3 Keys To Real Estate Due Diligence

U.S. commercial real estate (CRE) was recently valued at $22.5 trillion. That seems huge until you learn that the U.S. residential market is worth over $94 trillion. With single-family homes hitting yet another price record, that figure is growing.

As investors, how do we get a grasp on such a giant market? Like most things, the key is to break it down into manageable pieces. Despite the size and complexity of real estate, there are proven formulas to help guide your investment decisions.

In today’s article, I’m sharing three critical elements of due diligence you can apply to any real estate opportunity. Note that we can’t and won’t try to cover every aspect of real estate due diligence. But we hope this set of practical yet powerful tools will make you a better investor.

1. Property Type Matters

Describing real estate as an asset class is like classifying the thousands of publicly traded companies as stocks and leaving it at that. To make sound investing decisions, it’s important to understand the pros and cons of small and large cap stocks, value and growth, and domestic and international, just to name a few.  

Real estate is no different. Like stocks, different types of real estate are tied to different parts of the U.S. or global economy. Industrial real estate is heavily dependent on the growth e-commerce and demand for warehousing and logistics from companies like Amazon, Walmart, and FedEx.

Retail real estate on the other hand touches every part of the consumer economy. Fast food chains appeal to a certain consumer and are historically insensitive to the broader economy. A high-end mall with luxury retailers, however, may suffer during a recession.

The success of multifamily properties, also known as apartments, are closely correlated to the local job market and economy. A large influx of jobs can benefit a region’s multifamily properties for years.

Then there are cell towers, amusement parks, server farms, farmland, and everything in between. There are even funds focused entirely on mortgage debt tied to real estate. They often generate higher yields than owning the physical real estate at the cost of lower capital gains potential. Like stocks, it pays dividends to closely study the characteristics of each major real estate category.

That way when a specific investment opportunity is on your radar, you have a strong foundation to work from. Your unique risk profile and investment goals likely make certain categories a better fit than others. Fortunately, there are over a dozen to choose from.

2. Get the Details on Debt

One reason for real estate’s historic success as an asset class over many centuries and across continents is its potential for leverage. I’ll explain why this came to be.

Lenders can easily ensure the title, or ownership, to a property is legitimate. Properties can be visited and thoroughly inspected. Just like with your home, lenders can obtain cost-effective insurance to protect its value against most types of losses. It’s not difficult to steal a car or luxury watch and try to sell it on the black market. It’s not easy to steal 100-unit apartment building, much less sell it on the black market. Well-built real estate also has a long useful life of 50 years or more, so lenders are comfortable with long-dated mortgages. Provided it’s well maintained, the estimated life of the Empire State Building is 7,000 years. Clearly most buildings won’t last anywhere near that long, but you get the idea.

It’s easy to forget those are attributes generally unique to real estate. That’s why no one to my knowledge offers a low-cost 30-year mortgage on shares of stock or gold.

As a bonus, many types of real estate have historically generated steady income. Lenders love this too. They can underwrite the reliability of that income stream and have confidence that the borrower can stay current on their mortgage payments.

For all these reasons and more, most commercial and residential real estate is purchased using at least some debt. The U.S. government even subsidizes the cost of debt for residential properties through Fannie Mae and Freddie Mac. Your personal mortgage may even be through one of these government agencies.

In the financial world, we call debt leverage. Leverage is measured using a myriad of ratios, all of which compare the total amount or carrying cost of the debt against either the property’s cash flow or its value.

Independent of the type of real estate or its location, you’ll want to understand the mortgage tied to it. The loan-to-value (LTV) is the most common ratio. If the building was purchased and valued at $1mm and has a $650,000 mortgage, the LTV is 65%. Lower leverage is safer but may lower returns.

Interest coverage is another important metric. Properties should be able to cover their interest and mortgage payment obligations with rent money and still have a margin of error. Otherwise, if a tenant leaves or emergency repairs are needed, the property could be at risk of foreclosure by the lender.

Lastly, the interest rate and term of the debt matter a lot. Most banks and credit unions post the rates charged on commercial real estate loans on their websites. The interest rate on any mortgage should be near market rate. The length, or term, of a commercial real estate mortgage are usually five to 20 years. Keep in mind that if the mortgage matures before the end of the anticipated investment period, it may have to be refinanced. If rates are higher than expected or credit markets are in a downturn, that could turn into a serious problem.

3. Cash Flow is King

It’s hard to overstate the important of cash flow when it comes to real estate investing. There are a couple reasons for this.

First, since more real estate has leverage like we discussed, reliable cash flow ensures the property stays on top of interest, principal, and tax payments. From a risk perspective, many would argue nothing is more important. It’s hard to achieve a great return if the bank or county owns the property.

Second, historically, half of the returns from real estate investing are cash distributions. Capital gains play an essential role too, but distributions are a larger percentage for real estate than most other asset classes. The historical return from stocks, for example, is about one fourth dividends and three fourths capital gains.

And don’t analyze only the current cash flow from the property. Consider the potential for growth. That’s usually tied to the lease structure. For most triple-net leases, which is when the tenant pays for most of the expenses rather than the landlord, a 2-4% annual rent increase is standard. While not guaranteed, it’s a reliable indicator of what kind of income growth is feasible.

If your personal expectations are that inflation will stay high, however, the inflation-adjusted change in cash flow for a lower yielding triple-net property could be lower or even negative.

Conclusion

In this article, we discussed three key areas of real estate due diligence. By understanding the nuances of different property types, how leverage works, and real estate’s dependence on cash flow to generate attractive returns, we’ve covered a lot of useful ground.

These principles apply to the whole real estate universe including publicly traded Real Estate Investment Trusts (REITs), private real estate funds, and single-asset opportunities.

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Nothing in this blog is or should be construed as investment advice or an offer or solicitation of offers of investments. Both Real Estate Investments and Securities offerings are speculative and involve substantial risks. Risks include but are not limited to illiquidity, lack of diversification, complete loss of capital, default risk, and capital call risk. Investments may not achieve their objectives. Investors who cannot afford to lose their entire investment should not invest in such offerings. Consult with your legal and investment professionals prior to making any investment decisions. All Securities are offered through North Capital Private Securities, Member FINRA/SIPC.