When buying real estate, completing a thorough due diligence investigation is paramount. After the acquisition closes, the property is yours – along with all of its unique benefits and challenges. At that point, it is too late to address issues with the previous owner, including concerns that could have (and likely should have) been reviewed and resolved prior to closing. Missing important details can have a significant or devastating impact on the profitability of a real estate development project.
For existing buildings, the due diligence process is fairly well known. However, when it comes to buying undeveloped land or property you plan to redevelop, a different level of due diligence is needed. Here are some factors to keep in mind so you do not miss details that can set you back for years.
Due Diligence and Development Partnerships
When a potential acquisition involves a partnership or venture between a developer/builder and the financial source, it is imperative that the due diligence be thoroughly reviewed by both parties, including the physical aspects of the project. This is because the builder and the financial partner have differing risks and motivations for entering into the transaction.
For example, small builders who rely on financing for each deal may be more motivated to maintain their work pipeline than to maximize profit, leading them to be less than transparent with a property’s negative issues. Meanwhile, financial partners may have a number of investment opportunities to choose from, focusing on the most profitable placement for their funding.
This inherent conflict of interest is resolved when both parties complete separate, independent, due diligence.
Physical Inspections of the Property are Critical
There are many aspects to due diligence work, including document review, title, legal, environmental and financial analysis. It should also include physical reviews, such as inspections of the property. In order to be done properly, inspections require ample time, and too often this step is rushed, not thorough, or sometimes skipped entirely.
For land acquisitions, the physical review should include an engineering overview for feasibility. This can include geotechnical investigations to determine the suitability of soils and the existence of rock and subsurface conditions, and review of potentially hazardous materials, both on and under the surface of the site. The resulting report will give you a good idea of the scope of work needed to prepare the land for construction.
In a recent case, a client asked us to investigate the source of a significant subsurface condition. Unfortunately, the call came to us after the fact, when excavation was already complete and most of the materials moved off-site. We were able to determine that an adjacent property owner was likely culpable for the placement of the contamination, but it also appeared that the problem could have been identified by competent inspection of the property, based on the information and reports readily available. In this case, sufficient physical inspections were not performed before the land purchase, and the financial partner took a significant hit as a result of relying on faulty due diligence.
Due Diligence Checklists Are Only Part of the Solution
There are plenty of prepared “due diligence checklists” available to developers, encompassing many of the items mentioned here, as well as other steps that can be taken in the complete investigation cycle. However, you must be aware that these “canned” programs do not cover all potential issues for every property – no matter how comprehensive they appear.
For example, the ASTM’s E2018 Standard Guide for Property Condition Assessment is considered the industry standard for inspecting commercial structures. It has an entire section dedicated to “out-of-scope” considerations. Yet, even this document does not include the geotechnical investigations mentioned earlier that cost our client so dearly.
When a developer and investor are completing their pre-acquisition research, they must carefully evaluate and factor in all of the unique conditions of the specific property they are considering, rather than relying on a one-size-fits-all checklist.
While the tendency may be to rush into a “great deal,” there may be hidden issues not readily apparent. At a minimum, buyers should consider why no one else has purchased the property yet, as this question becomes more pertinent the longer it has been on the market.
How Can VERTEX Help?
Selecting, investigating, acquiring, developing, and selling real estate can be a complicated process for developers of any size. VERTEX can assist at each step along the way, from initial due diligence to full-cycle development management.
Bill Kennedy, CPA
Land Development Expert, Xpera Group
This article was originally published by Xpera Group which is now part of The Vertex Companies, Inc.