A Thorough List of Inspections and Reports Can Avoid Costly Mistakes
It’s not the sexiest part of the deal, but a lax due diligence process can spell disaster for even the most seasoned commercial real estate investor.
The short period to kick the tires between getting into contract and removing contingencies is a crucial step in any commercial real estate investment. Conducting thorough due diligence limits surprises, reduces risk, and generates invaluable insight into the opportunity. An air-tight checklist will guide you through what can at first appear to be a daunting task.
Regardless of property type or location, a comprehensive commercial real estate due diligence checklist should include the following:
Collecting Property Information
Basic data on the property is the backbone of your due diligence. Record information like lot and building size, number of floors, unit count, property type, parking, zoning, and current use.
Next, cross-check broker- or seller-provided information with public data and field measurements. Investigate any discrepancies vigorously, and don’t trust any piece of information that cannot be independently verified. If the broker forgot to include a mezzanine or other rentable area in the listed square footage, your price per pound just got a little juicier.
Evaluating Building Systems
One can break down even the most complex structures into their components. Inspectors and other experts are essential to assess each element of a building, so tap into your network and always hire vendors experienced in dealing with local building codes.
Inspect or hire experts to examine structural systems, electrical, plumbing, gas, heating/cooling, roof, windows, sprinklers, drainage, fire protection, elevator, and any common area amenities. Understand how utilities are brought to the building and metered, not just who pays the bills.
Conducting Inspections and Reviewing Reports
Investing in single-family homes necessitates relatively few inspections, whereas adaptive reuse opportunities and large multifamily communities may require an army of vendors to descend on the property.
Experts you may need include pest inspectors, contractors, architects, engineers, electricians, plumbers, general contractors, property managers, and environmental consultants. You may need to include a survey, Phase I or II (environmental), Property Condition Assessment (PCA), Maximum Probable Loss (MPL), and Underground Storage Tank (UST) reports.
Don’t forget to review non-physical items like building permits, violations, court cases involving the seller, and a preliminary title report. One broker we know had a fully developed due diligence checklist, but a neglected 30-year old building code violation popped up six months post-closing. The issue was more administrative than physical, but it delayed a refinance for several months and could have been much worse had the underlying problem been more material. The broker got off easy but now won’t move forward with a deal until any legacy violations are cleared.
Gathering Tenant Information
Most purchase agreements require that a seller disclose all legal contracts with tenants, including leases and any associated amendments or addenda. Review these carefully, tying the financial terms (rent, security deposits, utility obligations, etc.) in each contract to the rent schedule provided. Be on the lookout for an option to extend a lease at a sweetheart rate excluded from marketing materials. We recently found one of these “hidden” options during diligence. Still, since the seller received several offers higher than ours after going into contract, we were faced with the tough choice of walking away or moving forward with what was now a less attractive deal.
In many cases, an attorney can aid in this review at a relatively low cost.
In addition to leases, request that tenants provide an estoppel certificate to confirm lease terms, as well as a certificate of liability insurance.
Obtaining Seller Disclosure
Required seller disclosures vary widely by property type and deal specifics, so collect as much as is feasible without expending negotiating equity on non-essential items. Review historical operating statements, capital improvement schedules, service agreements, completed building permits, drawings, plans, and request information related to any lawsuits that may impact a property.
Updating Your Business Plan
It’s easy to be so focused on inspections, reports, and leases that you forget to think about what happens the day after closing.
Due diligence is as much about looking for pleasant surprises as it is bad ones. Refresh your capital improvement plan and rent projections as you find out more about the property and the neighborhood. If entitlements are a part of your business plan, learn as much as possible before your contingency period expires. Don’t be reckless with your checkbook, but spending a few thousand dollars on robust due diligence to avoid losing a few hundred thousand is as good an investment as you’ll ever make
Use tools to keep the process simple
CREXi’s Closing Tracker includes a Due Diligence Checklist, allowing you to manage and track your closings by creating a timeline, inviting closing parties, monitoring tasks, communicating amongst team members, and uploading your closing documents.