We often get the question, “What is a real estate due diligence analysis, anyways?” In this blog, we’ll provide a definition and identify the major parts. We’ll also talk about what it would potentially cost. Stay tuned!
Before we get started, my name is Logan Moore.
I’m a due diligence analyst for private real estate transactions. I work with financial advisors, family offices, and high net worth individuals to help them identify alternative investments that align with their values. For a couple of past interviews I did on the topic of evaluating private investments, check out the links below.
And now – let’s get on with it!
What is it?
Let’s start with a basic definition.
What is a real estate due diligence analysis?
In real estate, due diligence refers to the research done on a potential real estate investment to make sure that it is sound, from both an operational and an investment perspective. This exercise is necessary to protect the client from fraud or from making a bad investment decision.
A due diligence analysis should be performed by a professional due diligence analyst. It is best for this person to be:
- An independent third party who is not affiliated with the real estate investment firm in any way, financially or otherwise.
- Of an objective mindset
- Prudent in their analysis
- Willing to act in the client’s best interest and put the client’s needs before their own
- Ideally, adhering to the fiduciary standard, the highest standard of care in the investment industry.
Real estate due diligence checklist
There are several parts of an analysis. For the purposes of simplification, we’ve organized them into a real estate due diligence checklist:
#1 Legal document review
What are the due diligence documents in real estate? Typically, the analyst will review the private placement memorandum (“PPM”), operating agreement, and any other investor correspondence. These outline the key terms of the deal and help the analyst to gain a better understanding of the investment.
#2 Sponsor review
During this stage, the analyst will vet the sponsor or deal operator, looking into their background and track record. Public searches about the sponsor and their past dealings should be conducted. The analyst should directly contact the management team on your behalf to review their experience and gain additional information regarding your potential investment.
#3 Asset review
This is an analysis of the investment itself. The analyst will review the details about the property, or in the case of a fund, the fund thesis. This should include a review of the pitch deck and other promotional materials as well as independently obtained information such as public records.
#4 Underwriting analysis
The analyst will look at the underwriting model for the investment to determine how feasible the property’s funding is. Factors that are taken into account include (but certainly not limited to):
- The capacity of the investment property to generate income (such as rental rates)
- Key assumptions such as exit cap rate, projected rent and expense growth, and vacancy
- The amount and type of leverage (i.e. debt) the property is using
- Ability to pay debt service and cash flow to investors
It’s important to include underwriting in the due diligence analysis because it provides insights as to the ability of the project to generate expected returns.
#5 Stress testing
A stress test looks at the property’s ability to perform in different scenarios. For example, if interest rates were to hike by 1%, what would the impact on the property’s income-generating potential be? The analyst is looking for an indication of how an investment is likely to perform, or not perform, when different risk factors come into play.
#6 Broader market analysis
Understanding the market in which the company or real estate asset operates is an important part of real estate due diligence. The analyst will look at criteria such as the state and/or municipality in which the property is operating, what real estate prices are for similar properties, the current trends for real estate in that area and for that type of investment, and income levels in the area of domicile. It is also useful to consider the broader economy and macroeconomic trends that may have an impact on the investment.
Cost factors
The cost of a real estate due diligence analysis can vary based upon the scope of work and depth of analysis required. For an institutional caliber analysis, the cost could be five figures or more. The fee for a real estate due diligence analysis may be assessed as a fixed fee or on an hourly basis.
It is customary for the real estate due diligence analyst to assign a quote for the work prior to agreeing to work together. If you are in the search process, make sure to obtain all quotes in writing. Make sure to gain clarity on what the depth of the analysis will be, what reports you’ll be provided with, etc.
Did this help at all?
Thanks for reading to the end of this blog about what real estate due diligence is. Did you decide that private real estate investing is worth it for yourself or your clients? If so, let’s set up a time to talk. I am a due diligence analyst and financial advisor with over eleven years of experience evaluating investments and would be happy to provide insights that can help you get started.
