Chapter 7 | Real Estate Due Diligence Analysis

Overview

Listen to this narration if you prefer

 

Due diligence is the investigation conducted by a prospective financial stakeholder in a transaction prior to putting their capital at risk.  It involves analyzing both the facts about the property and competitive market, as well as the robustness of the assumptions made for your financial model.

Summary

The following is a basic breakdown of what is covered during the due diligence process for real estate:

  • Title – Title reports contain detailed legal property descriptions and information about the property, including its previous usage and ownership.
  • Survey – A title survey will feature a description of the property and will detail where improvements have been made, as well as what can potentially be added. Easements which have been granted should be noted in this description.
  • Environmental – According to the current Superfund Law, you are liable for environmental damage regardless of whether you were the source or not. You are still permitted to collect from the original polluter via a tort claim but the capital outlay for environmental damage can be substantial.  Due diligence helps determine if these problems exist before you purchase the property.
  • Legal – You will also need to conduct legal diligence to determine if there are outstanding legal claims associated with the property.
  • Revenues – It is necessary to challenge the cash flow assumptions. Revenue can be broken into three components: creditworthiness of the tenant, current leases, and the long-term competitiveness of the property.
  • Expenses – It is necessary to understand what costs tenants pay for in a lease. For operating properties, an investor should carefully explore the property financial statements and entity tax returns from the last 3-5 years.
  • Capital Expenditure – Capital expenditure reserves are the cash reserves for future capital projects. The reserves should cover routine capex and additional funds for unforeseen issues.
  • Loan Documents – It is important to understand how a property is encumbered by debt if you plan to assume that debt. The covenants and detail in existing loan documents will determine what a new owner is permitted to do.
  • Neighborhood and Market – Understanding the neighborhood and market within which your property is located is critical, as the attractiveness of the market will determine the viability of the property in the long run.

Questions

These are the types of questions you’ll be able to answer after studying the full chapter.

1. What are easements and why are they important to understand?

2. Why are environmental issues critical?

3. How can loan covenants hinder a transaction?

4. What does structural due diligence include?

Audio Interview

The least flashy, most important investing activity (4:03)

BRUCE KIRSCH: We learn about due diligence analysis. And this is probably the least high-profile and the least sexy part of the real estate business. And this is probably the last reason why students would be attracted to working in commercial real estate.

Typically, they gravitate towards it because what they perceive is a lot of glamour, these huge transactions that are in the headlines, beautiful architecture that’s being pulled out of the ground, and the fancy cars that some people drive, and they know that they’re in the real estate business. And so due diligence is on the total opposite end of the spectrum, but is as important as it is unsexy. So how can we get students to value the significance of it?

PETER LINNEMAN: You know, it is the reason I put the chapter in the book. I think, as you know, if you looked at most books, you will not find anything on due diligence. And you go, really?

This is the process of proving out that the things that I’ve been told or things that have been represented to me are really true. What– I’m going to take at face value everything a broker tells me? I’m going to take at face value all my biases or vague remembrances or assertions by a seller, I’m going to take at face value? Of course not.

It is so important because you’re buying it in the belief that those things basically are true. And therefore, you better really spend time figuring out is it true? If they told you the leases last 10 years, you better check and make sure the lease lasts 10 years. They told you the lease was for $20 a foot. You better check it out. They told you that there’s no loan on it. You better check that out, and just on and on and on.

And it is absolutely critical. The most critical part of the acquisition process, bar none, is due diligence. Since it’s not mechanically numerate, and you can do it in your office at 2:00 in the morning on a spreadsheet, a lot of young people believe it’s not critical.

It is not necessarily creative, but it is essential. It’s careful work that has to be done. And quite frankly, it’s how you learn the business because you find out all the tricks. You find out the trick is, yes, there are no property taxes, but that’s because the building nine years ago was given a 10-year tax abatement. So it’s true what they told you. But the first year you own the building, you’re going to pay taxes.

And you just kind of learn all these tricks for– yes, you told me you replaced the elevators. I assumed you replaced them with modern system elevators. But they’re not modern systems elevator, and I assumed that I had a modern system elevator. You told me that the roof was repaired recently, but you didn’t tell me that it was just patched, as opposed to replaced, on and on and on and on.

I don’t know how you make it sexy, but it is critical, and it’s how you learn the business. You learn much more about the business doing due diligence than sitting at a spreadsheet. They’re both important in the process, but due diligence is far more important.

BRUCE KIRSCH: I like to think of it as a flight check. Let’s say you’re–

PETER LINNEMAN: That’s well said.

BRUCE KIRSCH: You’re a fighter pilot, and you’re on an aircraft carrier, probably worth your time and effort to do one last check, or have your specialist do that one last check down the entire list. OK, do we have the fuel that we need, and so on and so forth. And where are you guys going to be when I come back and I’m on fumes? Let’s just double-check things.

PETER LINNEMAN: Perfect analogy. Perfect analogy. And it doesn’t seem as sexy as flying, but nobody would fly without doing it.

Key Terms

To view the definition, click or press on the term. Repeat to hide the definition.

The investigation made by a prospective financial stakeholder prior to putting capital at risk.

A signed statement by a tenant certifying that a lease exists, confirming certain lease terms such as reimbursement obligations, and stating that there are no defaults, and that rent is paid to a certain date.

A comprehensive investigation and evaluation of significant factors affecting and influencing boundary locations, ownership lines, rights of way and easements within or immediately surrounding a certain lot, parcel, or quantity of real estate.

Encumbered real estate has a lien, charge, or other financial liability attached to the property.

When a property is free and clear of any encumbrances such as creditor claims or liens; an unencumbered asset is much easier to sell or transfer than one with an encumbrance.

A right to keep possession of property belonging to another person until a debt owed by that person is discharged.

An enforceable claim or lien on a property created by a security agreement such as a mortgage.

A right to cross or otherwise use someone else’s land for a specified purpose.

The right for someone to cross through the property for transportation, ingress, or egress purposes.

U.S. federal environmental law that states that a property’s current owner is liable for the environmental damage on the site regardless of whether the current owner was the source or not.

A test of a building’s structural integrity. The higher the building’s score, the worse its structural integrity.

The act of having the jurisdiction re-evaluate a property’s current assessed value given new information or circumstances related to the property.

The cash amounts set aside for funding future capital projects such as major renovations or roof or elevator replacement.

Payment of a property’s purchase price in a piecemeal manner over time.

Debt on a property that can be transferred from the current owner to a new owner along with the transfer of title.

A study conducted for contemplated retail developments to determine whether the area is “over-retailed” (over-served by other retail properties) or “under-retailed” (under-served by retail).

Chapter Headings

  • What is Due Diligence?
  • Wrong but Useful
  • Little Mistakes + Big Numbers = Big Problems
  • Title, Survey, Environmental, and Legal
  • Revenue, Operating Expenses, and Capital Expenditures
  • Capital Expenditure Needs
  • Loan Documents
  • Neighborhood and Market

The Top Quarterly Publication for Commercial Real Estate Investors

 

 

Excel for Real Estate Certification

 

 

REFAI Certification

 

Investment Strategy Specialists

 

Looking for investment analysis software?

valuate app logo

 

Financial Modeling Self Study Courses

 

Quarterly Capital Markets Webinar Slides

0:00
0:00