Before buying real estate of any kind, it stands to reason that research on the asset should take place. Doing so helps ensure the minimization of post-sale shocks or surprises. This research -- known as due diligence -- provides you with an in-depth look at your potential investment.
Because you’ll be putting a lot of money into the real estate, your due diligence will require more than a glance at some financial statements and a cursory “walk-through” of the property. The process requires time, effort, and patience.
Defining Due Diligence
Due diligence is an investigation into, or an audit of, a target investment, with the concept dating back to the passage of the Securities Act of 1933. Through that law, brokers were responsible for fully disclosing material information relative to the investments they were selling. The law also protected brokers from being sued for failure to disclose something about which they might be unaware.
When it comes to real estate purchase and ownership, due diligence means you, the investor, will research, review, and understand all materials and information pertaining to an investment. This allows you in-depth familiarization with the property, so that you can:
- Decide if you want to move forward with a purchase
- Realistically anticipate how your property will perform
With this concept in mind, successful due diligence should begin even before a target property is in your sights.
In the Beginning
Successful due diligence begins with knowing why, exactly, you want to buy a property. Understanding investment goals will have a bearing on what kind of asset you’ll target. Different real estate types will require different due diligence procedures; an apartment offering steady cash flow differs from land on which you might want to develop.
Once you know your target investment, you should take the next steps.
Study and shop. See what’s for sale in the area in which you’re interested, and gather market demographics and fundamentals. Also, seek out sales comps. This information both shores up your negotiating position, while letting you know what you can reasonably expect from a potential target asset.
Find the money. Many real estate deals fall through because of financing, or lack thereof. You can avoid this by researching before bidding. Talk to lenders, and determine what they will underwrite. Reach out to equity partners, to learn what might pique their interest. While it’s not required that you have financing in place when you make an offer on a property, laying the groundwork helps build relationships, while providing a realistic picture of debt and equity availability.
Getting to Know You
You’ve found your ideal property. You like the fundamentals and, thanks to your foresight, have an enthusiastic lender lined up. You’ve signed the contract, and are in the escrow period, during which you’ll be well-advised to perform the following due diligence activities.
Walk the property. Never buy real estate “sight unseen.” You need to be physically present, to study both the exterior and interior. Examine traffic patterns and infrastructure around your property. Also, carefully study the area and neighborhood environment, to determine factors that could impact property operations, such as low-lying flood-prone areas, or wooded areas that could lead to wildfires. Speaking of Acts of God . . .
Understand insurance options. You will need to insure your property. However, not all standard policies cover natural phenomenon, such as earthquakes, wildfires, or flooding. As such, if you buy that flood-plain-located apartment complex, you’ll need specialized insurance, which will impact your operating expenses.
Go platting. That plat map, which can be obtained at the local city hall or town hall, will tell you the actual size of your property, as well as where the boundaries, nearby streets, and easements on that property are situated. This information prepares you for the time when the local gas utility “trespasses” on your easement to dig up the ground for a new pipe placement.
Recognize regulations. Municipal, county, and state laws can impact your target property’s operations. Environmental assessments will be a concern if you want to develop or expand. Parking could be an issue if you own an office building. In addition to knowing the in-place laws, you’ll need to keep track of potential regulations. For instance, if you decide to buy that nice-looking multifamily property in that great neighborhood, rent control under discussion by the local city council might impact eventual profit margins.
Consider the numbers. Another due diligence “must” involves understanding your target real estate’s financial operations. This means a pro forma analysis involving calculations that determine current and potential investment returns. The results of this analysis can serve as a final determination about whether you buy the property, or take a pass. The pro forma can include, but isn’t limited to, potential gross income, vacancy allowances, operating expenses, and net operating income.
Knowledge is Power
The goal of due diligence is to ensure you understand every facet of the target property, and manage risks and surprises once you own it. Information collected during the process places you in a stronger negotiating position, while helping you understand what you can realistically expect from your real estate. As such, due diligence is not something that must be “gotten through.” Rather, it’s an important and necessary facet of any real estate purchase you make.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.