Key Takeaways

  • Prior to consummating a commercial real estate purchase, we perform a significant amount of due diligence to make certain the property is safe for occupancy and to confirm that its title can be transferred legally.
  • Due diligence can be broken down into four categories: market, financial, physical, and legal.
  • The goal of market due diligence is to verify that the market exhibits the characteristics necessary to facilitate rent and price growth.

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.

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.

Financial Due Diligence

Financial due diligence may also be called “underwriting” a deal. 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.  To complete this task, it is necessary to perform financial due diligence to validate the assumptions that must be made in the proforma.

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 

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.

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    

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.

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) 

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.

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.

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