Due Diligence

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Anyone ever involved in financing a real estate-related transaction -- either as a lender or a borrower-- probably has come to realize the complexities involved in judging a property's ability to generate income.

Creating a financial package that satisfies a lender involves much more than presenting a sound balance sheet. It requires, among a host of other criteria, the lender's review and analysis of market demographic studies, the prospects for the local job market and the property's ability to absorb possible economic fallouts. Even the impact of a property's competition is evaluated.

Not surprisingly, borrowers may be hesitant to divulge such information, believing some of their findings might raise a red flag with a cautious lender and kill a once-promising financing arrangement.

However, despite the common misperception among borrowers that a lender's request for this information is merely a precursor to backing away from a deal, lenders recognize there is no such thing as a risk-free transaction. But to have a comfort level with the transaction, they do need to be assured the risks are identified, understood and ultimately mitigated.

For that reason, lenders increasingly are turning to experienced due-diligence providers to confirm a particular asset can cover its debt service and to provide recommendations to address any potential concerns.

Over the years, the term "due diligence" has come to mean different things to different people.

Due diligence is not appraising. Rather, financial due diligence is the process conducted by an objective third-party to identify and quantify the risks and other relevant issues associated with real estate transactions and financing.

The process gives lenders a clear picture not just of valuation but also of cash flow and cash-flow preservation. It also creates a detailed analysis of each asset's ability to perform in both expected and unexpected market and financial conditions. Most importantly, a complete due-diligence report provides solutions to mitigate potential concerns of a lender or rating agency.

For the most part, much of the information secured during the due-diligence process is the same for any type of property. However, some property-specific factors also are considered.

For example, an evaluation of a shopping center will examine whether or not the property has the proper "tenant mix" for the specialty niche shops to complement the anchors and chain stores. It also will consider retail factors such as sales per square foot and tenant operating costs.

Taking another example, lenders looking at a multifamily project will review competing rental rates, occupancies and operating expenses. They also may want to evaluate other proposed or newly renovated properties, which may lead to more competition for the project and a saturated market. Likewise, the presence of strict zoning regulations and lack of developable sites may indicate entry barriers for future competition.

Hotels and resort properties also have their share of nuances. Historical occupancies, average daily rates (ADR), market mix, marketing plans and current tax and insurance statements are reviewed during the due-diligence process. The property's competitive position -- also known as its competitive set -- is assessed in terms of its location, physical attributes, amenities and indicators such as occupancy, ADR and revenue per available room (RevPAR).

Regardless of the type of property, lenders want to get an improved understanding of the demographic makeup of the area in question; particularly its income level and the average age of the work force. The local employment base also is taken into consideration.

Borrowers would be well advised to provide the due-diligence team with at least three years of comprehensive historical operating statements on the property. And they should be prepared to readily provide dates and costs of all past capital improvements.

Also keep in mind that certain lenders may install "rating agency parameters" to build in cushions and a degree of comfort for the transaction and to facilitate securing the loan.

Due-diligence results, regardless of the real estate asset in question, typically will be accompanied by real solutions to mitigate any potential issues or problems that have been uncovered with the proposed financing.

By no means should any single issue be considered a deal breaker. In some cases, adjustments as simple as removing a one-time capital expenditure from the operating expenses or understanding the seasonality of a market may very well lead to a more profitable transaction for all parties.

The length of the due-diligence process depends on the borrower. It can last anywhere from a few days to a few weeks, based on the complexity of the transaction and the availability of quality information and communication. With cooperation from all parties involved, proper due diligence can ensure both borrowers and lenders achieve their business objectives.

Copyright 2001 American City Business Journals Inc.
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