Due diligence is concerned with the investigation of the property being considered for purchase or used for collateral and the assessment and verification of the investment parameters being used to decide whether to invest in a property – either as a direct purchase or a loan. The real estate investor going the solo route will have to do all information gathering, assessment and verification him self. The investor utilizing the services of a real estate adviser will only have to spot check and verify the due diligence already done by the adviser. As the relationship develops between the investor and his adviser, the investor should be spending less and less time verifying information submitted by the adviser, although the investor should never totally abandon due diligence efforts.
The first item to consider when performing due diligence is the appraisal report. We have the appraisal done by an appraiser we know and whose work we are comfortable with. The appraisal is a full appraisal, encompassing market, cost and income approaches to determine value. Although we are most concerned with the comparable sales approach, if the other approaches result in a lower figure we will use the lowest figure to determine value. We insist that at least four comparable properties be used to determine market appraisal, as well as a different four (as rental comps) to determine value by the income approach.
The appraisal report should be fully read to obtain the appraiser’s opinion of the neighborhood and area that the subject property is located in. Appraisals will also have sections pertaining to the growth potential of the property area as well as verification of property demand for rental purposes. All this information must be assimilated by the real estate investor to help determine his degree of interest in investing in the property. The appraiser himself and the appraiser’s work should be familiar to the investor.
The appraiser should be MAI certified, and should have significant experience in appraising and valuing the type of property being considered. Pay particular attention to the comparables being used as a basis for valuing the subject property. These “comp” sales should be recent (one year or less) with few adjustment differentials with the subject property. Especially with residential property appraisals, the comps should be in the same neighborhood as the subject property. Being able to validate the appraisal’s accuracy is an art as much as a science. Specific knowledge of real estate industry procedures and standards are necessary, as well as local knowledge of a particular area. Real estate remains a localized business. If the investor does not have the knowledge to render a reasonable judgment as to real property valuations in a particular location, than outside expertise must be brought in to access the situation.
METHODOLOGY AND PROCEDURES USED IN THE APPRAISAL PROCESS
An appraisal is defined as “the act or process of developing an opinion of value.”
(Appraisal of Real Estate, Twelfth Edition, Appraisal Institute). Real estate appraisal involves selective research into appropriate market areas; the assemblage of pertinent data; the use of appropriate analytical techniques; and the application of knowledge, experience, and professional judgment to develop an appropriate solution to an appraisal problem. The appraiser provides the client with an opinion of real property value that reflects all pertinent market evidence.
The underlying principles in the appraisal process are supply/demand, anticipation, change, competition, substitution, opportunity cost, balance, contribution, surplus productivity, conformity, and externalities.
In arriving at a final value conclusion for real property, an arduous and systematic process is undertaken. This process, as detailed in The Appraisal of Real Estate, Twelfth Edition is set forth below.
The valuation process begins when an appraiser identifies the appraisal problem and ends when the conclusions of the appraisal are reported to the client. Each real property is unique, and opinions of many different types of value can be developed for a single property. The most common appraisal assignment is performed to render an opinion of market value; the valuation process contains all the steps appropriate to this type of assignment. The model also provides the framework for developing an opinion of other defined values. The valuation process is accomplished through specific steps; the number of steps followed depends on the nature of the appraisal assignment and the available data. The model provides a pattern that can be used in any appraisal assignment to perform market research and data analysis, to apply appraisal techniques, and to integrate the results of these activities into an opinion of defined value.
Research begins after the appraisal problem has been defined and the scope of work required to solve the problem has been identified. The analysis of data relevant to the problem starts with an investigation of trends observed at the market level – international, national, regional, or neighborhood. This examination helps the appraiser understand the interactive relationships among the principles, forces, and factors that affect real property value in the specific market area. Research also provides raw data from which the appraiser can extract quantitative information and other evidence of market trends. Such trends may include positive or negative percentage changes in property value over a number of years, the population movement into an area, and the number of employment opportunities available and their effect on the purchasing power of potential property users.
In assignments to develop an opinion of market value, the ultimate goal of the valuation process is a well-supported value conclusion that reflects all of the pertinent factors that influence the market value of the property being appraised. To achieve this goal, an appraiser studies a property from three different viewpoints, which are referred to as the approaches to value. The three approaches are described below.
(1) In the Cost Approach, the value is indicated as the current cost of reproducing or replacing the improvements (including an appropriate entrepreneurial incentive or profit) minus the loss in value from depreciation plus land or site value.
(2) In the Sales Comparison Approach, value is indicated by recent sales of comparable properties in the market.
(3) In the Income Capitalization Approach, value is indicated by a property’s earning power, based on the capitalization of income.
One or more approaches to value may be used depending on their applicability to the particular appraisal assignment, the nature of the property, the needs of the client, or the available data. The three approaches are interrelated; each requires the gathering and analysis of data that pertain to the property being appraised. From the approaches applied, the appraiser derives separate indications of value for the property being appraised.
To complete the valuation process, the appraiser integrates the information drawn from market research, data analysis, and the application of the approaches to form a value conclusion. This conclusion may be presented as a single point conclusion of value or as a range within which the value may fall. An effective integration of all the elements in the process depends on an appraiser‘s skills, experience, and judgment.
A physical inspection of the property and neighborhood should be done to verify appraiser’s conclusions and to determine property condition. If property condition is a concern, or if renovations will be required to bring the property up to standard, then the services of a licensed property inspector should be obtained and a thorough property inspection by the inspector should be undertaken. The property inspector will issue an inspection report, which of course should be read to determine any physical defects in the property. If the services of a property inspector are not used, the mortgage lender himself should plan on spending a sufficient amount of time inspecting the property to be satisfied that the property has no major physical defects.
On any commercial properties or multifamily properties being considered for mortgage investment, the lender should, as part of the due diligence, examine all financial documentation relating to the property. While we as investors are not interested in the owner’s personal finances, we are most interested in the property’s finances. At a minimum the investor must see rent rolls, examine leases, be provided with current and past financial statements and pro forma income and expense projections.
Verification of the information provided will be done by a combination of checking with the parties concerned and through the investor’s ability to determine if the numbers “make sense” based on his knowledge and experience dealing in these properties. Due diligence is an on going process of evaluating and investigating each investment opportunity. An experienced real estate advisor will be able to assume a large part of the due diligence burden performed on each loan request.