The Importance of Financial Due Diligence for Real Estate Funds

Sponsoring a real estate fund comes with many different responsibilities. Protecting your partners’ investments requires you to consider risk mitigation, be familiar with the market, perform property assessments, consider deal structures and terms, acquire financing, and more. Many of these responsibilities (collectively called due diligence) should be performed well before you purchase your first piece of property.

What is due diligence?

Due diligence is the exercise of care you should take before entering into any new agreement. When it comes to real estate, you need to perform certain tasks to determine if an investment is worthwhile. Will that investment be profitable to you and your co-investors in the long term? Or will that rental property be in low demand, be expensive to maintain, or not meet your diversification goals? These tasks will vary depending on the contract. But generally, you’ll have more and better-quality data to help you make investment decisions after you perform adequate due diligence.

Real estate due diligence is a broad concept that covers many different risk areas. For example:

For this article, we’ll focus on financial due diligence.

What is financial due diligence in real estate?

Financial due diligence is the process of reviewing a property’s financial information before purchasing it or investing in it. Every property is different, so your due diligence for one may look different than it did for a prior investment. But here are a few common financial due diligence tasks you should perform as a real estate fund sponsor.

Third-Party Valuations and Assessments

Although it will come at a cost, paying for a third party to perform a valuation or property assessment can be insightful. Not only might those assessors uncover something you hadn’t considered, but their unbiased reports will be essential when you seek financing or new investors.

Lease Reviews

If you’re assuming a prior owner’s tenants, be sure to look at their lease agreements. Those lease terms may not be what you were expecting. For example, existing tenants may have signed a lease that limits rent escalations. If your plan is to upgrade those units, you may not be able to ask for a price increase until those leases terminate.

Unencumbered Assets

Ask the seller for evidence their property is free from liens resulting from back taxes, unpaid utility bills, etc. You should also verify the property isn’t involved in a lawsuit or being used as collateral for other debt.

Revenue Estimates

Gather all the information you need during due diligence to build accurate estimates. How accurate are the seller’s rent rolls? Are they correctly estimating vacancy rates, or are vacancies higher in that area than what’s reflected on their reports? Will you be able to continue to collect those same rents when you take over, or will a new negotiated agreement with existing tenants change rental prices? Being both skeptical of the seller’s projections and aware of how the market will impact those estimates is essential.

Expense Estimates

Even a slight miscalculation of an annual expense can compound as you project those numbers out three, five or ten years. Consider home insurance in Florida, where premiums have tripled since 2019. If your financial estimates didn’t take these price jumps into account, your investment may be much less profitable than you originally thought.

Tenant Analysis

If your property will have tenants, perform a thorough tenant analysis in your due diligence. You can do this by reviewing their leases, evaluating historical occupancy rates and looking for delinquent payments. These tasks help you understand tenant quality so you can better estimate the amount and timing of your rental income.

Hidden Expenses

Purchasing real estate may come with taxes and fees you weren’t prepared for. Proper due diligence can uncover these hidden costs, including:

• Title fees and title insurance
• Notary fees
• Transfer taxes
• Survey expenses
• Recording fees
• Utility installation costs
• Cost of obtaining building permits
• Inspection and appraisal fees
• Professional fees in knowledge areas like legal, accounting, architecture, etc.

Consider these expenses when assessing the profitability of a new investment.

Market Evaluations

When investing in a market unfamiliar to you, pay for a market evaluation report from a trusted professional who knows it well. You’ll have better insight into how the market is likely to shift in the next few years.

What should you do after you’ve purchased the property?

Your job isn’t done just because the transaction is. It’s important to perform financial due diligence throughout the term of your investment. Doing so helps you identify risks before they become problems (and better budget for repairs, maintenance and capital improvements).

No matter your real estate investment goals, you can’t reach them unless you have a solid financial foundation. Having accurate financial information empowers you as the fund sponsor to make more informed decisions and manage your risks effectively. This allows you to optimize real estate portfolios for yourself and your business partners. Reach out to our James Moore real estate experts if you want help building a due diligence framework.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.