What is Real Estate Due Diligence?

Real Estate Due Diligence is the structured process of auditing real estate assets. It is an important step in the investment process that can be carried out at any point of the investment timeline and is carefully carried out by specialists using established analytical techniques. Real Estate Due Diligence is a more comprehensive auditing process which covers different parties involved in the transaction. There are several different areas covered by Real Estate Due Diligence, including Market, Legal, Tax, Technical, Environmental, and Financial Due Diligence. A Real Estate Due Diligence Report is typically produced at the end of the audit. Having reports for each of these areas promotes transparency for all parties involved in the transaction and investment.

Who can request for the Real Estate Due Diligence

Real Estate Due Diligence can be requested by any of the parties directly involved in the real estate transaction.

A vendor or seller of the property may request for Real Estate Due Diligence to obtain an opinion on the market value and identify any strengths or weaknesses in the property. This is known as Vendor Due Diligence.

A buyer or investor may also request for Real Estate Due Diligence to ensure that a property is of standard and does not have any undisclosed defects. This is known as Buyer Due Diligence or Investor Due Diligence.

A thorough Real Estate Due Diligence process is often a requirement for a real estate transaction to complete, and any irregularities or red flags discovered in the process would need to be discussed and resolved, prior to closing the deal.

Regardless of whether the property transaction is successful, a property owner may still request for due diligence. This might be used for refinancing, revaluing, or evaluating purposes, allowing the owner to make more informed decisions regarding the property, for example whether it should be sold, or whether refurbishments should be carried out.

Types of Real Estate Due Diligence

The two most common types of Real Estate Due Diligence are Buyer Due Diligence and Vendor Due Diligence, carried out on behalf of the buyer or investor and vendor or seller respectively. A Real Estate Due Diligence team is typically made up of expert professionals from the Real Estate, Law, Taxation, and Business Administration divisions. Teams are generally disallowed from auditing the same real estate asset on behalf of both the buyer and vendor during a single transaction, unless agreed to by both parties, in order to avoid potential conflicts of interest.

Buyer Due Diligence

The Buyer Due Diligence process is carried out in stages on behalf of the buyer in a real estate transaction.

In the preparation stage, the Real Estate Due Diligence team prepares the required documents for the audit, collects information, prepares the fact sheets, and compiles checklists for the Due Diligence process. The information collated at this stage should include an analysis of the surrounding area with detailed information such as the projected population growth, property value trends, vacancy rates, proportion of renter-occupied properties, and median rental rates. General financial information is also collected, including the costs and expenses, taxes, maintenance fees, and any other fees associated with the real estate being transacted.

Next, the team carries out each type of audit, going through the pre-prepared checklist and gathering more specific information through physical inspections of the property and analysis of the financial information relating to the property. This allows the team to produce a sound financial report about the property’s profit and loss statements, rent roll, invoices, as well as an inspection report detailing any flaws or potential physical defects in the property, for which the seller may be accountable for.

After all this information is collected, it will be documented and analysed. Data collected, including photographic documentation, is structured and evaluated by the team of experts and compiled into the Real Estate Due Diligence Report.

The Real Estate Due Diligence Report typically uses the Discounted Cash Flow Method (DCF), Sales Comparison method, and the Income Capitalisation method. The DCF method projects future cash flows of the real estate asset, and applies a discount rate in order to obtain the present value of the asset. The Sales Comparison method uses comparable properties in the region to appraise and evaluate the property, for example by comparing the yield, per square meter or square foot rent, and the selling price. The Income Capitalisation method is sometimes incorporated into the valuation of a real estate asset, and assumes that an asset is an income-producing asset and is held in perpetuity.

Read also: What is Capital Gains Tax?

Vendor Due Diligence

Vendor Due Diligence typically includes all the steps previously mentioned for the Buyer Due Diligence process, however might differ slightly according to varying buyer or vendor requirements.

When Real Estate Due Diligence is conducted, the vendor has various obligations and duties that they need to comply with for a transaction to be successful. This includes disclosing all necessary information to the buyer to avoid creating issues with the transaction.

1) Vendor’s Incidental Obligations of Disclosure
Following the Real Estate Due Diligence process, the buyer and seller are required to conduct a discussion and explicitly state any facts for which they wish to exclude liability. This should be expressed in the form of a Disclosure Letter. The vendor will still be liable for any known defects mentioned in the Real Estate Due Diligence Report for which the vendor does not exclude liability in their Disclosure Letter. For example, if both parties are aware that the roof tiles have been damaged by weather and the seller wishes to exclude liability, the seller is required to state this clearly within the agreement document.

In addition, the buyer should also inform the vendor of any material defects found in the audit that the vendor should be liable for to prevent violating regulations.

If the vendor has given the buyer a warranty that any defects have been resolved, their knowledge or imputed knowledge is not relevant, as the guarantee from the vendor is taken to be the truth, regardless of whether or not the defects were noticeable.

Doctrine of caveat emptor applies to all real estate transactions, where the responsibility lies on the buyer to perform his own due diligence and to be alert of any defects in a contract of sale.

2) Vendor’s Duty of Disclosure
The notion that the vendor is not liable for material defects overlooked by the buyer also forms part of the vendor’s duties. However, some exceptions to this rule apply, such as if the vendor has assured the buyer of the absence of the specific defect or if the vendor has intentionally disclosed the defect during the transaction process. In such cases, the vendor can be held liable for the defects.

A title is a legal document which states the name of the property owner. In the case of defects with the title of the property, the vendor may also be held liable for any losses. The principle lies in the fact that the vendor should be held responsible for the title, regardless of any duty of disclosure or negligence on the part of the buyer.

The vendor also has a duty to divulge information to the buyer as requested. Vendor Due Diligence can benefit both the buyer and the vendor, since it provides transparency and gives the buyer a clearer picture of the property’s attributes in detail, while also giving the vendor a good sense of the positive and negative aspects of their property and how it may affect their transaction.

Having the information from a Real Estate Due Diligence Report earlier on in a real estate transaction ensures that both parties know what they are entering into.

Finally, the vendor also has a responsibility to assist the buyer with any parts of the Real Estate Due Diligence process and cooperate with the team as needed.

Why is Real Estate Due Diligence needed

Real Estate Due Diligence serves a few main purposes during a real estate transaction. Firstly, it provides a starting point for making key decisions in the real estate transaction process, such as setting a purchase price. It also allows the vendor to be aware of any opportunities or threats they may face with the property and make adjustments accordingly.

Finally, with respect to the contract, Real Estate Due Diligence can also establish the base criteria for the transaction’s contract and provide an idea of where each party stands when entering into the contractual negotiations.

Types of Real Estate Due Diligence

1) Market
Market Due Diligence is part of the Buyer Due Diligence process. In Market Due Diligence, the real estate market, location and corresponding marketability of the property are evaluated.

In evaluating the real estate market, the Real Estate Due Diligence team takes into account any appraisals from qualified real estate organisations, macro economic factors, demand and supply considerations, through a comprehensive analysis of the market.

With regards to the location of the property, a thorough location analysis is required, which may be impacted by the phase of the economic cycle. With a market analysis, the Due Diligence team has to consider the market trends, such as the demographics, unemployment trends and purchasing power trends. In addition, a microanalysis of other comparable properties in the market can provide some insight into the property’s value and performance.

The marketability of the property also has an impact on the buyer’s decision making when purchasing a property. These marketability factors include the property’s reputation, a SWOT (strengths, weaknesses, opportunities, threats) analysis, the current and future development potential or viability of the property, along with a cost-benefit analysis.

This is also affected by the property type - for example retail properties, office properties and residential properties are valued and evaluated differently. Residential properties may be evaluated based on the rental rates it can offer or its proximity to amenities, while retail properties evaluation criteria may be weighed more heavily on the amount of foot traffic in the area.

2) Legal
The Legal Due Diligence process is one of the most important parts of the Real Estate Due Diligence process as it allows the party requesting it to get information on the property before making an offer on it. This information is obtained from the companies register, land register, planning permission files, and inspections.

The Legal Due Diligence analysis focuses on the land usage and planning under public law, existing leases and agreements for the property, including any utility, maintenance or insurance contracts for the property. Land title search is an important aspect of legal due diligence. It ensures that the title is good and free from any encumbrances before the deal goes through. The requesting party would also require legal information for any existing employment relationships to facilitate future transfers, litigation details and the charges for the property overall, to ensure that the documents are in order and that a thorough transfer of these legal documents can take place after the deal is closed.

The Legal Due Diligence process also encompasses a few liability risks, which should be addressed in the report. After acquisition of the property, there may be existing businesses or employment relationships to be transferred to the buyer since these professional relationships have a fixed length depending on the contract or legal agreement. The Legal Due Diligence should also cover any additional development costs, statutory charges, builders’ liens and property taxes associated with the real estate asset.

After Legal Due Diligence is carried out, a Legal Due Diligence report will be prepared, containing the established risks, assessed risks, suggestions to avoid such risks, future recommendations and guidelines for future contractual negotiations.

The Legal Due Diligence audit should also be incorporated into the transaction agreement so that the opportunities and risks of the property are allocated between the buyer and vendor. In order for the Legal Due Diligence information to be included in the agreement, the vendor has to declare that they have submitted all the necessary documentation, that planning permission has been granted, that the property is not polluted or in a polluted environment, and that the vendor will take on any costs for which they are liable after the agreement has been concluded.

3) Tax
Tax Due Diligence should be customised based on the categories and brackets the parties fall into. The taxes involved in a real estate transaction may also have a significant impact on the financial aspect of the transaction and in evaluating the economic viability of the investment.

The specific calculations made with Tax Due Diligence depend on the taxable person or entity, as well as the taxable property or assets involved in the transaction. As a result, an individual purchasing a property may have a different tax rate than if a company was purchasing the property. Tax rates also vary across different countries, and buyers may be taxed at different rates depending on their citizenship or nationality.

4) Technical
Technical Due Diligence deals with all the aspects related to the physical structures of the property. This involves the collection and analysis of the basic documents and data for the property, such as floor plans, safety regulations and gross floor area.

The Technical Due Diligence team then assesses the structural quality and capacity of the property, which provide an indication of what improvements should be made, and its versatility. The Technical Due Diligence audit also covers some financial issues, such as the rate of return of the property, as well as utility and maintenance costs.

Finally, the type of property also plays into the Technical Due Diligence process. Larger commercial properties may require calculations of the gross leasable area, while residential properties follow a net leasable area. Certain built-in equipment and structural integrity should be checked for industrial properties, but may not be relevant for residential properties. Structural flaws, limitations or discrepancies can be grounds for a reduction in the purchase price.

These issues are all laid out in the Technical Due Diligence Report. The report contains a summary of the findings of the audit, project data, structural evaluation, floor space, costs, leases and service contracts, property management and maintenance.

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5) Environmental
While environmental factors are often overlooked in the Real Estate Due Diligence process, they can harm the property’s economic viability. The Environmental Due Diligence team typically consists of a geologist, asbestos technician and a lawyer experienced in residential pollution issues. This team prepares fact sheets, compiles checklists, makes enquiries and provides information on environmental issues in the investment.

The main categories in the Environmental Due Diligence audit are evaluations on the water supply source, hazardous waste and noise pollution, the building, including checks for asbestos, and legal issues like an analysis of weaknesses and non-compliance. The audit is then documented in the due diligence report, along with the risks for the buyer, which may include additional costs, polluted water or changes in environmental legislation that affect the property.

Because of the importance and potential severity of these environmental issues with regards to the property, it is imperative that they are detailed within the environmental due diligence report and resolved by the vendor before an agreement can be reached.

Environmental factors are becoming more prominent, with the introduction of green legislation regulating energy efficiency, water conservation and waste management, making Environmental Due Diligence more important than before due to the increased penalties for non-compliance.

Read also: ESG & Green Buildings: Should They Be an Investment Focus?

6) Financial
Financial Due Diligence is the process of collecting and assessing income, expenditure, opportunity, risk information, and assessment of the real estate deal.

The financial analysis involves the following steps - a cash flow projection for the selected planning horizon and periodic returns, an assessment of the value of the property, and an analysis of the credit and property ratings. Property ratings are calculated using the criteria below, each holding a specific weighting.

Financial Due Diligence also required the analysis of historical financial records for any potential risk factors or inconsistencies. This process can also uncover existing debts, financial position and cash flow information on the property.

Capital needs to be acquired to finance the property sufficiently, typically following this capital structure.

Read also: Knowing Your Capital Stack

*Mezzanine capital is not typically involved in the real estate investment process for individual investors, as they likely borrow from a single lender or bank.

In most real estate transactions, the majority of the capital is borrowed. This form of financing can include a mortgage loan, chattel mortgage, transfer of ownership through security, interest rate instruments, and collateral value, following the contractual terms of the loan. The financing can take place in the short-term (interim financing) or long-term (long-term financing).

The Real Estate Due Diligence Process

Some standard checklists also provide both vendors and buyers with the steps taken in Real Estate Due Diligence.

1) Pre-offer Due Diligence
Real Estate Due Diligence can take place before an offer is made to ascertain that the real estate asset meets the needs of the buyer or investor. A vendor may also order Pre-offer Due Diligence to ensure that they can resolve any defects and get an estimate for the value of their property before making a listing.

Any defects discovered and disclosed in a Pre-offer Due Diligence report will not be open for warranty claims for the buyer. The vendor will also not be liable for any breach of warranty for noticeable defects that the buyer did not identify at this stage in the transaction.

2) Post-offer Due Diligence
The Post-offer Due Diligence process is carried out to verify and confirm that the prior information was accurate and reliable. If Post-offer Due Diligence is conducted, any information collated during the Pre-offer Due Diligence is disregarded. After the Post-offer Due Diligence is conducted, the buyer is required to follow through with the original conditions laid out in the agreement, in spite of the defects found in the Post-offer Due Diligence, with some exceptions in the event that serious material defects are found.

Conclusion

Overall, the Real Estate Due Diligence process is comprehensive and requires cooperation from all parties involved, ranging from real estate experts to the buyer and vendor. However, while Real Estate Due Diligence may prolong the time taken for a transaction to close, it is often required by a buyer or investor as a condition precedent to complete the deal. Oftentimes it proves beneficial for everyone involved in the transaction, in providing transparency and in avoiding potential conflicts regarding the property in the future.

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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.