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Investor Services:
It is the investment manager’s responsibility to develop, implement,
monitor, and revise the investment strategy for the property — all of
which are grounded in the due diligence process. Going forward, the
manager will help determine whether to continue to hold the investment
or to sell it. The decision not to sell the investment is, in essence, a
decision to acquire the property at its current value. A pragmatic way
to think of it is that a hold decision is a purchase decision. Reliable
information and depth in the due diligence process is essential to make
these decisions.
For all of the above reasons, acquisition and loan due diligence must
be proactive and must supply the data needed to provide the basis for
the final decision to acquire, or not to acquire, the property or to
make the loan.
Areas of Due Diligence
We have discussed the fact that acquisition due diligence is complex
and time consuming, but at a practical level what does this mean? As a
reference, and to give you a feel for the true scope of the process,
this section breaks down the due diligence process into its component
areas of investigation.
Acquisition due diligence is focused in the following nine
interrelated areas:
- Market analysis
- Physical/property analysis
- Regulatory/compliance analysis
- Tenant analysis
- Financial analysis
- Risk analysis
- Transaction analysis
- ERISA analysis
- UBTI analysis
Market Analysis
Analyses of market factors are used to define the supply and demand
characteristics of the competitive real estate market, and to develop
appropriate market driven underwriting assumptions for rental rates,
rent growth, vacancy rates and other lease terms. There are two main
areas of market analysis: economic factors and real estate factors.
Economic: The performance of a real estate market is dependent
on the performance of the national, regional and local economies.
Generally, the expected rate of employment growth (job creation) in a
market is an indicator of the future demand in the market for office and
industrial space. Closely related to the expected employment growth is
the expected rate of population growth, which is generally an indicator
of the future demand for housing and retail development in the market.
The market’s primary industries, and the diversification of those
industries within the local and regional economies, will also affect the
amount of risk in the market and, therefore, the risk of the investment.
Real Estate: The analyses of the real estate factors include
the analyses of the market as a whole, the sub-markets and the
property’s neighborhood. The due diligence process attempts to define
the expectations for the market and sub-markets and the competitiveness
of the property within these markets. Expectations for the performance
of the real estate market are impacted by the economic expectations for
the area. Real estate factors analyzed as part of the acquisition due
diligence process include (but are not limited to) the following:
- Comparable sales
- Comparable leases
- Competitive properties
- Appropriate discount rates, capitalization rates and other
underwriting assumptions for comparable investments
- Under-construction, planned or potential new development in the
market
Understanding the amount of the supply in the market is equally as
important as understanding the expected demand to be derived in the
market. Anticipating and evaluating where demand is going to come from
is an extremely difficult issue. Demand is really created from
population and job growth, and the overall impact of a positive economy.
Any impact on one of these factors, can cause demand to be reduced and
would have a deleterious effect on real estate returns. While supply may
be constrained in various markets, the sources and drivers of demand
must be equally understood. This requires a great deal of understanding
of the market, and a focus on what the drivers of real estate demand
really are and where they are going to come from.
All of these factors must be carefully evaluated and included in the
financial model used to evaluate the investment. A sound, financial
model requires the ability to use "real" operational and market
information to create a valid model that is substantially grounded in
fact, and which the investment strategy accurately reflects.
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