Caveat emptor, as the saying goes – let the buyer beware.
It’s not like it was in grade school when you could call “take-backs” after getting up from your seat – after you close on a property, that’s that.
It's a general principle in real estate that buying a property “right” is the key to a profitable deal. Therefore, you'll be fighting an uphill battle if you fail to uncover a material fact that negatively impacts the property up-front.
So, to avoid buying a lemon, adequate due diligence is required.
Real estate due diligence is the process of investigating the facts regarding the physical and financial conditions of a property.
But not all real estate due diligence is the same. Different types of commercial real estate transactions require different types of due diligence activities.
And if you’ve never been through the process before, especially on a piece of land for investment or future development, the process can be downright daunting.
So, we wanted to make it easy for you and offer a step-by-step process to help guide you through real estate due diligence. We also have a comprehensive due diligence checklist specifically for land that you can download at the bottom (hint: you should never buy a piece of land without it).
In this article, we will discuss what you need to know when investigating property for land investing, site selection, and land development.
Structure the real estate contract to allow for adequate due diligence
The way you approach a land contract should be very different than how you'd approach an agreement to buy a house or even a commercial property.
Allowing yourself too little time to close leaves you exposed to the risk of buying a worthless property or one that you can't develop in the future.
Too much time, and the seller will likely balk at the offer, especially in a market where sellers have the leverage.
A properly structured land contract affords enough due diligence time to investigate a property thoroughly. If you plan to develop the property in the future, you may also consider aligning the contract to phases of the land entitlement process.
If you’ve managed the seller’s expectations, they should be willing to give you enough time to conduct your real estate due diligence, especially if they want to maximize their proceeds from the sale.
Start with a due diligence checklist
Remember how I mentioned you should never buy a property without a due diligence checklist?
That’s not hyperbole.
In fact, there’s so much information you need to analyze, and so much nuance associated with buying land, that working without a checklist frequently leads to project failure.
Occasionally, the property owner will have some of the information you need to satisfy your due diligence requirements.
But if you’re analyzing a property as part of your site selection process, or have plans for future land development, you’ll be on the hook for much of the investigative work.
Keep your real estate due diligence checklist handy and use it to guide you throughout the process.
Determine how you'll finance the property
This won’t be a deep dive into different strategies for purchasing land, but it’s a critical step during due diligence worth mentioning.
If you plan on using debt to help finance the project, it’s a good idea to have a conversation with your lender or several lenders early in the process.
They'll generally be interested in their own due diligence items related to the property that you'll need to make sure to complete. Additionally, especially regarding land or development financing, a lender will need to get comfortable early with both the project and the sponsor.
As the project sponsor, you’ll likely need to provide the bank with a personal financial statement.
If you’re raising capital for the land or using syndicated financing for real estate development, you'll need to prepare an offering memorandum early to begin courting investors.
Either way, it's good to engage with a lender early to determine if the project meets their general criteria before getting too deep into the process.
Legal & administrative real estate due diligence
Once the contract is finalized and fully executed, the real work begins.
Legal and administrative due diligence tasks aren’t glamorous, but they’re critically important to ensure you can legally buy a property.
The first step will be to collect and organize any files the landowners and sellers may have that will expedite the investigative process. You can structure your contract to stipulate that files need to be turned over within a specific time after contract execution, usually within 5-10 days. Those files can include:
- Title reports and a previous title policy
- Property surveys
- Easements
- Any existing land leases
- Historical tax bills
- Appraisals
The quicker you can get your hands on critical administrative data, the more thoroughly you’ll be able to understand what exactly is involved with the property you’re buying.
Sometimes you'll find that the same family has held vacant land for generations. It's passed down between family members, and ownership interest may be spread across a convoluted web of multiple families, decedents, and spouses. This poses a unique challenge from a legal ownership and title work standpoint.
Who actually has an ownership interest in the property?
An attorney can assist when navigating some of these challenges, so it's crucial to engage with them early and often.
Environmental due diligence
Environmental issues commonly impact land – some are small and manageable while others may be deal-breakers.
A landowner may have a previous phase I environmental assessment that will offer some insight into whether environmental issues have been detected in the past. For example, nearby gas stations and industrial properties or the presence of underground storage tanks (USTs) may require further investigation.
It's good to consult with an environmental engineer to determine the rigor of due diligence required to investigate a site thoroughly.
But environmental due diligence spans beyond just manmade negative externalities.
The physical environmental characteristics of a site play a significant role in the value and useability of a piece of property. It’s important to consider factors like:
- The presence of endangered species
- Wetlands and streams
- Tree cutting restrictions
- Soil and subsurface composition
- Floodplains and watersheds
Often each municipality has slightly different regulations that govern how you can use a site based on the presence or absence of critical environmental factors.
In some cases, federal law governs environmental regulations and prescribes how those situations impact a property.
A property’s environmental characteristics need to be investigated thoroughly to assess the feasibility of land for investment or development. We often suggest bringing on outside site consultants like environmental and geotechnical engineers to assist with your investigations.
Municipal due diligence
Most real estate developers are primarily concerned with what a piece of land can yield - how dense and what types of allowed development can be built.
Land investors instead are focused on value appreciation – what’s the site’s highest and best use and what will be the value of the property to a developer in the future.
Municipal regulations govern much of what can and can’t be done on a property. So, as you investigate the land, there are several municipal due diligence considerations to keep in mind:
- Land use & future land use
- Zoning
- Off-site improvements
- Setback requirements
- Tree conservation & open space requirements
- Impervious surface allowances
This isn’t an exhaustive list, but it’s a good place to start. Each municipality has its own development rules, which are usually codified in a unified development ordinance (UDO).
But beware - these ankle biters have a habit of derailing projects if they aren't investigated and considered early, especially during site selection with plans for future land development.
A civil engineer and land use attorney are experts in most municipal procedures. They’ll serve as critical resources to help you examine these real estate due diligence items.
Development feasibility due diligence
During site selection or land development, this is where the rubber meets the road. But even as a traditional land investor, you need to consider how a developer will assess and value the property on the back end when you exit the investment.
Development feasibility is an assessment of the critical factors that determine whether it’s likely a project will be a success.
As you investigate a property’s development feasibility, consider real estate due diligence items like:
- Necessary sitework
- Topography
- Access to utilities
- Buildable area
- Traffic impact analysis
- Nearby amenities
- Market fundamentals (households, income, etc.) & economic drivers
- Site sketch & proposed layout
Don't shortchange yourself when examining these items during your due diligence period.
Land development is a fluid process. Plans continually change because of the physical constraints imposed by the land and a market's economic factors. Therefore, it's essential to understand the elements that can impact the feasibility of a project to pivot and refine a plan.
If you don’t have experience, a real estate consultant or a knowledgeable real estate developer can help guide you through these processes.
Financial due diligence considerations
Will the project be profitable or not – it’s a simple litmus test that real estate investors and land developers use to determine if a project will be greenlit.
All the other real estate due diligence items you inspect throughout the process will help shape the project's financial viability.
Think about it this way. Let’s say you find a stream on the property you're inspecting - what does that mean for your project?
As a land developer, it means you can't build as much on the property. A stream may disqualify the site as a viable candidate if you're a business owner working through site selection. As an investor, it may mean that the property is less valuable because there are fewer useable acres.
The point is that every line item on your due diligence checklist translates to an objective quantitative measure that informs the overall financial picture.
In addition, there're a series of financial-specific due diligence items you should examine. Consider factors like:
- Post-development comparable sales/rents
- Comparable land sales
- Estimated soft/hard costs
- Residual land value
- Carrying costs
- Entitlement costs
As you begin to assemble critical financial data, you should consider building an investment or development proforma to assist your financial analysis.
Your proforma should include a financial model for the proposed project and will guide all your financial decision-making.
Sequencing your real estate due diligence activities
Hopefully, the breadth of real estate due diligence required to close on a piece of land didn’t scare you off.
There is a lot to consider, and insufficient due diligence on the front end can lead to serious problems.
The biggest challenge when investigating a property isn’t simply the laundry list of items you need to examine but how to properly sequence your activities to minimize your financial exposure.
When you put a piece of land under contract, the natural tendency is to rush and examine everything as quickly as possible.
But here’s the thing. Due diligence activities frequently compound on each other.
Let's say, for instance, you were planning on tying into the sewer line adjacent to the property. However, through the course of due diligence, it was determined that the sewer didn't have the capacity for your proposed project. Based on that finding, a soil study and perc test to determine the suitability of soils on the site for a septic system may be required. But is the site even large enough to accommodate a septic tank and drain field?
As you can see, an answer to the feasibility of one item may lead to several more questions. So, it's essential to have a working knowledge of the real estate development process to be able to pivot based on your findings.
You also need to consider what due diligence items are deal-breakers vs. nice to haves. Due diligence investigations can be costly. It probably makes sense to hire a civil engineer to assist with the site layout before spending the money on geotechnical work.
Rack and stack your priorities to help sequence your due diligence activities to avoid unnecessarily risking too much capital.
The role of a real estate consultant
Costly mistakes are the norm when it comes to raw land.
We’ve seen the common land investing mistakes before. We’ve seen real estate developers spend hundreds of thousands of dollars on due diligence only to find out the project doesn’t work. We’ve even seen business owners close on properties that proved unusable for the ground-up development of a new building for their business.
And before you spend a ton of money, you want a level of comfortability that it will be profitable to you as an investor or feasible for you as a developer.
A real estate advisor can help you answer those critical questions.
Arm yourself with the skills and awareness to make strong business decisions and avoid wasting time and money.
Learn more about how our real estate advisory and consulting services can help you on your next project. We can help you turn a complex process into a profitable one.
You can also get your free copy of our site selection and land due diligence checklist.
