Acquisition Due Diligence

Finding the right asset to make an offer on is only the first step of actually becoming the owner of real estate. Behind the scenes, and before closing, there is a lot that happens to ensure the property is fits as an addition to your portfolio. On the front end, before submitting an offer, you’ve run the numbers (determined the cap rate you want to achieve and evaluated the return of an asset at multiple leased percentages, baked in holding costs, maintenance, value-add opportunities, and contingency funds) and formulated your offer. What happens after going under contract is the real nuts and bolts of the acquisition process. This doesn’t discount the importance of choosing the right property and negotiating the best deal; without these aspects, there isn’t a deal to be had. But, properly going through your due diligence checklist will help give confidence in a purchase decision as closing day approaches.

What might be considered during due diligence? There are some due diligence items every property would benefit from going through, and others that are more specific to individual uses.

Our goal is to provide a guide to some of the most important due diligence items to consider, but will not be a complete list of all potential due diligence items as every property is different and should be evaluated based on its unique characteristics. Below is an outline of some of the most common due diligence items, what to look for, and a suggested approach.

Common Due Diligence Items

The due diligence period is the buyer’s opportunity to uncover everything they need to know about a property, allowing time to look for red flags that will either need to be resolved before closing, accepted as they are, or lead to termination of the purchase contract. As part of the purchase contract negotiation, a purchaser and seller will determine the length of the due diligence period, including potential built-in extension periods. The length is generally determined by the purchaser’s need and the length of time a seller will tolerate being under contract without a guaranteed closing. For example, if confirmation of land use and zoning change needs to be confirmed for the purchaser’s end use to be acceptable on the property, a longer due diligence period will be required to allow time to go through the jurisdiction’s rezoning process. No matter the length of the due diligence period, using this time wisely can provide all of the information required to move towards closing.

Title Search and Obtaining Clean Title

Does the seller have the sole ability to sell the property in question? The title to the property gives a snapshot of the property’s history. It’s a record of everyone who’s owned the property and everyone who has ever had a claim to a property. A thorough title search will uncover the chain of ownership including sellers, purchasers, mortgages, and any other liens that may have been assessed to the property. Clean title will show that the seller/selling entity is the current and only owner and that the liens assessed will be satisfied at closing. If there are other ownership claims, they will need to be tracked down and satisfied before moving forward.

ALTA Survey, Legal Description, and Environmental Reports

ALTA stands for American Land Title Association and is the group that coordinates and compiles the information needed to tie a particular piece of land to a particular title history. The ALTA survey creates a visual representation of title showing the physical boundaries of a particular property using the legal description found on the title and adds in any easements and encroachments that may exist and providing the Book and Page where a recorded document can be found in the county’s records office. The ALTA survey is accompanied by the written legal description and any legal documents that correspond with what is represented on the ALTA survey.

Environmental reports reveal what is in the soil on the property in question. During due diligence, either ask for copies of the most recent reports the seller has available or hire a company to perform a Phase I and potentially a Phase II environmental study. The Phase I study looks at the historical use of a property and uses visual clues to indicate if a property has any likelihood of being contaminated. A Phase II study goes a step further and takes soil samples around the property and at various depths to show whether there is contamination present.

Covenants, Conditions, and Restrictions

Often, properties in a larger development or property that is subdivided from a larger parcel, will have recorded covenants, conditions, and restrictions that dictate property use, architectural design, maintenance agreements with neighboring parcels, and any number of other things the seller of the property has decided to include. If there are any CC&R’s attached to your property, obtaining a copy of the CC&R declaration will outline the rules you will need to abide by. CC&R’s are important whether the property is improved or unimproved,  but are especially important to fully understand when buying unimproved property – you want to make sure your intended use is allowed under the CC&R’s, otherwise, you might close on a property you are unable to use.

Seller’s Documentation on Current Operations

When buying a performing asset like multifamily, self-storage, office, and retail, understanding how the asset is performing can help confirm the initial underwriting (or show where the numbers need to be adjusted) and highlight where there might be an opportunity to increase the revenue from the asset. Included in this documentation from seller’s should be current leases and amendments, a current accounting of income from leases and other sources, common area maintenance costs, and other expenses and service contracts that may be in place. A current rent roll will show current rental rates, square footage of each user, lease commencement, initial lease length, lease termination date, and security deposit amounts.

Physical Inspection of the Property (Improved and Unimproved) and Mechanical Systems

Looking at the information about a property on paper only gives part of the story. During the due diligence period, physically walking the property and having a contractor or inspector checking the physical structures and specialists inspect the physical systems (HVAC, plumbing, electrical, etc.) uncovers any other red flags that may exist. Unlike when buying a house, you won’t typically go to the seller and ask for repairs, but you may be able to use what you’ve discovered to negotiate a price reduction to help offset any unexpected costs that many have been uncovered.

Zoning Confirmation and/or Rezoning

Zoning codes are written by individual jurisdictions and are used by cities and counties to create uniformity in the use of a specific area and to impart design guidelines that help create a pleasing aesthetic. Depending on the intended use, going through a rezoning process might be necessary. Rezoning can take several months and require working with people who specialize in rezoning – attorneys and engineers that will work with the jurisdiction to gather all the necessary documentation and be your advocate with the council members. Rezoning is possible but can sometimes be a bumpy ride.

Final Thoughts

This should not be considered a complete list of due diligence items, but rather a starting point – every property is unique and should be evaluated as unique. Negotiating the length of your due diligence period based on your end-use needs and using the time effectively can uncover any red flags that might exist, helping make the final decision of moving forward with the purchase of an asset.