Albert Einstein: “Everything should be made as simple as possible, but not simpler.”
Commercial Real Estate Due Diligence – the Four Areas of Inquiry
I’m a big fan of Albert Einstein. He’s one of my intellectual heroes. He could see and understand what others could barely imagine. His greatest gift, I believe, was his ability to find answers to questions others didn’t even know existed.
Real estate due diligence requires insight as well. To find the answers, you must know the questions.
Of course, I’m no Albert Einstein but, then, real estate due diligence is not inter-galactic science.
The term itself is confusing. “Due diligence” is used grammatically like it’s a thing or a process. “We need to complete our due diligence”; or “Let me review your due diligence”; or “due diligence is expensive”. I admit, I use it the same way.
In fact, however, “due diligence” is a standard of conduct. Due diligence refers to the degree of diligence we should exercise to investigate and analyze all important issues facing a particular transaction. That is to say, the degree of diligence that is “due” under the circumstances.
This definition has two important components:
- a focus on “important issues”; and
- 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 what degree of investigation is due.
Failure to accurately identify these two threshold considerations will lead to one of two outcomes. The due diligence investigation will be either: (1) incomplete – and therefore ineffective to discover and resolve the important transaction risks it is intended to protect against; or (2) overly broad – in which case it will be more time-consuming and expensive than it needs to be. Either way, its value is diminished.
Due diligence can be expensive. We need to avoid making it more expensive than necessary.
So, how do we make sure we get full value for our due diligence dollars? By making sure we know the right questions to ask, and then answering them.
This requires two preliminary sets of questions:
First: What is the vision for this property? Why is it being acquired, and how will it be used?
Second: What is necessary to be known in order to confirm the vision can be fulfilled?
To be sure, we must know the first to answer the second. It is in answering the second that due diligence must be exercised.
For guidance, please review: “Due Diligence Checklists for Commercial Real Estate Transactions”.
For commercial real estate, there are four principal areas of concern:
- Market Demand
Once the vision is clear, addressing these four areas of concern will determine whether that vision can be fulfilled. Within these four areas of concern we will find all the questions that need to be asked and answered to determine the feasibility of any commercial real estate transaction or project. How straightforward is that?
So what do these areas of concern entail? In simple terms, they can be summarized by a description of the inquiry they present.
1. Market Demand
Market demand asks this question: Is the proposed project needed or wanted by target consumers 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 market demand, the transaction or project should not go forward. If you are developing, financing or investing in a real estate project, make sure there is market demand for what is being offered. If you are a strategic user intending to occupy and use the property yourself, market demand may be satisfied by your own business needs. If you are investing on speculation, be sure you know the demand of your intended market.
Determining market demand seldom involves a legal question. No attorney time is necessary. [See? I’m saving you money already.]
Access asks this question: Assuming adequate market demand to justify the proposed transaction or project, can target consumers seeking the goods or services to be offered at or from the property get to it with ease? This aspect includes evaluation of:
- existing or proposed highways, streets, and drives that will serve the site;
- availability of in-and-out curb cuts for consumers and for delivery trucks and vans;
- vehicular traffic flow to, from, and within the project site;
- volume and convenience of pedestrian traffic;
- ability of the project to accommodate the needs of the disabled in a manner compliant with Title III of the Americans with Disabilities Act (ADA), 42 U.S.C. §12181, et seq.;
- adequacy of available parking (which, for business reasons, may need to be greater than the minimum required for zoning);
- availability of public transportation; and
- all other factors that may affect the flow of consumers and users to and from the site.
Use asks this question: Can the property be used as intended? This aspect includes an inquiry into:
- applicable zoning and private land use controls;
- availability of utilities;
- internet/social-network connectivity and availability of telecommunications;
- site topography;
- quality of soil compaction to enable improvement using cost-effective methods of construction;
- evaluation of the environmental condition of the property to determine whether environmental impediments exist that would prevent use of the property as intended absent remediation, institutional controls or environmental impact mitigation; and
- all other factors that may prevent the site from being used as intended.
Finances asks these questions: (a) Can funds be obtained to acquire, construct, and operate the project? and (b) Will the investor receive an adequate return on investment to justify proceeding with the transaction or project?
To answer these questions we must know the cost of acquisition or development and the net operating income and capital recovery expected to be generated by the project.
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 assessments; tenant allowance or build-out requirements; and all other factors having an economic impact.
Although finances are primarily a business concern, certain aspects of project finance do fall within the realm of legal due diligence. Thus the reference to one-half of the Finances concern being within the realm of attorney conducted due diligence.
Documentation of equity investments and project loans, as well as hybrids such as mezzanine financing, demand the attention of legal counsel.
If the property is leased, an evaluation of the amount, velocity and durability of the revenue stream and any financial commitments of the owner/landlord are often considered by counsel.
Certainly, if public money is sought to reduce the net cost of development, legal counsel is required.
Other Due Diligence Concerns
The four areas of concern described above pertain to the “real estate” aspects of the transaction. If you are dealing with commercial real estate, your due diligence must focus on these issues.
Every capital transaction has other due diligence concerns as well. These other concerns are beyond the scope of this post, but may include issues pertaining to entity structure, authority of the parties, income and capital gains taxation and tax deferments, securities, and the overall structure of the transaction, to name just a few.
Commercial real estate due diligence is not rocket science but . . .
. . . it certainly helps if you know what you’re looking for.
Thanks for listening!