Why Perform Due Diligence?
Learning how to perform due diligence can mean the difference between success and failure in commercial real estate investment. If you are new to the field, you will want to pay close attention to the meaning of the term and how to get the job done quickly and efficiently.
The general meaning of due diligence describes the process of obtaining knowledge about something you are purchasing – especially something with a big investment, like a business or a commercial property – before signing the contract to buy it.
Performing due diligence has two purposes: the first is to relieve the buyer of some of the risk involved in making a purchase without sufficient knowledge to know what they’re really getting into. The second is to relieve the seller of any liability that could result from the buyer not having this kind of information available. Due diligence is an example of “win-win” for both parties in a transaction. It is always best to enter a business deal knowing as much as possible about the risks you are taking on. And it’s also best for the seller to give buyers access to whatever they need to make an informed decision.
When you buy a commercial property, you usually present an offer contingent on your ability to perform full due diligence within a certain period of time, often 30 days or less. In commercial real estate, it is understood that you need access to certain documents and access to the building to conduct a physical inspection. Once you have completed your examinations, you have the right to withdraw your offer without penalty if you are not satisfied with the financial, legal or physical condition of the property.
What Is Needed
The most important documents to request during your due diligence period include the following: income or operating statements that show all gross rental income and all expenses; general ledger reports with detailed descriptions of expenses; maintenance and repair reports; soil and geological reports, including Phase I and possibly Phase II environmental site assessment reports; structural engineering reports that tell whether the building has passed all required tests and inspections for structural integrity, fire safety, earthquake safety and so on; any previous appraisal reports if available; all current and existing leases; and the rent roll that shows all leased and vacant spaces, along with all rents that are past due. All financial reports should include those from the current year and the last three years.
You can also request any available building and engineering plan drawings that are available, including original plans and those made for recent improvements to the building. And most investors choose to request a current title report on the property to make sure there are no surprises in that area.
The second aspect of due diligence is conducting a full, thorough physical inspection of the property, including the exterior and interior walls, windows and doors; the roof and foundation; the HVAC system; the elevators; the electrical and plumbing systems; the parking areas; and all leased spaces.
If you are not a licensed contractor, architect or professional building inspector, it is best to hire professionals to help you inspect the building properly and give you their opinions, preferably in writing. It’s important to have a team of professionals you can rely on to give you honest, informative feedback. If you don’t already have such a team in place, it is a good idea to start building one as soon as you can.
Of course, it isn’t enough to just have access to the documentation and reports you need to conduct due diligence. You have to be able to make sense of them, or they won’t help you much. If you are just thinking of getting into commercial real estate, but haven’t made any offers yet, now is the best time to give yourself a quick education on how to interpret all the reports that make up the due diligence process. It will be very difficult to invest wisely if you don’t understand what you’re reading, whether it is a cash flow statement, a soil inspection report or a title report. You don’t have to be an expert, but you should know the most important things to look for in each document.
If you are buying your first building, your due diligence obligation might seem a bit overwhelming. Admittedly, none of the documentation involved in due diligence gives you fascinating reading material. And while inspecting ducts, pipes and elevator shafts, you may feel that you’re in over your head in more ways than one! But these inspections, reports, documents and drawings will help you become a savvy, experienced, knowledgeable investor, which is the only real insurance for long term success. That thought should make the dry, technical language, legalese, old blueprints and strange ducting a bit more palatable.