Due Diligence in Real Estate Investments

The due diligence process involves corroboration of proofs by commercial property investors that may affect the overall worth of a property that the valuer may have overlooked before a property transaction is finalized.

The due diligence process can include rechecking the lease agreements for the main occupants and the past rental remittances to note any non-payments, generating duplicates of utility bills to justify the operational expenses, comparing prior cash flow reports of the prior owner for operational expenses and the corresponding revenues collected, conducting an environmental assessment to ascertain that there exists no substantial pollution on the property, conduct an in-person examination to ascertain that no structural complications exist on the property and ensure that the property condition concerning structures, foundation, and availability of social amenities are in a good state, conduct background checks through solicitors concerning any prior ownership disputes to ensure smooth and clear transfer by the seller, examine existing service and or maintenance agreements to justify any unresolved issues on the property, ascertain through property reviews whether the infrastructural additions are in the property’s borderline and confirm if there are matters that would impact the property value. Ascertain that the property adheres to the regulations concerning zoning, environmental impacts, parking allocations, etc., and ensure that property taxes, insurance, etc., have been duly settled.

It’s important to note the following:

• Before an investor acquires a property, a contract or “letter of intent” should exist to be signed by the parties to the agreement subject to due diligence being successfully conducted.
• If there are notable concerns during the due diligence exercise, the investor can bring the seller’s attention to renegotiate the price or call off the deal. This is especially possible where a conditional clause was stipulated.
• Due diligence helps to lower the risk of purchasing a property with underlying legal or physical issues.

Due diligence

Due diligence is essential to help an investor ascertain facts and conditions that may impact the outcome of a transaction.

The following due diligence process can guide a property investor before committing to acquire real estate property through debt financing:

• Investigate the title and other legal documents and keenly note any relevant discrepancies.
• Lease terms- Evaluate the period of remaining lease terms compared to the economic state, i.e., short remaining leases provide room for rental fee increments in an expansive economy. In contrast, longer leases provide leverage in a declining economy.
• Evaluate inflation protection level if the tenancy agreement provides a considerable rental fee increment to curb inflation at a predetermined rate.
• Analysis of the Statement of Financial Position: Due diligence should comprise an in-depth examination of the balance sheet, with distinct emphasis on the amount of leverage, the cost of debt, and the debt’s maturity.
• Review third-party reports and assessments, e.g., property appraisals, environmental impact assessments, and property condition assessment reports. These will help ascertain the property market prices to understand whether the property is correctly valued, over, or undervalued.

Question

An investor has entered into a contract to acquire a property that has just been renovated and has confirmed that some of the contractors engaged in the renovation exercise are yet to be paid their dues. In conducting the due diligence exercise, which of the following actions should the investor contemplate to ease his concerns?

1. Commission a property survey.
2. Perform an environmental study.
3. Review the public records for outstanding obligations on the property.

Solution

The correct answer is C.

A review of public records to understand outstanding obligations on the property filed by contractors is advised since an existing obligation can result in legal proceedings for the investor. Property survey and environmental study only serve to ascertain the property’s suitability concerning boundaries and environmental impact but cannot help identify underlying pending obligations.

A is incorrect. Conducting a property survey will not unearth outstanding obligations relating to the property.

B is incorrect. An environmental study will only reveal the property’s environmental impact.

Reading 36: Overview of Types of Real Estate Investment

LOS 36 (d) Explain the due diligence process for both private and public equity real estate investments.