Something that’s talked about in many real estate transactions is the idea of “due diligence,” or completing your due diligence before signing a contract. In commercial real estate, the due diligence process is a crucial stage of any sale.
In this article, you’ll learn what commercial real estate due diligence is and we’ll provide you with a checklist so you don’t miss any undisclosed problems with the seller’s real estate.
What Is Due Diligence?
In commercial real estate, due diligence is the act of thoroughly inspecting every aspect of a property, seller, financing, leases, rent roll, easements and more before you purchase the property. Some factors to consider include zoning laws, neighborhood, possible liens, legal liabilities on the property, violations or needed repairs.
“Real estate due diligence is the homework you have to do before you buy a property,” said Christina Ying, a partner in the Real Estate Department at the law firm Herrick, Feinstein LLP. “Due diligence can make or break a deal, and it really affects your bottom line.”
It’s best practice to complete due diligence before any contract is signed to ensure there aren’t any surprise issues with the commercial property you’re about to purchase. One way to ensure you’ve done your due diligence is by creating a due diligence checklist.
That said, the steps involved with due diligence might vary, depending on the type of property and the goals of that property. For instance, if you purchase an apartment building, due diligence would involve verifying tenant leases and examining tenants’ rental history to verify that they are paying rent. This will ensure the future financial stability of your purchase. However, a vacant land to be purchased for development would involve different steps, as you won’t be dealing with residential tenants.
Commercial Real Estate Due Diligence Checklist
Below is an example of a due diligence checklist. This checklist includes everything you want to complete before purchasing a commercial property:
- Gather and organize all of your documents. This can include property surveys, leases, appraisals, governmental documents, photos of the property, property title, tax forms, environmental reports, engineer’s or property condition reports, zoning documents, construction documents, material correspondence, city records, offering memorandums or any other documents that the seller might have.
- Investigate all documents. Once you’ve gathered all of the paperwork, make sure to thoroughly investigate and understand all of the documents. Often, this requires the help of a commercial real estate attorney as well as a financial advisor or accountant. In that investigation, you want to “look at the title, and try to determine if there’s any encumbrances or restrictions on the property,” said Ying.
- Figure out financing options. If you haven’t done so already, speak to a lender about the project to make sure you have the financing.
- Inspect the property. Spend time at the property, and check every possible corner to make sure there aren’t any obvious issues. It’s best to have a team of people with you, such as the property inspector, property management, a contractor, an architect, a broker, and anyone else you think is important. You can also ask business owners, tenants, or employees what they think about the property, as that could lead to some surprising answers and information.
- Bring in site consultants. First, you want an environmental engineer to check the current and past uses of the property and see if there is any contaminated soil, water, asbestos, lead-based paint and more. This is called a Phase I Environmental Assessment, and depending on the type of property (see: brownfields), you may need more than one phase. Next, hire a surveyor to determine whether the property encroaches on a neighbor’s property. Finally, traffic engineers can study the flow of traffic to and from the property and reveal potential infrastructural issues in the area.
- Next, you can utilize your architect and engineer. This is when you begin to put together your official plans for the property, such as renovations or development. Depending on your plans, you might need just an architect, or both an architect and civil engineer. If you do not have plans to renovate or develop the property, you would still need an engineer to conduct a property condition report that will identify any repairs needed.
- Deal with any legal issues. Make sure to have a commercial real estate attorney who can make sure there are no liabilities or legal problems with the property or seller.
- Close your deal. Once all of the above steps are completed, you can finally close on your commercial property.
Commercial Real Estate Due Diligence Timeline
On average, said Ying, the due diligence process for commercial properties takes between 30-45 days.
The process “takes just a few days if you have everything,” said Ying, “but what really drives the time is getting these materials,” which include the title, the environmental report and more.
Expert Tips for Commercial Due Diligence
Get a Free Look
Because the process of completing due diligence costs time and money, Ying recommends that potential property buyers get a “free look” on the property.
“A free look means that you tie up the property, meaning that nobody else can buy the property while you’re doing due diligence,” said Ying.
There are a couple different ways to do so. Ying recommended getting the seller to sign an exclusivity agreement agreeing not to sell the property or enter into a contract with another buyer during the period of time that you’re completing your due diligence. Another option, said Ying, is to sign a contract of sale, in which you pay a refundable deposit, and the seller gives you 30 to 45 days to complete due diligence. If you’re not satisfied with the property after completing your due diligence, you would be able to get your deposit back.
“That is what I call the free look, and that’s what I advise purchasers to do,” said Ying.
Complete Due Diligence Alongside the Financing Process
Matthew L. Holden, Esq., a partner in the Real Estate and Corporate practice groups at A.Y. Strauss advises buyers to “request your attorney to have the due diligence period run concurrently with the financing contingency period” in order to streamline the process.
Sometimes, Holden said, lenders require certain experts to be used in due diligence, so if you’re working with the lenders from the start, you’ll be able to ensure that you’re using the right experts.
“In certain cases,” said Holden, “lenders require that their environmental consultants are used for the Phase I Environmental Assessments and will not rely on reports provided by an independent consultant.”
For this reason, it’s a good idea to complete due diligence alongside the financing process, as the two processes might be more intertwined than you think.
Due Diligence Is an Essential Step to Purchasing a Commercial Property
When purchasing a commercial property, you never want to skip your due diligence. Due diligence ensures that there are no problems with your purchase, and it is absolutely essential to your decision-making before signing a contract.