Real estate investors know that due diligence in commercial real estate is an essential element of any successful investment. However, many investors find the process of conducting due diligence to be daunting.
This blog post will provide a comprehensive overview of the due diligence process, dispel some common myths about it, and offer tips for completing it successfully. By understanding what to expect during the due diligence stage, real estate investors can feel confident in making sound investment decisions when buying a commercial property.
What is Due Diligence in Real Estate?
Due diligence in real estate is the process of investigating and assessing a property before making an offer to purchase. This due diligence period – also known as the feasibility period – allows potential buyers the opportunity to learn as much as possible about the property. These include its physical condition, zoning regulations, environmental hazards, and any other factors that could affect its value or desirability.
Due diligence is essential to any real estate transaction because it allows buyers to make informed decisions about whether or not to proceed with a purchase. It also protects buyers from making costly mistakes that could result in financial losses or legal problems down the road.
What Happens in Commercial Due Diligence?
The due diligence process usually includes a review of the property’s legal documents, an inspection of the property, and interviews with tenants, landlords, and other relevant parties. Buyers should also research the local market conditions to better understand what they’re buying into.
The goal is to ensure that the property is suitable for the buyer’s needs and that there are no hidden risks or problems. When commercial real estate investors look at a potential property, they often hire a third party to conduct due diligence.
What should due diligence include?
Due diligence is the investigation or verification of a potential investment or product to confirm all facts, such as material risks, are considered. In commercial real estate, due diligence typically includes a review of financials, property condition, market trends, and zoning regulations.
The main areas included in due diligence are:
- Financial Review: A due diligence financial review assesses the historical performance and future prospects of an investment property. This analysis considers factors such as rental income, operating expenses, and capital improvements.
- Property Condition: A due diligence property condition assessment evaluates the physical condition of an investment property. This analysis examines factors such as the age of the property, building code compliance, and deferred maintenance.
- Market Trends: A due diligence market trend analysis considers current and future trends that could impact the value of an investment property. This analysis looks at factors such as population growth, job growth, and new development.
- Zoning Regulations: A due diligence zoning review assesses the land use regulations that could impact an investment property. This analysis focuses on property’s zoning classification and any proposed changes.
What are Due Diligence Documents in Real Estate?
When it comes to due diligence in commercial real estate, there is a long list of documents that you will need to review. This due diligence checklist will help you ensure that you have all the information you need to make an informed decision about your investment.
1. Purchase and Sale Agreement: This is the first due diligence document one will encounter when buying or selling a property. It outlines the terms of the sale, including the purchase price, closing date, and any contingencies that must be met before the sale can be finalized.
2. Title Report: A title search report is an important due diligence document. It shows who owns the property, any liens or encumbrances on the property, and whether there are any outstanding zoning violations.
4. Zoning Report: A zoning report is due diligence for commercial real estate because it ensures that the property can be used for the purpose you intend. For example, an office building should be zoned for commercial use with sufficient parking for both tenants and visitors.
5. Appraisal: An appraisal is due diligence for commercial real estate because it provides an independent estimate of the property’s value. This is important information to have when negotiating the purchase price of a property.
6. Survey: A survey is due diligence for commercial real estate that provides detailed information about the property boundaries. It also mentions and evaluates any structures or improvements located on the property.
7. Phase I Environmental Site Assessment: A Phase I ESA assesses the risks of contamination from hazardous materials present on the property.
8. Building Inspection Report: A building inspection report will identify any major defects or problems with the structure of the building. This is important to review to ensure that you are not taking on more repair costs than anticipated.
9. Financial Statements: Financial statements will provide information about the income and expenses of the property. Reviewing the profit and loss statement (P&L) and cash flow report helps to ensure that the property is economically viable.
10. Tenant Leases: Tenant leases and a tenant rent roll will provide information about the current occupants of the property and the terms of their leases. This is important to review to verify all obligations that come with owning the property and to identify any potential problems with tenants.
11. Insurance Policy: The insurance policy will outline the coverage and protections that are in place for the property. This is important to review to ensure that you have adequate coverage for your needs. In addition, asking for a claims history report on the property will help detect any issues you may have insuring the property.
12. Due Diligence Checklist: A due diligence real estate checklist is a document that outlines all of the due diligence items required before buying or selling a property. This checklist can be used as a guide to ensure you don’t forget any crucial steps in the due diligence process.
How Long Does Commercial Due Diligence Take?
The due diligence period typically lasts 30-45 days, during which time the investor conducts inspections, reviews documents, and interviews parties involved with the property. There are a few best practices that investors should follow when conducting commercial due diligence:
- Hire a qualified inspector to assess the condition of the property.
- Review all documents related to the property, including lease agreements, environmental reports, and building permits.
- Interview the property manager, tenants, and other parties involved with the property.
- Visit the property to see it firsthand and get a feel for the area.
The Bottom Line
Before investing in commercial real estate, it’s critical that you understand the due diligence process and what it entails. By taking the time to research a property thoroughly, you can avoid any unpleasant surprises down the road and negotiate a better purchase price.
When conducting due diligence, be sure to look into zoning regulations, environmental concerns, outstanding liens or lawsuits, the physical condition of the property, building code violations, and rental income and expenses. With this information in hand, you’ll be able to make an informed decision about whether or not to buy a particular piece of commercial real estate.
Frequently Asked Questions
When it comes to commercial real estate, due diligence is key. Whether you’re looking to buy, sell, or lease a property, it’s important to understand the process and what to expect. Here are answers to some of the most frequently asked questions about commercial due diligence.
How long is the due diligence period?
The length of the due diligence period can vary, but it is often around 30-45 days. During this time, the buyer may also request access for inspections and negotiate for any necessary repairs or requests for additional information from the seller.
Is due diligence refundable?
It is important to note that due diligence is not typically refundable. If the buyer decides to back out of the transaction during this period, they may still be responsible for any expenses incurred during their research. To protect themselves, buyers may consider including an “out” clause in their purchase contract, allowing them to cancel with minimal financial consequences if issues arise during the due diligence period.