Commercial Real Estate
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Commercial Real Estate
Due Diligence/Investigation Period  

   Due Diligence/Investigation Period

As part of the selection process prior to placing a property under contract, investors should carefully look at the demographics of the location, tenant quality, availability and term of debt, nature of improvement and lease terms among other factors. Everything but the location can change so understanding demographics is one of if not the most important considerations when purchasing an investment property.

When looking at demographics questions related the local economy, income levels and population growth/contraction are critical. Some of the more important questions to ask are is a barriers to entry, is the property strategically located for its intended use, if the property needs to be re tenanted what does that involve, is the property easily accessible, is there an over or undersupply of competitive buildings, what are the traffic counts, what are the spending patterns of the local community, what is the vacancy factor for similar buildings, what are local rents and their trends etc.

Once a property has been selected and placed under contract a critical phase of the purchase process is entered into called due diligence or investigation period. During this time the investor needs to invest both their time and resources to minimize the chance of any investment surprises that could adversely affect the property’s performance. A common mistake of novice investors is to not fully utilize this time or to fully understand the implications of what they find.

Below is a due diligence checklist. Like people all properties have their own set of unique qualities so the list should be considered a general guideline with the investor and their advisors expanding and refining as needed.

Checklist

Appraisal: Typically appraisers value properties using comparable sales, replacement costs, and the income approach. How reliable and realistic are appraisals using these three approaches? If few to no sales have occurred in the last several years how did the appraiser adjust the sales approach. Are the methods used in the appraisal relevant to the investor’s goals and do they make any sense? Who was appraisal done for and how reliable is the value given for the investor? An appraisal done for a lender might give a lender assurance that a loan is properly collateralized with its salvage value but could easily miss the true value of the property for an investor. Both the comparable sales and the cost approach are backward looking by their nature. Investors purchase a property for future value appreciation and income, something the past will not necessarily tell them. An appraisal can be an excellent source of information for the investor so they should be studied carefully. Once understood the investor can make their own determination of what the property is worth to them.

Environmental: Is there a current Phase I Environmental Report available to identify any environmental issues? Does the Phase I call for a Phase II and if so have the issues been remedied? If not who is going to correct and pay for those remedies? Does the party who is going to pay have the financial strength and willingness to meet their obligations?

Indebtedness: Can investor assume an existing loan and if so at what cost and terms? What happens to the new borrowers impounds for the loan for taxes, insurance, capital improvements etc.? What kind, if any, guarantees will the lender require? Is it a recourse or nonrecourse loan? The dollar amount of any fees for a new loan, are they reasonable?

Insurance: Are the improvements properly insured against possible loss? Is their adequate liability or business interruption insurance on the property. What will the new premiums be, does the tenant or the owner pay? How does this change effect the net operating income?

Litigation: Is there existing litigation related to the property or the seller? Does the seller have the ability to settle? Could the litigation result in a judgment? Could the litigation cause the sale to not close in a timely manner?

Management: If needed will the buyer manage or hire someone to manage the property and if so under what terms and conditions? Determine general management and lease-up fees and contract termination rights. Who controls the rent receipts and their use? Are they bonded?

Physical Condition: Check the property’s repair and maintenance requirements. Assess current condition, are there short or long term needs. What are the costs and who pays (are there guarantees for the roof, heating and cooling etc.). If appropriate have a qualified engineer examine the property and provide a written report of what is needed and what it will cost.

Property Taxes: When the sale closes will that trigger a reassessment and if so what will that do to the property taxes? How will that impact the net operating income of the property? Will the owner or the tenant have to pay the new taxes? How feasible is it to challenge the new assessment?

Service Contracts: Are any providers of service for the property owed any money? Will they continue to provide those services under the same terms and conditions?

Tenants: Review and confirm the terms of all leases related to the property. Pay careful attention to co-tenancy clauses. These clauses may permit a tenant to reduce/eliminate base rent, pay percentage rent, or terminate if an anchor tenant or another identified tenant leaves. Verify how many years are firm, are there any early outs that could allow a tenant to downsize or terminate the lease in its entirety? Look for language that deals with what happens in tenant bankruptcy or allows them to make claims against the owner. Require an estoppel certificate to have a clear understanding of what has and could transpire between the tenant and the seller (are there things outside of the lease that the current owner owes the tenant, is the rent different than what is stated in the lease etc.?). If investor is not experienced with reviewing leases they need to have an experienced attorney review them for them.

Title and Survey: Can and will the seller have the financial means to satisfy all liens and judgments that the buyer does not intend to assume? What covenants and operating agreements with third parties regarding access and maintenance of common areas exist if any. Who is responsible for the associated cost? Obtain estoppel certificates from any third party that there are no default on the seller’s part.

Violations of Laws: Is the property fully compliant with applicable laws, codes, and regulations, including zoning and subdivision ordinances? Contact the local governing bodies with jurisdiction over the property. If there are violations what are they, who is going to remedy them and who is going to pay for them?

Your Team: Successful investors usually have a team of trusted advisors that include their accountant, attorney and broker. Each member of the team should be relied on to do what they were trained to do. Asking an accountant or attorney to do a brokers job or visa versa can easily lead to undesirable results, lost opportunity and or capital. It is far easier and safer for an advisor to say no than to provide knowledgeable sound advice to go forward. Successful investors build a team of knowledgeable competent advisors who candidly understand the needs of the investor along with their own strengths and limits.

 

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