April 14, 2023
Assessing risk is a highly important aspect of portfolio management. Whether that assessment takes place in the lead up to an acquisition or throughout the final stages of disposition, Asset Managers and the CRE professionals who touch any step of these processes are more than familiar with due diligence.
There are many different types of due diligence used to uphold different legal requirements, and the process comes up frequently when selling insurance, business acquisition, and purchasing real estate. To find out more about the four different types of due diligence found in commercial real estate and industries beyond, read on for an in-depth look into this important process.
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What Is Due Diligence in Real Estate?
Who Is Responsible for Performing Due Diligence?
Market Due Diligence
Financial Due Diligence
Legal Due Diligence
Physical Due Diligence
Prophia’s Role in the Due Diligence Process
What Is Due Diligence in Real Estate?
Due diligence appears in more industries than simply real estate. Generally speaking, due diligence refers to a series of steps, carried out by a person, to ensure all legal requirements have been met when buying or selling something. This can take place in the insurance industry, residential real estate, mergers and acquisitions in business, and more.
In commercial real estate, due diligence refers to the process of conducting comprehensive reviews of commercial properties or a portfolio to identify risks or liabilities associated with a transaction whether that is the sale or acquisition of an asset. Performing due diligence requires both sides of the transaction to work together with up-to-date and accurate information to successfully come to a deal and complete the sale of a property.
A typical due diligence period in commercial real estate lasts for about 30 days, however, the process can be extended to beyond 60 if both parties’ documents require additional review.
Who Is Responsible for Performing Due Diligence?
Due to the legal importance of the due diligence process, there are a number of individuals, from each party, who are responsible for different aspects of the proverbial checklist. For instance, the seller may perform due diligence prior to any marketing efforts, meanwhile the buyer will perform their own due diligence, leading up to closing, in order to properly evaluate the condition of the property and assess any risk associated with the transaction.
Four Types of Due Diligence Found in CRE
Market due diligence
Buyers and sellers conduct market due diligence to analyze the property's market and competitive position. This allows all parties to assess the property's current and potential value based on the local real estate market and to identify any potential risks or opportunities associated with the property's location and market position.
When purchasing a property, buyers will want to search for assets in real estate markets that show signs of good health like job creation, tenant rents and commercial property prices that are projected to rise; consistent median income levels, limited competition in the area, and favorable zoning that encourage new business growth.
If all of the market dynamics appear favorable for an acquisition, the purchaser may then choose to move into another phase of due diligence to progress the transaction.
Financial due diligence
Financial due diligence involves a detailed analysis of the financial aspects of the property, including income and expense statements, rent roll, lease agreements, and other financial records. The objective is to determine the property’s market value and return potential.
Many aspects of performing financial due diligence fall on investment teams but ultimately, it’s very important for all parties to fully understand all expenses associated with the property. This includes reviewing historical cash flow statements, conducting tenant interviews, reviewing rent rolls, vendor contracts, and more.
The buyer may also generate a cash flow projection and use financial due diligence to prove the projected amount. Additionally, some parties may create a proforma projection of the property’s net income and expenses to paint a more detailed financial picture of the asset.
Legal due diligence
This involves a review of all legal documentation related to the property, including title deeds, zoning regulations, permits, environmental assessments, and other legalese like lease agreements containing tenant rights and options. Buyers and sellers enter into legal due diligence in order to identify any legal encumbrances like liens, unpaid taxes, or easements. Additional steps include:
1. Purchasing title insurance
2. Reviewing occupancy certificates
3. Obtaining estoppel certificates
4. Reviewing existing surveys or ordering a new survey on the property
Another aspect of legal due diligence in real estate may also call for the financial lender to review the Title and tax records to approve the transaction. Again, in legal due diligence, it’s very important all parties are working with the most accurate data in order to properly mitigate the risk of the transaction.
Physical due diligence
Physical due diligence in real estate thorough inspection of the physical aspects of the property. This includes physically inspecting the building's structure, electrical systems, plumbing, and other mechanical systems. The objective is to identify any potential physical risks or maintenance issues so they can be included in the negotiation and reach fair conclusions within the following categories:
1. Building safety: Is the property safe for occupancy?
2. Repairs: Does the property require any major repairs?
3. Environmental safety: Is the groundwater and soil free of contaminants from the previous or current tenant?
Structure and physical due diligence is a critical step for sellers in order to appropriately price an asset, it is also very important for a buyer to understand all outstanding maintenance to ensure they are budgeting properly for the acquisition. Property managers and building engineers will typically carry out the physical inspection on behalf of the buyer and the seller.
Prophia's Role in CRE Due Diligence
At every step of the due diligence process, it is critically important to work with the most accurate and up-to-date information—there is simply no room for human error. That’s why tools like Prophia, an AI-powered data extraction and analytics platform designed for CRE, can greatly help with data accuracy throughout every stage of due diligence.
What’s more, Prophia has saved real professionals real time in due diligence processes. In the case of Urban Renaissance Group’s acquisition of the Lloyd Center in Portland Oregon, URG’s investment team used Prophia to upload and abstract 100+ lease summaries in less than 10 business days. The speed and accuracy with which they received their critical due diligence documents was anything but the usual divide-and-conquer method they were used to and they were able to turnaround the deal in record time and with unprecedented accuracy.
“Still blown away by the speed in which we got back all of these abstracts.”
Jeff Vorhies, Director of Investments, URG
By linking back to original source documents, Prophia creates an accurate and easy-to-use data ecosystem that saves CRE professionals valuable time and energy while conducting acquisitions, carrying out due diligence activities, and completing and post due diligence tasks. To get an exclusive walkthrough of Prophia’s due diligence capabilities, get in touch with us directly.