The due diligence process is critically important in any commercial real estate transaction. Although developing a meticulous process is consistent with the best practices in the industry, it is surprising how many companies are less than thorough.
Experienced investors in commercial property leave no stone unturned in order to limit the possibility of post-transaction surprises and increase the likelihood of investment success. Employing a multidisciplinary approach to evaluating each potential transaction requires financial, operational and technical expertise as well as an in-depth understanding of local, regional and national markets.
The strategy in the multifamily sector is to be proactive, and complete as much of the due diligence as possible up front. Time is of the essence, especially when there is an active bidding process. By doing your homework well in advance, many due diligence items that other buyers have yet to complete become more confirmatory, even before moving on a deal. This includes an in-depth study of operations, market fundamentals and tax analysis that will position your firm “ahead of the curve” by the time a bid to purchase a property is made.
Taking A Market And Asset-Driven Approach
Due diligence includes analysis of the quality of the property and of the market, as both affect the returns on an investment. A high-quality property rarely overcomes the headwinds of a bad market, and even in a strong market, a property with significant unexpected repair requirements can result in significant losses.
The due diligence process must take into account not only what is, but what may be.
This includes the review of financial and operational performance, the consideration of environmental and legal concerns, the exploration of various financing options and the completion of a sensitivity analysis. Consider how the property would perform on an unlevered basis and account for possible downside scenarios such as negative rent growth, rising interest rates or a drop in occupancy.
An in-depth property due diligence process requires: personally visiting, walking through and inspecting every unit in every building; executing complete engineering assessments; and hiring third parties specifically to examine the plumbing, roofs and other building systems. Providing on-site teams with state-of-the-art technology such as iPads with apps to input data will help improve efficiency and reduce time spent both on-site and in collating the due diligence information. Solicit bids from local contractors for any repairs that may be required. Armed with this information, aggressive bidding begins knowing there is a fully vetted capital budget.
Adapting The Approach To Fit The Market
The approach to due diligence often differs from market to market. For example, in stable markets, due diligence is focused more on the property. In growth markets, the emphasis is more on understanding what’s driving that growth and the potential for continued development.
Defining and classifying a market as growing, stable or otherwise involves studying transaction volume and what properties are trading for. The goal is to identify fundamentally sound markets that have the necessary attributes to support long-term rent growth and sustained market appreciation. Key value and growth drivers include supply-demand imbalance, positive income and population growth, strong corporate presence, favorable business climate, diverse local economy and high living standards relative to price.
In a “hot” market where there is a tremendous amount of investment activity and strong competition, buyers are typically willing to bid aggressively for the market exposure. The ability to successfully complete deals in this type of market is a result of several competitive advantages, including the willingness to put up a significant nonrefundable deposit very early in the process and deploy a large team quickly to begin outside due diligence. This allows the firm to get comfortable with the risk involved and offer terms that are more competitive than other buyers.
Exploring Secondary And Tertiary Markets
While primary markets have historically accounted for the majority of deals and volume, economic momentum continues to spread into secondary and tertiary markets, raising apartment performance and enhancing the appeal of assets in these markets to investors seeking higher yield.
For example, Austin, Texas, draws a highly educated, upwardly mobile workforce attracted by the city’s dynamic lifestyle and economic opportunities. Austin ranks first in the United States for net in-migration and has the lowest unemployment rate among the 50 largest metropolitan areas. The city’s tech sector is thriving and demand for multifamily product is on the rise as new residents continue to move into this diversified growth market.
Another example is Tuscaloosa, Alabama. While this “off the radar” market may seem less attractive to many large institutional investors, it is, in fact, a stable tertiary market with a strong and diverse local economy and a need for high-quality, affordable housing.
The recent multibillion-dollar expansion of the Mercedes-Benz plant further strengthens the intermediate and long-term outlook of the market, where multifamily properties offer an attractive entry point, higher yields at inception and value-add opportunities to restore and renovate units to a level similar to new construction properties.