Below is a due diligence checklist. Like people, all properties are unique so the following list should be considered a general guideline with the investor and their advisors refining as needed.
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? The cost approach is limited in value but should be considered. The cost approach answers the question of would the investor be better off building their own or paying the “market” price.
The question is 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 assurance that a loan is properly collateralized with its salvage value but could easily miss the value for an investor. Both the comparable sales and the cost approach are backward looking by their nature while investors are buying the future potential of the property. Typically investors rely far more on the income approach in their decision making while using comparable sales and the cost approach as a secondary sources of insight.
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 obtain a new loan or assume an existing loan and if so at what cost and terms? What is required in the way of impounds for the loan for taxes, insurance, tenant improvements, other 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? What is the ratio of loan to value (LTV) and what risk does this create for the investor? Will the investor be able to refinance at a similar rate in five or ten years and what will that do to the value of their investment?
Insurance: Are the improvements properly insured against possible loss? Is there adequate liability or business interruption insurance? What will the new premiums be, does the tenant or the owner pay? How does this change affect the net operating income and future value?
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 conditions, 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 how will that affect property taxes and net operating income? Will the owner or the tenant have to pay the new taxes? How feasible is it to challenge the new assessment? Interviewing the assessor can be of value in both understanding local tax regulations and customs and to get a better feel for the local market and government agencies.
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 tenant bankruptcy or allows 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 or vice versa, is the rent different than stated in the lease etc.?). If investor is not experienced with reviewing leases it is important that they have an experienced attorney review them for them.
How financially strong is the tenant? Compare the net worth of the tenant to the obligations they will have under the lease. Will the tenants business endure or is it a fad or vulnerable to technological changes that could put them out of business? If tenant is rated by a rating agency translate that rating into how likely it is that that tenant will be able to meet their rent obligations in the future (see Tenant Ratings on this site for a details list of rating and their meaning).
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 relevant third party that there are no defaults on the seller’s part.
Potential Violations Laws, Regulations and Other Covenants: Is the property compliant with applicable laws, codes, and regulations, covenants including zoning and subdivision ordinances and condominium agreements? 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 the corrections?
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 vice versa can easily lead to undesirable results, lost opportunity, time 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 competent advisors who understand the needs of the investor along with their own strengths and limits.