The Importance of the Due Diligence in the Real Estate Market

The standardized and generally accepted definition of Due Diligence does not exist, and the term is usually not translated into local languages. Most often lawyers define it as a process of examination and research by a potential buyer to confirm that the buyer is purchasing exactly what he thinks he is purchasing. Essentially, Due Diligence is an analysis of the entire business of a company as well as an assessment of current and future risks in its operations.
It is similar with the real estate, Due Diligence is one of the most important steps taken in the process of buying properties, especially the property of greater value, as it includes analysing the legal, technical and financial aspects of the property and is an essential phase before closing the deal. Its implementation is important for all market participants, because it avoids the possibility of intentional or unintentional misleading of one party in the transaction.

Step 1 – Market Analysis and Valuation

Detailed analysis of the market is the first step, having in mind that the overall property market, location and marketability of the property are analyzed. A detailed analysis of the location, market trends, economic parameters, such as demographics, unemployment and purchasing power, as well as SWOT analysis (strengths, weaknesses, opportunities, threats), current and future development potential of the property, as well as real estate valuation and cost analysis are executed. Market analysis and comparable transactions provide an insight into the potential of the property, which influences a positive decision to enter the next phase of the analysis – Due Diligence.

Step 2 – Due Diligence

a) Legal Due Diligence
The legal analysis is one of the most important parts of the real estate inspection process, as it allows the buyer to gain insight into the legal aspects before making the purchase decision. Relevant information is obtained from the register of business companies, real estate cadastre, land registry, planning and technical documentation, valid agreements and other related legal documents.
Legal Due Diligence usually includes reviewing the legal status of transactions, tangible and intangible assets, labor agreements, compliance with tax regulations, analysis of the most significant contractual relationships, encumbrances, litigation or other proceedings related to the transaction, as well as an assessment of all legal risks that may occur.

b) Tax Due Diligence
Taxes involved in a real estate trade can also have a significant impact on the financial aspect of the transaction and on the assessment of the economic profitability of the investment, therefore the specific calculations of the taxpayer or entity, as well as the taxable property or assets included in the transaction, are important. As a result, an individual purchasing real estate may have a different tax rate than if a company were purchasing the property. Tax rates also vary between countries, and buyers may be taxed at different rates depending on their citizenship or nationality.

c) Technical Due Diligence
Technical Due Diligence covers the items related to the physical aspect of real estate and always includes an on-site property inspection. It is necessary to carefully inspect the building from the basement to the roof, note all defects and risks, estimate the costs and support all this with photo documentation. Technical Due Diligence provides insight into the functioning of the facility, all systems, devices and equipment, necessary maintenance work, checks the status of permits and considers possible risks of the property’s functioning in the next few years.
A precise pre-purchase analysis gives the buyer a stronger negotiating position and helps speed up the process of buying or selling real estate. Certain technical flaws identified on the facility may have an impact on the purchase price, as the condition of the object is usually reflected in the price. Given the risks of investing in real estate, no significant purchase should be considered without proper technical Due Diligence.

d) Financial Due Diligence
Financial Due Diligence is the process of analysing all financial statements related to the property, income, capital investments and operating expenses, as well as potential risks.
Financial analysis includes cash flow projection for selected time span and periodic returns, valuation and credit and asset rating analysis. Financial Due Diligence also requires the analysis of historical financial statements for any potential risk factors, non-recoverable costs, losses, debts or any inconsistencies.

e) Commercial Due Diligence
Commercial Due Diligence is important when buying the property that generates rental income (office buildings, shopping centers, logistics parks, etc.), and the key objective of this phase is to analyse in detail the existing lease agreements and all commercial terms of the agreements, to compare them with the current market conditions, in order to evaluate the sustainability of the income that the subject property can achieve in the forthcoming period.

f) Environmental Due Diligence
Although environmental factors are often overlooked in the real estate analysis process, they may harm future economic viability.

The main categories in environmental Due Diligence are assessments of water supply, hazardous waste and noise pollution, building quality, including asbestos checks, and legal issues such as weakness and non-compliance analysis. Environmental factors are becoming increasingly important, with the introduction of new laws and principles of green building and sustainability governing energy efficiency, water conservation and waste management, making environmental Due Diligence increasingly important due to increasing penalties for non-compliance.

The Due Diligence process is usually carried out by experts and consultants on behalf of the investors. Legal Due Diligence is performed by lawyers or specialized agencies for legal consulting, Tax Due Diligence is executed by financial advisors, while Technical Due Diligence, Financial Due Diligence, Commercial Due Diligence, as well as market analysis and valuation can be done by consultants and experts from CBS International.