Due Diligence: Best Practices & Considerations

August 3, 2017

EquityMultiple’s dedicated team of real estate underwriters is core to our value to investors. Each offering that reaches the EquityMultiple platform has survived several layers of due diligence and extensive vetting. Some of this rigorous diligence is based on foundational real estate investing best practices. Some is powered by technology and proprietary analysis methodologies. EquityMultiple evaluates a consistent flow of quality projects from a nationwide network of experienced sponsors. Ultimately, only about 5% of these projects pass EquityMultiple’s due diligence process and are selected by our Real Estate Team.

Key Takeaways:

  • Quality real estate due diligence is essential to successful investing, and a combination of quantitative and qualitative practices.
  • Best-practice real estate due diligence involves analysis of the market, sub-market, property, and business plan.
  • EquityMultiple’s due diligence process involves multiple layers, with only around 5% of the investments we evaluate chosen for the platform.

This article takes a look at both general real estate due diligence practices and EquityMultiple’s in-house protocols and standards.

Commercial Real Estate Due Diligence Practices

As with any investment, evaluating a real estate project comes down to assessing risk factors versus potential return. Most successful real estate investors are risk-averse, model return potential conservatively, and comprehensively consider risk factors. Before any analysis takes place, the due diligence process usually begins with a “sniff test” regarding the basic tenets of the investment.

Initial Screening

Success of real estate investments hinge on macroeconomic and microeconomic factors. Initial screening usually begins with a macroeconomic assessment: given broad market dynamics, is the combination of market, property type, and strategy viable with respect to risk-adjusted return potential? In many cases, a potential investment will be a “hard no” based on these dynamics. For example, as of late 2020, real estate due diligencegiven the severe sector-specific impact of COVID-19, most hospitality or physical retail investments will not be considered by risk-averse real estate firms (including EquityMultiple). There are exceptions to every rule, however; a triple-net lease retail property leased to an essential business, such as a pharmacy, may hold promise.

As part of initial screening, EquityMultiple also assesses the sponsor’s track record and that of its principals. A lack of experience within the market, property type, and specific strategy will typically disqualify a sponsor and their project. Whenever possible, EquityMultiple’s underwriting team seeks to evaluate prior projects completed by the sponsor.

Risk Factors 

If a potential investment passes initial screening, EquityMultiple conducts a broad assessment of risk factors associated with the investment. Such risk factors may include:

  • Market-specific risk: the larger a market and more diversified its local economy, the less risky a commercial real estate investment will be. A less established market may hold significant potential, but also entail greater risk; in these opportunistic geographies, macro shocks could have a more deleterious effect on the local real estate market. 
  • Financial risk: the more conservative an investment’s leverage and debt service coverage, the less risky the investment. A higher degree of leverage generally means a higher risk of borrower default and less buffer for equity investors. 
  • Property risk: If an investment entails ground-up development, significant value-add improvements, or a significant lease-up effort, the investment will entail a higher degree of risk. Other idiosyncratic factors–such as environmental remediation or an onerous local permitting process–can also add risk to a project.   

EquityMultiple’s underwriters assess these risk factors versus both modeled potential return and the last dollar basis of an investment: a “worst-case scenario” calculation of how much an asset would need to be sold to cover investors’ principal. 

Return Modeling

All investments entail risk. The question is, having conservatively and comprehensively examined risk factors, is return potential sufficient? In order to understand return potential, EquityMultiple’s Real Estate Team considers a host of factors, including:

  • Rent and asset value growth potential: returns on a real estate investment are primarily a function of cash flow (mainly coming from property rent rolls) and appreciation – successfully liquidating the asset at a price greater than the sum of acquisition and improvement cost. We look at market-specific trends and prevailing competitive property sets (data on prevailing rents and asset pricing) to assess return potential. In many cases, EquityMultiple targets assets that are acquired at a significant discount to replacement cost. 
  • Cap rate analysis: capitalization rates are key to forecasting asset pricing trends. By analyzing data at the property type level, the market level, and the asset quality level, EquityMultiple’s underwriters project a range of “exit cap rates,” indicating the potential range of asset value at the end of the hold period and after improvements to the property and rent rolls. 
  • Pro forma analysis: EquityMultiple examines each line item on the sponsor’s pro forma, scrutinizing all cost items and income figures. 

With these and other analyses, EquityMultiple’s underwriters form a range of target returns. If the target return objective is attractive relative to risk factors and alternative investment opportunities, the investment will proceed to the negotiation phase, wherein EquityMultiple seeks to build in additional investor protections in the deal’s structure. 

If an investment survives all layers of diligence and is presented on the platform, all risk factors are presented in full transparency on the offering page and within the investor packet. 

EquityMultiple’s Further Diligence

An Investment Committee Comprised of Industry Leaders

Real estate investing is a quantitative business. But despite technological advancements, commercial real estate investing is a fundamentally human business; success in real estate investing requires industry connections and intuition borne of experience. Each investment evaluated by EquityMultiple’s Real Estate Team must pass unanimous vote by our Investment Committee, which is comprised of professionals each with decades of real estate experience. EquityMultiple’s Board of Advisors often provides consultation on potential investments, including vetting of the project’s sponsor firm.  

Partnering Only with Select Sponsors

EquityMultiple conducts extensive in-house due diligence and vigilant asset management throughout the lifecycle of each investment. However, the originating sponsor is critical in ensuring profitability. 

As such, EquityMultiple seeks to partner with sponsors who possess extensive underwriting, diligence, and execution experience within the market or markets in which they operate. We prefer to work with sponsors on a recurring basis, taking a collaborative approach to asset management. 

The following are some of the checklist items EquityMultiple’s Real Estate Team considers when evaluating a prospective first-time partner real estate firm.

Property Walkthroughs

A senior member of EquityMultiple’s Real Estate Team typically visits the target property before a final determination is made. A hands-on assessment of the property and the proposed scope of work help inform further evaluation of the project plan, timeline, and pro forma cost items. A walkthrough of the neighborhood can help provide a clearer sense of the property’s appeal to renters and prospective future buyers.

Company-Level Underwriting Items

  • Sponsor criminal background check and credit check
  • 2-year sponsor personal tax returns
  • Sponsor track record (and that of its principals, where applicable)
  • AML KYC form
  • Current sponsor banking relationships and contact info
  • Pro Forma Title Policy
  • Management Agreement
  • Certificate of Good Standing

Project-level Underwriting Items

  • Excel pro forma and financial model
  • Senior and/or mezzanine loan documents
  • Operating agreement
  • Operating financials
  • Rent rolls
  • Purchase & sale agreement
  • Org. chart / proposed deal structure
  • CapEx history & budget
  • Certification of Formation of target entity
  • Tax & utility bills
  • Property photos
  • Site / floor plan
  • All leases & abstracts
  • Estoppels (if applicable)
  • Lease / sale comps
  • Tax returns for borrowing entity
  • Operations and maintenance agreements
  • Certificate of Occupancy
  • Public and private permits
  • Tenant stacking plan
  • Tenant delinquency reports
  • Property payroll schedule
  • Third party reports (such as an appraisal, property condition assessment, environmental reports)

Real Estate Due Diligence – The Bottom Line

EquityMultiple’s fee structure on equity investments aligns our interest with that of our investors: we generally do not earn a profit unless our investors do as well. We are also committed to the asset management process and to addressing investor questions and concerns throughout the lifetime of each investment. For these reasons, we are incentivized to select only those investments that we strongly believe will perform well. 

Our due diligence process involves several layers and is designed to pare down to only those investment opportunities that we feel provide strong potential for compelling risk-adjusted returns.

  1. Vetting of the originating real estate firm (the partner lender or sponsor)
  2. The partner real estate firm’s underwriting
  3. Market-level due diligence
  4. Asset-level due diligence (including property tour)
  5. Conservative risk assessment and return modeling
  6. Final approval of Investment Committee

While no investment platform can guarantee home runs 100% of the time, our due diligence measures should give you comfort as you begin your investment journey with EquityMultiple.

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