By George Wilson, managing director
IVI International, a CBRE Company
Real estate investors have various options when it comes to the physical due diligence investigation of potential investments.
Not only are there multitudes of engineering inspection options — there are just as many price tags.
Choosing the engineering inspection option that is the least costly may save you money initially, but that decision could result in significant exposure for you down the road.
Debt vs. Equity Due Diligence
It is common today for equity investors to conduct what is known as debt due diligence. The problem? Debt due diligence is designed for lenders and offers little protection for equity investors.
That’s because lenders are primarily concerned with two things: the potential costs the borrower will incur at initial loan closing and during the term of the loan, and having information on file should the loan default and the property’s title transfer to the bank.
By contrast, equity due diligence is intended for investors, who, because they have the highest risk position with regard to the property, require a much more thorough inspection.
Equity investors also know that the margin for making a profit on real estate sales can be a narrow one, so the misidentification of costly issues prior to closing can put that profit in jeopardy.
Along with greater risk protection, an appropriate level of equity due diligence can save investors money by providing information that they can use to negotiate the final purchase price.
Indeed, equity inspections are designed to identify a range of risk issues, including deficiencies and deferred maintenance items that can adversely affect the current value of the asset.
What’s more, equity due diligence’s more conservative approach can help investors develop a more accurate capital reserve schedule for future planning, leading to better decision-making today.
What to Ask For
If you need an equity due diligence investigation, be sure to let the firms you’re considering know your risk tolerance level and provide as much information about the physical plant to be purchased as you feel you can divulge. Be sure to also advise about and discuss the following:
Specific issues or concerns that are important to you;
Issues each due diligence provider feels could be areas of risk for the type of asset in question;
Where the potential high costs might be, for example:
Systems prone to significant repairs (water leak concerns are generally high on most clients’ lists)
Replacement of expensive systems that wear out, including major mechanical systems, roofing, paving, elevators and the like.
The resources that each due diligence firm has at its disposal to devote to the project. Be sure to ask about available specialists for specific systems who can be brought in if the inspection warrants it.
How to Choose a Provider
Before choosing a due diligence firm, be sure to investigate your options and ask for references as well as recommendations from other investors. There are numerous firms out there with varying capabilities.
A handful have established reputations in providing equity due diligence services and are the ones most often selected by major institutional investors, such as the equity-investing arm of banks, pension funds, and insurance companies.
These investors generally have the lowest risk tolerance of any group and hire experienced due diligence firms known to complete a thorough inspection that will uncover issues with potential investment properties. References from these major institutional investors could therefore be extremely valuable.
Fees, however, should not be the deciding factor. Debt due diligence is a less expensive service. Investors often shy away from firms that provide equity reports due to concerns about price.
The cost of a debt report is a closing cost to a loan and is subject to market pressures that keep fees low. The cost of an equity report generally starts at a higher level because the service is focused on the investor’s much lower risk tolerance, so more time and effort is devoted to the report.
Equity inspections are often conducted by senior-level staff who have the requisite experience to readily pinpoint issues.
That’s not to say you should ignore price altogether: You should feel comfortable that you are receiving the appropriate service for a given fee.
An Educated Investor is a Savvy Investor
Real estate investors who are adept at getting to a level of due diligence that best aligns with their risk tolerance and their budget are typically the most successful.
The more that equity investors can learn about the options for due diligence in the marketplace, for instance that most expedient is not the best, the more evident it becomes that the appropriate level of investigation that they need is one that identifies the building components that can be the most costly to repair or replace.
The result will be more confident investment decisions.