Due diligence is the process of evaluating and understanding a potential acquisition, partner, or buyer and there are various types of due diligence processes in the real estate sector. Real estate is one of the fastest-growing sectors in India evidenced by a sharp increase in real estate transactions involving buying, selling, leasing, and financing of properties. In addition to transactions in urban areas, we have also witnessed large scale procurement of land from individuals in villages close to the urban, industrial, and commercial centers. Similarly, there has also been an increase in leasing (both short and long term) of commercial office space.
The increase in real estate transaction values combined with the growing participation of the organized sector in real estate has resulted in heightened awareness of the risks involved and, consequently, the need for ensuring that the risks are identified and minimized in such transactions. ‘Legal due diligence/ title search’ of the real property clearly the mode for achieving these objectives.
Due diligence is probably the most important aspect of a transaction involving real estate immediately following a broad understanding of the commercials. This process has the potential of not only impacting the commercials but also determining the feasibility of the transaction itself. While the commercials often pay high importance to expedite the conclusion of a transaction, it is critical in the interests of the players to provide adequate time and attention to the detailed due diligence of the property involved. It is important to realize issues such as title, permitted use, the legality of construction, encumbrances, and easements which have the ability to impact the very nature of the property and its suitability to the commercial needs of the transaction.
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Different types of due diligence
Various types of due diligence provide businesses with the confidence and knowledge to get exactly what they want out of a prospective deal. Few of them will enable companies to spot issues before they cause harm, whilst others provide valuable information on the true cost of a business transaction. Different types of due diligence enables companies to gain knowledge to empower their business decisions.
The most effective type of due diligence maintains close co-operation across the main categories which include financial, commercial, M&A, customer, tax, legal, and vendor due diligence.
Legal Due Diligence
Legal Due Diligence is a type of due diligence that ensures that there are no legal issues in buying a business or investing in it. In this, the solicitors will review the important legal documents of the target firm such as employment contracts, board meeting minutes, articles and memorandum of association and patents and copyrights, or any other property-related documents.
Tax Due Diligence
This type of due diligence is performed simultaneously with the financial procedure. This is aimed at ensuring that there are no past tax liabilities in the seller firm that might have materialized due to mistakes or deception and could hold the acquirer liable for it.
Financial due diligence
Financial due diligence a type of due diligence that is conducted by a prospective buyer in order to evaluate the financial stability and health of the assets up for sale. The company’s financial data is scrutinized, and any mitigating areas that could pose a risk are identified. It is very beneficial, as the buyer gains knowledge of the historical and actual financial performance of a company, alongside forecasting it’s future financials.
The guide to financial due diligence lists the key benefits and information on the process.
Physical due diligence
This type of due diligence must be performed before making or finalizing an investment, clients (builders or lenders). Building on our years of hands-on experience, we should carefully evaluate and inspect the physical condition of properties through detailed building condition reviews. Our reports also include a detailed estimate of anticipated capital expenditures over a ten-year horizon.
Building Inspections Covering
- Vertical Transportation
- Building Envelope & Roof Condition
Third-Party due diligence
Third-party due diligence is undertaken by a business when it is looking to outsource work to an external company, in order to understand the level of risk involved. It has become increasingly important in recent years due to the introduction of strict anti-bribery legislation, which requires companies to provide evidence that they have sufficient anti-bribery measures in place.
Whom to approach for due diligence?
It is important that you exercise due diligence while you purchase a property. A buyer and a seller can carry out the due diligence process on their own. However, there may be certain defects in the property that can be identified only with the help of an expert. The various experts facilitating the due diligence process include real estate agents, lawyers, financial advisors, auditors, etc.
The lawyers are generally approached to verify the title of the property, check for legal competence, drafting and verifying the terms of the title, sales or conveyance deed, etc. A real estate agent is hired to help in valuing the property as they help in comparing the price of the property with similar properties. The financial advisors or auditors can also help in identifying any encumbrances on the property.
Other professionals can also be hired to carry out the general inspection on the property. A home inspector or a real estate agent can come handy in such circumstances as they can check facilities such as roof, plumbing, electrical, heating and cooling, kitchen appliances, and water heater.
Due diligence on real estate sponsor
The Sponsor is considered to be one of the most important factors that determine whether or not a real estate deal turns out to be successful. How do we define a Sponsor? The Sponsor (also known as real estate operator or general partner) is the company that manages the real estate offering from start to finish and carries out all of the investment plans.
The first thing we look at is the track record of the Sponsor. Now imagine that you are an NBA scout searching for basketball talents for your team. Would you recruit a player without conducting any due diligence on the player? Probably not. You would probably have to look at his previous experience and how he performed in college before making a decision. The same thing can be applied for real estate due diligence. Investors should do research on the Sponsor’s investment track record and the team experience. Real estate investors should also keep an eye out for past litigation, bankruptcies, liens, and judgments.
If a Sponsor has had multiple bankruptcies in the past and he/she is the sole decision-maker in the deal, you may need to assess whether he/she is the best person to lead the project. Or if the Sponsor has pending litigation for breach of contract or securities law violation, that is a major red flag. Investors could also do a quick Google search on the Sponsor. An easy way to search is to type in the name of the managers and Sponsor with words such as “fraud”, “lawsuit”, “scam”.
Lastly, investors should pay attention to how much equity the Sponsor is contributing if it’s a joint venture (JV) equity deal. The typical Sponsor equity portion is between 5 to 10 percent of the total equity contribution. The significance of a due diligence exercise lies in following each of the above-detailed steps, the absence of even one could make a huge difference. The purpose of due diligence in real estate is to collect enough information on the property to make the smartest buying decision possible. Due diligence is intended to hold sellers accountable as well as save buyers from making a bad purchase. So get out there and do your due diligence!