Due Diligence Analysis as an Investment Tool
Posted August 30, 2007 · Ejike Okpa II
In a developed economy, land as a corporeal resource constitutes a major portion of a nation’s economic wealth. In US, land as represented by real estate; its use, ownership and the various activities that emanate from it, constitute about 70% of the economic wealth. Because of the activities in land, various professions derive their practice based on what happens in the real estate industry. Real estate is not just the physical land and buildings but rather the various interests and rights that are created as a result (Bundle of Rights).
In US, the highest title to land is Fee Simple [Freehold], from which other rights/interests such as leasehold are created. To participate as an investor in the real estate market one needs the guidance of a professional to help them understand the various issues that affect, influence and drive the market. To get started, Due Diligence is the first step.
There are various professionals in the real estate industry namely real estate appraisers, investors, lawyers, accountants, brokers/agents, architects, and so forth. Without prejudice, the one profession that has the most influence and determining impact on real estate especially in a capitalistic economy, is the real estate appraiser (estate surveyor). The appraiser’s role in estimating market value which is used in most real estate transaction, determines the level of investment. By the nature of appraisal body of knowledge, as promulgated by The Appraisal Foundation and outlined in the Uniform Standards of Professional Appraisal Practice (USPAP), any property to be financed by a federally insured financial institution must be appraised by a certified/licensed appraiser in the state the property is located. The market value therefore, determines what is built, loan-to-value ratio - how much that can be borrowed, what return to expect, risk analysis, and so forth.
The role of the real estate appraiser - estate surveyor in the case of Commonwealth nations’, is very crucial in ensuring that market value on which loans are made, are done by those who have the proper training. The appraiser can perform due diligence to assist an investor assemble the required information prior to deciding whether to invest or not. While such service is not limited to the appraiser alone, the appraiser’s unique knowledge of the various factors that affect value and drive the real estate market places him/her on top and above any other professional in the real estate sector.
Clients who want to analyze commercial property purchase, need experienced professionals to perform due diligence as an integral part of an investment decision matrix. The mere availability of capital does not make a market. The complex factors and issues that tend to affect commercial property performance and desirability in a given locale, ultimately makes the market. In today’s market, availability of capital is not usually the problem because capital has been abundant during the past decade.
Through analysis offered via due diligence a ‘go and or no-go’ conclusion is made. In an investment situation, the acquisition of a property may be offered as a set of properties with stand alone conditions and performance challenges that only properly done due diligence reveals risks as well as reward inherent in a portfolio. A buyer may like a certain select properties in a portfolio that suits their investment criteria. However, some complexity and constraints may force the buyer to overlook an opportunity because identifying properties in the portfolio to analyze maybe cost prohibitive.
Due Diligence enables an investor to duly separate, aggregate and array salient factors in order to determine which properties in a portfolio is suitable for further investigation. While owners/investors may elect to do so themselves such may be costly as buyers’ often react emotionally when engaging in transactions that involve large outlay of capital. It is better that a professional is retained to do the analysis as they approach the analysis objectively. Studies indicate that owners/investors who perform their own due diligence from a ‘do-it-yourself’ scenario, often end up regretting the penny-wise pound-foolish consequences of their action. If an owner/investor elects to have their own done, they should use their findings to compare notes with a report by a third party. In fact, when third party financing is used to purchase real estate which is the case in most transactions in US, an owner’s analysis of a pending transaction is not placed any weight because of bias and various conflict of interest. That is why third party reports by duly certified and qualified professionals are used, and such professionals are held liable for any misleading and or mispresentation that negatively impact the property analysis.
*Investment Decision Points - IDP’s*
There are several points worthy of note in a due diligence analysis. While the listed points are not limited to the one shown here, they represent majority of issues an owner/investor would want to consider before committing to a major commercial real estate purchase.
What is the low and high range of rents in the given market and how does that impact the acquisition price likely income potential?
Can rents be increased? What sort of capital improvement/renovations will increase rent? Is the improvements required from the perspectives of demand and competition in a given market?
Is current use the highest and best use of the land given market condition, and other factors and influences?
What renovations or repairs to the improvement will achieve target occupancy level? Using comparable properties, what is the amount of investment to complete the improvements?
Will operating expenses be reduced to a level to achieve desired return on invested capital given the purchase price?
Some of the items to consider in a due diligence are as follow:
* Maps/Site Drawing/Site Plan
* Subject Photos
* Capital improvements (Historical and Planned)
* Service Contracts & Leased Equipment
* Certificate of Occupancy
* Zoning/Warranties/Guaranties/Licenses/Permits
* Certified Operating Statements
* Current Rent Roll
* Budget projection
* Proof of Utilities (electric, gas, water, sewer)
* Current Real Estate Tax Bills
* Insurance Certificate - Premiums
* Lease and Amendments
* Neighborhood Area data
* Demographics
* Litigation
* Title and Survey Review
* Review available reports - appraisals, engineering studies, etc.
_Ejike Okpa II, is a real estate consultant with more than 20 years in the industry. Experience includes work in US and some African countries. He is a graduate of real estate from Harvard School of Design, aertified General Real Estate Appraiser in the State of Texas and was an estate surveyor in Nigeria prior to migrating to US._
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