What is Commercial Real Estate Due Diligence?
Purchasing commercial real estate often requires a ton of money. Accordingly, these transactions entail a significant amount of risk. If you don’t uncover major issues before a purchase, you can end up in a world of trouble as a new owner. To avoid these “buyer’s regret” situations, real estate investors conduct certain due diligence measures to vet a deal before closing on a purchase. But, new investors likely won’t anticipate all the potential pitfalls in a deal. As such, we’ll use this article to answer the question, what is commercial real estate due diligence?
Specifically, we’ll cover the following topics:
- An Overview of Commercial Real Estate Due Diligence
- Property Due Diligence
- Operating History Due Diligence
- Legal Due Diligence
- Financing Due Diligence
- Final Thoughts
An Overview of Commercial Real Estate Due Diligence
Due Diligence Defined
Merriam-Webster defines due diligence as research and analysis of a company or organization done in preparation for a business transaction. In simple terms, due diligence entails the efforts you take to prepare yourself for some sort of business transaction.
Prior to hiring a landscaper, due diligence may include reading online reviews and asking for client references. Prior to closing a multi-billion dollar business acquisition, the background studies you take would likely be far more thorough, costly, and time consuming. But, regardless of scale, the goal of due diligence remains the same: take measures to protect yourself before a transaction rather than uncovering problems after a transaction.
Due Diligence in Commercial Real Estate
In commercial real estate, the overarching goal of due diligence is the same – only the context differs. Prior to completing a transaction (e.g. buying an apartment building), investors analyze key elements of the deal prior to closing. This analysis helps mitigate the risk of encountering unforeseen issues after you complete the purchase.
For example, if you don’t complete a thorough property inspection, you likely won’t realize that the building’s HVAC system doesn’t work properly. This could result in tens of thousands of dollars in unexpected repair costs. Alternatively, say you don’t conduct a title study before closing. You may end up purchasing a building that a prior owner still can legally claim.
While these are just two examples of potential issues uncovered through due diligence, they should illustrate the importance of doing your research before closing on a deal.
The Importance of Subject Matter Experts
Of note, very few (if any) real estate investors have the knowledge and experience necessary to conduct their own due diligence. As we outline below, due diligence ranges from operational to legal to structural issues. Consequently, commercial real estate investors understand the importance of assembling a team of subject matter experts during the due diligence process. From real estate attorneys to civil engineers to general contractors and more, effective due diligence requires multiple experts.
In the next sections, we’ve divided due diligence into four primary categories: property, operating history, legal, and financing. Though not an all-inclusive list, understanding these aspects will give new investors a strong grasp of the commercial real estate due diligence process.
Property Due Diligence
These steps include research into the physical property, that is, the state of the land and any improvements on it.
Commercial real estate property inspections largely parallel residential ones. Conducted by a licensed inspector, these inspections review the building’s current condition, along with the status of major systems (e.g. HVAC, water heaters, etc). For investors, inspections provide key insight on a property’s immediate or future maintenance items.
Environmental Site Assessments
If you buy a commercial property that has environmental damage, you become responsible for that damage, its clean-up, and, potentially, legal issues arising from it. Accordingly, investors conduct environmental site assessments to identify potential contamination issues. Known as a Phase I ESA, an initial assessment will identify cause for concern. A Phase II ESA – if necessary – will then go into far more detail analyzing environmental issues.
Key takeaway: You don’t want to buy a property then find yourself liable for millions of dollars and years of clean-up and lawsuits.
Structural and Civil Engineering Issues
A property inspection will not cover a building’s structural integrity. However, if a property inspector observes indicators of structural damage (e.g. cracks in the walls or foundations), investors will likely hire a structural engineer to conduct a full structural inspection. Repairing structural damage can cost a ton of money, potentially negating a deal’s profitability.
Civil engineers, on the other hand, focus on the land itself. They can help you determine whether soil supports future building. Additionally, civil engineers drive the utility connection process, so they’re critical to include early in the due diligence process to determine whether a deal remains feasible.
Initial Design Collaboration with Architect and G/C
In conjunction with the above, property due diligence requires working with an architect and general contractor (G/C) to design the new building or renovations to an existing one. Without their professional input, an investor cannot realistically assess whether a property’s reality will align with the underwriting numbers.
Operating History Due Diligence
Operating history due diligence includes the past performance of some commercial real estate as an income-producing asset. That is, does this property generate sufficient net operating income to justify acquiring it?
Of note, these steps pertain primarily to stabilized properties – not land for a ground-up development, which inherently has no operating history. However, in any deal, investors need to project future operating results, and past performance can assist in this process.
Rent Roll and Existing Leases
The rent roll outlines the key information about all units and their current tenants (e.g. rents, lease durations, renewal options, security deposits, etc.). This information helps establish your projected operating budget’s “top line,” that is, future rental revenue.
However, you shouldn’t take a rent roll at face value. To truly understand performance, investors should study the current lease agreements. Do any lease terms give tenants the right to break leases upon changes in ownership? What are the renewal terms? These are just two of the questions you’ll want to ask during your due diligence.
Review Prior Years’ Financials
In addition to the revenue results, investors need to analyze a property’s operating expenses to fully understand a property’s profitability (or lack thereof). Typically, sellers will provide a trailing 12 (“T-12”) – a monthly profit and loss statement over the past 12 months. Ideally, investors can look at operating results for the past three years, as this will provide more insight into seasonality and trends.
Utility Bills and Tax Records
Unfortunately, people can manipulate financial records like a T-12. As a result, to verify performance, investors should request source documents for operating expenses (e.g. past utility bills and tax records). This way you can verify that the seller’s financial statements align with reality.
Legal Due Diligence
Legal due diligence largely revolves around two elements: ownership and permissions. That is, does the seller actually have the ownership ability to sell the property as described, and does the municipal zoning support your future plans?
A title review confirms that the seller actually owns the property and that no one else has claim to it via outstanding liens. These could be mechanic’s liens from unpaid repairs or tax liens for past-due tax bills.
If you buy a property and then some prior owner or lienholder makes a claim to the property, you can get tied up in significant lawsuits. Identifying these issues before closing avoids these undesirable situations. A real estate attorney will facilitate the title review.
Boundary surveys, as the name suggests, outline the boundaries of a property. However, in commercial real estate, investors usually opt for a more thorough ALTA survey. An ALTA goes into more detail by annotating property boundaries, current improvements, and any easements. Additionally, an ALTA survey will connect the written title description on the deed with a visual depiction of that property.
In simple terms, an ALTA survey confirms that what the contract says you’re buying is, in fact, what you’re buying.
Municipal zoning rules dictate what you can and can’t do with a property. For example, cities likely don’t want developers building infant day cares in the heart of an industrial district.
During the due diligence process, investors confirm with the municipality that they’re allowed to do what they want to do with a property, typically via a zoning confirmation letter. Without this confirmation, you could end up buying a property that you cannot use as planned during your underwriting.
Financing Due Diligence
The final due diligence category includes the steps necessary to make sure you can successfully finance the deal.
Before approving a loan, lenders will conduct their own deal due diligence. But, what we’re discussing here is due diligence from your perspective. This entails working with a lender early in the due diligence process to confirm their loan terms and requirements. Without this information, you cannot accurately underwrite a deal, and you may not ultimately receive loan approval.
Similarly, if you plan on bringing on equity investors, your due diligence should include early communication with these potential investors. This will allow you to confirm their deal requirements (e.g. minimum required returns, time horizons, maximum cash to contribute, etc.). Failing to conduct this due diligence could result in you unable to close on a deal, as you wouldn’t receive cash you planned on receiving.
Thorough due diligence helps commercial real estate investors avoid costly mistakes. By doing the necessary research up front, you minimize the likelihood of issues coming back to haunt you after purchasing a property.
But, as the above article illustrates, the due diligence process includes a lot of items and often overwhelms new investors. We can help. If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities – and the associated due diligence requirements.