Before deploying investor capital into a commercial real estate asset, we have a duty to ensure that the property is safe for occupancy, that its title can be cleanly transferred to us as the new owner, and that its finances meet our return requirements. To verify that these things are true, we invest a significant amount of time and resources in a detailed and lengthy due diligence process prior to consummating a purchase.
Broadly, there are four types of due diligence that we complete prior to purchase: Market, Financial, Physical, and Legal. Details on each are provided below.
1. Market Due Diligence
Market due diligence occurs early in the transaction lifecycle and it is focused on assessing the quality of the market in which the property is located. We prefer vibrant, growing markets where tenant rents and commercial property prices have the greatest chance to rise during our stewardship of the property. While performing market due diligence, we look for the following data points as evidence of a strong market:
- High levels of job creation
- Strong net migration, meaning more people moving into the market than out of it
- Diverse economic base, meaning the largest employers cover several different industries like education, technology, financial services, or medicine
- Median income levels consistent with the intended use of the property
- Multiple modes of transportation with access points near the target property
- Favorable supply & demand characteristics that are indicative of the potential for rising prices
- Limited competition in the area immediately surrounding the target property
- Favorable zoning and regulatory environment that is welcoming for businesses
Comprehensive and detailed market due diligence is critical to the success of the transaction. To obtain the above information, we utilize a combination of publicly available data and proprietary paid databases. If the market dynamics appear favorable, we proceed with the transaction and move into the financial due diligence stage.
2. Financial Due Diligence
Financial due diligence may also be called “underwriting” a deal. Creating a projection of a property’s future cash flows is a critical part of determining a property’s fair market value and its return potential. It is common to create an initial cash flow projection, and to then use the financial due diligence to prove or disprove the original assumptions that went into it. To calculate potential investment returns, it is necessary to create a proforma projection of the property’s income, expenses, net operating income, and debt service.
The first step in the financial due diligence process is to request a series of documents from the seller. They include:
- Rent roll – including a listing of security deposits and lease terms
- Property Tax bills for the most recent two years
- Operating statement for the most recent two years
- Utility bills for the most recent two years
- Two years of invoices for all property insurance policies
- Bank statements for all accounts
- Copies of all tenant leases and service contracts
- Inquire about past or possible future special assessments
This process then includes the following key activities:
- Review the property’s current rent roll, and compare this to its financial statements and bank account deposits to ensure that fund flows are consistent.
- Review the property’s operating expenses, including property taxes, and compare them to actual invoices and bank account outflows to ensure that the amounts are consistent.
- Review all existing leases to look for key lease terms, such as the start date, end date, rent rate, security deposits, and future rental increases; this analysis is then compared to the rent roll to ensure they match.
- Review service contracts for key financial terms like start date, end date, and required payments. This analysis is compared to the corresponding line items in the cash flow projection to ensure they are consistent.
- Review market income and expenses for comparable properties in the same market. This type of analysis could highlight whether the property’s current rental rates and expenses are too low or high relative to the market, and the result could highlight opportunities for change.
When these documents are combined with our knowledge of the local market and purchase price, we can calculate our own valuation of the property. We can also create a more accurate proforma. Although it is an estimate, the proforma and its associated cash flows are a critical component of the buy/don’t buy decision. If we can safely conclude that our investment objectives will be met and we can verify the output of the model with historical documentation and market data, we will make an offer on the property.
The document that contains the official offer is called a “purchase agreement” and it is often prepared with or by a real estate attorney. One of the major clauses in the contract sets a “due diligence period.” Typically, it is between 30 and 60 days from the date the contract is executed and it sets the start of physical due diligence.
3. Physical Due Diligence
The goal of physical due diligence is to inspect the property from top to bottom to ensure that: (1) the property is safe for occupancy; (2) there are no major surprise repairs needed; and (3) the environment has not been contaminated by any of the current or previous tenants. To complete this effort, there are a number of key tasks that need to be accomplished:
- Hire a structural engineer/building inspector to review all structural components of the property like the roof and all support systems.
- Order and review a phase 1 environmental site assessment to ensure the groundwater and/or soil is not contaminated. If it looks like it may be, additional environmental reports (like a phase ii environmental site assessment) may need to be ordered.
- Review property records and the property itself for any evidence of asbestos.
- Walk through all units to review their condition and to assess whether any repairs need to be made. Test all electrical outlets, faucets, toilets, and light switches to make sure they work.
- Review records of previous repair activities to see if there is any deferred maintenance
Thorough physical due diligence requires specific expertise in building construction and engineering. For this reason, it is not uncommon to engage the services of outside experts and consultants to complete all or some of the work. For example, it may prove to be well worth the expense of hiring a roofing expert to determine that it is safe, and to provide an estimate of the number of years left in its useful life. This will provide peace of mind for the owner that it is safe, and it will also allow them to budget for the cost of replacing the roof over the long term.
If physical due diligence reveals some major structural or environmental issue, it could halt the deal in progress. In most cases one of three things happens, nothing, price renegotiation, or in extreme cases we may walk away. If the property is determined to be in good condition with no major issues beyond minor repairs, we will proceed with legal due diligence.
4. Legal Due Diligence
From a timing standpoint, some portions of legal due diligence happen at the same time as physical due diligence and the goal is to ensure the title to the property can be transferred cleanly to the new owner. Key tasks that need to be completed as part of the legal due diligence process include:
- Purchase title insurance
- Verify certificates of occupancy
- Work with the title company to obtain a title commitment on the property
- Obtain a property survey to ensure there are no encumbrances or encroachments on the property
- Obtain the necessary estoppel certificates, if applicable
- Work with the lender to prepare and review loan documentation
- Review and verify the existence of any warranties for major systems on the property premises (like roof or HVAC)
There are a significant number of legal considerations in a commercial property purchase. In most cases, these concerns are managed by a real estate attorney whose responsibilities fall into four buckets:
- Contracts: A commercial real estate purchase involves a number of contracts. For example, the loan documents, purchase contract, and warranties may need to be reviewed and approved by competent legal counsel to ensure that the language is fair to both parties.
- Title: A property’s title grants ownership rights to a certain party. In order to ensure that the title can be transferred free and clear of defects or competing ownership claims, it is necessary to perform a title search, review the resulting title report, and to purchase title insurance.
- Survey: It is necessary to review an existing survey or to order a new one to ensure that the boundaries of the parcel are clearly understood, and to see if there are any easements, encroachments, or encumbrances that affect the use of the land.
- Zoning: It is important to understand the local zoning code to ensure the current use of the property is consistent with it.
The point of legal due diligence is to prevent any legal issues in the transfer of ownership with the property, and to ensure that its intended use is allowable under local rules. If the title looks good and the property is free of any liens or defects, the transaction is ready to close. Once closed, the due diligence process is complete and ownership of the property is transferred.
5. Environmental Due Diligence
The goal of environmental due diligence is to ensure that the land underneath the property is free from any harmful pollutants or contaminants. To make this determination, there are several tasks that need to be completed:
- Review the current rent roll for potential polluters. For example, businesses like gas stations, dry cleaners, car washes, or auto repair shops are notorious for working with potentially harmful chemicals or solutions.
- Order environmental reports like a phase I environmental site assessment to ensure that there is no evidence of environmental contamination. If there is, it may be necessary to complete a more detailed phase II environmental site assessment to test and verify the existence of pollutants.
If pollutants exist, it may be necessary to hire additional experts to develop a remediation plan to clean it up and to budget for the cost of this need.
6. Operational Due Diligence
Finally, the point of operational due diligence is to ensure the asset’s existing property manager is competent and has maintained the property well. Operational due diligence is also necessary to develop a plan for the property once ownership has been transferred. The key operating due diligence tasks include:
- Review the current property manager’s performance and decide whether they will be retained.
- If the property manager will not be retained, it is necessary to identify their replacement and develop a plan for the transfer of responsibilities.
- Develop and implement a marketing plan for the new property to ensure it is always full of rent paying tenants.
If the operational due diligence checks out, comfort can be taken that there are no big surprises lurking once the transfer of ownership is complete.
What About The Transaction Sponsor?
The due diligence described above is from the standpoint of a transaction sponsor or investment manager looking to ensure that a property is as advertised prior to a purchase. However, there is another perspective in which due diligence should be considered. If a passive investor is considering a real estate investment with a transaction sponsor, the investor needs to perform his or her own due diligence on the sponsor and on the deal.
It is important to ensure that transaction sponsors are experienced and reputable. It is also necessary to ensure that they have a consistent track record of delivering stable returns. Their websites, biographies, and resumes should be reviewed in detail to ensure this is the case.
Individual investors also need to perform a significant amount of due diligence on the investment being offered by the sponsor. This includes a review of the deal itself, the tenants, the market in which the property is located, and the cash flow split between the sponsor and investor(s). The financial incentives of the sponsor and investor should be aligned.
Final Thoughts
Due diligence is one of the most critical parts of the commercial real estate transaction lifecycle. Taking a thorough and detailed approach is necessary to ensure we are acquiring institutional quality assets on behalf of our investors. To make certain we don’t forget anything, we use our own due diligence checklist which allows us to repeat the process over and over with a high degree of consistency.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
To learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
