Due Diligence in Real Estate

Published on 18th September 2007

In a developed economy, land as a corporeal resource constitutes a major portion of a nation's economic wealth. In US, land as represented by real estate; its use, ownership and other activities emanating from it constitute about 70 percent of the economic wealth. Due to activities on land, various professions derive their practice based on what happens in the real estate industry. Real estate is not just the physical land and buildings but rather various interests and rights that are created as a result (Bundle of Rights).

In US, the highest title to land is Fee Simple (Freehold), from which other rights/interests such as leasehold are created. Investors in the real estate need guidance from professionals to help them understand issues that affect, influence and drive the market. To get started, Due Diligence is the first step.  

There are various professionals in the real estate namely real estate appraisers, investors, lawyers, accountants, brokers/agents, architects, and so forth. The real estate appraiser (estate surveyor) determines the impact on real estate especially in a capitalistic economy. The appraiser's role in estimating market value determines the level of investment. The Appraisal Foundation and Uniform Standards of Professional Appraisal Practice (USPAP) demand that for any property to be financed by a federally insured financial institution, it must be appraised by a certified/licensed appraiser from where the property is located. The market value therefore, determines what is built, loan-to-value ratio - how much that can be borrowed, what return to expect and risk analysis among others.  

The role of the real estate appraiser/estate surveyor is crucial in ensuring that the market value on which loans are made is done by professionals. The appraiser can perform due diligence to assist an investor assemble the required information before deciding whether to invest or not.

Clients who want to analyze commercial property need experienced professionals to perform due diligence as an integral part of an investment decision matrix. The mere availability of capital does not make a market but rather, the complex factors and issues that tend to affect commercial property performance and desirability in a given locale.  

Through analysis offered, an investor can decide whether to invest or not. In an investment situation, the acquisition of a property may be offered as a set of properties with conditions and performance challenges. Well done due diligence can reveal risks as well as rewards inherent in a portfolio. A buyer may like certain select properties in a portfolio that suits their investment criteria. However, some complexity and constraints may force the buyer to overlook an opportunity because identifying properties in the portfolio to analyze may be cost prohibitive.  

Due Diligence enables an investor to separate, aggregate and array salient factors in order to determine which property is suitable for further investigation. While investors may decide to do so themselves, this may be costly as buyers often react emotionally when engaging in transactions that involve large outlays of capital, unlike a professional who is objective. Studies indicate that investors who perform their own due diligence from a 'do-it-yourself' scenario often end up regretting. If an investor does due diligence by himself, he should compare notes with a third party’s report. In the US a third party’s report is used more often to purchase real estate, unlike an owner's analysis as it is biased. That is why third party reports by duly certified and qualified professionals are used and are thus held liable for misleading or mispresentation. 

Investment Decision Points 

Several points are worth noting in due diligence analysis. They represent majority of issues an owner/investor would want to consider before committing to a major commercial real estate purchase.   

a. What is the low and high range of rents in the given market? How does that impact on the acquisition price? 

b. Can rent be increased? What sort of capital improvement/renovations will increase rent? Is the improvement required from the perspective of demand and competition in a given market? 

c. Is the current use the highest? Is the land used best, considering market conditions? 

d. What renovations or repairs to the improvement will achieve target occupancy level? Using comparable properties, what is the amount of investment to complete the improvements? 

e. Will operating expenses be reduced to achieve desired return on invested capital given the purchase price? 

Some of the items to consider in due diligence are:  maps/site drawing/site plan, subject photos, capital improvements (historical and planned), service contracts and leased equipment, certificate of occupancy, zoning/warranties/guaranties/licenses/permits, certified operating statements, current rent roll, budget projection, proof of utilities (electric, gas, water, sewer), current real estate tax bills, insurance certificate – premiums, lease and amendments, neighborhood area data, demographics, litigation, title and survey review, and  engineering studies among others.

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