Independent Due Diligence Can Make (or Break) An Equity Investment Deal
With an uncertain economic forecast and the cost of capital rising, equity investors are understandably cautious, keen to ensure that their investments are carefully considered and set up to limit risk, stay on schedule and ultimately succeed. As a result, we’re seeing some investors slowing the pace of pre-development in hopes of an improved debt service environment in 2023 and leveraging the opportunity to thoroughly examine the health of potential projects to optimize their investment strategy.
Equity investment firms are often managing multiple projects across various sectors simultaneously at locations across the country. Their expertise in the financial and real estate aspects of investing are significant, while the internal resources available for the myriad of details involved with the technical disciplines of the design and construction process may be limited.
Whatever the specific circumstances faced by an investor, a thorough and expert due diligence process will serve to mitigate many potential risks, including scheduling delays and cost overruns, and provide critical guidance for an efficient construction implementation. Augmenting the investment team’s financial prowess with deep technical knowledge of the overall pre-development, design and construction process will support a more successful closing transaction.
Is the project even feasible?
In a nutshell, due diligence is a process in discovery designed to deliver investment security through thorough risk assessment. As an investment deal comes together, strong due diligence can be the determining factor for a project’s eventual success.
Proper due diligence reaches well beyond simply assessing the condition of an existing property or reviewing architectural plans for a new structure. Today’s informed investor needs to understand which governing bodies have influence over the project, what environmental conditions might have an impact and, most important, whether the investor’s vision and pro-forma for the property is feasible.
What about technical considerations?
Assessing the project from a technical perspective is imperative, including a thorough understanding of the property type, location, and the specifics of the investor’s vision for development. Beyond possessing appropriate disciplinary training - architecture, engineering, mechanical/electrical/plumbing/fire protection (MEP/FP), cost estimating and sustainability - a technical assessment team must be mindful of how all of the aspects of the project tie together. As contracts, various environmental reports, drawings and other relevant documents are each analyzed independently, how they relate one to the other must also be understood.
An example of this is offered by a project in the mid-south region of the US: the equity investor discovered that their contingency was almost immediately exhausted due to extensive rock removal required to accommodate planned utilities and structures. This created a significant budget gap and put the investor at risk. Following an independent, third-party assessment, it was discovered that the contractor’s allowance was insufficient to deal with the existing site conditions even though geotechnical reports had plainly outlined that rock is highly typical of the region and the specific property being developed. Failure to perform a pre-development due diligence left the investor in a compromised position with no remaining contingency very early in the project.
Legal and Permitting
Careful analysis of the legal, jurisdictional and title impacts on a property explores the variety of authorities that might govern the premises and their effect on both potential limitations and opportunities for an envisioned development. Sometimes nuanced and highly complex, these regulatory requirements, if not clarified and accounted for, can generate appreciable project delays and result in significant unplanned costs.
For an existing property, current permits are examined, noting any language limiting traffic, parking, signage, occupancy and other use restrictions. The title report for the property is also thoroughly reviewed to reveal existing easements, public utility locations, established rights of way and requirements for open space. Special Overlay Zones related to the Federal Emergency Management Agency (FEMA) or the Federal Aviation Administration (FAA) may also be identified.
Entitlements for a new development, especially for complex, multi-function properties, can be complicated and varied by geographic regions. Understanding permitting requirements early, as part of a thorough due diligence, is critical to development planning to make sure a project starts on time and stays on schedule.
With some projects, multiple approvals may be required at distinct stages in a development. Identifying these, including the specific stipulations and demands of each, can help inform project phasing so that needed information is gathered in a timely fashion and potential delays are avoided. Seeking separate/phased permits can, in fact, help accelerate schedule and achieve milestones sooner.
A significant phase of a professional due diligence process looks at special considerations for the intended use, unusual site conditions and other potential impacts that may challenge the investor’s vision and intended use for the property.
For example, an investor may identify an older building constructed prior to modern noise attenuation standards implemented when an airport was built nearby. Due diligence will review the new code standards and identify the costs associated with upgrading the entire building to include acoustically rated windows and other measures needed to ensure compliance.
Another investor looking to develop a new structure might select a property adjacent to a seasonal wetlands area prompting the involvement of city planning and environmental agencies. The known nesting schedule of a local bird species can significantly influence the implementation and/or occupancy plan for this type of property, negatively altering the investor’s pro forma.
The ultimate goal of a professional due diligence process is to determine if the investor’s objectives can be achieved - the entire process should be directed with that end in mind. Many projects, especially those with complexity, call for additional professional resources to conduct a thorough due diligence that encompasses the intricacies of the construction process, specific technical proficiencies and/or regionally specific knowledge of code and permitting.
Having the appropriate group of professionals gathered to support an investor’s internal team in conducting a complete due diligence assessment optimizes a project’s potential ROI by confirming the validity of the pro forma, identifying risk potentials and providing a detailed guide for a successful construction process.