Due diligence is a crucial step in any real estate acquisition. It involves a comprehensive evaluation of the property, the seller, and the local market to ensure that the investment is sound and in line with the investors’ goals and objectives. This article will outline the key components of performing due diligence in a private commercial real estate acquisition.
It is important to undergo due diligence in an order that requires expenses later in the due diligence process. You do not want to have an accepted LOI and immediately spend a few grand on condition or survey reports without undergoing a financial audit; if the numbers do not work, the rest is irrelevant! Having said that; the parts of this due diligence process are in no particular order and should be arranged depending on the timing of execution, the particular deal, your chosen lender, and your chosen property management company.
Financial Review: This relates to reviewing the financial information related to the property. This includes reviewing the property’s historical financial statements, such as its income and expense statements, as well as any recent appraisals or market analysis reports. The buyer should also review any leases or rental agreements in place, to determine the property’s current and future cash flow potential. This should be executed in the form of a financial audit report and a lease audit as outlined in the next sections.
Financial Audit Report
A financial audit report is a report completed by a real estate consulting firm, or possibly your property management company. The purpose of the report is to understand the ‘actual’ income, and expenses, and to determine the most realistic pro forma.
This report should be one of the first tasks of due diligence aside from knowing the market, and submarket, and underwriting the deal ‘in-house’.
The lease audit is a comprehensive analysis of the ‘in place’ leases on the property. This report will be conducted by your chosen Property Management Company, and its purpose is to analyze the current lease charges, stated expenses, lease language, and more.
The results of the lease audit will help verify that the current lease charges are accurate and in line with the lease language.
Market Analysis: Next is reviewing the local real estate market and assessing the property’s market value. The buyer should compare the property to similar properties in the area, and review any recent sales or rental data. This analysis will help the buyer determine if the property is appropriately priced and if there are any potential market risks associated with the investment. The market analysis should also include an assessment of the surrounding area, including the traffic flow, and pedestrian activity. This analysis should be executed in the form of a market condition report as outlined in the next section.
Market Condition Report
A market condition report is a report that is executed by your property management company. This report is an in-depth analysis of the submarket including; rental rates, occupancy, competitiveness, new construction, and more. The purpose of this report is to ensure the projected rental rates, occupancy, and overall performance of the property.
The results from this report will either ensure you on your assumptions or encourage you to make changes to your pro forma rental rates and occupancy.
Property Inspection: Next is to thoroughly inspect the property. This involves a physical examination of the property to assess its condition, location, and zoning. The buyer should also review any recent renovations or upgrades made to the property, as well as any ongoing maintenance or repair needs. The property inspection should also include any potential environmental or zoning issues. This should all be executed in the form of a property condition report, and a walkthrough report as outlined in the next two sections.
Property Condition Report or PCA
The property condition assessment (or PCA) is a report that provides overall information on the condition of the property. This report can be completed by the person(s)/company of your choosing but should be completed by a licensed contractor. Depending on the contractor that is completing the report, the report should include a basic understanding of the condition of major parts of the property. The report should include photos and a description of major problematic areas, as well as a summary of the expected costs, or capital improvement that would be necessary to bring the property up to ‘par’.
This report will either confirm your assumptions or encourage you to make changes to your deferred maintenance or capital expenditures that will be necessary to operate the property.
The walkthrough is what it sounds like; walking every single square foot. There is no shortcut in this process. This report/walkthrough should be completed by a general contractor and/or the correct vendor for each trade type (Ie HVAC, Pool, Plumbing, Electrical, Roofing, etc.). Your chosen third-party management company may be able to assist in this process as well. This process includes walking every square foot and looking at plumbing, electrical, roofs, HVAC systems, boilers/chillers, pools, foundations, and more. No shortcuts! Another part of this inspection should include an audit of historical maintenance requests. Have there been many requests for mold, water, roaches, etc.?
The final walkthrough report should ensure the property’s condition and deferred maintenance expenses that you and your management company have underwritten the project. Or, this report will uncover undisclosed problem areas of the property such as; aging roofs, water damage, faulty electrical issues, and more.
Legal Review: Next in the due diligence process is to perform a legal review of the property and the transaction. This includes reviewing the property’s title and any liens or encumbrances on the property. The buyer should also review any existing contracts or agreements related to the property, including any leases or rental agreements. Additionally, the buyer should review any relevant local, state, and federal laws and regulations that may impact the property or the transaction. This step is crucial to ensure that the buyer is fully aware of any legal obligations or restrictions associated with the property and to ensure a smooth and successful transaction. Part of this process is to perform a title report as outlined in the section below.
A title report is completed by your chosen title company and its purpose is to verify the legal ownership and description of the property and to ensure that the title is free and clear of any past liens or claims that could affect the purchase.
Due Diligence Report: After completing the above steps, the buyer should compile a due diligence report that summarizes their findings and provides a comprehensive evaluation of the property and the transaction. The report should include an assessment of the property’s physical condition, financial performance, legal compliance, market value, and any other relevant factors. At this point, the buyer should have a complete understanding of the property and the outlook of the investment and will need to execute a few more steps in the due diligence process (depending on city requirements and their internal due diligence rules) before successfully completing the acquisition.
The following sections in this article outline the final due diligence steps in a real estate acquisition. Please note that not all of these steps may be 100% true for every given market. Depending on the city, or lender requirements, further or less due diligence may be required.
A Site Survey is a report that is executed by a local service provider. This report will appear in a map form and its purpose is to get an accurate description of the property and to understand the actual boundaries of the buildings on site, and/or the corners of the land area.
Aside from the fact that most lenders will not loan on a property without understanding its boundaries, you want to have 100% knowledge of the property’s boundaries and descriptions.
Environmental Site Assessment OR ESA
An environmental site assessment (or ESA) is an assessment executed by a lender-chosen party. The purpose of an ESA is to identify any potential environmental contamination liabilities. The report will look at the existing property’s physical improvements, as well as the historical land usage.
This assessment will ensure that the property is not contaminating the environment from a potential old gas leak, chemical spill, etc.
An appraisal is a report that is executed by a lender-chosen third-party appraiser. The purpose of the appraisal is to determine the value of the property based on the capitalization rate (Cap Rate) and the net operating income (NOI). Since lenders base their loans on the value of the property (Loan To Value or LTV) – it is important that the appraisal comes in equal to or even better, above the contracted purchase price. If the appraisal comes in below that determined purchase price, the bank will need to get a 2nd appraisal, and if the appraisal does still not meet the underwritten value, the purchase price will need to be negotiated, or the buyer will need to bring more of a down payment.
A green report is an energy report that is executed by energy-efficient consultants that are qualified by your chosen lender. The purpose of the report is to determine what improvements can be made to improve the energy and water efficiency of the property. The report will include the potential cost savings that can be achieved by addressing the identified opportunities.
For properties located in high-risk areas of earthquakes, a lender may require the property to receive a seismic report which gives a ‘Probable Maximum Loss Assessment’ (or PML) that will estimate the risk of structural damage in the worst-case scenario.
In conclusion, performing due diligence on a commercial real estate acquisition is a critical step in making a sound real estate investment. By thoroughly evaluating the property, the seller, and the local real estate market, the buyer can ensure that their investment is well-informed and aligned with their investment goals and objectives.