In a typical commercial real estate transaction, the contractual terms of sale allocate a specific period of time for the buyer to perform “due diligence” on their potential purchase. The actual amount of time is negotiated between the buyer and seller, but typically ranges from 30-60 days.
What is Due Diligence in Real Estate?
When a property is advertised for sale, it is common for the marketing documents to portray it in the most positive light possible. In reality, every property has strengths and weaknesses and it is up to the potential buyer to verify/identify them.
From the moment that a property is placed under contract, the buyer is on the clock to conduct their due diligence, which involves a significant amount of research and verification to ensure the property is as advertised in the marketing documents. When doing so, buyers, particularly those who are acting on behalf of investors (like us), have a responsibility and an obligation to be as thorough as possible to prevent any major surprises down the road.
Because there are so many tasks to complete in a relatively short period of time, it is common for experienced buyers to use a “Due Diligence Checklist” to ensure no stone is left unturned. Our buyer due diligence checklist has 100+ line items and has been developed through years of experience and dozens of transaction repetitions. In general, the due diligence tasks are divided into three categories: (1) Financial; (2) Lease and Contract; and (3) Physical. Each is discussed in detail below.
Financial Due Diligence
Typically, a property’s marketing materials include a proforma, which is a financial projection of the estimated cash flows over a defined holding period. Often, a property’s asking price is based on this projection so the purpose of financial due diligence is to verify or justify every single line item in it for accuracy. To start, it is customary to ask the seller (or their representative) for a series of documents, including:
- Rent Roll: A listing of all property tenants that includes their monthly rent payments, security deposits, and lease expirations.
- Trailing 12 Months Income Statement: A profit and loss statement for the property that shows the actual income and expenses for the previous 12 months.
- Actual Bills: To support the income statement, actual bills can be used to verify line item expenses. This includes bills for property taxes, insurance, and utilities.
- Bank Statements: Actual statements for the property’s operating and reserve accounts
Once this documentation has been received, it is the buyer’s responsibility to review it and compare it against each proforma line item for accuracy. For example, if the actual rent roll shows $50,000 in monthly rental income, but the proforma estimates $75,000, it is up to the buyer to reconcile the difference and determine if it is realistic. Large real estate firms, like ours, employ a team of financial experts who have a significant amount of experience with this sort of financial due diligence. Smaller firms or individual buyers may conduct the due diligence on their own or outsource it to a third party like an accounting firm.
Lease and Contract Due Diligence
Lease and Contract due diligence is part financial analysis and part risk management. To complete it, potential buyers should request all property leases and service contracts so they can be reviewed for things: (1) their financial liability; and (2) potential legal issues.
With regard to financial liability, it is important to understand the financial impact of each existing contract, how long it will remain in existence, and how it reconciles to the income statement. For example, we like to manage our own properties. So, we will specifically look at the existing property management contract to see what the typical monthly payment is, when it expires (and if there is an early out), and if the true monthly payment is reflected in the operating statement. Doing so will allow us to determine when we can bring this function in house and how the cost savings will impact property returns.
Regarding potential legal issues, it is critically important that buyers understand their contractual performance obligations under each lease and/or contract. For example, it is common for retail leases to contain a clause that prohibits the leasing of other space to a similar business. For instance, a lease to a national coffee shop may specifically state that the property owner is not allowed to lease space to another coffee shop. Knowing this ahead of time has a significant impact on the property’s business plan.
In our case, we have a legal team that reviews all existing leases and contracts for key information and clauses. Often, they will write them up in an “abstract,” which is included in the deal package sent to our credit approval committee.
Physical Due Diligence
Physical due diligence involves a thorough review of the property’s physical condition to what level of renovations may be needed and to identify any potential issues that could create a big (meaning expensive) surprise down the road. Because a commercial property contains a complex set of mechanical systems, it is common to hire third party experts to complete some aspects of the physical due diligence, including the:
- Appraisal: An analysis of the property’s current condition and expected value based on comparable properties.
- Inspection: An analysis of the property’s major systems such as air handling, electrical, and plumbing.
- Environmental: An analysis of the property’s surrounding environment, including the soil and groundwater underneath.
- Survey: An analysis of the exact boundaries of the property and the location of all of the improvements on it.
- Title Report: An analysis on the property’s chain of ownership and identification of potential issues.
- Regulatory Issues: An analysis on the property’s current use and whether or not it fits the municipality’s zoning requirements.
It is not uncommon for physical due diligence to uncover some sort of issue that was not disclosed in the marketing documents. For example, the property inspection may reveal a previously unknown plumbing leak and associated water damage that cannot be seen by the naked eye. In this case, it is important for the buyer to understand the cost of repairing it so they can adjust their financial models accordingly.
While it is important to use physical due diligence to understand the current condition of the property, it is also important to use it to determine if there are any major capital expenditures required in the near future. For example, if it is revealed that a property’s roof needs to be replaced in 3 years, the buyer can build this cost into their business plan and set aside a portion of the property’s income over time to pay for it.
What to Do If An Issue Is Discovered?
The nature of a commercial real estate transaction mandates that the Due Diligence period be relatively short, usually 30-60 days. As such, it often happens in parallel with other aspects of the transaction. If a major issue is discovered in the due diligence process, one of three things typically happens:
- Nothing: If the issue is relatively minor and can be fixed at a small cost, the buyer may decide that it is not worth derailing the transaction over. They will budget for the repair and keep moving forward.
- Renegotiation: If the issue is material and the cost to fix it is significant, it is common for the buyer to go back to the seller to renegotiate the purchase price in light of the new information. For example, if a pollutant is found in the groundwater and it is going to cost $75,000 to remediate, the buyer may go back to the seller to negotiate responsibility for this expense.
- Walk Away: On occasion, the issue is a “show stopper” and significant enough to cause the buyer to walk away from the transaction. Usually, this happens in one of two instances: (1) it is a major structural flaw in the property that renders it unsafe for tenants or prohibitively expensive to repair like a crack in the foundation; or (2) it appears as though the seller tried to hide the issue causing the buyer to lose confidence. Sometimes, walking away means forfeiting a large, non-refundable deposit, but it can be worth it to prevent a significant loss down the road.
Interested In Learning More?
First National Realty Partners is one of the country’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.
Before consummating the purchase of a property, we invest a significant amount of time and resources in a thorough due diligence program to ensure the property is suitable for our investors.
If you are an Accredited Investor and would like to learn more about our investment opportunities, including zero cash flow properties, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.