Diligence pays off

As real estate investors compete for increasingly scarce opportunities, the need for due diligence to be conducted quickly has never been greater. By Dave Keating

Homework has never been fun. But as children we quickly learn that failing to do it, or enough of it, can have negative consequences. Yet there are few students in the world that have never been caught unprepared for a test, a cold sweat pouring down their brow as they find themselves staring down at an intimidating list of questions.

The same torrent of sweat can pour from the face of a real estate investor who hasn't done their homework on an investment. After the ink dries on the purchase agreement, sometimes they find they've signed on to more than they bargained for. And often, a little extra due diligence could have alerted them to the dangers coming down the road.

But in today's highly competitive real estate market, where more and more firms are competing for a small number of real estate opportunities, due diligence must be not only thorough, but also rapid.

“In hot real estate markets, investors are willing to cut due diligence thoroughness in order to do a good deal.”

“Most people would say that because acquisitions are much more competitive, the due diligence time is compressed,” says Gary Stevens, a partner with Landmark Partners. “If you want to be competitive, you have no choice but to try to do as much as you can in a short period of time.”

No wonder, then, that GPs are eager to recruit multi-faceted deal teams—from legal advisors to debt providers to environmental auditors—to help ensure their deal execution is as robust and rapid as possible. This means that kicking the tires has become not only more involved and condensed, it has also come to encompass more people.

“More deals are intermediated these days,” says Mike Hoffmann, president of the placement agency Probitas Partners. “This raises the quality and level of information. And for advisory groups, it's a growing business.”

But even with the growing business for advisory firms, some GPs say that increased competition is forcing investors to conduct their due diligence too quickly. Jonathan Philips, a senior director of Cherokee Investment Partners, which invests in environmentally contaminated properties, says the specific concentration of his firm mandates that they take their time with diligence. But he says firms bidding for traditional properties might be forced to cut corners.

“In hot real estate markets, investors are willing to cut due diligence thoroughness in order to do a good deal,” he says. “If there's more competition, some people think they can sacrifice some due diligence, and sellers can require or demand less due diligence time if they have more suitors.”

If due diligence time is rushed, what are the essentials that must be examined for a real estate transaction? Whether firms do their homework internally or externally, there are some basics which every diligence process starts with. Real estate firms are likely to start by looking at an asset's physical and structural engineering, its tenants and their credit, and the property's operating expenses. They're also likely to make sure that the anchor tenants for a property are planning to stick around for some time or, if they're not, that they have eager tenants waiting in the wings.

“You start by asking, ‘What has the operating history of my target been for the last three years?’” says Gary Koster, the head of real estate fund services for Ernst & Young. “You beat up the past, seeing what the expenses of the property have been and how it compares to industry norms. You're projecting, if I was in that role, what could I have done with it?”

For these basic considerations, the most important information may not be coming from what a seller is providing you. The seller can tell the buyer what rents are in place, when the leases expire, and what the expense structure and operating expenses are. But Probitas' Hoffmann says you really have to put in your own legwork to fully understand a property.

“You've got to test out the validity of the numbers they're giving you,” he says. “Talking to tenants is one of the things that I did when I was a principal. You should sit down and interview each of the tenants in the building because they know the asset better than you ever will.”

Investing in a single asset or building is one thing, but what about properties that are overlaid with an operating business, such as hotels, casinos or senior living facilities? According to many industry practitioners, these types of assets require an entirely different level of due diligence.

“In an asset deal, all you really care about is what the asset creates in terms of its value,” says Koster. “But when you're buying into a company, things like the corporate litigation history and the prior tax posture all have an impact on the purchaser going forward. Those complications need to be vetted thoroughly.”

Investing in new or emerging markets can present its own set of unique due diligence challenges. Malcolm Wright, who is with the transaction services department of the advisory group KPMG, says investing across borders requires much more due diligence than domestic investing, especially in emerging markets.

“When you go offshore, financial data is not always what it first appears,” he says. “There are more complicated tax structures as you go overseas. You need to ask, ‘Are the assets and liabilities valued correctly?’ Doing due diligence in a lot of these countries is not that easy.”

Examining cultural differences can also be an important step in these cases. Hoffmann gives the example of an investor who built a beautiful modern building in Warsaw with a completely sealed air conditioning system. However the client built the structure without realizing that in the EU, by law, you must have access to fresh air in every office. In addition to that, most tenants in Warsaw wanted that level of access.

“Developers who aren't sensitive to local demand often build products that are great from a US perspective, but aren't great for the market,” he says. “That means diligence requires having a local presence.”

Local laws and regulations can also present difficulties. Koster says some GPs don't give enough consideration to legal challenges that can come up down the road.

“You have to ask, ‘How comfortable are you with the current legal regime and your ability to enforce your rights and obligations in that country against others,‘” he says. “’How difficult is it for somebody out of country to negotiate the political climate?’”

Koster says China has been a particular concern in this respect, as investors have flooded to a country where the rule of law can often seem unpredictable and arbitrary. Wright says that he has a simple strategy for calculating how much due diligence is needed in specific areas.

“A simple way to look at it is, if you are investing outside the US or Europe, then for every hundred miles you go, your due diligence needs to ramp up another notch,” he says.

Environmental due diligence is another area that can save a lot of headaches down the road. At Cherokee Investment Partners, where investment is focused on environmentally damaged property, this type of diligence is of paramount concern.

“For any investor, the economics for a transaction would be flipped upside down if we were to spend a whole bunch of money buying an asset and working on it and then have issues discovered afterwards,” says Philips.

Failing to check out environmental liability can have severe consequences. In 1980, the passage of the superfund statute at the federal level in the United States established strict liability for environmental problems, meaning that investors can be held liable for pollution even if they didn't cause the problem. Today, environmental due diligence is essential in order to avoid inheriting contaminated land.

Jonathan Gallagher, a managing partner at Cherokee who has also worked as an environmental consultant, says it took a while for investors to learn that skipping out on environmental due diligence can spell disaster.

“A lot of the capital providers found that after they had lent money, pollution was found, and then they would find themselves with a worthless piece of property,” he says.

Since that time the process investors follow for environmental due diligence has become fairly standard. If the assumption is that the property is clean, an investigation of all publicly available information about spills, pollution conditions or proximity to old factories can tell you if this assumption is correct.

“A qualified environmental professional will go to the property and inspect it, and we'll conduct interviews and research with the site's previous owners and occupants of the property,” Gallagher says. “You have to bring in scientists and engineers. The expertise has really grown. Back in the 1980s people would misestimate the damage or not understand what was going on with the regulators. But it's complicated, and a lot of people simply don't want to deal with it.”

With all of these concerns, it's no wonder that many firms have decided to hire outside advisory agencies to conduct their investigations. Consultants say the sheer proliferation of deals, as well as their increasing complexity, has meant a surge in business.

“People are outsourcing because they're able to get the best athletes in that space,” says Probitas' Hoffmann. “Most small to mid-size firms can't afford to have a full-time environmental engineer, seismic engineer, regulatory attorney and someone to do the financial oversight.”

“There's no substitute for experience,” adds Koster. “Every time you do another deal you're building up your database of potential issues.”

The use of an advisory firm becomes even more important when a firm is dealing with a country, location, property type or volume that they're not accustomed to working with. Some of the larger firms can afford to do this work internally. But given the cyclical nature of this business, that can be a risky model. By assembling an internal due diligence staff, a firm is making a bet that no matter how much acquisition work they're doing, they'll have enough activity for that team. Some firms prefer to stay lean, outsourcing due diligence for their busiest times. Other firms are more bullish and believe they can withstand the cycle.

“If you are investing outside the US or Europe, then for every hundred miles you go, your due diligence needs to ramp up another notch.”

Of course, the burden of due diligence doesn't fall entirely on the buyer. Most sellers are now realizing that if they're more open in their disclosures they'll get a better price. This often requires a seller to do a little research into their own asset before putting it up for sale.

“People discount the price where they perceive risks or unknowns,” says Stevens of Landmark Partners. “The more complete the info they have the less likely they are to lower their offer. And the brokerage community is setting a pretty high bar for what sellers need to disclose.”

“When it comes to disposing assets, you need to know what it is you're disposing of,” agrees KPMG's Wright. “Even for private equity firms who may have been a little hands-off in their ownership, knowing where the bodies are buried as you go into a sales process will make it less painful for all concerned.”

In these types of cases, a smart seller will perform due diligence on their own asset before offering it to the world for inspection. By conducting vendor due diligence, a seller can put the best face on what may be a lousy holding. However, even with more honest data, a seller in a private sale is never going to be as forthcoming as a company that is publicly traded.

“Particularly in real estate, data tends to be relatively poor in quality, compared to investing in a public company,” says Cherokee's Philips. “Information is often anecdotal, and traditionally developers have relied more on intuition than data. But this is slowly changing I think.”

Many investors have learned the hard way that gut instinct might not be the best way to prepare for a deal. But with a little homework, investors may be able to avoid a big headache later on.