What factors can jeopardise real estate due diligence?

08. January 2018 | Drooms Global

The global real estate investment industry is heating up. Core markets are experiencing growth, with cross-border investment slowly on the rise. As demand in the primary cities intensifies, secondary cities will see a spillover when it comes to competition leading to heightened risks and the need for stronger due diligence.


According to EY’s Global Market Outlook 2016, there is intense competition in the real estate sector. The report stated the time was now for ‘a new era’, marked by “rising interest rates, potential falls in property values over the longer term and the emergence of distressed opportunities”. This will require investors to be more innovative, as the environment is ripe for competition.

There is fear that increased competition could compromise the quality of due diligence. The urgency to complete deals can lead buyers and sellers to rush the deal-making process. So, what are the factors that could jeopardise real estate due diligence and which issues are often rushed due to time constraints?

Tax issues for cross-border transactions

While cross-border deals are increasing, the growing concern relates to tax issues in particular. Hogan Lovells’ June report identified how current tax reforms in Europe and in the US will “have the potential to re-shape the nature of the U.S. and the European real estate investment market”. For investors, due diligence becomes crucial and should not be rushed or pushed aside. A big factor here can be the language barrier – Drooms NXG’s real-time machine-based translation feature can be one way of ensuring documentation is properly analysed and understood. The Drooms NXG data room software is a proprietary technology developed by Drooms’ own team of programmers and linguists. Drooms NXG enables direct translation of users’ documents in the data room. This boosts efficiency with large numbers of international participants. Due to direct translation available in the data room, documents never have to leave the high-security environment.

 

The structure of the deal impacting the ultimate exit

How an investor structures the deal is another key part of due diligence. It is said a good investor knows his or her exit strategy before striking a deal and this is true for real estate investments as well. Just like deal structuring, exit mechanisms range from dividend distributions to the sale of the asset. The problem is, when it comes to deal structuring, investors often focus on the short-term and forget to factor in plausible complications and exit options. It’s essential to use modelling to clarify the different outcomes prior to the deal being finalised.

 

Legacy liabilities from prior owner’s legal and regulatory violations

The due diligence process is certainly jeopardised if liabilities are not properly examined prior to the deal taking place. It’s imperative to find out what liabilities the seller has and if there have been previous issues that might still come to haunt you – even if they were cleared up at the time. In such instances, proper document collection becomes key – there should be no avoidance or incomplete data transfers during due diligence. Preparation of documents and their transparent and secure use is crucial.

 

Regulatory issues when structuring cross-border and domestic deals

Rushing might also ruin the due diligence process when it comes to regulatory issues. This is especially important for cross-border deals because you are not just dealing with a single legislator but two or more. Not paying attention to the antitrust and security regulations can be a costly mistake even when working on domestic deals. The regulatory environment can sometimes be mixed with politics, cross-border real estate in particular has got a lot of stick in the past. A grasp of the current political landscape aswell as the relevant regulatory framework is required.

 

Broader prospects for property (e.g. product type, sector or industry)

Of course, there are also concerns regarding the broader prospects of the property which must be dealt with at the due diligence stage. Again, these can be heavily tied into the political landscape of the region. In cross-border due diligence especially, it’s essential to have local experts guiding the process.

 

Potential liens

Finally, the existence of potential lien issues can also jeopardise the due diligence process. Tax liens are a common problem. There must be adequate research, verification of the liens and understanding of the current regulatory framework. For the liens, a title report is often the most efficient way of figuring out where the rights and liabilities lie.

As the above shows, there are plenty of important elements buyers and sellers need to factor in when performing real estate due diligence. The increase in competition shouldn’t rush a given deal. In the long-term this could actually prove far more costly than a missed opportunity.