When you’re looking for commercial real estate and finally, after months of searching and putting in the bid, you’re chosen as the winning purchaser, spend a little time celebrating! But while finding that perfect property presented its own challenges, a new set of challenges arise once the price is settled: the due diligence phase.
You wouldn’t buy a car without checking under the hood or taking it for a test drive—protect yourself from a potential nightmare by reviewing the physical, legal, and financial risks that may accompany a potential commercial real estate investment. Conducting this review—or due diligence—will likely require you to hire a team that includes inspectors and lawyers familiar with the challenges that such a purchase brings.
Buyers generally have 30 to 60 days to find property issues that might lead to more substantial problems once the deal concludes. That doesn’t give most buyers much time to gather, review, and analyze a vast quantity of information. While time consuming and potentially stressful, skipping the due diligence phase rarely yields positive results.
Due Diligence Defined
Due diligence safeguards buyers from potentially dangerous financial gambles, facilitates effective negotiations that lead to secure investments, and limit post-sale surprises. Hidden details that thorough due diligence uncovers help prevent transactions from turning into costly mistakes.
The key word in the due diligence process? Comprehensive. For real estate investments that involve potentially millions of dollars, thorough due diligence becomes non-negotiable and includes providing commercial real estate buyers with information like:
- The governing bodies that may have influence on a property
- Environmental conditions that may impact the premises
- The feasibility for turning the buyer’s vision for the property into reality
Types of Commercial Real Estate Due Diligence
Investors generally acquire commercial real estate with different objectives in mind: investment, real estate development, or business operations. These objectives can determine the depth and process of due diligence. The ultimate goal, however, remains the same—to reduce or mitigate financial uncertainties by conducting detailed inspections of each element involved in the purchase.
Commercial property buyers should direct their due diligence to several different areas: building(s), systems, and property(ies) physical; legal, jurisdictional, and title analysis; financial; operational; and environmental. But depending on the intended use of the real estate you’re purchasing, you may elect to invest more time on certain components of the due diligence process.
Physical due diligence provides an opportunity to identify issues and architectural or engineering concerns. Engineers inspect a building’s current condition, review original plans, and ensure the building’s bones are structurally sound. Appraisers review historical operations and determine whether the appropriateness of the purchase price. You might hire other consultants to inspect a building’s roof or identify items for immediate and long-term repair. This due diligence helps create a picture for the size of a renovation budget, should you decide to make renovations, upgrades, or adaptations.
To ensure a smooth transition, you’ll need a legal team to conduct legal due diligence. They’ll determine entitlements and obligations by studying title policies of prospective acquisitions. They may also recommend obtaining an updated survey report to ensure the information about your site is most current.
Because commercial acquisitions carry significant financial risk, it’s important to conduct financial due diligence. Conducting a series of audits allows you to determine the property’s cash flow and ensure the income and expenses match what the seller stated. Those audits may include:
- Lease audits: The legal team compares hard copy leases to the rent role to verify accuracy
- Contract audits: This file audit reviews existing service contracts, like snow removal, landscaping, office equipment/technicians, or third-party maintenance providers
- Rent roll analysis: The legal team analyzes expiration/rollover schedule timing, terminations, renewals, relocation options, and existing lease schedules
- Cost analysis: This audit analyzes operations historically to identify expected expenses, opportunities to save money, and develop a realistic budget
- Market analysis: This audit provides an accurate way to estimate future rents by evaluating similar property locations, amenities, and other variables
Depending on the purpose and function of the building you’re purchasing, you may want to conduct operational due diligence. For example, if you’re buying an apartment building, you may want to vet and hire a property manager. If you’re purchasing a building you intend to use for retail/restaurant space, you may want to develop a marketing plan to rebrand the property once the sale’s complete. Setting up these key operational pieces so they’re ready to go once the sale is complete saves time, headaches, and expenses.
When deemed necessary, environmental remediation can carry a substantial financial burden. It’s better to find those issues before completing the sale. Hiring a professional to analyze environmental compliance and conduct a cost-benefit analysis makes good fiscal sense. Depending on your situation, a geologist performs an Environmental Site Assessment (ESA) (Phase I) to analyze environmental contamination resulting from past use and potentially recommend a Phase II ESA site test, which could include groundwater and soil testing.
Commercial Real Estate Due Diligence Checklist
The clock has started, and you’ve got 30 days to complete your due diligence. Where do you begin? Assemble your team and assign specific roles to each team member, so that nothing is missed, including the steps below.
- Get a building condition assessment to identify any defects. It’s also helpful if you’re planning to renovate.
- Research the building’s history and evaluate and analyze any liens and obligations you find.
- Review insurance policies—especially those for older buildings—for past claims that might identify potential liabilities or defects.
- Verify which documents you need from the municipality.
- Conduct financial due diligence, by reviewing your business plan or cash flow projections with your accountant and prepare a synopsis of your financing needs for the lender.
- Determine what lender’s conditions you must meet prior to the purchase, like an environmental assessment and the building inspection.
- This checklist template, from Property Metrics, offers a very comprehensive list for people buying commercial real estate property, with information about acquisition actions/documents, title/survey/zoning, tenant/lease, financial/financing, service contracts, litigation, insurance, inspection/review, personal property inventory, governmental review, property operations/management, and miscellaneous actions.
According to the American Bar Association, those who purchase commercial real estate are considered “sophisticated parties,” and consumer protection laws that exist to protect residential home buyers rarely apply to commercial real estate purchasers. When done correctly and rigorously, due diligence ultimately enables you to protect yourself legally and financially.