Due diligence may not be the most glamorous component of the commercial real estate process, but in today’s market, it’s more important than ever. After all, lenders’ underwriting standards and lending criteria have undergone a major overhaul; buyers need to rethink their focus as well.
In order to substantiate value — and protect your investment – due diligence is essential. Due diligence is simply an investigation that examines all material aspects of a property. A cursory evaluation is not enough, especially in a market with distressed properties. In order to be adequate, a commercial real estate investigation must be meaningful, focused and, most importantly, thorough.
The due diligence process for commercial properties is very different – and much more detailed — than the due diligence process commonly applied to residential transactions. Few of the consumer protection laws that apply to residential purchases also apply to commercial real estate purchases.
This means that buyers, whether investment or strategic, must investigate, evaluate and assess for themselves, the risks simply stated in the phrase caveat emptor, or buyer beware. Fortunately, most commercial purchase agreements include a study period– commonly between 30-180 days depending on the project complexity—to conduct the examination.
Performing adequate commercial real estate due diligence mitigates the potential for unpleasant surprises, which can become particularly disagreeable after a buyer is legally bound to purchase a property. For investors and users concerned with next generation tenants, the due diligence process begins with an in depth financial analysis of the property since commercial real estate value is generally a function of net operating income.
The goal of the income analysis is to determine the property’s actual current income, if any, as well as an assessment future income potential. In order to paint a clear picture, it’s essential to examine tenant payment histories, additional revenue sources, and costs related to maintaining and operating the property. Prospective purchasers of investment properties should request copies of all lease agreements, detailed financial records, and many times, estoppel certificates. All of these items provide critical information about the income generated and collected, as well as the relationship between the landlord and tenant.
Of equal importance is the expense side of the financial statement. Prospective purchasers should review closely expenses related to operating and maintaining the property. Large ticket items related to the building infrastructure such as HVAC, electrical capacity, and plumbing systems in addition to the condition of parking areas, and roof systems deserve to be closely scrutinized. Most include taxes and insurance in their review; however, many expenses are often overlooked when conducting financial analysis. Exterior and lot maintenance costs, capital reserves, management fees often don’t make it onto the list of expenses for consideration even though they can represent a substantial cost—many times 10-15% or more of gross revenues. A meticulous review of all income and expenses will pay off. Remember, if you do the math, the math will tell you what to do.
Property Condition Review
The more complicated the physical structure, the less tolerable simplistic property condition reviews become. Even through a property may look perfect from the outside, without a thorough investigation, purchasers may be unpleasantly surprised with any number of hidden issues after the purchase is complete. These problems and deficiencies may require costly and time-consuming fixes — on the purchaser’s dime. Older structures might require major renovation to bring them up to the Americans with Disabilities Act (ADA) standards or local code, but even newer buildings can hide major problems. Purchasers can avoid these issues by performing a comprehensive property condition review.
A property review should be tailored to the intended use of the property. Purchasers may find it helpful to create a review team that consists of structural, electrical, mechanical, and environmental specialists to perform a comprehensive evaluation. Many times, lenders will require some of these studies to be completed as part of the loan process.
The property review process consists of a visual analysis that documents existing deficiencies and a review of documentation, from initial construction and any later renovations from both local government as well as state and federal regulatory agencies.
Key Focus Areas
While each structure is unique and each due diligence review should be customized, there are a few key areas a purchaser and their team should focus some attention.
- Reconstruct the financial analysis and meticulously review income and expenses.
- Check allowable uses according to land use regulations and any covenants.
- Verify integrity of the building’s structure and capacity of infrastructure.
- Review prior environmental studies or look for evidence that further investigation may be required.
- Review a current survey to check for encumbrances, easements, and ensure you are actually buying what you think you are.
- Confirm the property meets current building code and utilize local government officials.
The circumstances of each transaction will determine what degree of investigation is required. The level of diligence required under the circumstances is the diligence that is due. Once this comprehensive investigative strategy is complete, investors may choose to reexamine the purchase price from an informed position. Committing to due diligence before the closing saves investors future money, time — and headaches.
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Tim Reamer provides brokerage and consulting services related to commercial real estate in Harrisonburg, Virginia and throughout the Shenandoah Valley. He specializes in net lease investment real estate, tenant and landlord representation, and general commercial representation.SHARE