Merriam Webster defines due diligence as the reasonable care a person takes to avoid harming other people or their property. The dictionary goes on to elaborate its definition as research and analysis done in preparation of a business transaction.
- Someone does due diligence when they assess information and value for a transaction
- Most people encounter a due diligence process in real estate
- There is a legal due diligence process that securities traders must follow
- Due diligence in business gets very complicated and time consuming the more complex the transaction is
Anyone making a purchase should perform due diligence. This can be as simple as inspecting fruit at the grocery store to make sure it is fresh, but it also applies to very complex business deals.
What Does it Mean When Someone Does Their Due Diligence?
Due diligence is an audit or investigation of the information a seller provides during a transaction. Most people think of this type of audit with large investments, real estate deals, business mergers, or corporate acquisitions. These can be complicated, time-consuming, and require skilled professionals. However, any time you enter a legal agreement you should take these steps to ensure that the seller gives you accurate information and the value is fair.1
What Does Due Diligence Mean in Real Estate?
Even single-family residential transactions are complicated and involve a lot of money. Therefore, any real estate transaction requires careful planning. This process begins before you even bid on a property. For any real estate transaction, due diligence begins with learning the neighborhood before you even consider bidding.2
Residential Real Estate
Thousands of residential real estate deals happen every day across the country, so they are the most straightforward contracts. Most of these contracts allow for a 10 – 15-day period to perform due diligence depending on the area. Attorneys or title agencies often use generic contracts, but even so, every deal is unique. Buyers and/or sellers often change these contracts to meet their needs. The steps you should take for the residential property include:
- Learn what your budget is for buying a house
- Find a neighborhood and learn all you can about schools, transportation, and other infrastructure
- Make a list of important features and make sure the house includes those requirements
You should do these before you even begin looking for a house. The second phase of due diligence begins after you submit the contract. These steps include:
- Hire a licensed professional to perform a thorough inspection of the house
- Your lender should appraise the value of the property, but if you pay cash, it is still a good idea to take this step
- Order a title search of the home
These last 3 usually have a deadline to get them completed, usually 10 – 15 days. The seller wants to get this phase done as quickly as possible, but if you need more time, you can negotiate before you sign the contract. Even when buying a single-family home there is a lot that goes into the due diligence process. We recommend that you work with an experienced, knowledgeable real estate agent to help you. They can help you learn many important factors that you may not even think of on your own about the home buying process.
Rental properties are more complicated than residential. One reason is the scope of the investment. You can buy a one-bedroom condominium to rent, or you can finance a large apartment building with many investors. Therefore, these contracts are less generic and more complicated.
While all the steps listed above for residential property are important for rental properties, they are more complicated. Further, you have the added steps for ensuring the financial health of the investment. For rental properties you need to consider these before you bid on a property:
- Area and neighborhood analysis
- Pro forma financial statements for the property
- Review of financing options
Each of these can get quite complicated. For instance, your neighborhood analysis may include population and job growth projections, median household income, vacancy rates, crime rates, and several other factors. After you select a property, you need to:
- Perform physical inspections
- Review financial statements
- Deal with legal and loan issues
For simple investments, such as 1-, 2-, or 3-unit rentals it may not be much more complicated than buying a residential home. While you will probably work with a real estate agent and a lawyer just like buying a home, you will also need to add an auditor, usually an accountant, to look at the cash flow of the investment.
For large transactions, you will need a team of professionals to help you. In fact, there are companies, like Deal Room, that specialize in due diligence for complex investments.
Commercial or Industrial Real Estate
For commercial real estate, you have the same due diligence concerns that you do with rental properties, but these transactions are even more complex. This is because you have the added concerns of the business for which you are buying the property. Do the land and buildings meet the needs of the enterprise?
- Are the building and land adequate for the purpose of the business?
- Is there sufficient space for parking?
- Is there adequate infrastructure, such as loading bays and/or rail lines?
There are many other concerns specific to each individual venture. Commercial and industrial land deals are always very complicated and require a team or professionals to navigate the due diligence process.
What Does Due Diligence Mean in Law
Sellers in many markets are not legally bound to perform due diligence on they what they sell. For instance, we showed above that the burden of performing due diligence in residential real estate falls mostly on the buyer. However, the law does require sellers to disclose any problems with the property that they know about. If they fail to disclose a known issue they can be sued.
Another example, on a smaller scale, is a grocery store. They have a responsibility to ensure the quality of the products they sell. However, they may get a bad piece of produce that they do not know about. Most businesses will replace the product or refund the customer’s money. Most people, though, will not sue the store or bring criminal charges for such an incident.
With securities, such as stocks and bonds, there is a legal due diligence requirement that brokers and dealers must meet. The Securities Act of 1933 made securities dealers liable to disclose data and information about the instruments they sell. This protects buyers in securities markets and provides transparency in the markets. Underwriters:
- Conduct an audit of the investment
- Validate information disclosed in offering documents
- Obtain appropriate legal assistance
- Investigate any red flags
- Ensure no contractual agreements hamper the transaction
Congress passed this law after the stock market crash of 1929 to protect buyers in securities markets. Ultimately it helps the markets because companies have an incentive to always disclose accurate information about the health of their businesses. If they do not, then securities buyers have legal recourse for remuneration.
What Does Due Diligence Mean in Business
While there may not be a legal obligation to disclose information pertaining to a transaction, any business must carefully assess the risks and costs of any transaction. This due diligence includes:
- Research the seller’s reputation
- Consider the environmental impact
- Supplement purchases with insurances and warranties
- Evaluate and compare the prices of competitors
A business must perform adequate due diligence before selling a product or service in order to maintain a good reputation. On the other hand, a company that makes a purchase has a due diligence responsibility to its owners, employees, and customers to efficiently manage its business.
Final Thoughts on What Does Due Diligence Mean
Due diligence is an investigation to verify the accuracy of a seller’s information and appraise value. To put it very simply it answers the question, is this deal worth it? The more complex the transaction is, the harder it is for a buyer to assess the information and value.