COMMERCIAL REAL ESTATE INVESTING: DUE DILIGENCE

Due diligence is the process of evaluating the commercial property that you have under contract by checking and confirming information about that property. The importance of this process in commercial real estate investing is two-fold:

First, you learn specifics about the property which enables you as the Buyer to make an informed decision.

Second, it allows you to uncover potential problems before closing escrow.

The due diligence clause in the Letter of Intent to Purchase allows the Buyer to analyze the property for a free period of time, typically 30 to 60 days.

A Due Diligence Checklist should be submitted as an Exhibit to the Letter of Intent to Purchase and referred to in the paragraph outlining the due diligence to be conducted. Click here for a sample of a Due Diligence Checklist.

Due diligence can be broken down into three main parts:

PHYSICAL INSPECTION

FINANCIAL INVESTIGATION

LEGAL INQUIRY

Of the three, I believe that the physical inspection is the most important because the types of problems which may be discovered during the physical inspection can be the most costly to correct.

The Physical Inspection

The physical inspection should include the inspection of the walls, roofs, foundations, doors, doorways, windows, mechanical systems, electrical systems, plumbing systems, parking lots, landscaping areas and air conditioning systems.

I recommend that you hire a professional inspection company to do the inspection, as well as a few specific subcontractors if you are concerned about the equipment, such as air conditioning units, elevators, escalators, electrical power systems or plumbing systems. You should interview at least three companies and ask them for sample reports.

Financial Investigation

First rule: Don’t believe anything given to you by the seller. Always double check everything.

In order to perform a thorough financial investigation, be sure to obtain the following from the seller:

Income and Expense Statements – You should obtain at least the past three years of Income and Expense Statements, as well as the Balance Sheet on the property.

Rent Roll – At a minimum, the Rent Roll should show you the Tenant’s name, unit number, square footage, current rent, date of occupancy, lease expiration date, any options, and the amount of the security deposit. You need to verify this information with the lease and compare it to the Income Statements.

Tax Returns – Obtain Tax Returns for at least the previous three years and compare these very carefully with the Income and Expense Statements.

Lease Agreements – I suggest that these documents be reviewed by a person familiar with the particular type of Lease, as apartment leases are different from office leases which are different from industrial leases, etc. I also suggest that you obtain an Estoppel Certificate for each lease, which is a document sent out to each Tenant to have the Tenant verify the existence of the Lease and its terms. Here’s a standard Estoppel Certificate for a commercial lease.

Utility Bills – Obtain the past two years of electricity, gas, sewer, water, trash, cable, telephone and internet bills for the property and compare these to the expense statements.

Property Tax Bills – Obtain the past two years Property Tax Bills and compare these to the expense statement. Also, contact the local Tax Assessor’s Office to determine how the property will get reassessed after you purchase it, and what kind of increases that you can expect in the future.

Legal Inquiry

Get the following documentation from the seller and get professional help to review it if you have questions:

Environmental Inspection –Usually you will need to get a Phase I Environmental Site Assessment which shows you the past use of the property and the surrounding area, as well as any onsite and offsite environmental problems and liabilities. The seller may or may not have this report, and you may need an updated report for your lender.

Survey and Title Inspection – These documents verify the property size and describe the property, showing any liens, judgments, easements or encroachments on the property. Any title issues must be cleared by the Seller before you can close.

Report on Building Code violations – You should go the City’s Planning Department’s records to find any reports of violations. The Seller must clear any outstanding violations prior to closing.

Zoning – Verify the current zoning on the property to make sure that the existing use is conforming.

Insurance Policy – If you can get the claims history, it can give you a lot of information concerning the property’s experience with fires, flooding, lapses of coverage or policy cancellations. You should also start shopping for insurance right away and get at least three quotes.

Licenses, permits or certificates – You may be required to post business licenses, permits and certificates to operate your property. Make sure that you get these from the Seller and if the Seller doesn’t have any, check with the City to see if any are required.

Service and Vendor Contracts – Closely review all of the service and vendor contracts and determine whether you have the right to continue or discontinue them. Make sure that you have all equipment guarantees and warranties.

Personal Property Inventory – Obtain a detailed list of all personal property that will transfer to you as the new owner. You should use a Bill of Sale to document all of these items.

Police Reports – Contact your local police department and see if they have any past or current reports of problems, and review them carefully to understand the future problems that you may face. Also, go to the property for a couple of hours at different times of the day to review if there are any illegal activities going on at the property.

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