Due Diligence
What does well-executed due diligence look like in real estate acquisitions? For financial firms that understand the needs of sponsors, it is highly personalized. The older model of due diligence was focused on forcing sponsors into complying with a specific, rigid approach. The improved approach to due diligence sees asset-management services providers working directly with sponsors to understand their viewpoints and interests.
This is the approach that Rastegar takes; to work with a highly skilled, third party due diligence team that takes over where our inhouse team leaves off, crosschecks our work-product and assumptions, and adds its own layer of assumption verification to the process.
This article describes the due diligence process we undertake and how our independent, third party due diligence team, provides an extra layer of certainty for our investors.
The Due Diligence Process
The third party due diligence process includes three key components:
- Creating a sponsor-specific due-diligence checklist.
- Building processes using technology and a team of people.
- Executing on assets.
When a firm does this while acting as a third party, they are able to provide a level of customization that enables the process to go along as if the sponsor was performing all due diligence on their own. The big benefit of this for the sponsor is that they do not need to maintain a team of two, three, or four people with very little work to handle between acquisitions.
The third-party aspect of due diligence is important. When a firm takes on the role of facilitating an acquisition process, the priority needs to be on data over recommendations. There needs to be a neutral tone taken toward collecting information, plugging into models, and creating a final report.
Each sponsor gets to act as their own approval committee so neutrality is important because in-house vetting is a pitfall for so many sponsors. When they bring a project that has already been determined a "perfect fit" in their mind to an in-house team, employees may skew their research in an attempt to avoid upsetting the boss.
Defining Due Diligence
It is important to create a baseline definition for due diligence in real estate before moving forward with exploring all the roles this step can actually play in an acquisition. In real estate, due diligence is the period of time taking place between an offer being accepted and the parties come together for closing.
The most notable feature of due diligence is that the burden to perform it properly falls on the buyer/investor. In order to fulfill the requirement for due diligence, the buyer must take on a comprehensive appraisal and evaluation that establishes its assets, identifies its liabilities, and projects its commercial potential.
What Should Due Diligence Achieve?
Ultimately, due diligence serves the purpose of empowering sponsors to make informed investment decisions. Due diligence covers structure, land, and environment. By using a third-party servicer, a sponsor is able to shed the overhead and infrastructure associated with having an in-house team of experts and forecasters capable of performing due diligence.
Generally, due diligence in real-estate investing takes between 30 and 60 days. Some of this time is devoted to waiting for title searches to come through. Other aspects include modeling, site visits, and retaining experts to provide reports on specific aspects of a property's condition.
Due diligence can also help sponsors to adjust their expectations regarding financing. Yes, the outcome of due diligence often allows a sponsor to decide if they should buy a property but a thorough due diligence process also answers the question of whether or not a sponsor will be capable of getting a mortgage before extensive amounts of time and energy have been invested into a project. Part of due diligence is attempting to get initial mortgage approval to see if a deal is even viable through traditional financing.
Due Diligence in Action
Traditionally, due diligence has been a two-tiered process that forces sponsors to make decisions based on limited criteria. First, there is the initial screening. Next, post-agreement due diligence is completed once a sponsor is under contract. Under the updated model, a firm works with each sponsor to understand what they are trying to build. It is not uncommon for a checklist to have more than 100 action points that require review and confirmation.
Stages of Due Diligence
Screening is the first step in performing due diligence. This is largely a sponsor-led step that involves identifying specific property types in specific locations. The sponsor may also frame screening in the context of finding properties that achieve a specific net operating income (NOI).
The third-party support really comes in once the underwriting process begins. During this stage of due diligence, the underwriter collects knowledge with a heavy lean toward comparable sales in the area. In the case of an apartment project, this includes collecting information about rental rates, vacancies, and tenant-satisfaction rates at comparable and competing properties. Information is also pulled regarding sales pricing, purchasing pricing, taxes, and more.
Once underwriting information is collected, it is placed into a model that is either a standard model or sponsor-provided model. The results enable the sponsor to either sign an agreement or move on. If a sponsor would like to sign on, a purchase and sale agreement (PSA) that is contingent upon further due diligence is generally drafted up with a 14-day to 60-day window for verification. The next step is an intensive in-person evaluation of the property to allow the underwriter to create a final model. By placing a property under scrutiny, the sponsor can compare photographs and property statistics that were provided against a real-world assessment.
Due Diligence Line Items
What exactly goes into the models used for performing due diligence?
Common line items include market data, demographics, employment data, comps, rent trends, taxes, expense trends, environmental title, and site inspections. By plugging this information into a model, an underwriter can generate an idea of where rent prices and occupancy rates can realistically land by integrating property details with local economic data.
While some of the information underwriters need can be obtained through public record, environmental and architectural questions are generally answered by hiring environmental or architectural firms specializing in performing due-diligence activities.
Some of the line items are more about what the property will cost versus what it will generate. For example, environmental and structural data can provide assumptions for potential upcoming capital expenses needed to get a property in compliance. For the sponsor, this is one of the best ways to get an understanding of the out-of-pocket number needed to get to the value required from the property to hit profit targets.
Why Does Due Diligence Look at Demographic Trends?
This question is becoming more and more important as people begin to shift toward secondary markets instead of primary markets. The answer is that growth patterns are increasingly becoming important when performing due diligence because demand is less predictable compared to how it was back when primary markets were the only markets that really counted to investors.
For a sponsor interested in developing real estate in a market that is attracting millennial or Gen Z populations, demographics can be worked into the process for due diligence. Many investors are extremely interested in tracking trends of younger generations because these are the renters and buyers who are generally chasing career opportunities mixed with quality of life and affordability.
If an area is being discovered by millennials and Gen Z, it is almost certainly also being discovered by investors. For a sponsor who is interested in breaking into Austin, Dallas, Raleigh, Nashville, and other thriving secondary markets, it is important to work with a third-party servicer with experience in producing the unique analysis needed for these markets compared to primary markets.
How Customizable Is the Process of Due Diligence?
The answer to this question is, Very.
However, that does not mean that a sponsor should assume that reinventing the wheel for every new property that needs to be investigated is the right decision. In reality, many firms choose to use general and repeatable models for the sake of expediency. One thing that many sponsors with big plans for creating proprietary tech for vetting properties soon learn is that creating a custom model from scratch can take weeks.
By utilizing pre-built models, sponsors can get straightforward answers because the truth of the matter is that learning whether or not something is a fit is fairly simple as long as a good model is being used. Additionally, using a model that has been built on the fly can make it difficult to interpret results because there are no benchmarks placed on previous properties. The accuracy and fidelity of the information being imputed is also important. When a model is fresh, it can be more difficult to detect errors in information or calculations.
Due Diligence as Leverage
Due diligence obviously has a protective quality for the sponsor. However, it can also have a leveraging quality. One aspect of due diligence that is separate from the "confirmation" aspect of the process is the "valuation" aspect. The revelations about a property that are brought to light during due diligence give the sponsor a chance to decide what they truly think a property is worth. They can then compare their own figure to what the seller thinks the property is worth. This creates the opportunity for the sponsor to decide if they believe they can get the seller to come down to the sponsor price.
Underwriting of Debt
Underwriting debt is an important checklist item. Like other aspects of performing due diligence, debt underwriting can be customized based on sponsor expectations. A typical sponsor may want to do a 65% loan-to-value (LTV) ratio. Others might want to go higher or lower. The focus is more about the approach than the percentage.
This is where utilizing a third-party servicer capable of also working with a debt broker becomes important. Working with a debt broker allows a due-diligence servicer to with dozens of banks and private funds using their well-established lender-broker relationships.
This familiarity works to the advantage of the sponsor in big ways. Consider a sponsor who does deals at a frequency of about one deal per year. This sponsor doesn't necessarily speak the "lender language." Lenders can be apprehensive about sponsors with big plans who don't have the terminology that lenders are looking for to confirm that a deal is viable. The truth is that lenders can get scared off pretty easily. When a third party that is immersed in lender language and protocol is speaking on behalf of the sponsor, the process can be much smoother.
An experienced servicer with longstanding relationships with lenders also understands what a lender truly needs to see. For a sponsor, they may be an instinct to conceal or hold back information from a lender. Meanwhile, a servicer will understand why a lender is requesting information. There is also an understanding of the format that the information needs to be in.
Remember that banks and lenders are performing a due-diligence process of their own. If one detail is out of place, a lender is both capable of and likely to reject an application that has already been given preliminary approval. A third-party leads a sponsor using their understanding of what financial statements should look like, the right wording to use, how to provide accurate information, and much more.
Final Thoughts
Due diligence is not just about finding problems. When handled properly, it is also about finding opportunities. Properly performed due diligence will leave the sponsor with a holistic answer regarding the true value of a property based on how income potential stacks up against costs to get a property ready for its intended purpose.
Due diligence is often thought of as a form of protection for investors. While this is 100% true, it does not paint the full picture of what due diligence can do for a sponsor when it is executed properly. Due diligence is also an important part of the exploration process for sponsors as they try to determine the full potential of a property.
For the average sponsor, completing due diligence with an in-house team does not make sense. This type of plan would require a sponsor to retain several staff members with the ability to both create and update models for property analysis.
This is why we work with third-party servicers who are brought in to perform due diligence using established models created by a large team of experts in the worlds of tech, finance, and real estate.
