Due Diligence More Crucial Than Ever in a Down Market

During a building boom, less experienced contractors and developers unwittingly become involved with projects beyond their capacity.

By Randall Etnyre

Plenty of confusion surrounds the current financial crisis, commonly understood to be the product of a boom-and-bust housing bubble. It is shocking how little we learned from the dot-com speculation bust. The scandals of massive insurance giants should remind us of the end of the last political cycle, when Enron and Arthur Andersen struggled for financial survival. Many like to compare the current recession with the fallout of the 1982 S&L collapse. Though each scenario has its own unique pathology, two factors are inherent to both: human folly and poor due diligence. Due diligence is essentially a tool for assessing risk. Each industry has its own standards. In real estate, the projected return on investment is justified by an accurate appraisal of value. Lenders rely on due diligence to limit exposure to risk. Just like a medical exam, the value of the due diligence is based on the quality of the diagnosis.

Randall Etnyre is a project manager with CA Partners Inc., a Dallas-based construction consulting firm specializing in reporting to real estate lenders and investors. He can be reached at retnyre@capartnersinc.com.

Whether investing in the stock market or doubling down at the casino, capital investment requires some type of risk-versus-reward analysis. Much of the construction due-diligence process is based on quantitative analysis of a project easily translated into costs. Common sense dictates that new construction projects generally involve less risk than renovation projects, due to unknown variables. Since the S&L collapse in the early 80s, lenders and investors have understood the value of quantifying risks. Quality of construction documents is another area that can impact costs if not properly evaluated. Construction-issued drawings obviously involve less risk than design development drawings. Another qualitative factor involved in determining the risks relates to the experience of the contractor and developer.

No matter how accurate a contractor’s estimate, if it excludes city code requirements, adequate structural design or owner-selected finishes/fixtures, it will not represent the actual construction costs. During a building boom, the less experienced parties unwittingly become involved with projects beyond their capacity. This can be due to ineffective project management, poor understanding of risks or both. As well, the quality of land declines after a prolonged construction boom; the easiest land to develop is developed first. When this happens, greater due diligence is required. Although the land sale may be somewhat lower, the cost to improve infrastructure, remove existing structures or remediate environmental conditions must be evaluated. As lending regulations remain at the center of the financial controversy, thorough due diligence will continue to be a critical part of a healthy construction industry.

Since construction is considered a leading financial indicator, many people are looking to the industry for signs of a recovery. Although there is plenty of data available, a clear picture is not yet apparent. In February, housing starts increased for the first time in approximately eight months, with most of the increase relating to multi-family construction.

After years of material price increases, material prices are showing sign of stabilizing. The Turner Construction Co.’s first quarter 2009 building cost index shows a decrease in domestic commercial material costs. The index number of 866 is down 5.8% from the fourth quarter 2008 index of 919. The previous downturn in new project starts has made the labor market more competitive as well.

The real estate bubble burst was in large part due to manipulated demand in the form of low interest rates. The political powers will initiate building with infrastructure improvements, community development and public works projects. The construction industry appears to be at a critical juncture. Lending institutions are waiting to see what kind of regulations will be required, and developers are waiting for banks to start lending again. Optimists are hoping for a slow start to construction in 2009, with a potential recovery starting in 2010. No doubt, wise use of government intervention could help to stabilize the credit markets. History does seem to have a tendency to repeat itself, with the help of human folly. Let’s hope that the construction industry can lead the recovery by example, with a proper respect for the all-too-often lost art of due diligence.