Introduction:
If severe flaws are not discovered before purchase, you may be in a world of turmoil as a new owner. To avoid “buyer’s remorse,” real estate investors use due diligence techniques to analyze a deal before closing on a purchase. Find out how you can avoid these flaws as much as possible via your due diligence.
Investing in Commercial Real Estate
When conducting commercial real estate transactions for customers, it is critical to undertake due diligence on the property and the transaction to avoid any unpleasant surprises after the sale closes.
Due diligence in commercial real estate allows the buyer to analyze the terms of the deal. This is especially important when the seller is financing part or all of the deal. Purchasers must be comfortable with the terms and reserve needs and guarantee that they can comply with the lender’s reporting obligations.
Purchasing commercial real estate sometimes necessitates a large sum of money. As a result, these transactions are fraught with danger. If severe flaws are not discovered before purchase, you may be in a world of turmoil as a new owner. To avoid “buyer’s remorse,” real estate investors use due diligence techniques to analyze a deal before closing on a purchase. However, new investors are unlikely to anticipate all the potential transaction problems. As a result, we’ll utilize this article to explain what commercial real estate due diligence is.
We’ll go through the following subjects in particular:
- An Introduction to Commercial Real Estate Due Diligence
- Due Diligence in Real Estate
- Due Diligence in Operating History
- Due Diligence in Legal Matters
- Due Diligence in Financing
- Last Thoughts
An Introduction to Commercial Real Estate Due Diligence
Due Diligence Explained
According to Merriam-Webster, due diligence is the investigation and analysis of a firm or organization in preparation for a business transaction. In layman’s terms, due diligence refers to the steps you take to prepare for a commercial deal.
Doing research before hiring a landscaper may include checking online reviews and requesting client references. Before closing a multimillion-dollar business acquisition, your background research would be significantly more extensive, costly, and time-consuming. However, regardless of magnitude, the purpose of due diligence remains the same: take precautions before a transaction rather than discover difficulties after the fact.
Commercial Real Estate Due Diligence
The overarching purpose of due diligence is the same in commercial real estate; only the situation alters. Before closing a transaction (such as purchasing an apartment building), investors examine crucial aspects of the transaction. This examination helps to reduce the possibility of unexpected problems once you finish the transaction.
For example, if you don’t conduct a thorough property inspection, you could not notice that the building’s HVAC system isn’t functioning properly. Unexpected repair bills could total tens of thousands of dollars. Assume you do not undertake a title study before closing. You can buy a building that a previous owner can still lawfully claim.
While these are only two examples of potential difficulties discovered during due diligence, they should highlight the need to conduct thorough research before closing on an acquisition.
Subject Matter Experts’ Importance
It is worth remembering that real estate investors have the appropriate knowledge and skills to do their due diligence. Due diligence covers various issues, from operational to legal to structural. As a result, commercial real estate investors recognize the need to gather a team of subject matter experts during the due diligence process. Effective due diligence necessitates the involvement of several professionals, ranging from real estate attorneys to civil engineers to general contractors and beyond.
We’ve organized due diligence into four major categories in the following sections: property, operating history, legal, and financing. Though not exhaustive, comprehending these areas will provide prospective investors with a solid understanding of the commercial real estate due diligence process.
These procedures involve investigating the land’s physical property or state and any changes made.
Commercial property inspections are similar to residential property inspections. These inspections, conducted by a licensed inspector, examine the building’s existing state and the status of major systems (e.g., HVAC, water heaters, etc.). Inspections provide important information to investors about a property’s immediate and future maintenance needs.
Environmental Site Evaluations
If you purchase a business property with environmental damage, you are liable for the damage, its cleanup, and any legal concerns. As a result, investors conduct environmental site inspections to identify potential contamination problems. An initial evaluation, known as a Phase I ESA, will identify areas of concern. A Phase II ESA will analyze environmental issues in greater depth if necessary.
The main point is that you don’t want to buy a property and then be held liable for millions of dollars in cleanup and lawsuits.
Issues in Structural and Civil Engineering
A property inspection will not cover the structural integrity of a structure. If a property inspector notices structural damage (for example, fractures in the walls or foundations), investors would almost certainly hire a structural engineer to undertake a comprehensive structural investigation. Repairing structural damage can be extremely expensive, potentially offsetting the profitability of a transaction.
Civil engineers are always concerned with the land itself. They can assist you in determining whether the soil is suitable for future construction. Furthermore, civil engineers are in charge of the utility connection procedure. Thus they must be included early in the due diligence process to establish whether a contract is still viable.
Collaboration on the Initial Design with the Architect and GC (General Contractor)
In addition to the preceding, property due diligence necessitates collaboration with an architect and general contractor (GC) to design a new structure or renovate an existing one. An investor cannot judge if a property’s reality will match the underwriting calculations without the assistance of a specialist.
Due Diligence in Operating History
Due diligence on operating history encompasses the past performance of some commercial real estate as an income-producing asset. Does this property create enough net operating income to justify its purchase?
It should be noted that these stages apply mostly to stabilized assets, not land for a ground-up development, which by definition has no operating history. However, in each transaction, investors must forecast future operating outcomes, and historical performance might help in this process.
Existing Leases and the Rent Roll
The rent roll summarizes the most important information about all units and their existing tenants (e.g., rents, lease durations, renewal options, security deposits, etc.). This data assists in determining your predicted operational budget’s “top line,” or future rental revenue.
You should not, however, take a rent roll at face value. Investors should research current lease agreements to understand performance accurately. Do lease conditions give renters the right to break leases when ownership changes? What are the terms of the renewal? These are only two of the questions you should ask during your research.
Examine Previous Years’ Financials
In addition to revenue data, investors must properly examine a property’s running expenses to comprehend its profitability (or lack thereof). Sellers will typically present a trailing 12 (“T-12”) – a monthly profit and loss statement for the previous 12 months. Investors should ideally examine operating results for the previous three years since this will provide better insight into seasonality and trends.
Utility bills and tax documents
Unfortunately, people can alter financial records like a T-12. As a result, investors should request source papers for operational expenses to verify performance (e.g., past utility bills and tax records). This way, you can ensure that the seller’s financial statements are accurate.
Due Diligence in Legal Matters
Legal due diligence is primarily concerned with ownership and permissions. Does the seller have the upper hand to sell the land as indicated, and does local zoning support your long-term plans?
Title Evaluation
A title search verifies that the seller owns the property and that no one else has a claim to it through outstanding liens. These could be mechanic’s liens resulting from unpaid repairs or tax liens resulting from past-due tax bills.
If you buy a property and some past owner or lienholder lays a claim on it, you may be embroiled in major litigation. They are identifying these issues before closing helps to avoid these unpleasant circumstances.
ALTA Survey
As the name implies, boundary surveys outline the boundaries of a property. However, investors prefer a more comprehensive ALTA study with commercial real estate. An ALTA provides further information by marking property borders, current improvements, and easements. Furthermore, an ALTA survey will link the written title description on the deed to a visual representation of that property.
An ALTA survey certifies that what the contract says you’re getting is what you’re getting.
Zoning
Municipal zoning regulations govern what you may and cannot do with a property. Cities, for example, are unlikely to want developers to locate newborn daycares in the middle of an industrial district.
During the due diligence process, investors certify with the municipality that they have the legal right to accomplish what they desire with a property, generally with a zoning confirmation letter. Without this assurance, you risk purchasing a property you cannot utilize as planned during your underwriting.
The third category of due diligence includes the steps required to ensure that you can effectively finance the transaction.
Lender Prerequisites
Lenders will undertake their deal due diligence before issuing a loan. But what we’re talking about here is due diligence from your point of view.
Investor Prerequisites
Similarly, your due diligence should include early contact with these possible investors if you intend to bring in equity investors. This will help you to confirm their deal specifications (e.g., the minimum required returns, time horizons, maximum cash to contribute, etc.). Failure to do this due diligence may result in you being unable to close a contract since you will not receive the cash you expected.
Due diligence assists commercial real estate investors in avoiding costly mistakes. By conducting the necessary research ahead of time, you reduce the probability of problems rearing their heads after you purchase a property.
However, as the preceding article indicates, the lengthy due diligence procedure frequently overwhelms novice investors. We can assist you. We’d love to discuss other real estate investing opportunities for your specific scenario! Send us an email, and we’ll arrange a meeting to discuss available passive real estate investment opportunities and the accompanying due diligence needs.
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