What Is Due Diligence in Commercial Real Estate Investing?
08 02 2017
All investments carry some level of risk, and purchasing an investment property is often one of the largest financial endeavors an investor will make. Outside of discussing the decision with your financial advisor, ensuring you’re going into the situation informed is crucial. You’ll need to do your due diligence.
Simply put, due diligence is “doing your homework.” In commercial real estate opportunities, a property’s value is determined by assessing the stability of its income stream and weighing it against the operating costs. Due diligence helps to verify that the income the property will generate is consistent with information the seller has provided. It also into account all expenses associated with the property, from taxes to insurance to maintenance costs.
When Does Due Diligence Take Place?
Due diligence starts during the negotiation process. The purchase agreement should include a list of required due diligence items – essentially, every document concerning the building and its tenants. Once these documents have been delivered, the buyer needs at least 30 days to complete the process. A multi-tenant property, such as an office building, retail space, or apartment complex, tends to be more difficult to evaluate than other property types and may take additional time.
In most cases, an investor will want to bring in outside help. This can include hiring a professional inspection company to do a physical inspection of the property, a financial advisor or accountant to assess its financial status, and an attorney to review the legal terms with the assistance of a title and escrow company.
However, investors shouldn’t rely solely on these third parties to perform due diligence. A best practice is to read the materials yourself first, take note of the things that stand out or that you need clarification on, and then compare your notes with the professionals.
Step One: Physical Inspection
Physical due diligence seeks to identifies damage and structural mistakes that can be extremely costly to fix. It goes beyond performing a walkthrough of the property’s interior and exterior. Physical due diligence also involves inspecting the structure (walls, roof and foundation), interior systems (doors, doorways, windows, and weatherproofing), and mechanical and electrical systems (heating, air conditioning, and plumbing).
The goal of physical due diligence is to assess the level of wear-and-tear on the property and make sure the building is up to code. Investors should take note of which improvements have been made recently and which items will need to be upgraded in the future. For residential buildings especially, investors will also want to have a pest inspection done.
Step Two: Financial Due Diligence
Financial due diligence is essentially an audit. It involves verifying that all financial aspects of the property – including rent, other income, expenses and loans – are accurate and comprehensive. The goal is to confirm that the rental revenue promised by the seller exists, and to investigate any inconsistencies between the projected and actual figures. During this step, investors should work with a financial advisor or accountant who has experience in commercial real estate investing.
Financial due diligence should start with evaluating the seller’s tax returns, which is the quickest and easiest way to understand how the property has performed. Investors should also compare the lease agreements to the seller’s bank accounts. Very few buildings use one, boilerplate lease, so investors will need to review different leases for different tenants because each will have its own terms and concessions. Lastly, investors should ask for the payment history of each tenant and adjust the expected cash flow for any chronically unreliable ones.
Financial due diligence also requires reviewing any expenses you’ll be responsible for if you purchase the property. This includes the status of outstanding loans and debt to outside contractors.
Step Three: Legal Due Diligence
The final step is legal due diligence, where it is especially important to enlist the help of outside experts. Investors should hire an attorney and a title and escrow company to identify any issues with the title, potential environmental problems, or legal issues such as encroaching onto a neighboring property. Your attorney should also sign off on the legality of tenant leases, employment contracts, service contracts and warranties.
The attorney doesn’t have to be local but should be familiar with state laws where the property is located. However, the title and escrow company should be local, as different cities have different closing practices. It’s important to note that title and escrow companies are neutral parties by law and cannot favor the buyer or seller.
Putting It All Together
Never purchase a property based solely on the “pro forma” information provided by the seller – this is usually the “best case scenario,” and the actual performance could end of being significantly lower. Once you have a more complete physical, financial and legal picture of the property, you can reassess its value and determine whether the value and risks in front of you are worth your furthered consideration.
Due diligence requires a lot of work, but it can help you and your financial advisor make the best financial decision for you and your situation. Work isn’t always fun, of course – but it’s always worth it.
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