The European real estate sector continues to flourish in regions such as the UK and Germany, despite strong and unpredictable economic and political headwinds. Successful transactions depend on high quality and detailed due diligence, but competition for the most lucrative deals can sometimes lead organisations to compromise on this stage of the process.
The biggest challenge is that the size of real estate transactions is increasing exponentially because of regulatory and compliance requirements and also because of the broader volumes and types of documents involved. This means that more manual processes are required simply to find the right data.
The trend for higher volumes and larger transactions in real estate, including higher levels of risk and multiple languages, has important implications for the way in which investment professionals manage the greater complexity of due diligence. They are increasingly looking for technology such as machine learning which helps to reduce manual searches and to automate physical processes, saving time and money and increasing efficiency.
The growth in the value of real estate transactions is not the only challenge facing real estate professionals. There is also increased competition for real estate investment opportunities, driven by the vast amounts of ‘dry powder’ - investment funds that have built up over the past decade and that are widely available in the marketplace.
In research undertaken by Drooms with real estate professionals, the majority (60%) of respondents said that the focus on due diligence had increased significantly over the past two years compared to just 16% who said it had decreased. Three quarters of respondents (73%) said that the focus on due diligence would increase still further in the year ahead, driven by factors such as increasing deal costs (cited by 75% of respondents) and inherited tax risk and other liabilities (50%).
There’s a requirement to consider the whole lifespan of a property, not just its current value and this means that more documents and data are involved in the supporting paperwork of a real estate asset. For example, investment professionals need to understand the broader context of a property deal, such as whether the area housing a property is likely to see an influx of businesses or tenants in the future, what potential environmental factors may have an impact and whether new infrastructure is planned for the area.
Interestingly, respondents surveyed for our study believe that many factors are in danger of being overlooked or underestimated in real estate purchases. These include tax issues relating to cross border transactions (mentioned by 50% of respondents), how a structure will impact an ultimate exit (46%), legacy liabilities from prior owners’ legal and regulatory violations (35%) and regulatory issues when structuring cross border and domestic deals (27%).
Difficult to access documents
Building on this, respondents in the study report that there are a number of document types that are difficult to access when performing due diligence during a real estate transaction. Notably, they include environmental and sustainability compliance with current and planned regulations, mentioned by 56% of investment professionals surveyed for the study.
The second most difficult to access document type is the seller’s litigation history (48%), followed by their seller’s financial records including tax returns, service contracts and operating statements (44%), permission rights for change of use (36%), existing tenant leases and payment history (28%), environmental suitability assessment (28%) and tax certificates (20%).
The findings above serve to build a picture of complexity in real estate transactions that is increasingly difficult to manage using non-specific cloud services. The growing number of moving parts, including legacy liabilities and tax issues, mean that a different approach is required.
The role of virtual data rooms
Data rooms have always been the hubs of real estate transactions. They include all of the data and documents required by parties involved in a transaction and in the past were based in physical, lockable rooms with filing cabinets and limited opportunities for individuals to view relevant pieces of paper. As recently as 16 years ago, there were only physical data rooms in Europe with lawyers doing due diligence stuck in cellars with piles of physical folders.
In line with most other business processes, data rooms have been automated and transformed in terms of speed, ease of use and security by smart technology. Today’s virtual data rooms (VDRs) present the opportunity for all parties to share documents in parallel, rather than in serial.
This is still seen as the major benefit of VDRs, according to our research with investment professionals. Most respondents (84%) said that the ability for all parties to review relevant documents associated with a transaction is the main benefit of using a VDR for a real estate deal.
Smart technologies coming down the track, such as machine learning, will automate this process still further.
Machine learning is coming down the track
The volume and breadth of documentation involved in real estate due diligence continues to grow exponentially and it’s become increasingly important for users to quickly and efficiently navigate their way through to focus on the essentials.
Real estate investment professionals are looking for ways to reduce manual processes and use technologies such as machine learning to identify key terms and red flags, rather than physically plough through paper documents.
Respondents surveyed for our study endorsed this view. When asked which technological development will bring the biggest benefits to real estate due diligence in the next decade, more than two thirds (68%) of real estate professionals said it would be automated document analysis software.
The second highest response was for smart data rooms (56%), which would use technology such as machine learning to reduce the need for manual processes in due diligence. This was followed by artificial intelligence technology replacing manual due diligence work (40%), business intelligence software (40%) and technology for monitoring development of real estate projects (24%).
The overwhelming requirement, according to our study, is for technology that can assist real estate professionals in their ability to swiftly assimilate knowledge and insights from a huge range of data and documents.
It needs to be as intuitive and as powerful as the consumer retail platforms that we all know and love, but to build on their ‘search and suggest’ capabilities to ensure that everyone involved in a deal can share documents effectively. This includes the ability to translate documents from multiple languages in real-time, a must-have feature in an era of cross-border transactions and international due diligence teams.
Being able to sift through paper documents to find this granularity of information would be nigh on impossible using manual processes. Given that respondents to our study believe competition for investment opportunities is leading to compromise in the quality of due diligence, the only way forward is for ever smarter VDRs that can harness the capabilities of machine learning and – further down the line – artificial intelligence.
Jan Hoffmeister, Co-Founder at Drooms
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