Albert Einstein:
Everything should be made as simple as possible, but not simpler.
R. Kymn Harp: D² = I + F?
[Due diligence = Insight + Focused Investigation]
I am a great admirer of Albert Einstein. He is one of my intellectual heroes. He could see and understand what others could barely imagine. I think his greatest gift was his ability to find answers to questions that others didn’t even know existed.
Real estate due diligence also requires knowledge. To find the answers, you must know the questions.
Of course, I’m not Albert Einstein, but, then, real estate due diligence is not an intergalactic science.
The term itself is confusing. “Due diligence” is used grammatically as if it were a thing or a process. “We need to complete our due diligence“; Prayed “Let me review your due diligence.”; Prayed “due diligence is expensive“. I admitted it, I use it in the same way.
In fact, however, “due diligence” is a standard of conduct. Due diligence refers to the degree of diligence we must exercise to investigate and analyze all material issues facing a particular transaction. That is, the degree of diligence that is “due” in the circumstances.
This definition has two important components:
1. a focus on “important issues”; Y
2. the degree of diligence appropriate under the circumstances of the particular transaction.
The art of the deal, so to speak, is in understanding what is “important” and how much research is due.
Failure to accurately identify these two threshold considerations will result in one of two outcomes. The due diligence investigation will be: (1) incomplete and therefore ineffective in uncovering and resolving the significant transaction risks it is intended to protect against; or (2) too broad, in which case it will take longer and cost more than necessary. Either way, its value is diminished.
Due diligence can be expensive. We have to avoid making it more expensive than necessary.
So how do we make sure we get the full value of our due diligence dollars? Making sure we know what questions to ask and then answering them.
This requires two preliminary sets of questions:
First: What is the vision of this property? Why is it purchased and how will it be used?
Second: What is necessary to know to confirm that the vision can be fulfilled?
To be sure, we must know the first to answer the second. It is in the response to the second that due diligence must be exercised.
For guidance, request a copy of my article: “Due Diligence Checklists for Commercial Real Estate Transactions“.
For commercial real estate, there are four areas of concern:
1. Market demand
2. Access
3. Usage
4. Finances
Once the vision is clear, addressing these four areas of concern will determine whether that vision can be met. Within these four focus areas, we will find all the questions that need to be asked and answered to determine the viability of any commercial real estate transaction or project. How simple is that?
So what do these areas of concern imply? In simple terms, they can be summarized by a description of the query they present.
1. Market demand
“Market demand” asks this question: Do target consumers need or want the proposed project in the geographic area within which the property is located?
Market demand is the most fundamental of the four aspects of commercial real estate. If there is no demand in the market, the transaction or project should not go ahead. If you are developing, financing or investing in a real estate project, make sure there is market demand for what is on offer. If you are a strategic owner who intends to occupy and use the property for yourself, market demand can be met by your own business needs. If you are investing in speculation, make sure you know the demand of your anticipated market.
Determining market demand rarely involves a legal question. The time of an attorney is not necessary. [See? I’m saving you money already.]
2. Access
“Access” asks this question: Assuming market demand is adequate to justify the proposed transaction or project, can they be easily reached by targeted consumers seeking the goods or services to be offered on or from the property? This aspect includes the evaluation of:
has. existing or proposed highways, streets, and roads that will serve the site;
b. availability of inbound and outbound curb cuts for consumers and for delivery trucks and vans;
against the flow of vehicular traffic to, from and within the project site;
d. volume and convenience of foot traffic;
me. the project’s ability to accommodate the needs of the disabled in a manner that complies with Title III of the Americans with Disabilities Act (ADA), 42 USC §12181, et seq.;
F. adequacy of available parking (which, for business reasons, may need to be greater than the minimum required for zoning);
gram. availability of public transportation; Y
H. all other factors that may affect the flow of consumers and users to and from the site.
3. Usage
“Use” asks this question: Can the property be used as intended? This aspect includes an inquiry about:
has. applicable private land use and zoning controls;
b. availability of public services;
against topography of the site;
d. quality of soil compaction to allow improvement using cost-effective construction methods;
me. evaluation of the environmental condition of the property to determine if there are any environmental impediments that prevent the use of the property as intended in the absence of remediation, institutional controls or environmental impact mitigation; Y
F. all other factors that may prevent the site from being used as intended.
4. Finances
“Finance” asks these questions: (a) Can funds be obtained to acquire, build and operate the project? Y (b) Will the investor receive an adequate return on investment to justify proceeding with the transaction or project?
To answer these questions, we need to know the actual cash cost of acquisition or development and the net operating income and capital recovery that the project is expected to generate.
We must determine whether costly environmental remediation or institutional controls will be required; the amount of applicable user fees; environmental impact mitigation costs, if any; real estate taxes; special evaluations; tenant assignment or building requirements; and all other factors that have an economic impact.
While finance is primarily a business concern, certain aspects of project finance fall under the purview of legal due diligence. Therefore, the reference that half of the Finance concern is within the scope of the due diligence performed by the attorney.
~ Documentation of equity investments and project loans, as well as hybrids such as mezzanine financing, that require the attention of legal counsel.
~ If the property is leased, the attorney often considers an assessment of the amount, speed, and durability of the income stream and any financial commitments from the owner/lessor.
~ Certainly, if public money is sought to reduce the net cost of development, legal advice is required.
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Other Due Diligence Concerns
The four areas of concern described above are relevant to the “real estate” aspects of the transaction. If it’s commercial real estate, your due diligence should focus on these issues.
Every capital transaction also has other due diligence concerns. These other concerns are beyond the scope of this article, but may include issues related to entity structure, party authority, income and capital gains taxes and tax deferrals, securities, and overall transaction structure, to name just a few.
Commercial real estate due diligence isn’t rocket science, but…
…it certainly helps if you know what you’re looking for.