Due Diligence: What is it?

"Due Diligence" is among the most often used and seldom understood terms in commercial real estate. It is bandied about like it is a "thing" or, sometimes, a "destination". It is neither.

Due Diligence is a "process". The process of investigating and discovering all material facts and information important to the project at hand. It is the process of answering in the affirmative questions that must be answered "yes" and answering in the negative questions that must be answered "no". It is the research, discovery or confirmation of all that is necessary to make a commercial real estate project or transaction a success.

Note that the term is "Due Diligence", NOT "do" Diligence. It is the exercise of such degree of diligence appropriate to the circumstance. Not every avenue of inquiry is relevant to every transaction.

The "secret" to cost-effective Due Diligence is tailoring the inquiry to the specific objectives of the party for whom the investigation is being conducted.

There are, in general, four "types" of parties active in conducting Due Diligence. They are: (i) the "Strategic Buyer" (which may include a long term lessee); (ii) the "Financial Buyer"; (iii) the "Developer"; and (iv) the "Lender". The transaction objective of each of these parties is different from the objectives of the others – although there is certainly some overlap.

General Objectives:

(i) The "Strategic Buyer" is acquiring the property for its own use and must verify that the property is suitable for that intended use.

(ii) The "Financial Buyer" is acquiring the property for the expected return on investment, and is primarily concerned with verifying the amount, velocity and durability of the revenue stream.

(iii) The "Developer" is seeking to add value by changing the character or use of the property – usually with a short-term to intermediate-term exit strategy. The Developer must focus on whether the planned change in character or use can be accomplished within budget.

(iv) The "Lender" is seeking to establish two basic lending criteria:

(1) "Ability to Repay" – The ability of the property to generate sufficient revenue to repay the loan on a timely basis; and

(2) "Sufficiency of Collateral" – The "quick" disposal value of the collateral, to assure adequate funds to repay the loan, carrying costs and costs of collection in the event forced collection becomes necessary.

To be effective, Due Diligence must be exercised from the initial contemplation of a project through its conclusion, and beyond. It never really ends. Unfortunately, for some, it never really begins.

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