How to Conduct Real Estate Due Diligence during M&A (+ Checklist)

Kison Patel is the Founder and CEO of DealRoom, a Chicago-based diligence management software that uses Agile principles to innovate and modernize the finance industry. As a former M&A advisor with over a decade of experience, Kison developed DealRoom after seeing first hand a number of deep-seated, industry-wide structural issues and inefficiencies.

The highly specific nature of individual physical real estate assets, and the technology that supports them, makes due diligence an absolute necessity.

Whereas country-level data can help to establish whether a company is an attractive investment, two similar buildings located literally a street apart can face dramatically different prospects.

Many companies are empowered by innovative solutions built by real estate tech startups. Which can add additional value to the business and should be considered during diligence.

So, this is the DealRoom rundown on real estate due diligence during M&A.

What is real estate due diligence?

Real estate due diligence is the analysis or investigation of a real estate asset with the aim of establishing the true value of the property.

A property’s value can be impacted positively and negatively by a number of issues, including the general economy, its owners and tenants, businesses located nearby, and even something as seemingly unrelated as traffic flows.

Why is real estate due diligence important?

There are at least three major reasons why real estate due diligence is so important:

1. Illiquidity: Real estate is usually considered to be the most illiquid asset, meaning that once a buyer and has signed the contract on a property acquisition, they’re usually committed to it for an extended period of time. Depending on what the exact nature of the property acquisition, that could mean tying yourself for several years into a certain type of tenant, customer, employee.
2. Cyclical: Real estate is a highly cyclical asset, which seems like a fantastic investment when times are good and far less so when economic cycles come to an end (several hotel groups and retail chains will currently be familiar with this dilemma). Many of the big gains made in real estate investments have been because of inheritance or dumb luck rather than due to intelligent investment decisions.
3. Fit for Purpose: When architect Frank Lloyd Wright delivered the Guggenheim Museum in 1959, it was clear that the museum’s owners hadn’t conducted due diligence: The museum’s curved walls presented a major challenge for anybody looking to hang traditional paintings - the principal purpose of a gallery. Modern-day investors need to keep a better eye on the building’s suitability for purpose to ensure that it retains its value for their own company and others in the future.

How the real estate due diligence process works

At DealRoom, we’re accustomed to telling investors that due diligence cannot start early enough, and this is probably even more true of real estate than it is of companies.

The most successful real estate investors don’t even make a call without being armed with a stack of information that often the owner won’t even be in possession of:

• Local construction trends,
• local rental trends,
• large local businesses,
• tax breaks on properties in the area, etc.

Thus, your first due diligence tasks don’t even have to involve a specific property.

You’re probably more interested in understanding the street, the neighbourhood, and the city. You can complement your knowledge with that of real estate agents, but it is usually unwise to rely on their advice on its own.

Once you’ve made these early steps into the due diligence process, you can begin the more specific task of conducting due diligence into a property or group of properties in the chosen locality.

The real estate due diligence checklist

The list below is far from exhaustive, but provides some indication of the detailed analysis that should be conducted by anybody considering an investment in real estate:

Financial due diligence

(see also DealRoom’s financial due diligence checklist here)

1. Gross rental income and other incomes (if applicable).
2. Vacancy and credit loss.
3. Landlord tax deductions.
4. Tax and insurance liabilities.
5. Rent variability.
6. Previous years’ rent variations and tenant breakdown (if applicable).
7. Operating expenses (property management fees, maintenance, utilities, etc.)

Legal due diligence

1. Chronology of ownership
2. Outstanding legal obligations on the property or its present owners
3. Legal encumbrances of the property.
4. Other rights on the property (if applicable)
5. Zoning, building control, environmental, and other regulations.
6. Access rights.

Property and land due diligence

1. Architect and engineer inspection.
2. Costs required (if any) to repurpose building.
3. Feasibility of repurposing building to company’s purposes.
4. Wastewater inspection.
5. Status of building (e.g. protected, of historical importance, etc.).
6. Environmental rating of building.
7. Land survey.
8. If possible and/or applicable, talk to the current tenants about the building, how it functions, how they feel about it, its rental value, what made them choose it, etc.

Economic due diligence*

1. How have prices in the area trended over the past one, two, five, and ten years, compared to other parts of the city?
2. What are the drivers behind this growth? (young families? Startup companies? Traditional firms moving out?).
3. Are there any factors which make the area a particularly `safe bet` (e.g. the biggest hospital in the region, good schools, a technology cluster).
4. Are new constructions limited by the lack of development land, allowing you to take advantage of limited mid-term limited supply?
5. (If there are tenants) What kind of stability can the current tenants guarantee for future rents?

*As mentioned earlier in the article, much or not all of this can usually be conducted before interest is registered in the property, providing you with a more informed valuation of the property.

Conclusion

Whether you’re a real estate investor conducing real estate on a new addition for your company’s existing portfolio, a property manager for a large regional company, or even a director at a small company pondering a real estate acquisition, we can help.

The DealRoom platform is versatile enough to cater for the spectrum of due diligence requirements. And as this article outlined, good real estate investments begin with good due diligence processes.

Talk to us today about how we can maximize your real estate investment process.