Commercial Real Estate: Due Diligence Explained
If you are planning to buy a commercial property, either as an investment or for your business, you should consider conducting due diligence as it is an important element in your negotiations and in the contract. Due diligence is defined as research and analysis of a company or organization done in preparation for a business transaction.
From a commercial real estate (CRE) standpoint, due diligence is the process of doing “homework”—checking and confirming any important information on the property you are planning to purchase. It is a systematic way of analyzing and mitigating risk or financial uncertainties from a business or investment decision.
Due Diligence Period
A due diligence period is the time allowed for a buyer to enter the property and conduct inspections, examinations, and tests to all areas of the property as the buyer deems, in their sole discretion, appropriate and necessary.
When does the due diligence period start and how long?
Since the objective of due diligence is to reveal all elements affecting the feasibility of the buyer’s intentions—whether the property is a good, average, or a bad deal, it is reasonable if you want to conduct due diligence as early as possible.
Due diligence period can occur prior to or after signing the purchase and sale contract. However, if you prefer to conduct due diligence prior to signing the contract, the seller will usually limit what is provided and require a confidentiality agreement to be signed. Typically, the due diligence period in CRE is 30 days or less depending on the needs and processes of both parties. It can be extended up to 60 days if there are necessary documentation needed to be reviewed as long as both parties agree to the extension.
There are three (3) major areas in the due diligence process that we think you should focus on:
Physical Due Diligence
A thorough examination of the physical condition of a commercial property is part of the acquisition due diligence process that you cannot afford to go without. The physical assessment of the property is the most important of the three because this is the area that is costly to correct and can greatly affect the property’s long-term value.
Performing physical due diligence will help you understand if the commercial property you are planning to buy has been properly maintained or not. If not, you can use this information to better negotiate the sale price or even back out of the transaction.
Hiring a professional inspection company that specializes in physical due diligence of a commercial property can be highly beneficial to make sure that all areas of the property have been assessed and checked thoroughly. The inspection company should perform inspections not limited to:
- Building/property condition assessments
- Building/property risk assessments
- Capital expenditure forecasts and cost plans
- Facilities management reviews and risk analyses
- Property management KPIs
- Replacement cost estimates
Financial Due Diligence
One of the essential due diligence steps is financial investigation. Financial due diligence is investigating a property’s cash flow by checking the income and expenses if it matches the seller’s representations and to determine if the property’s rent roll is sustainable.
To mitigate risks, a proper review of the asset’s financials should be conducted before closing the acquisition of a commercial property. Do not believe the books and records given by the seller. It is your responsibility to check and double-check the financial statements of the property by verifying each dollar reported coming in and spent on the property.
Since this process is a series of audits—lease audits, contract audits, rent roll analysis, cost analysis, market analysis, etc., it is helpful to hire a qualified accountant who has experience in commercial real estate accounting. This qualified accountant will be part of your A-team in all of your real estate transactions moving forward so make sure that you only hire the best of the best.
Legal Due Diligence
This phase of the due diligence process focuses on the variety of jurisdictions that might govern a property. Legal due diligence involves:
- Title examination
- Survey report
- Analysis of existing permits
- Liens and tax issues
Many problems may arise in acquiring a commercial property without proper legal due diligence. Such potential deal-breakers—potential environmental problems, defects on the title or survey, proper and improper special uses and encroachments that affect the property can put your investment property at risk.
Hence, before you go forward with this deal, hire a real estate attorney in conjunction with a title insurance company and a CRE broker who are committed to having these risks mitigated or identified before you sign the purchase and sale agreement.
Conducting due diligence prior to any purchase of a commercial property is essential since a lot of elements should be thoroughly inspected, investigated, reviewed, and tested. A risk assessment is necessary to avoid any problems that may arise in the future which could cost you some serious damage either on your finances or on the property itself.
If you fail to gather all the information necessary during the due diligence period and it expires, there is no turning back if ever you uncover discrepancies or potential problems that do not align with your intentions and visions for the property. With that being said, your deposit money becomes non-refundable and you will either go forward with the transaction, or withdraw from the deal with your deposit money forfeited.
This is why for every transaction with millions of dollars on the line, rigorous due diligence becomes a “non-negotiable” for any real estate investment.
Even after outlining all the information above, investing in CRE can still seem daunting. That’s why the Leveraged CRE Investment Team at Commercial Properties, Inc. is here to help you achieve your investment goals. Contact us at (480) 330-8897 or email us at firstname.lastname@example.org.
Need help on how to get started investing in commercial real estate? We got you covered! We prepared a free e-book that will serve as your guide to achieve your long-term business goals or obtain that property you’ve always been dreaming of!
Phill Tomlinson is a commercial real estate broker with Commercial Properties, Inc. (CPI) in Scottsdale, Arizona, and owner of the Leveraged CRE Investment Team specializing in investment sales and tenant/landlord representation in the Phoenix and Scottsdale submarkets. Phill applies over 21 years of experience in the Real Estate industry helping investors and owners maximize their returns.
Bookmark www.leveragedcre.com to learn more about the Commercial Real Estate market and keep informed of relevant real estate strategies designed to maximize your income property investment results. Connect and follow Phill on Social Media at sm.leveragedcre.com/smplatform. #LeveragedCRE