- Commercial properties are expensive and it is a best practice for investors to perform a significant amount of research prior to purchasing them.
- In commercial real estate parlance, this type of research is known as “due diligence” and there are three types that should be performed prior to making a purchase.
- Financial due diligence is necessary to validate proforma inputs and assumptions.
Commercial properties are expensive and the sums of money invested can be significant. As a result, it is incumbent upon all investors to perform a significant amount of research prior to consummating a purchase. In commercial real estate parlance, this research is referred to as “due diligence.”
In order to understand what types of due diligence need to be performed prior to purchase, it is first necessary to understand exactly what it is, where it occurs in the transaction lifecycle, and why it is important.
What is Due Diligence?
In general, Due diligence is the process of performing research. As it relates to real estate specifically, due diligence is the process of inspecting all aspects of a property to ensure its condition is as advertised by the seller.
From a timing standpoint, the due diligence process officially begins when a purchase and sale contract is executed. In most cases, one of the clauses in the contract will outline a specific due diligence period during which the buyer has to perform their due diligence. The exact time period varies by transaction, but it typically ranges from 45-90 days.
Within that time period, there is a lot of work done. Experienced investors typically work from a due diligence checklist to ensure they don’t miss anything. While the contents of each checklist can vary slightly, the tasks that need to be performed can be grouped into three categories: financial, physical, and legal. Details on each are below.
Financial Due Diligence
The primary aim of financial due diligence is to validate the initial pro forma inputs and assumptions. To accomplish this, it is necessary to ask the seller for a number of financial documents including:
- Trailing 12 Months Income Statement
- Balance Sheet
- 12 Months of Bank Statements
- 12 months of utility bills
- 3 years of property tax bills
- Copies of service contracts like landscaping, property management, and insurance policies
- All tenant leases
Once received, investors can review these documents and compare them to the respective line items in the pro forma. For example, assume that the pro forma models $100,000 in monthly rental income. However, a review of each individual lease reveals that actual monthly income is $90,000. This is an important difference and the pro forma updates can have a material impact on property cash flows and investment returns.
Financial due diligence requires a specific skill set, strong attention to detail, and a talent with numbers. For the largest purchases, it is not uncommon for investors to hire an accounting firm or an outside expert to manage the process on their behalf.
Physical Due Diligence
Commercial properties are physical structures whose condition degrades over time. For that reason, it is important to inspect the property from top to bottom to ensure that its physical condition is suitable for occupancy. It is also important to inspect the surrounding environment to make sure it has not been damaged by the property’s presence.
In most cases, physical due diligence requires hiring third-party experts to review various aspects of the property and to complete reports attesting to their findings. These include things like:
- Property Appraisal: To validate the property’s condition and valuation
- Building Inspection: To review the property from top to bottom, which includes things that can be seen by the naked eye and those that can’t. Typically, the inspector uses special equipment to assess the condition of electrical, plumbing, and roofing systems. They also look for things like asbestos that could be harmful to occupants.
- Structural Review: A structural engineer is responsible for ensuring the property is safe to occupy. Their work may include things like looking at the roof, the foundation, and other key structural systems to ensure they are safe.
- Environmental Inspection: For loan purposes, every property requires a Phase I Environmental Site Assessment (ESA) to determine whether or not there are any issues with the surrounding environment, particularly the water supply. Certain businesses like dry cleaners or gas stations are notorious for releasing pollutants into the environment and this information needs to be known. If anything is found, a Phase II report may need to be obtained to assess the scope of the damage and the cost for repairs.
The goal of physical due diligence is two fold. First, to gain confidence that the property is safe to occupy. Second, to understand exactly what the condition is, what repairs are needed, and when they need to be performed. On the second point, this information allows the repair cost to be budgeted and reserved for over time so there are no surprises.
Legal Due Diligence
There is a major legal component to the transfer of a property from one owner to another. As a result, legal due diligence needs to be performed to ensure that it changes hands correctly – and legally. Legal due diligence includes obtaining and reviewing the following documents:
- Title Commitment: A document that discloses all of the liens, defects, encumbrances, and obligations that affect the property
- Title Insurance: A type of insurance that protects against defects in the property’s title.
- Certificates of Occupancy: A type of document that approves occupancy of the property for its intended use.
- Survey: A document that outlines the legal boundaries of the property.
- Estoppel Certificate: A document that shows all outstanding liens, fines, or fees due to an association or common ownership interest.
- Contracts & Loan Documents: The documents govern the sale of the property and the financing of it. They should be reviewed in detail to ensure there are no clauses detrimental to the buyer.
Because the legal aspects of a commercial real estate transaction require specific knowledge, it is common to outsource legal due diligence to a qualified real estate attorney.
What to Do If An Issue Is Discovered
From the above, it can be seen that there is a lot of due diligence work that needs to be done in a relatively short period of time. If an issue is discovered, one of three things typically happens:
- Nothing: The vast majority of the issues found during the due diligence period are relatively minor and do not interrupt the flow of the transaction. In most cases, they are noted by the buyer and a plan is made to address them once ownership changes hands.
- Renegotiate the Price: If the issue is of some consequence (meaning expensive to fix), but not enough to stop the deal’s progress, there may be a renegotiation of the purchase price. For example, if the repair is going to cost $100,000, the purchase price could be lowered to reflect it.
- Walk Away: This is always the last resort, but if the issue is big enough, it could cause the buyer to walk away. For example, if the groundwater supply is found to be contaminated and the remediation is going to be extremely costly, a buyer could decide it is not worth the hassle and walk away from the deal.
The decision about what to do is unique to the buyer as they can perceive issues differently. For example, one buyer could perceive an issue to be major while another may see it as relatively minor.
Interested In Learning More?
First National Realty Partners is one of the real estate industry’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
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