Unless the market gives you a lot of margin for error in making investments (meaning you can buy at such an attractive price and return that you have room to make mistakes and still do well), I believe investors need to be careful on due diligence and the assumption they make in the underwriting process. First comes a thorough understanding of the particular target asset, its relative position in the market, knowing how best to reposition or lease the asset. It really needs a complete business plan following the purchase with research and testing of each assumption and conclusion going into the business plan, which may take working with certain consultants, market studies and the like. In addition, there is basic due diligence: making sure the asset is in compliance with local zoning laws and ordinances, reviewing each commercial lease to confirm underwriting for rents and escalations and to make sure there are no unusual provisions that could cause a problem down the road (unusual options to renew, expand or terminate the lease), engineering to assess deferred maintenance and needed capital expenditures, environmental reports to ensure no large expenses will be required to comply with environmental laws, careful review of any issues relating to title, and more. A major miscalculation can turn a pretty good deal into a bad one if you miss something important, but this does require that you incur certain expenses in order to do these things in advance.
How should due diligence processes change in 2018?
Our fund has had a pretty aggressive approach to its real estate investments in the United States as we have had a high tolerance for risks as we have put a lot of faith in strong market conditions. We understand that market conditions will change at some point and are looking to tighten our underwriting procedures. What risks are still reasonable moving forward and what are areas where it makes sense to eliminate risks?
From my point of view the only risks which will change going forward regarding the due diligence process will be the construction costs and bank financing.
Your diligence should always be thorough. Your risk tolerance seems to be what you are looking to adjust. The markets are tight today. You are unlikely to find bargains. So i agree that your underwriting standards should be tightened up. Since I have no idea about the type of assets you invest in, I don't know how to advise you. While the fast answer is that this is not the time for development, I would tread lightly in that area. I would look for opportunities where there are disruptions and I would tread carefully. If you co-invest, I would choose partners with a solid track record.
Due-diligence process should always go under review year by year and tweaked according to market conditions. Each investor has a different approach and assesses opportunities under different lenses. Therefore, to pinpoint one or a few ways to eliminate risk would be unjustifiable for me propose.