but it is equally vital to understand how the property has operated historically when attempting to more accurately project how it is going to operate. Here are three scenarios where a comprehensive understanding of the historical financials of an asset can help mitigate inaccurate financial assumptions.
In our first scenario, you must be able to identify unrealistic reported numbers. Remember, with the seller attempting to maximize their sale price, you must be prepared for some line-items to be over or under inflated in an effort to maximize the reported NOI. You may uncover atypical operational expenses in the trailing months that may or may not truly reflect the historical operations of the asset. Perhaps the improved operations can continue. Perhaps you find the reduced expenses to be unsustainable or damaging to the long-term suitability of the asset.
Next, validating correct expense recovery structures if any, and how they may change in the future. For example, in the case of modified gross leases, any potential lease roll is an opportunity for a base-year reset which could significantly decrease expected expense reimbursement recoveries.
Similarly, when commercial leases dictate reimbursement caps or unique expense recovery structures, you may not see a dollar-for-dollar benefit within the projected NOI, dependent on how expense pass-throughs have and will be allocated. Any significant change in expense levels and allocations and you may find yourself further exposed than assumed.
- Market Analysis:
Lastly, you will want to reaffirm property market assumptions made in your original underwriting. Market rents, vacancy rates, leasing costs, average down time, unit turn rate, competitive finishes or amenity packages, even the cost of labor all vary depending on market. These are all blanket assumptions made prior to any official due diligence is conducted that have significant influence on long-term cash flows. It is essential to ensure your market leasing assumptions are supported with real market data and actual property performance.
At the end of the day, you are pursuing an investment on behalf of yourself and your partners. Your investors entrust you with their capital for achieving a return on their investment. What is more important than the assurance your financial projections are sound?
Physical due diligence
Physical due diligence is commonly noted as the largest blind spot to real estate investors prior to closing. While sometimes preliminary property condition details are shared with you, other times they are not. Regardless, the onus falls to the purchaser to examine the overall condition, compliance, and long-term suitability of the physical property itself, as well as the site on which it sits. After all, you are most likely buying the property for its long-term cash flow, it is only logical you will want to ensure the investment will be around to pay out.
Your goal is to rule out material defects, identify deferred maintenance, minimize short term capital expenditures and eliminate surprises. So, where do you start?
- Third-Party Inspectors:
Bringing in certified consultants offer a professional, unbiased opinions on the current condition. They will help to estimate future expenditures required to sustain the physical structure, make necessary improvements, and discern if all major mechanics are adhering to code and in good, working order. This may include any or all of the following professionals; a structural engineer, a roofer, an HVAC specialist, etc. In addition to confirming the capital budgets and agreed upon pricing reflects the work required, this also offers an opportunity to verify potential recent capital improvements made to the property, ensuring they were done in a satisfactory manner. These reports will highlight the presence and difference between preventive or predictive maintenance, and deferred maintenance. It is typically accepted any work not required within the first 24 months of acquisition is considered an ownership/operational expense. This may vary from project to project and is in contrast of work required sooner, which are considered deferred maintenance issue and may result in a price adjustment and negotiation.
- Title & Survey Reports:
Partially physical, partially legal, an official American Land Title Association (ALTA) survey and a detailed title search are used to rule out any non-conforming issues with the property’s current use or encumbrances against the title. The survey report will ensure an updated, accurate survey is on file and adhered to. The title search, subsequent title transfer, and title insurance policy are utilized to confirm and secure a clear title during the transition of ownership. Together these will outline all access rights, setbacks, zoning designations, liens, zoning restrictions, encroachments, and deeds. It will also uncover any potential easements or restrictions, or can even help uncover additional development upside. It is noteworthy, any potential issue or encumbrance placed against the property, or its title, stays with the property itself opposed to the controlling ownership at the time of any potential transgression.
Environmental issues may not be applicable for every real estate deal, but when relevant, they can prove a difficult obstacle to remedy. The vast majority of properties have a small likelihood of possessing historical environmental issues, however, for some property types (Gas Stations, Dry Cleaners, Nail Salons, etc.), that likelihood is drastically increased. When there is a potential history of contamination on a site or its adjacent parcels, a preliminary Environmental Site Assessment (ESA), or Phase I, may either be required or may already be on file. If a reasonable level of risk is determined, a Phase II may be required, at which point site samples are taken, including soil and groundwater testing. Remediation recommendations are made based on these results. This is a vital step prior to taking control of any property as environmental remediation can prove extremely costly and ultimately, challenge the entire feasibility of the acquisition.
- Appraisal/Property Condition Report:
An Appraisal and a Property Condition Report (PCR), are third-party reports, often required by a lender to ensure the agreed upon valuation is appropriately supported. The determining factors include the overall physical condition on the property, both the in-place, as well as historical operations of the asset, and overall market fundamentals. These findings can serve as an audit to your own due diligence period as many of the reviewed items should have already been examined. Much like yourself, for a lender to be willing to put forward funds, the physical condition of the property must check out, the financial underwriting must not be deemed overly risky, and the suitability of the site itself must not be encumbered or contaminated.
Perhaps the most obvious portion of due diligence process, the physical due diligence period is as essential as any portion of the entire process as it is truly your time to ensure you are safeguarding your investors capital against foreseeable physical latent defects that will prove costly and affect your returns over your hold period.
Operational due diligence
Operational due diligence is the aggregate application of the discoveries made in methods discussed above. It will result in the merger of your investment strategy and capital budget. These insights allow your team to update your projections to accurately plan and execute based upon the findings uncovered during the bidding and earlier due diligence work. More focused on the business-side of the property, this is an opportunity for your management team to take a deep dive into the static, in-place operations utilized by the existing ownership, distinguish strengths from weaknesses while identifying potential upside. This includes fine tuning assumptions relating to capital improvement projects, tenant improvement allowances, renewal probabilities, preleasing, value-add opportunities, and more. The initial data points uncovered will guide your operational strategies and shape your capital budgets over the duration on the projected hold period.
For example, let’s assume you are pursuing a value-add commercial real estate deal. In your original pro-forma, you underwrote rental bumps upon renewals. Based on findings during due diligence, your leasing team cannot support the pace of rent growth based on the conditions of the units and common areas. Instead, it is determined improvements to the property will need to be made in order to raise rents. At this point, the onus lies with your management team to accurately determine the cost benefit of said improvements factoring the additional capital budget required to achieve your pro-forma rents, and ultimately if your assumed returns are feasible or need to be revised.
Operational due diligence is where the rubber hits the road. Has all the work your team did on the front-end led you closer to a successful close? Have your assumptions and capital budgets stood up to what has been uncovered during due diligence? Is the management team you have in-place suited to execute on the operational strategies that are required to unlock the properties highest-and-best use? These can certainly feel like daunting questions to answer within a 45-60 day period, but if you have the right team in place and know what to look out for, they don’t have to be.
What’s a roadmap without proper road hazard warnings? Based on experience and market feedback, below are a handful of major deal killers to be on the lookout for during your due diligence:
- Real estate tax increase
There are instances where your acquisition of the property affects the taxes. Different municipalities and states handle their taxes differently, however, it is not uncommon for real estate taxes to dramatically increase upon a sale. Whether the local tax assessor’s office is allowed to “chase a sale” or it has been a decade since the last formal reappraisal, it is vital to consult a real estate tax attorney during, if not before, your due diligence period to better anticipate any pending increases and avoid any surprises post-closing.
Insurance quotes can vary heavily dependent upon the operator. For example, there are unquestionable benefits of scale. Large groups may be splitting insurance cost across large portfolios. Perhaps, rates were locked in under an outdated contract. Or maybe, your lender may require more insurance coverage. Regardless, it is important to get individual quotes and not rely on prior ownership’s historical rates.
Capital reserves can differ wildly from owner-to-owner or property-to-property. Much of it is down to preference or strategy, however, when financing an acquisition, lenders may possess more substantial reserve requirements than owners prefer. If this requirement is not anticipated or met, it could put the deal in jeopardy.
- Environmental issues
We touched on the importance of environmental due diligence above but let’s review. Environmental issues can be completely out of your scope of control. They are expensive, have lasting, long-term effects, and can be impossible to remediate. While some municipalities offer incentives to remedy, if not handled appropriately, environmental contamination can result in liens and can drastically limit potential use of a property. Unless you are specialized in dealing with the issues, environmental issues can be a non-starter for many savvy buyers.
- Unaccounted deferred maintenance
Many times, the successful completion of a transaction boils down to the willingness of each party to compromise as issues arise. Non-disclosed, big budget items that are material to the cost-basis in investment can present difficulties. If a seller or lender is not willing to conform to account for the adjusted cost-basis, you may be looking at an impasse.
The saying goes, “surprises don’t kill deals, time kills deals”. Due diligence, by design, is a mechanism to uncover surprises, however, two parties with a common goal can oftentimes find resolution. Notwithstanding, time is one resource all parties involved may not be able or willing to compromise on.
Too many groups rush to closing without diligently inspecting their investment. It is important to view this review period as an investment rather than an expense. A deal gets killed because something gets uncovered and proves an impasse? GOOD…you just saved yourself exponentially more time and money finding it out on the front end. A proper, meticulous due diligence period can increase returns for your partners and allowing you to focus on your next acquisition.
In an industry built on margins, any efficiencies gained or disasters avoided can dictate the underlying success of investments. Many say their best deals are the ones they don’t do. Avoiding disastrous projects will dictate sustained success. The importance of due diligence should not be overlooked. To rush through due diligence to closing without a plan of action is to willingly practice negligence.