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.
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.
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?
The least flashy, most important investing activity (4:03)
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The investigation made by an investor prior to making an investment.
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.
The process of retrieving documents evidencing events in the history of a piece of real property to determine relevant interests in and regulations concerning that property.
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).
- 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
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