“Due diligence” refers to the process of gathering all the information you need to know before purchasing a property. This stage of the acquisition is CRITICAL, and the most important thing you need to know is to save enough time to review and understand any risks that could potentially affect your ability to generate cash flow from the property.
In a residential transaction, the due diligence process is relatively straightforward. The purchaser pays for a property inspection and then reviews the report to negotiate further repairs or discounts.
In Commercial Real Estate, due diligence is much more comprehensive and nuanced. In a sense, the property condition is one of the easier things to assess, especially compared to figuring out the impact that a pending lawsuit or insurance claim might have on the property’s commercial value.
From the initial property visit all the way to the closing financial statements, here are the basic areas you NEED TO COVER in your due diligence.
The Physical Property
Be sure to look over every property description and report you can obtain. You will want to look at the most recent survey, drawings, engineering plans, environmental impact reports, and any blueprints the seller or their agents can provide.
Hire a professional to inspect the condition of the property and all the major systems (HVAC, plumbing, roof, foundation, parking lots, etc.)
Consider the impact any easements or restrictions on the land could play in the future. If you are thinking about building or renovating a property, there could be new laws or building codes in place that will require updating to bring the asset into compliance.
Another important aspect to review are the ongoing maintenance contracts the seller has with other businesses. What service contracts (including utilities) will you be committing to in the purchase? How long are you committed to these as the new owner? These details are important to discover in the due diligence period.
This should go without saying, but read over every lease agreement the seller has with current tenants. You should know the financial status of all tenants, as well as have a complete accounting of their rental history, contributions to common area maintenance, and their security deposits.
Get to know your potential tenants before you buy!
Review the most recent title policy and all title insurance documents related to the chain of ownership, as any legitimate claims on the ownership of the asset could potentially nullify your right to purchase the property (even after the fact!).
Also, be sure to ask the seller to disclose the status of any former and ongoing property insurance claims, as these could affect the future value of the asset.
The seller should supply all zoning compliance and other certificates of approval from the city or municipal jurisdiction and inform you of any pending decisions.
Also extremely important, TAXES! Obtain a real estate tax payment history, and records of any incentives, protests, or resolutions to any tax appeal procedures.
Are there any unsettled lawsuits affecting the property or the owner? Be sure to avoid any responsibility for the previous owner’s litigation.
Due diligence is the process of understanding the asset and understanding the market analysis to obtain all the information you need to evaluate your CRE purchase and submit the most effective offer.
In the second part of the due diligence series, we’ll talk about everything that goes into a thorough market analysis.