Real Estate Due Diligence: A Simple Guide for Investment Properties

Ask the Right Questions, Make Better Real Estate Investments

As the world population grows and cities expand, investment real estate opportunities are looking more and more bounteous. PricewaterhouseCoopers (PwC) predicts that investable real estate will have increased by 55% in 2020 from 2012. With greater opportunities, however, come more risks.

Most people know that they should do some “homework” before purchasing investment real estate. But what does real estate due diligence really look like?

This article describes several forms of general due diligence that can help you make an informed decision before purchasing an investment property.

No matter the property type, some diligence items will always be on your checklist.  That said, it is critical to understand that your due diligence requirements depend on the type of asset you are investing in. Here is a short list of investment property categories to consider; each comes with a unique set of inquiries necessary to fully understand its risks and opportunities:

• Vacant land for development
• Apartments
• Retail businesses
• Industrial buildings
• Properties with an operating business component, such as hotels and parking garages

Why Is the Property on the Market?

Word to the wise: investment real estate due diligence should begin here.

Why is the property on the market? This simple question can reveal much about the prospective success of your investment. It can also reveal what additional due diligence may be needed before you buy.

If you are purchasing a new building directly from a merchant builder or developer, your due diligence will focus more heavily on construction and warranty issues and market data on current rents and operating expenses, as you will not have a relevant operating track record for the property.

In contrast, if the property has been operating for some time, the sale may be motivated by issues relating directly to:

• The seller (i.e., partners wanting to part ways, need for liquidity)
• The financing (i.e., imminent maturity of an existing loan)
• The tenancy (lease terms recently renewed, or soon to expire)
• The market (rise or decline in property values, neighborhood demographics)

Each of these reasons suggests an emphasis on different forms of real estate due diligence.

Who Are the Tenants and Can You Trust Them?

The performance of investment property depends largely on cash flow. You need to understand the likelihood that the tenants will fulfill their lease obligations – and what security you will have should they fail to do so.

If your tenants are individuals, you will want to verify the rent rolls and understand the leasing criteria of the seller’s property management.

With a commercial tenant, you can rely on credit rating companies such as Standard & Poor’s or Moody’s, public securities filings and tenant financial statements. These may help predict whether the tenant and guarantor have the financial wherewithal to honor the lease obligations.

Additionally, information about the tenant’s operations at the property – lines of business, tenant-funded capital improvements or sales volumes –can indicate whether the tenant is likely to renew or extend the term of its lease.

What Are the Real Estate Market Conditions?

Diligent investors consider two different aspects of the market: trends related to the asset itself and those related to the location of the property.

Asset-specific due diligence includes comparable sale prices, rental data, vacancy rates and appraisals. Investors often use a “cap rate” to compare investment properties. The cap rate is the net operating income (NOI) or net income generated by the property (less taxes and operating costs) divided by the sale price. The higher the cap rate, the less expensive the property, and the greater the risk.  Your due diligence should include understanding the factors contributing to the risk.

Locational market trends include demographics and average household incomes near the property, the number and type of employers in the area and access to amenities like public transportation.

Economic incentives, such as tax abatements and interest rates, can apply to either the property itself or the neighborhood.

What Is the Physical Condition of the Property?

In addition to what you can readily see from a property walkthrough, two types of third-party real estate due diligence are common for commercial properties.

Property condition reports (PCRs) address building and structural aspects of the property, such as the condition of the roof, heating, plumbing and construction materials.

Environmental site assessments (ESAs) include a Phase I environmental study, and potentially a Phase II or deeper analysis if the original report discloses an area of potential concern. A Phase I study looks to rule out potential RECs (recognized environmental conditions) or possible contaminants in the area. A Phase II study may include an assessment of soil, water and air samples, as well as an investigation into contaminant sources.

Lenders commonly require both a PCR and an ESA before providing a mortgage loan for a commercial property.

Real Estate Due Diligence = Legal Due Diligence

There are a variety of legal items you or your attorney should review. A title search confirms whether your seller has free and clear title to the property to convey to you, as well as any potential restrictions or benefits that may run with the property (i.e., easements, restrictive covenants, condominium declarations or zoning).

A related item is a survey, which will show the property’s legal and physical boundaries, as well as the location of utilities and any easements. Ideally, the title report and survey will be consistent with one another.

Will You Use Financial Leverage?

If you finance your investment with a mortgage, it is wise to do some due diligence on prospective lenders to ensure that you get a loan best suited to your needs.

Different lenders may offer alternative terms for your project (e.g., interest rate, loan term, amortization schedule, guaranty requirements, interest-only periods, prepayment options) depending on the credit of the tenant(s), the terms of the lease(s) in place and the degree of leverage you require.

Lenders also vary in required loan covenants, such as reserve requirements.  While agencies like Fannie Mae or Freddie Mac may offer more competitive rates, a local bank where you have an existing relationship may prove easiest to work with.

Make Better Decisions Based on Facts and Circumstances

Thoughtful real estate due diligence will not guarantee that your property will perform as expected, but it should give you comfort that your investment decision is sound based on facts and circumstances at the time of closing.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Due Diligence in Real Estate Deals, Investing in Commercial Real Estate and Investing in Residential & Multi-Family Real Estate. This is an updated version of an article originally published on January 26, 2017.]