Do Your Due Diligence!
Due Diligence the Right Way
Commercial real estate properties are a completely different animal from residential properties in regards to assessing value. That may seem like stating the obvious, but it is easy to overlook the many details that come into play.
For commercial real estate, value is determined in an inverse proportion to the degree of risk inherent to the continuance and stability of the income stream from the property. And of all the commercial property types, perhaps none is more complex in evaluation than a multi-tenant property, either office or retail.
For commercial real estate, value is determined in an inverse proportion to the degree of risk inherent to the continuance and stability of the income stream from the property. And of all the commercial property types, perhaps none is more complex in evaluation than a multi-tenant property, either office or retail.
It is important to always contact a Commercial Broker before purchasing an investment, as it is their job to remain up to date on local property values, market trends, city zoning laws, etc. to ensure you are getting the property you;re paying for with no unexpected surprises. If you are looking to invest in commercial real estate, contact Pacific Coast Commercial.
Until then, familiarize yourself with the important information about due diligence for commercial real estate.
The function of due diligence is to verify, verify, verify.
The exception to that general statement is a true triple-net property. Much of the terminology used for years by commercial real estate professionals has been abused to the point of making what should be easily understood a mish-mash of doublespeak.
Since understanding exactly what kind of property is being considered is of utmost importance in selecting the course of action, it is worth a short digression to clarify this particular term "triple-net."
Since understanding exactly what kind of property is being considered is of utmost importance in selecting the course of action, it is worth a short digression to clarify this particular term "triple-net."
A note on triple-net properties
Rarely will you find a true triple-net, multi-tenant property. A true triple-net leased property means the tenant is responsible for all expenses of operating the property, including property taxes; property casualty, and liability insurance; all maintenance including: structural components, mechanical systems, plumbing and drainage systems, glass, and the roof.
Ownership of the property is vested fee simple, inclusive of the entire "bundle of rights" inherent to real estate. In short, the only responsibility of the owner is to designate where the rent check goes. In the case of a multi-tenant property, about the only way to make that happen is to have a master lease for the whole building, and the master lessee then sublets to the individual tenants.
Obviously, an owner focused on maximizing returns and enhancing value is not going to be very keen on the idea of leaving the fate of a property representing a sizeable investment in the hands of a tenant for sub-lease, except in the most unique of situations. Hence, a multi-tenant deal represented as a triple-net investment bears a hard, hard look.
Chances are the property is the subject of a poor definition rather than a triple-net lease. While due diligence for a true triple-net property is somewhat simpler due to the reduced exposure for risk and expense.
Ownership of the property is vested fee simple, inclusive of the entire "bundle of rights" inherent to real estate. In short, the only responsibility of the owner is to designate where the rent check goes. In the case of a multi-tenant property, about the only way to make that happen is to have a master lease for the whole building, and the master lessee then sublets to the individual tenants.
Obviously, an owner focused on maximizing returns and enhancing value is not going to be very keen on the idea of leaving the fate of a property representing a sizeable investment in the hands of a tenant for sub-lease, except in the most unique of situations. Hence, a multi-tenant deal represented as a triple-net investment bears a hard, hard look.
Chances are the property is the subject of a poor definition rather than a triple-net lease. While due diligence for a true triple-net property is somewhat simpler due to the reduced exposure for risk and expense.
Due diligence starts in negotiations
Due diligence actually starts in the contract negotiation. Unless the seller understands what you are going to be asking for before the deal is signed, there is going to be automatic trouble in getting to the closing table.
When negotiating the contract, be sure to provide ample time (at least 30 days AFTER delivery of all documents) to complete due diligence. Agreements usually state that a written notice that all due diligence is complete and satisfactory IN OUR SOLE DISCRETION, or there is no further obligation and are entitled to the return of the earnest money deposit.
Generally you will not proceed with due diligence until after the contract is executed by all parties. It is important to also keep any time triggers tied to the delivery date of the LAST document, with provisions for the extension of time based on the appearance of any non-disclosed material defects.
By requiring a written acceptance of the due diligence items, you retain control of the deal. You will also have a small bit of leverage on the seller as the drop-dead date nears.
When negotiating the contract, be sure to provide ample time (at least 30 days AFTER delivery of all documents) to complete due diligence. Agreements usually state that a written notice that all due diligence is complete and satisfactory IN OUR SOLE DISCRETION, or there is no further obligation and are entitled to the return of the earnest money deposit.
Generally you will not proceed with due diligence until after the contract is executed by all parties. It is important to also keep any time triggers tied to the delivery date of the LAST document, with provisions for the extension of time based on the appearance of any non-disclosed material defects.
By requiring a written acceptance of the due diligence items, you retain control of the deal. You will also have a small bit of leverage on the seller as the drop-dead date nears.
Leave no stone unturned
EVERY document concerning the building and its operation MUST be examined.
This includes leases with any and all extensions and modifications, notes and mortgages, whether you are assuming them or not, title policy, certificate of occupancy, insurance policies, ADA compliance, elevator maintenance contracts, tax tickets and history, licenses (in some jurisdictions), parking lot contracts, etc.
Using the list generated in the Purchase Agreement, go over each item and assign the task for it to some member of the acquisition team, whether it's the lawyer, surveyor, building inspector, environmental firm or whomever. Make sure they are each contacted, given the timetable for the deal and then follow-up on a very regular basis.
Except for financing, more deals are blown in this stage than any other. It only takes one missing document to completely stall a closing. Each day a closing is stalled, the chances increase for some other element of a deal to come unraveled. Do not skimp on these details. If you're not going to do them yourself, then make a nuisance of yourself making sure your delegate gets the job done.
This includes leases with any and all extensions and modifications, notes and mortgages, whether you are assuming them or not, title policy, certificate of occupancy, insurance policies, ADA compliance, elevator maintenance contracts, tax tickets and history, licenses (in some jurisdictions), parking lot contracts, etc.
Using the list generated in the Purchase Agreement, go over each item and assign the task for it to some member of the acquisition team, whether it's the lawyer, surveyor, building inspector, environmental firm or whomever. Make sure they are each contacted, given the timetable for the deal and then follow-up on a very regular basis.
Except for financing, more deals are blown in this stage than any other. It only takes one missing document to completely stall a closing. Each day a closing is stalled, the chances increase for some other element of a deal to come unraveled. Do not skimp on these details. If you're not going to do them yourself, then make a nuisance of yourself making sure your delegate gets the job done.
Study those leases!
Of the due diligence documents listed for office/retail properties, the most important are the leases, insurance policy, and title policy. The leases are supremely important.
Very few properties of any considerable age have just one boilerplate lease... over time every owner gets in the position of having to sign a tenant at any cost, and the language of the lease will reflect concessions that one tenant holds out for.
Read every word of every lease. Make notes of things you don't understand or need to clarify. Then have someone else read every word of every lease, and take notes. Then compare notes. Then go after the answers.
Understand every element of every lease. You want to be able to ask such obscure, penetrating questions of the owner about each one of his tenants that he tells me stuff he didn't mean to tell you, but figures he better because you're hot on the trail to find out.
There is also the possibility that your questions will bring back a memory of a tenant fact or a quirk in some system that you wouldn't otherwise have known. So ask the questions, and ask, and ask, and ask. This is the only chance you will have to elicit information from the owner with him having an attitude of wanting you to be satisfied.
After you close, he may or may not return a call when you have a problem, but before he gets your money, he's going to be pretty interested in getting you the information you're asking for, or a damn good reason why he can't get it. When you sit down with the owner (or manager) to go over the leases, also ask for the payment history on each tenant.
If there is a problem tenant, you will want to know about it up front. If the problem is chronic, you will discount the cash flow accordingly, which translates to a lower price when value is determined by the NOI.
Similarly, if the owner or manager says they don't have detailed payment records or bank statements verifying deposits, you have an opportunity to explain why the property just became more risky for you, and how that risk translates into a lower price. Often, the records somehow become available.
Very few properties of any considerable age have just one boilerplate lease... over time every owner gets in the position of having to sign a tenant at any cost, and the language of the lease will reflect concessions that one tenant holds out for.
Read every word of every lease. Make notes of things you don't understand or need to clarify. Then have someone else read every word of every lease, and take notes. Then compare notes. Then go after the answers.
Understand every element of every lease. You want to be able to ask such obscure, penetrating questions of the owner about each one of his tenants that he tells me stuff he didn't mean to tell you, but figures he better because you're hot on the trail to find out.
There is also the possibility that your questions will bring back a memory of a tenant fact or a quirk in some system that you wouldn't otherwise have known. So ask the questions, and ask, and ask, and ask. This is the only chance you will have to elicit information from the owner with him having an attitude of wanting you to be satisfied.
After you close, he may or may not return a call when you have a problem, but before he gets your money, he's going to be pretty interested in getting you the information you're asking for, or a damn good reason why he can't get it. When you sit down with the owner (or manager) to go over the leases, also ask for the payment history on each tenant.
If there is a problem tenant, you will want to know about it up front. If the problem is chronic, you will discount the cash flow accordingly, which translates to a lower price when value is determined by the NOI.
Similarly, if the owner or manager says they don't have detailed payment records or bank statements verifying deposits, you have an opportunity to explain why the property just became more risky for you, and how that risk translates into a lower price. Often, the records somehow become available.
A goldmine of information
The insurance policy can be a gold mine of information, especially in the case of a building with some age. Insurance inspectors have seen every trick in the book, and if you can get a copy of the last risk assessment you can be miles ahead of the game. The insured (generally the owner) has to request this, but insist on getting a copy.
Also get a claims history for the property. In many cases you will have to rely on the owner's memory if he has switched insurance companies frequently. That fact alone isn't a red flag. Many owners shop insurance regularly because the industry is so competitive and volatile. Some people don't.
But at the very least, require an affidavit from the owner that says he attests to the truth of the claims represented as being complete to the extent of his knowledge. Courts are littered with suits against "successors in interest" as a way to get an insurance company to settle for the cost of litigation, and very few seller will stand still today for a clause in the contract that states warranties survive closing.
An existing title policy will give you the obvious information regarding easements, rights of way, etc. Be on the lookout for any special exceptions to title. Get a General Warranty deed if you can get it. A savvy seller will offer a Special Warranty deed which will only guarantee title for the period s/he owned the property.
Physical due diligence items can be handled in a number of ways, and the methods will vary depending on the organization and resources of the buyer, the nature of the property, and the type of financing used. You should not go into inspection as there are experts in the field that would be routinely engaged to satisfy the various engineering and environmental requirements in today's world.
There is no substitute for thorough due diligence, but it can be a two edged sword. You've never seen a property without some hidden defects, though you have often not found them until after we own it.
Some investors are so professional in their due diligence that they routinely make full asking price offers, knowing that they are going to beat the seller down with the due diligence info.
Also get a claims history for the property. In many cases you will have to rely on the owner's memory if he has switched insurance companies frequently. That fact alone isn't a red flag. Many owners shop insurance regularly because the industry is so competitive and volatile. Some people don't.
But at the very least, require an affidavit from the owner that says he attests to the truth of the claims represented as being complete to the extent of his knowledge. Courts are littered with suits against "successors in interest" as a way to get an insurance company to settle for the cost of litigation, and very few seller will stand still today for a clause in the contract that states warranties survive closing.
An existing title policy will give you the obvious information regarding easements, rights of way, etc. Be on the lookout for any special exceptions to title. Get a General Warranty deed if you can get it. A savvy seller will offer a Special Warranty deed which will only guarantee title for the period s/he owned the property.
Physical due diligence items can be handled in a number of ways, and the methods will vary depending on the organization and resources of the buyer, the nature of the property, and the type of financing used. You should not go into inspection as there are experts in the field that would be routinely engaged to satisfy the various engineering and environmental requirements in today's world.
There is no substitute for thorough due diligence, but it can be a two edged sword. You've never seen a property without some hidden defects, though you have often not found them until after we own it.
Some investors are so professional in their due diligence that they routinely make full asking price offers, knowing that they are going to beat the seller down with the due diligence info.
Quality of the tenants
Commercial properties are particularly vulnerable to sudden economic downturns. A building with a 100% occupancy rate can become 50% overnight with the bankruptcy of a large tenant because that tenant's business may be dependent on market factors in China, or Russia, or Serbia.
To assess the risk of the likelihood of the continuance of the income stream from a commercial property, you have to gauge the underlying quality of both the tenant base as well as the physical asset, and that's what due diligence is all about.
Examination of rent rolls, payment histories, and credit files of existing tenants can be very enlightening in quantifying the risk quotient of a particular tenant. But much information can be collected just in the normal course of conversation regarding a tenant's business. Ask open-ended questions, and seek out any resource available to aid in your decision making.
To assess the risk of the likelihood of the continuance of the income stream from a commercial property, you have to gauge the underlying quality of both the tenant base as well as the physical asset, and that's what due diligence is all about.
Examination of rent rolls, payment histories, and credit files of existing tenants can be very enlightening in quantifying the risk quotient of a particular tenant. But much information can be collected just in the normal course of conversation regarding a tenant's business. Ask open-ended questions, and seek out any resource available to aid in your decision making.
You'll rarely have all the answers...
The end result of a thorough due diligence process is that when the time comes to present your deal to either partners, investors, lenders, or another buyer, you will have the level of information and knowledge surrounding the property that very clearly states that you are a professional at what you do.
Preliminary due diligence checklist:
- Financial records: Annual profit and loss statements (P&Ls) past 3 years minimum (5 years preferred)
- At least one year monthly P&Ls (preferably two years)
- Balance sheet (3 years)
- Rent Roll including term, deposit, and payment history
- Tax returns- 3 years
- Insurance: Insurance Policy; including all riders, risk assessments, and disclosure affidavit for carrier
- All Existing Loan Documents: including notes, deeds of trust, closing statements, title policy, rate riders, etc., and contact names and numbers.
- Deed
- All Leases: entire copies plus any addendum or riders.
- Any service or advertising contracts: (Trash, extermination, maintenance, management, commission agreements, union agreements, vending, billboard, pay telephone, etc. and any instrument or contract to be assumed by Purchaser)
- Copies of all recent appraisals, engineering reports, environmental reports
- Survey (as-built), legal description, architectural and engineering plans and specifications
- Payroll register: List of employees including name, position, wage rate, and entitled benefits
- Business license
- Physical inventory of furniture, fixtures, and equipment, and supplies.
- Utility bills: Water, Sewer, Gas, Electric (at least two years of monthly statements) (or recap report from provider showing usage and cost)
- Bank statements showing deposits for last twelve months (optional)
- Phone system documents (y2k compliance letters)
- Computer systems (y2k compliance letters)
- Fire System inspection reports and y2k compliance
- Property Tax tickets for the past three years (real estate and personal)
- Litigation History: details of any past or pending litigation (if none, then affidavit from owner)
Comprehensive due diligence: pre-closing
- Engineering Inspection and Survey
- Environmental Inspection and Survey: Key Issues: Asbestos, Lead Paint, underground tanks, wetlands
- Environmental Phase One: An Environmental Phase One (1) Assessment is an inquiry conducted to determine the environmental status of a property or facility in connection with a real estate property transaction. It follows standards which includes those published by ASTM.
- Environmental Phase Two: Assessments/Subsurface Investigations: These projects include but are not limited to subsurface drilling and sampling, monitoring well installation and sampling, ground penetrating radar, and asbestos and lead sampling.
- LUST survey- leaking underground storage tanks
- Financial Audit
- Title Search and policy
- Property tax verification
- Tenant Estoppel Letters
- Mortgagee Estoppel letters
- Legal Verification's: licenses, permits, zoning
  
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