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Most people know that they should do some “homework” before purchasing investment real estate. (Interested in real estate investing? Start here.)
But what does good due diligence really look like?
This article describes several forms of general due diligence that can help you make an informed decision before purchasing an investment property.
No matter the property type, some diligence items will always be on your checklist. That said, it is critical to understand that your due diligence requirements depend on the type of asset you are investing in. Here is a short list of investment property categories to consider; each comes with a unique set of inquiries necessary to fully understand its risks and opportunities:
Vacant land for development
Apartments
Retail businesses
Industrial buildings
Properties with an operating business component, such as hotels and parking garages
Why Is the Property on the Market?
Word to the wise: due diligence on investment real estate should begin here.
Why is the property on the market? This simple question can reveal much about the prospective success of your investment. It can also reveal what additional due diligence may be needed before you buy.
If you are purchasing a new building directly from the developer, your due diligence will focus more heavily on construction and warranty issues rather than the past track record of the property.
In contrast, if the property has been operating for some time, the sale may be motivated by issues relating directly to
- the seller (i.e., partners wanting to part ways, need for liquidity)
- the financing (i.e., imminent maturity of an existing loan)
- the tenancy (lease terms recently renewed, or soon to expire)
- the market (rise or decline in property values, neighborhood demographics)
Each of these reasons suggests an emphasis on different forms of real estate due diligence.
Who Are the Tenants and Can You Trust Them?
The performance of investment property depends largely on cash flow. You need to understand the likelihood that the tenants will fulfill their lease obligations—and what security you will have should they fail to do so.
If your tenants are individuals, you will want to verify the rent rolls and understand the leasing criteria of the seller’s property management.
With a commercial tenant, you can rely on credit rating companies such as Standard & Poor’s or Moody’s, public securities filings and tenant financial statements. These may help predict whether the tenant and guarantor have the financial wherewithal to honor the lease obligations.
Additionally, information about the tenant’s operations at the property—lines of business, tenant-funded capital improvements or sales volumes can indicate whether the tenant is likely to renew or extend the term of its lease.
What Are the Market Conditions?
Diligent investors consider two different aspects of the market:
- trends related to the asset itself, and
- those related to the location of the property.
Asset-specific due diligence includes comparable sale prices, rental data, vacancy rates and appraisals. (Read more about pricing commercial real estate.)
Locational market trends include demographics and average household incomes near the property, the number and type of employers in the area and access to amenities like public transportation.
Economic incentives, such as tax abatements and interest rates, can apply to either the property itself or the neighborhood.
What Is the Physical Condition of the Property?
In addition to what you can readily see from a property walkthrough, two types of third-party real estate due diligence are common for commercial properties.
Property condition reports (PCRs) address building and structural aspects of the property, such as the condition of the roof, heating and plumbing systems, and construction materials.
Environmental site assessments (ESAs) include a Phase I environmental study, and potentially a Phase II or deeper analysis if the original report discloses an area of potential concern.
Lenders commonly require both a PCR and an ESA before providing a mortgage loan for a commercial property.
Legal Due Diligence
There are a variety of legal items you or your attorney should review. A title search confirms whether your seller has free and clear title to the property to convey to you, as well as any potential restrictions or benefits that may run with the property (i.e., easements, restrictive covenants, condominium declarations, or zoning).
A related item is a survey, which will show the property’s legal and physical boundaries, as well as the location of utilities and any easements. Ideally, the title report and survey will be consistent with one another.
Will You Use Financial Leverage?
If you finance your investment with a mortgage, it is wise to do some due diligence on prospective lenders to ensure that you get a loan best suited to your needs.
Different banks may offer alternative terms for your project (interest rate, loan term, amortization schedule, guaranty requirements) depending on the credit of the tenant(s), the terms of the lease(s) in place and the degree of leverage you require.
Lenders also vary in required loan covenants, such as reserve requirements. A local bank where you have an existing relationship may prove easiest to work with.
Make Better Decisions Based on Facts and Circumstances
Thoughtful real estate due diligence will not guaranty that your property will perform as expected, but it should give you comfort that your investment decision is sound based on facts and circumstances at the time of closing.
MAYBE YOU WANT to start investing in real estate, but you do not have enough capital to purchase a quality commercial property.
Alternatively, perhaps you are concerned about placing a large sum of capital into a single piece of real estate. Maybe you do not want to personally guaranty a mortgage loan—or take on the management and maintenance responsibilities of property ownership.
Investing in a real estate syndication enables you to acquire a diversified portfolio of properties with the same amount of capital, and without having to undertake managerial or financial burdens.
What is a real estate syndication?
A real estate syndication is an aggregation of capital from multiple participants to invest together in particular real estate opportunities.
A sponsor structures each syndicated investment raises the capital, secures any necessary financing and manages the assets.
Think of syndications like a group of friends and family pooling their funds together to make an investment—however, sponsors of commercial syndications are generally real estate professionals, and the investors are typically unrelated to one another.
What can a real estate syndication invest in?
A syndication may be formed to acquire an individual property or a portfolio of several assets with common attributes (i.e., similar location or tenant).
Syndications often provide an opportunity to invest in larger or more exclusive properties with better credit and higher yields.
These investment properties may be extremely tough for you to acquire independently.
Syndications also offer a way to diversify your real estate holdings—you provide only a portion of the total equity in exchange for a corresponding fractional ownership interest in the property. So, instead of investing all of your capital in a single asset, you can spread your funds among multiple properties.
As noted above, investors in syndications will not have property management responsibilities, and they will typically have no personal liability for any mortgage on the property (other than their invested capital).
The sponsor provides operational and financial reporting. The sponsor also makes periodic distributions of cash flow and/or proceeds.
How to evaluate a real estate syndication
The most important considerations when assessing a syndication are the experience, credibility and sophistication of the sponsor.
You will want to be comfortable that the sponsor has a track record of acquiring, managing and successfully completing similar investments.
The individuals responsible for the syndication must have an excellent reputation within the real estate community.
If any of the sponsor’s past investments did not work out as planned, you will want to find out how the sponsor conducted itself to communicate with, and maximize value for, investors. This is particularly important now that real estate syndications may be offered through crowdfunding over the Internet, where you do not interact with the sponsor face to face.
Investors obviously should evaluate the real estate deal itself, and assess whether it is in line with their personal risk tolerance.
Investors should consider the following:
Answer these important questions before electing to invest in a real estate syndication.
How likely is the projected cash flow?
Income from an investment with a single tenant under a triple-net lease will be more certain than a multi-tenant property, or where the tenant is not responsible for all of the operating expenses. While a long-term lease with one tenant provides a degree of stability—assuming the tenant performs—a property with more tenants and shorter lease terms, such as apartments, allows flexibility to adjust rents frequently based on the market and lessens the impact of a vacancy.
How much leverage is used, and what are the terms?
While leverage can help increase your cash flow, loans often have lender-friendly covenants triggered by changes in cash flow. At some point, the loan will mature. The greater the loan amount in relation to the purchase price—and the greater the outstanding projected loan balance on the maturity date—the higher the risk.
What is the exit strategy?
You should understand how long the sponsor intends to hold the property and the expectations for return of principal at the end of the investment period. You should also determine whether you can liquidate your investment if you want to exit early. Find out what will happen if the property cannot be sold profitably at the end of the intended investment period.
Use trusted advisors to help find the best investment for you
Investors must receive a private placement memorandum describing the investment, the sponsor, the deal structure (including the relationship among investors and between each investor and the sponsor), projected cash flow and returns, and the associated risks.
Ideally, the offering materials will include an opinion from a reputable legal or financial advisor.
It is possible to lose your entire equity investment if the project does not perform as expected, and there may be obligations to contribute additional capital under certain circumstances.
It is, therefore, important for investors to review the offering materials carefully, and to consult with their own financial, legal, or tax advisors before investing in a syndication.
The current election cycle generated a high volume of articles about the virtues or vices of real estate investment. (Exactly which depends on your political leanings.) Unfortunately, the pundits’ understanding of the tax laws has proven lacking. Perhaps the most prevalent misconceptions surround the like-kind exchange rules found in § 1031 of the Internal Revenue Code. That provision allows taxpayers to defer paying certain taxes when they exchange a business or investment property for a similar property of greater or equal value rather than selling for cash. While the majority of the recent commentary focuses on real estate, especially in light of Donald Trump’s businesses, individuals and companies use § 1031 in many legitimate industries. Repealing these provisions would not only fail to generate additional tax dollars for the government but would also stifle domestic economic growth. Today’s column seeks to clarify some of the misconceptions perpetuated by these articles.
Myth: § 1031 Exchanges Allow Taxpayers to Permanently Avoid Real Estate Taxes
Section 1031 provides a mechanism to defer tax, not to evade or avoid tax liability. It doesn’t even reduce the amount to ultimately be paid. Like-kind exchanges affect only the timing of when real estate investors pay certain taxes.
To completely defer the payment of certain taxes at the time she sells a property, § 1031 requires that a taxpayer jump through a series of hoops, including
1. not taking any cash proceeds whatsoever,
2. purchasing replacement property of greater or equal value,
3. acquiring all replacement property shortly after the first property transfers,
4. ensuring the owner of the new property is the exact same taxpayer as the selling party (i.e., not creating a new company or buying out investment partners),
5. acquiring replacement property that is “like kind” to the relinquished property, and
6. holding the replacement property for investment or business use rather than personal use. If the property owner fails to follow any one of these requirements, the taxpayer pay tax on the transaction for the year the investor sells or transfers the original property.
Further, even if all of the necessary steps are followed, the deferral of taxes is only temporary; an overwhelming 88 percent of properties acquired through like-kind exchanges are later disposed of through fully taxable sales. (See The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges In Real Estate, David C. Ling & Milena Petrova, Marc & June 2015, p. 54.) And when the sale actually occurs, the tax bill will apply to a more expensive replacement property because the § 1031 rules require the new property to be of greater or equal value than the original property [see above].
Myth: § 1031 Is Bad for the U.S. Economy
While it may seem counterintuitive, § 1031 exchanges actually encourage investment, create jobs and stimulate the economy. One reason is the rule that replacement property is of greater or equal value, as discussed above. So businesses and investors are actually “trading up” and investing in more (or more expensive) property than they started with. The tax deferral also encourages people to sell instead of holding their assets and to invest in capital improvements. Each sale consequently employs a variety of people (i.e., contractors, surveyors, environmental consultants, escrow officers, and public utility workers). These transactions stimulate the economy, in part, because it diverts capital gains tax revenue to productive use.
1031 exchanges play an integral role in many industries besides real estate. These include construction, truck and air transportation, equipment/vehicle rental and leasing, and oil and gas extraction and pipelines. They encourage transportation companies to upgrade their vehicles. They also encourage businesses to improve their systems and equipment. Research shows that elimination of § 1031 exchanges in these industries would reduce America’s annual GDP by $27.5 billion, according to the 2015 “Report on the Economic Impact of Repealing Like-Kind Exchange Rules,” from Ernst & Young LLP. Repeal of § 1031 would also lead to increased cost of capital, reduced levels of investments, slower economic growth, a concentrated burden in those industries that rely heavily on like-kind exchanges, and the long-term contraction in the overall U.S. GDP of approximately $8.1 billion annually, the same report estimates. §1031 keeps money here in America, as only U.S. property qualifies for an exchange.
Myth: § 1031 Exchanges Favor Developers
Contrary to recent reports in the New York Times, developers rarely use §1031 exchanges. A developer’s real estate is their inventory, not property held for investment. Further, §1031 exchanges can only capture the value of improvements made within 180 days after the sale of the taxpayer’s relinquished property. As significant real estate developments take substantially longer than six months to complete, §1031 does not provide a useful tax shelter for such projects.
Myth: § 1031 Only Favors the Wealthy
1031 is one of the few incentives available to, and used by, taxpayers of all sizes. Exchanges help individuals, partnerships, limited liability companies and corporations. In fact, 60% of exchanges involve properties worth less than $1 million. And more than one third sell for less than $500,000, according to the May 2014 report from the Federation of Exchange Accommodators, “Impact of IRC §1031 on the Economy.”