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What Scope Do I Need?

How Much Due Diligence Is Enough?

Commercial real estate can be the foundation of a successful business or investment portfolio, but surprises can turn things sour in a hurry which is why physical due diligence on the asset can be so important.

Why is Due Diligence Important?

Contamination at properties can cost more than a property is worth, limit the future use of properties, give tenants an excuse to break a favorable lease, and generally wreak havoc. Structural and architectural concerns can increase near-term cash requirements as well as capital needs and operating costs during ownership. Earthquakes and other natural disasters can wipe out an investment, and seismic retrofit ordinances implemented by a number of cities can require substantial retrofit or even demolition of buildings. The list of potential risks goes on and on. 

What Does “Duly” Diligent Mean for You?

Many owners, investors, and lenders conduct some level of due diligence to protect from these risks, but the objectives of these investigations are not always made clear, and the connection between the underlying concerns and eventual management of risks may not be well understood. As a result, the amount of due diligence completed and interpretation of the available information don't always provide the information and recommendations needed to protect from related losses. 

Too little due diligence can lead to significant problems, but too much will eat into profitability. Finding the right balance is important, and off-the-shelf due diligence products may or may not be a good fit.

  • Environmental investigations, for example, come in a number of flavors. The most obvious concerns might be found by a Transaction Screen, but even a full Phase I Environmental Site Assessment (ESA) will not rule out the potential for financial and other impacts. For example, a standard Phase I ESA performed in accordance with the commonly-accepted protocol, ASTM E1527, is intended to support defenses to CERCLA liabilities, but users may find higher impact from state or local regulations, or may be more concerned with occupant welfare, reputational risks, and eventual profitable sale of the property. These things extend beyond simple CERCLA liability, and without clear communication of your objectives the assessment may not provide enough information to understand your risks.
  • Similarly, Property Condition Reports and other investigations of the physical condition of properties can take many forms. Limited observations by a generalist may be adequate in low-risk situations, but assessment by an engineer or architect can provide a deeper understanding of properties, and evaluation by specialists in mechanical, electrical, and plumbing, facades, roofs, elevators, etc., can provide increased certainty for investors as well as information to support long-term management, repositioning, or rehab of properties.
  • ALTA Surveys also meet a predefined set of needs, but if you only want to identify the boundaries of a site, ALTA may be too much, or if you need to understand setbacks, flood zones, locate site features, etc., then a basic ALTA survey won't be enough.
  • In the seismic risk space, a real estate lender may be concerned with whether a borrower's equity is adequate to allow them to recover loan funds if an earthquake causes damage to a building, but the borrower may be more concerned with local retrofit requirements, business interruption, or loss of inventory. Alternatively, they may seek a more thorough evaluation of engineering or a more conservative estimate of damage might be needed to adequately evaluate these and other business risks.
  • Risks resulting from the condition of improvements, construction management, zoning requirements, subsurface conditions, contamination, and other concerns also affect property owners, buyers, and lenders differently, depending on their specific near-term and long-term objectives.

This is the first in a series to explore why different stakeholders may need different levels of due diligence to help property owners, investors, and lenders decide how much due diligence is really needed on properties to protect their unique interests.

Factors to Consider

When deciding on a scope of work, it’s important to consider how the information obtained will help to meet your goals as well as your risk appetite and risk tolerance. Any and all of the following may be pivotal in deciding how much due diligence to perform in different areas:

  • Welfare of occupants
  • Reputation
  • Fiduciary obligations
  • Legal and compliance obligations
  • Loss of principal
  • Capital requirements
  • Availability of additional funds
  • Materiality of the investment
  • Probability and materiality of the risk
  • Reduced return on investment
  • Direct and indirect liability
  • Business interruption
  • Loss of occupancy
  • Loss of inventory
  • Lost opportunity
  • Liquidity of the investment
  • Limitations on future use
  • Third-Party disclosures and representations
  • Third-party contractual obligations

Based on those factors, we will answer some of the most common scope concerns in this blog series:

  • Is the baseline standard (ASTM or other) enough for your needs? Do you need specialists or add-ons?
  • Are there known property issues wherein risk mitigation is key?
  • Ensuring you are working with qualified assessors and compliant with regulation
  • How to approach known risks in moving forward with transactions

As with anything, knowledge is power. Understanding, and in some cases, examining, the “whys” of your unique transaction is key to making smarter short-term financial decisions that can pay off in the long term. This series will clear up some of the long-standing misinformation around foundational due diligence services.