Due Diligence Real Estate: Three Criteria To Determine an Appropriate Scope

Due Diligence for real estate investors is commonly accepted as being important.  Most realize they should get a property condition report, however, understanding how to implement a scope of due diligence that is appropriate to a specific asset is what separates the most successful real estate investors from their less-successful counterparts. 

 

Most investors understand the necessity of doing their homework when it comes to researching the historical financial performance of a potential investment, as well as the underlying market conditions that may impact a property moving forward. However, many seemingly sophisticated investors frequently seem to underestimate the potential impact that the physical condition of the asset can have on their ability to achieve their projected financial returns.  The reality is that lack of proper diligence in this area can completely derail the most well-thought-out financial plans. 

 

For instance, consider an investment where a building’s cooling capacity is significantly undersized and the cost to correct the deficiency was unanticipated, or other projects where the costs to address issues associated with a building that requires costly seismic retrofit and/or extensive ADA upgrades were not anticipated in the acquisition underwriting. These are just a few examples of the kinds of costly issues that could be overlooked with an inadequately scoped assessment. 

 

So how do you protect yourself?  The answer is to develop a physical due-diligence plan based on the following three criteria.

 

1.Risk Tolerance:  This could be dependent on a number of factors, but is usually tied to the level of financial exposure represented by the investment.  Some of the factors that should be considered are the size of the investment and/or your fiduciary position (e.g. general partner versus limited partner).  It stands to reason that a large financial exposure would warrant a greater level of diligence than a smaller investment, but we frequently see clients that do not appear to make a distinction and instead go with a one-size-fits-all approach.  The same is true of the fiduciary consideration.  However, the best approach is to make sure that your due-diligence efforts are scaled in proportion to your level of risk.

 

2.Purpose of due diligence.  If you are conducing due diligence to satisfy your own requirements, the scope could be considerably different than if you are conducting the assessment for the benefit of a lender.  As an owner, you will likely be interested in obtaining a detailed understanding of condition, one that limits the potential for unforeseen capital outlays by you and/or your partners.  On the other hand, if you are being required to produce a report for your lender, then you will likely conduct a more limited assessment targeted at providing enough information for the lender to protect its underlying security interest.  Whereas you will bear the burden of dollar loss, the lender is not likely to incur any ill effects until your equity has been depleted.  Accordingly, the scope of due diligence should be appropriate to the intended target audience.

 

3.Complexity of the Asset: The level of diligence should be scaled based upon the complexity of the asset.  Smaller assets usually have less sophisticated building systems and, therefore, warrant a more limited approach.  It should be noted, however, that this only holds true if the dollar investment is proportionate to the size of the asset.  If either the cost of the property or your equity investment is disproportionately higher, then you may want to consider a more extensive scope of due diligence.  Also, do not be fooled into believing that a newer property is less likely to have problems.  We frequently see newly completed facilities with significant structural defects and/or code deficiencies, such as a 1.2-million-square-foot warehouse facility that required a complete tear-off and replacement of a one-year-old roof.

 

In general, a limited assessment is usually performed by a single evaluator (typically a senior architect or engineer) with broad experience in the various building disciplines.  Occasionally, the generalist’s capabilities will be augmented with another specialist to address a more complex property feature that is beyond the generalist’s expertise (e.g. seismic risk assessment or elevator systems).  Field work for a limited assessment usually takes about one day.  Research and reporting will normally take another one to two weeks, depending on the complexity of the task.  Overall, the effort should take two to three weeks from start to completion.

 

Conversely, larger, more-complex assets usually require a more-comprehensive scope of assessment that is performed by a multidiscipline team of evaluators.  Such a team commonly comprises an architect, mechanical/electrical engineer, structural engineer, and roofing consultant.  Other disciplines that may be appropriate could include HVAC testing contractors, elevator consultants, curtain wall consultants, geologists, parking consultants… and the list goes on and on.  Field work for a more-comprehensive assessment typically takes from two to four days; again, depending on the complexity of the transaction; again, the overall effort will likely comprise two to three weeks.

 

Bottom line:  If you are performing “due diligence real estate” it is more than just getting a Property Condition Report.  Sophisticated investors understand that the potential gain on an investment is largely cast in place on the day that escrow closes.  Rarely does dumb luck enter in to the equation; rather the success of an investment is more typically tied to the level of due diligence exercised on the front end of a transaction. 

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