How Does Due Diligence Work?

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Due Diligence Hotel Investments

2 Variables: (length of time & amount) Two important variables in a purchase and sales agreement include the amount of time that is being requested in the due diligence period and the amount of the due diligence deposit funds. While these are two major variables, there are several other variables worth considering. Developers should always consult and discuss other variables with a local attorney when negotiating purchase, sale, or due diligence instruments.

Due diligence time is a very critical time for a potential buyer or investor.  This is the period of time in which a buyer or investor is going to find out whether their plan is feasible and worth moving forward. The questions you need to ask and tasks that must be completed during this review process can include:

  • Whether your development is financially feasible: How much will your development cost?
  • What interest rate will you borrow money at?
  • What is the predicted return on your equity investment?
  • It’s also a time that you’ll want to inspect the land and the structural integrity of it. Various engineers will conduct soil borings and lab studies to determine geotechnical and site plan data and how that may affect or bring about hidden construction costs.
  • Will the city or local municipality allow it? Often times, developments can be restricted by regulations of the city or local municipality. It could be the case that only specific types of developments such as office space or hotel constructions can be built in a given area which must follow specific zoning rules. This is also known as entitlement process.

Due Diligence Time Period

Depending on the amount of time you need to complete all of these tasks, it can affect your deal. Shorter due-diligence periods are more attractive to sellers, therefore it is more likely to demand and receive a price reduction if your proposed due-diligence period is relatively short. The same goes the other way. If the amount of time being requested in the due-diligence period is long, it will probably require a higher purchase price to induce the seller to agree.

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Due Diligence Dollar Amount

The second variable in a due diligence deposit is the size, or the dollar amount, of the actual deposit itself. This variable allows the investor to do a variety of things. Sometimes you can propose to modify the terms and amount of your deposit. You can make the deposit refundable or non-refundable, essentially changing the amount of risk you are willing to take. Oftentimes, the risk you take with your due diligence deposit can have an impact on the amount and terms of the actual purchase price in the contract.

A quick example might help clarify how this works:
Imagine there is a piece of land that I would like to buy for $1.2m, but the land is listed for sale at $1.3 million. To induce a seller of real estate to sell the land to me at the lower $1.2 million price, I may offer a $100,000 non-refundable due diligence deposit to the seller. Many times, that seller will be induced by the chances that I don’t close on the deal and the potential of earning easy $100k. You can customize these terms, allowing your money to go non-refundable after a specific amount of time in the total due-diligence period, or right away. Again, some of this depends on the risk you are willing to take. Sometimes, offering a non-refundable deposit is a way to stick out among other buyers. If you are competing against a diverse group of buyers, offering a non-refundable deposit is a sure way to get the seller’s’ attention. Sometimes the land appears to be very risky and seems like there might be topographic or geotechnical issues with the land, and you may want to specify that your due-diligence deposit will remain fully refundable until you have had time to research potential problems with your civil engineer.

Where does your due-diligence deposit stay? It should technically be deposited into escrow with a mutual joint order escrow agreement. This ensure that your money is in safe/neutral hands and can not be accepted or deposited without a joint order from all parties. But this can also be customized. If you intend to offer a non-refundable deposit, the deposit can sometimes be sent directly to the seller or seller’s attorney. As always, make sure to hire a local attorney to advise you through any transaction.

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