Conducting Proper Due Diligence on a Commercial Property

Updated on August 11, 2020

The Private Equity Real Estate Podcast – Show 3

Summary
This week we focus on what happens after you get a property under contract and how crucial it is to conduct proper due diligence. Our guest to help us break this topic down is Chris Palermo, co-founder and one of the managing principals at First National Realty Partners. Chris gives us a look into the firm’s process and why they have closed every deal that they have put under contract so far. Some amazing info on this episode of The Private Equity Real Estate Podcast. If you want to hear any topics from the pros we bring on the show, send me a mail at Ncucci@fnrealtypartners.com

Show Notes
We mentioned a few books on today’s show. Links below!

Different types of leases:
https://www.fnrpusa.com/different-types-of-commercial-real-estate-leases/

Chris’ favorite business book:
https://www.amazon.com/Think-Grow-Rich-Landmark-Bestseller/dp/1585424331

If you are interested in more info about us or would like to see our current deals, please visit www.FNRPUSA.com

Announcer:
You’re listening to the Private Equity Real Estate podcast, brought to you by First National Realty Partners, where investors learn from private equity experts and insiders. We share our own real-world experiences so you can know exactly what it takes to be highly successful at investing in passive commercial real estate opportunities.

Nick:
Hey, what’s going on, everyone? You are listening to the Private Equity Real Estate podcast brought to you by First National Realty Partners. This is the ultimate resource for passive real estate investors. I’m your host, Nick Coochy. Today on our show we have one of the founders and managing partners of First National Realty Partners, Chris Palermo. Chris, we appreciate your time. Thanks for coming in. How’s the week going for you so far?

Chris:
It’s going well, Nick. Thank you. I really appreciate it.

Nick:
Yeah, you know it.

Chris:
Thank you for having me on the webcast.

Nick:
Of course. Did you have a good fourth?

Chris:
Yes, I did.

Nick:
All right, cool.

Chris:
And yourself?

Nick:
It wasn’t too bad. It was pretty hot. I got to hang out with the wife and the kid and just do the thing. It was pretty laid back.

Chris:
Very nice. Very nice.

Nick:
So we haven’t had you on the show yet, and I’m hoping you can just kind of give us a little bit of background into your career and how you found yourself where you are today.

Chris:
Okay. So I got into the real estate industry and on the investment side back in 2001. And I would say about a decade ago, I started doing my own deals on the side. And at that time, I met my current partner, Tony. We were working together and then, together, we said to ourselves, “We know every aspect of this business, we might as well dive in and start our own operation.” And, we started out with a half a million-dollar piece of real estate, which was eight multifamily units with two retail spaces down below. Within a year from that we were doing two to $5 million real estate deals. And we slowly graduated up to $15 million, all the way up to $50 million deals to where we are today.

Nick:
That’s fantastic, and I know a good number of operators and real estate investors, and that’s just, it’s really impressive how quickly you guys have been able to do it. I mean, and one of the things that I noticed when I just look from the outside in is you’ve put a really strong team around you. How are you guys able to find that team?

Chris:
You have to understand the thing is, is that we love real estate. We love the business. We’ve been involved in every single aspect of this business and we live it day in and day out. So, we had a very good vision and a very good plan of exactly what we needed to be successful. And, we stayed focused on making sure that we fulfilled that. And, so it was a culmination of passion and understanding exactly what we needed to do. And, our goal is to continue to get better. And, our goal is to try to learn, to figure out a way to constantly do things better.

Nick:
As anybody who means it should be doing, right? We were on the phone last week and I asked you, I said, “What’s your favorite part about real estate?” Zero hesitation, you’re just like, “Negotiation. I love negotiating.” And we’re going to dig in today on the due diligence process. But before we dig in there, tell me, what is it about negotiating that you love?

Chris:
All right. So, this goes for a $20 million piece of real estate, or a $200 mahogany desk. There’s nothing better in the world than getting a deal and knowing that you’re getting a deal. So in order to do that, I think that you have to have the ability to articulate in a way or negotiate or use the English language in your favor to be able to get the best possible deal. So I think that all comes with negotiating. Understanding what drives the person that’s selling you the product and what will get him to move. And knowing that you’re walking away with something, which I think it turns into an art form, as life goes on.

Nick:
Absolutely. So, was there a moment, was there a time in your career where it just clicked and you were like, “I’m good at this. I like this. I like negotiating.”

Chris:
Well, the thing is, is that, and I don’t know whether it’s the truth or a lie, but when I get emotionally involved and tied to a piece of real estate, I tend to tell myself, based on certain things, what I think the true value is of the property. And then when I get myself stuck on what that price is, it’s validating on the other side on why we think X, Y, and Z.

Nick:
Got it. And this is a big piece of what we’re about to dig into. It is no small task to take down a huge piece of real estate. And we’re going to focus on that due diligence process. So, we look at a thousand deals before we get one. So when we think we’ve got a great deal, we’ve got a great deal. And then from there, let’s say you’ve just got it under contract. What’s next? What’s the first thing that you do?

Chris:
Well, the thing is, is that the most critical point of a deal, I think, is when you actually get a property under contract. There’s only so much that you can learn from an OM that you receive from a broker who represents a seller, who’s trying to sell a piece of property. And you’re buying a property with, let’s say, a certain tenant or tenants in place for a certain period of time. And you’re willing to accept a certain amount of income for that time. If there are certain issues within that property that you’re buying, whether it’s the underwriting for the deal, whether it’s the physical plants in the deal, any money above and beyond, whether it’s money that you’re not receiving or money that comes out of pocket is going to change that equation.

Chris:
So conducting the proper due diligence, the methodical due diligence in and out is critical to making sure that you get the deal that you thought that you were originally getting.

Nick:
Yep. And I know you guys have told me that you have like a hundred point checklist that you go-

Chris:
Yes.

Nick:
I don’t want to go through, I don’t think we have four hours to go through everything, but can you kind of give me a general idea? What are the big buckets that we need to hit on to make sure-

Chris:
Okay. So the first thing that you want to look at is you want to underwrite the numbers. You want to make sure that the NOI and the cash flow and everything that was projected to you in the broker’s OM, is accurate. I would say that’s number one. Number two, I would say is, is making sure that the tenants that are currently in the location are performing up to what was told to you or articulated to you from the broker or whoever was representing the seller and selling you the property.

Nick:
And a question there, on the numbers and on the tenants, how frequently do you find that the story that you’ve been pitched in the OM isn’t the real deal?

Chris:
It’s never the real deal. You have to be able to uncover and unpeel the onion layer by layer. And, just like they say anything in life, knowledge is power. You have to make sure that you have knowledge and in life, you have to do what I always say is you can’t go into a deal, regardless of what it is, unless it’s a win/win for everybody. In this scenario, the win/win is to have an excellent piece of real estate, but most importantly, have tenants within that piece of real estate that are doing well. If you have a win/win relationship, you have sustainability. So although physical plants and other things is part of the building, I think the most important thing is making sure the numbers are real, of course. And making sure that the tenants that are there, are happy.

Nick:
When it comes to making sure that the tenants are happy…

Chris:
And I would say happy and doing well, of course.

Nick:
Of course.

Chris:
Because you could be doing well, but you have leaks in the back. And although you’re doing well, you’re not happy for somewhat other reason, but happy and doing well.

Nick:
And that’s one of the things I was going to dig into is, you’ve got a great piece of real estate, but you have a lease with a tenant that just isn’t optimal. What can you do? What are the options there?

Chris:
During the due diligence process, we do what’s called tenant interviews, where we interview all the tenants. We find out exactly what’s going on. And then eventually we have them sign an estoppel. If we find out that a tenant’s on the way out, or is going to leave, what we do is we will take out, and let’s say the building, for example, was a triple net, which means they participate in the common area, maintenance charges and taxes. We’ll evaporate there NOI from the underwriting. And then we’ll have to factor in what kind of costs would be associated from doing, let’s say, a refit out, marketing the property, leasing commissions, that space. So depending on who the tenant is, how much square footage they’re in, it can be a make or break for the deal, depending on the tenant. So it’s very, very critical.

Nick:
Of course, because yeah, you can’t purchase on future numbers. You have to purchase on what the actuals are going to be on your way in.

Chris:
Well, exactly. We’re buying these property based on, not only what are they paying, but how long are they paying us? So now, if we have to turn around and take a step back, that can materially change, that can impact the valuation of the property in a significant way.

Nick:
Absolutely. Well, thanks for digging into that. So what’s next? What’s next on the-

Chris:
So, I think that you have to look at… You want to look at, obviously, historical data, which would be, are there any environmental issues? Were there any tenants that were here in the past? Let’s say like a laundry mat, for example, that could have created any type of environmental issue. And then, we’re looking at, of course, building power plants. We’re looking at parking lot, retaining walls, roofs. Give you an example, we did a deal years ago. It was a smaller deal. The roof was 100,000 square feet of roof that needed to be replaced. Well, if you factor in, let’s say, an average cost of $8 a square foot for a brand new roof, you’re talking about $800,000. Well, $800,000 on a $20 million deal materially changes what we thought was the cap rate on that deal, which means the return that we’re going to get on that deal.

Nick:
Yeah, absolutely. And regarding environmental issues that may arise, have you run into anything where you had to walk away from a deal?

Chris:
We’ve ran into environmental issues. One of our properties, we had a laundromat that was there since the 70s and the chemicals they used that created, let’s say, some minor environmental issues. On that particular deal, we were able to negotiate with the seller, which the seller funded a half a million dollar reserve to allow us to clean up the work, which ended up only costing us about $200,000. So on that particular deal, in that scenario, we actually made a net net $200,000 profit because we made the seller reserve a $400,000 credit, which was the original estimate.

Nick:
Got it. And it’s still, I mean, that’s a good example where it’s still the win/win/win that we’re looking for, because ultimately the seller was able to sell the building. You guys were able to get the deal, felt good about the deal and the community gets a cleanup.

Chris:
Yeah. We’ll look, at the end of the day, we want to make sure when we’re going in to buy a property, where assuming in our mind, and not that we’re… We’re not really articulating this to the seller, but we’re assuming that we’re getting a building that I would call “trade ready”, which means all the working systems are operating and in decent order. Of course the tenants are happy. The numbers are real. And if any of those deviate, it was taught to me very early in the business, and I’ll share this with the listeners, that the negotiation starts in a deal once a contract is signed. So when we’re going out and we’re performing all of our due diligence, at the end of the day if we thought we were buying X, but we’re really getting Y, there’s going to have to be some type of credit or consideration for the issues that we uncovered, whether it was a misstep in the underwriting, some type of physical issue that wasn’t talked about beforehand. And at the end of the day, if we walk away, the next buyer that comes in is probably going to have the same issue and problem that we have.

Nick:
Yeah.

Chris:
So, we try to leverage it and frame it in the best possible way to make sure that we get the best possible results for ourselves and our partners.

Nick:
That makes perfect sense. All right. So what would be… Is there anything else? What would be the next piece that we would concern ourselves with?

Chris:
You see, at the point of going through all the systems and making sure that everything was perfect or identifying whatever issues were and figuring out a remedy or a solution, at that point in time, we would just want to follow whatever protocols that our bank lays out for us to go out to closing and ultimately, close the property.

Nick:
Gotcha.

Chris:
So that might include a certain percentage of the tenants signing an estoppel, signing off on their lease that everything’s good with them. And at that point in time, once the bank has the comfort, they do all of their backend work, like title searches and such. And at that point in time, we move towards closing and we close the property.

Nick:
Great. And what’s the typical due diligence window that you have?

Chris:
I would say due diligence usually runs between 30 to 45 days, which means that’s a time where we can go out and do all of our audits and inspections and come to a conclusion as far as what we want to do. And then, we’re probably closing a deal within 15 to 20 days after the end of due diligence.

Nick:
Yep. And we’ve got 30 to 45 days, as you call it, to really figure everything out, to really find out if we don’t want this building that we’ve got under contract with all those moving parts. Who are you having conversations with most of the time? Who are the people that you have on speed dial, ready to talk to?

Chris:
So, well, let me say this for starters, we would never want to come into a situation where we say, “We don’t want to do this deal.” You make your money on the buying real estate. And what matters is what your cost basis is. So if there are issues, let say, that weren’t underwritten or weren’t articulated when we were looking at a property that we uncover, and let’s say we have a seller who’s really motivated to sell, those issues can actually become an opportunity for us for upside. So I would say the closest people that we’re dealing with would be our lender, our attorney, the broker that’s representing the seller and any of the third parties. Building engineers that we’re going to leverage off of to get the answers that we want. And this process, as soon as we sign the contract, the process starts typically immediately because I don’t know how other people do their business, but when we acquire a property or we have a property under contract, before we even have the contract signed, we’ve already have, for the most part, the financing lined up.

Chris:
So we’re never getting into a deal on a fishing expedition where we’re steering our ship here and there based on what may or may not happen. We want to make sure unequivocally that we have all of our ducks in a row, that we can close this from a financial standpoint, based on what the numbers represented. And if there are any material issues, again, we’ll look to remedy in whatever which way, shape or form.

Nick:
That is great. And let me back up for a second. Did you hear, I said speed dial before? Because that’s not even a thing, so I’m showing my age right there.

Chris:
Yeah, yeah. And me not responding, I guess I’m showing mine as well.

Nick:
So you’ve done a lot of deals in your career, and as you’ve gone back and forth at the table, what do you think is the most common misstep that you see people make?

Chris:
Well, the problem is, is that, you see, we look at this as unconsciously. We’re going to make sure that we follow through on every single bit of due diligence and make sure that we’re getting a deal 100% that we thought that we were going to get. And we’ll fight it. I think the biggest missteps that people make is that they don’t even know that they can do it, or they were afraid to actually step up and maybe they walk away from a deal or they say, “Oh, you know what? I’ll do the roof myself.” Remember the people that are selling this property are selling for a reason. They’re not selling for… They’re not just throwing the property up there to see what comes by. There’s a reason why they’re selling. They want to sell.

Chris:
And at the end of the day, you have to stand up for yourself, you have to fight and you have to make sure that when you see issues, you tackle them. And you go through it and make sure that you get exactly what you thought that you were going to get from day one. So I’d say that the biggest issue is that people don’t follow through on it and they become a little bit more reserved, I guess.

Nick:
That’s great info. So when you find yourself going back and forth with a potential seller, what are some of your favorite negotiation tactics?

Chris:
Well, I wouldn’t really say anything’s my favorite or not my favorite. I would say it’s depending on what the situation is, and what way can we bring this deal to a closing? So, we’ve done a credit at closing, we’ve done reserves of which we have a specific amount of time to do whatever work is. Let’s call it a roof, for example. We’ve had sellers get insurance policies against certain issues that, let’s say, possible environmental issues of which we couldn’t verify. So the way that I would answer that is, depending on the situation, would dictate kind of where is the gap? Where is the issue at the end of the day?

Chris:
Again, the most important thing is to create a win/win, where everybody feels like they’re making out. And when it’s something that’s property-specific, if there’s an issue with the roof or there’s issue with the siding, if there’s some engineer that’s coming out from the bank, that’s coming out to do the report on the property, you bet nine out of 10 times it’s going to be uncovered each and every time. So whatever issue you’re going to have with me, you’re going to have with somebody else. At the end of the day, we want to figure out how to bring this deal home because remember, like you said, we’re looking at thousands of properties and we’re choosing one or two. We’re looking for the best located, best tenant synergy, best tenants that we think are going to be around, properties that are going to last 30 years from now.

Chris:
So at the end of the day, when we steer our ship towards a deal, we really want to do it. So whatever makes the most sense, whatever is the win/win and whatever the situation is will dictate whatever pattern we want to use.

Nick:
It’s funny that you say win/win because you literally just answered my next question, which is… But I want to ask anyway, because I’d still like your perspective on this. That a lot of people look at negotiations in these deals as a battle or a game of chess. And my question was going to be, is there ever a win/win in these negotiations? Or only winners and losers? So you just said, it’s got to be a win/win. So I hear you there. But do you think it’s a game of chess? Do you feel that way about it?

Chris:
Well, you have to do what’s right for the property. You have to do what’s right for the investors. It’s not even a… It’s more of a matter of survival and instinct and knowing what’s right and wrong. When I look at these issues, the way that I try to articulate and frame it, that there’s no other option out of it. And I try to articulate to the seller, or the seller/broker, that no matter what happens, the next person behind me is going to have the same other issue. So let’s just try to get on with it. Let’s figure out how to make the win/win because what I’m asking for is reasonable. So, again, I don’t know. Am I excited when I get them on the first call to agree to what I asked for? Absolutely. Because I want to close the deal as fast as humanly possible. I want my asset management team to get into this deal and I want to start collecting rents and income. I don’t want to hold it up, because the more time that’s wasted going back and forth negotiating, that’s less money that we’re making over time.

Nick:
Well, I really appreciate what you just said, which is what I’m asking for is reasonable. What I really like about that is you’re, “Hey, I sat with my team. This is what we feel is fair and is the way to move forward. And either you do or don’t agree.” And I guess with that said, how ready do you have to be to walk away from a deal?

Chris:
So the way that I answer that is this: we provide enough information for the guys to not walk away from the deal. We put it in a stance that, no matter what, we’re going to get what we’re looking for, because we’re going to present it. We’re going to be so organized in how we present it and articulate it that these guys are going to have no choice but to say, yes. But bottom line is this: if we get a property and we think we’re buying X and we’re getting Y and they’re not really going to come to the table 100%, we’re going to walk away.

Nick:
Yeah.

Chris:
And we’re going to articulate that. And the reality is this, every single deal that we’ve gotten on the contract, that we’ve underwritten everything else, we’ve closed on. It’s never happened where we had to walk away. And it’s because for the most part, we’re playing in a field where you have a legitimate seller and you have a legitimate buyer. The reason why people work with First National Realty Partners is because they know that if we get a property in the contract, we’re going to close.

Nick:
That’s awesome. So any final thoughts on the due diligence process you would want to share with the listeners?

Chris:
So I would just say that due diligence is critical to the success of the deal. Don’t be afraid to renegotiate. Remember that the issues that you uncover will be the same issues for the other people that are, for the next person that’ll come by if you walk away. The sellers are selling for a reason. Usually the sellers are reasonable people. And if you articulate your point in a way… You can articulate your point in a way for you to get your way each and every time, as long as it makes sense.

Chris:
And then lastly, but not least, never go into a deal unless it’s a win/win for everybody. You preserve your relationships, you preserve your reputation and everybody wins. Everybody’s happy and you can go on and do great deals.

Nick:
That is amazing info right there. So we ask everyone who comes on three quick questions.

Chris:
Sure.

Nick:
So I’m going to ask you, what’s your favorite food?

Chris:
Well, considering that I became a vegetarian over the last seven months, I would say my favorite food nowadays is a salad.

Nick:
There you go.

Chris:
If you asked me about six months ago, I would say marinaded T-bone steak.

Nick:
There you go.

Chris:
Yeah.

Nick:
Okay. Do you have a favorite business book?

Chris:
Think and Grow Rich by Napoleon Hill.

Nick:
Awesome, awesome book. And if you could travel anywhere in the world tomorrow, where would you go?

Chris:
I would go to Hawaii.

Nick:
Any specific Island?

Chris:
Yes. The Big Island.

Nick:
The Big Island?

Chris:
Yeah.

Nick:
Nice.

Chris:
Yeah.

Nick:
That’s awesome. Well, hey, we appreciate the time you spent with us today, Chris. Hopefully, you’ll swing back soon and hang out?

Chris:
Absolutely. Anytime. I really appreciate you having me on your podcast.

Nick:
Absolutely. And thanks, as always, to everyone who’s listening to the Private Equity Real Estate podcast. This show is brought to you by First National Realty Partners. One of the top syndicates of private institutional-quality commercial real estate in the country. If you’re interested in learning more about First National Realty Partners, or would like to get access to our private offerings, please click the link in the show notes or visit FNRPusa.com.

Nick:
A quick reminder that the show is for educational purposes only and should not be considered a solicitation to purchase securities or be construed as tax, legal, investment or accounting advice. Thanks again for listening. And we will see you next week.

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