Introduction
Due diligence is one of, if not the, most important periods in the real estate investment process. It is during the due diligence phase that the investor looks for any factors which can change the financial merits of the purchase. These factors may prompt the investor to either renegotiate terms with the seller or walk away from the deal entirely. As many successful real estate investors have told me, sometimes the best deals are the ones you don’t do.
What is due diligence? Due diligence refers to the period before closing when the potential buyer investigates the physical, environmental, legal, and financial aspects of the property in detail.
The Purchase and Sale Agreement and Escrow Deposit
The due diligence phase begins shortly after the signing of the purchase and sale agreement.
In the previous post in this series, I provided an overview of how investors value commercial real estate using the income approach. If the investor establishes that the estimated value is above or at least equal to the purchase price, then she will deliver a letter of intent (LOI) to the seller. The LOI is a generally nonbinding agreement outlining the terms of the purchase. The attorneys on both sides of the transaction work from the terms of the LOI to create a purchase and sale agreement, the actual contract for the sale of the property.
Once both parties sign the purchase and sale agreement, the buyer puts a deposit into an escrow account. This is an account overseen by a third party which temporarily holds funds in accordance with the terms of the contract. This initial deposit is called earnest money.
The earnest money deposit is generally refundable, or “soft”, for a period of 60 to 90 days. It is during this period that the buyer conducts due diligence and obtains financing.
Conducting Due Diligence
Because the deposit becomes nonrefundable, “goes hard”, at the end of the due diligence period, this phase is an intense period requiring the buyer to work long days. The buyer generally works exclusively with outside consultants to inspect the various aspects of the property. Lenders and institutional equity investors require these studies before providing financing. Some lenders may also require the investor to use specific vendors to conduct these studies.
Seasoned real estate investors have extensive due diligence checklists, but at a minimum, due diligence includes the following:
- Environmental study
- Survey
- Building inspection
- Title search
- Lease and tenant review
The amount of work the buyer has to do in the due diligence phase will also depend on the amount of information provided before contract signing and the buyers knowledge of the local market. For example, the buyer should have conducted a thorough review of the property’s operating costs and created proforma financials before contract signing. Seasoned real estate investors understand the costs of operating a property and can spot red flags before putting a property under contract.
All items in the due diligence process are important, of course, but I’ll briefly discuss the core items mentioned above.
The environmental study must be conducted by a qualified environmental engineering firm. There are two studies: phase one and phase two. The phase one study is an overview investigation mostly involving a site inspection and study of the property’s historical use. The primary purpose of the phase one study is to determine the likelihood of environmental contamination. The phase one study may be sufficient if it concludes there is a very low likelihood of potential environmental problems. If the phase one study finds any potential problems, the buyer will likely have to order a phase two study. The phase two study involves physical testing of the soil and the building itself to determine any environmental issues. If the phase two study confirms the existence of environmental issues, the study will also include recommendations to remediate the issues. Because of the additional work involved, the phase two study is significantly more expense than the phase one study.
The buyer will generally also order a survey of the property. The survey helps confirm or refute the site description outlined in the purchase and sale agreement. Obviously, the buyer wants to avoid any disputes with adjacent property owners, and the survey can clarify site boundaries. The survey also helps identify the existence of easements, which are rights of use granted to a third-party. Easements can impede the ability of the buyer to make site improvements, so it’s important for the buyer to know exactly where such easements lie.
The building inspection involves an assessment of the physical condition of the property. The inspection usually focuses on the potential for costly improvements, such as for mechanicals (HVAC, plumbing, and electrical), roofing, the existence of mold or other factors. The inspection should also focus on the structural integrity of the building, which involves an inspection of the building’s foundation and load-bearing walls. The prospective owner should also have an inspection to determine compliance with the American with Disabilities Act (ADA), which requires that a commercial property provide access and accessibility for persons with disabilities. The ADA compliance inspection is usually performed by a specialist other than the building inspector. Noncompliance with the ADA can lead to significant liability for a property owner, so this inspection is very important.
On the legal side, one of the most important items is the title search. The purpose of the title search is to determine the existence of any liens placed on the property. Liens can be placed on the property from various sources, such as contractors, tax authorities, and lenders. The buyer wants a “clean” title, free of any liens.
The buyer will also want to review the leases and should be able to speak directly with the tenants. The buyer should look for any provisions in the leases that may become liabilities later. The buyer will also want to get the tenants’ opinion on the property and develop a good relationship with them.
As mentioned above, the point of the due diligence process is to identify any items that may require a renegotiation of terms with the seller, or which warrant the buyer to walk away from the deal. The various reports compiled over the due diligence period will be sent to the lender. The buyer will also reference these findings in the package used to obtain equity financing.
In the next post, we’ll review how commercial real estate investors obtain financing from lenders and equity investors.
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