What is Due Diligence in Commercial Real Estate?

 

WHAT IS “DUE DILIGENCE”?

The purpose of a due diligence investigation is to enable the buyer to discover as much as possible about the property before he or she is obligated to buy it.  This includes discovering information that the seller may not want the buyer to know or perhaps information of which the seller isn’t even aware.   We recommend preparing a thorough due diligence checklist that the buyer presents to the seller early in negotiating the deal.  Thorough due diligence consists of three broad categories of investigation:  financial due diligence, physical due diligence and legal due diligence. We will discuss each of these three aspects of due diligence in turn.

FINANCIAL DUE DILIGENCE

The two most important questions a buyer needs to answer are:

  • How much income is the property currently producing (what is the property’s “Net Operating Income” or “NOI”)?
  • How much income will it produce when I am running it?

To answer the first question, the buyer must gain an accurate understanding of the property’s financials as they currently exist and as they have existed in the near past.  There are two “sides” to the financial due diligence “coin”:  the income side and the expense side.

With respect to income, the buyer should insist upon obtaining the actual financial data of the property going back at least three (3) years.   A shorter period may fail to disclose problems that are not entirely resolved.   The buyer should also request the tax returns for the entity that owns the property.  The buyer can use the tax returns to verify the internal financials.   Buyers can safely assume that expenses will not be understated on a tax return.  As for the income, if there are significant discrepancies in the reported taxable income on the tax returns and those reported in the internal financials, the buyer should be concerned.  If the seller was willing to lie to the IRS, the seller will be willing to lie to the buyer.

While the Purchase and Sale Agreement should require the delivery of tenant estoppel certificates at closing, it is still important to conduct a due diligence investigation of the leases.  The buyer should review each and every lease relating to the property.  The buyer needs to identify the termination dates of the various leases and assess the risk that one or more tenants will vacate at the end of their lease term.  The buyer should also note any discrepancies, concessions, or landlord obligations to make improvements or renovations.   A rent roll is another key piece of data for the buyer.  A rent roll typically shows the unit number, the tenant name, the rent amount, any past due balance, and the lease expiration date.  The buyer should request not only a current rent roll, but past years’ rent rolls, if available. Beware if the current rent toll contains a number of recent tenants.  Sellers sometimes will fill a property with low quality tenants to boost the occupancy rate prior to marketing the property for sale.

The Buyer also needs to examine the “expense side” of financial due diligence.  A thorough understanding of the property’s operating expenses is essential to develop a baseline for the buyer’s projections for its first year of ownership.  Digging into the expenses relating to a property may also point out issues that the buyer will want to further explore in the legal/physical due diligence phase.

One of the largest line-item expenses in commercial properties, particularly multi-unit residential properties, is often the utility bill.   The buyer should request at least two years of the actual utility bills to determine both the cost and the usage.  The only way to determine the actual consumption is to track the usage (gallons, kilowatts, etc.) on a per-occupied unit basis (for multi-family) or per square foot basis (for office and retail), using the actual bills to match cost and usage.  This can identify seasonal spikes in usage and can even uncover abnormal conditions, such as gas leaks or water leaks.

Property taxes are also a significant expense item.  This information can be obtained directly from the municipality or the county, and is usually available online.  The title report (discussed in the legal due diligence section) will show whether the taxes are delinquent.  If so, this is good information for the buyer, as it indicates the seller may be under financial stress and is therefore motivated to sell.   It is important to determine whether there are any special tax reductions or tax breaks that apply to the seller but which may expire or which may not be applicable to the seller.

The buyer should request copies of the seller’s current insurance policies.  The basic information in the seller’s policies can be used by the buyer to obtain price quotes from insurance agencies.  Getting the actual policies enables the buyer to compare the cost on the operating statements to the actual premium on the policy.

The buyer should attempt to verify all remaining expense items.   By learning as much as possible about how the seller operates the property, the buyer can better analyze how its own operation of the property might differ and how that might result in higher or lower expenses.

PHYSICAL DUE DILIGENCE

As its name suggests, physical due diligence is concerned with the structure of the building itself and the physical features of the land and surroundings. Standard third-party reports required by lenders and buyers are the appraisal, environmental investigation, zoning compliance, and building/engineering reports.  We usually recommend that the buyer hold off on ordering these reports until the financial due diligence has been completed and found to be acceptable.  These third party reports are not cheap, so it does not make sense for the buyer to incur the expense if the financial due diligence reveals problems.

Phase I Environmental Reports are the minimum standard for most lenders. Based on the findings, a conclusion will indicate whether or not any further environmental investigation is needed.  For a site with suspected contamination, we recommend a Phase II investigation with appropriate test drilling and sampling of ground water.  A site with confirmed contamination from a prior user, or with an environmental risk identified in a Phase II report, will require a Phase III environmental investigation, remediation, and ongoing monitoring.

The buyer should also research the zoning requirements of the site at the planning department in the city/municipality or the county in which the property is located.  The buyer should NOT rely upon the seller’s statement that the property is in compliance with zoning.  If the buyer is planning to make any changes to the property, then it is important to review the zoning regulations for the zone in which the property is located.  We work closely with our colleagues in the firm’s land use department when there are questions about the current zoning status or the ability of the buyer to make changes after the purchase.

The Building/Engineering investigation is the commercial property equivalent of the home inspection in a residential deal. The engineer will test the all of the property’s systems – HVAC, electrical, fire suppression, etc.  The engineer will also evaluate structural components, such as the roof and building envelope, and will note any deferred maintenance problems.   These engineering reports are extremely valuable to the buyer and should be reviewed very carefully.

LEGAL DUE DILIGENCE 

The most important aspect of legal due diligence is the title examination.  Working with a title insurance company, we can provide a “commitment” to issue a title policy, sometimes called the “title binder.” We carefully review the title commitment with the buyer, to ensure the seller can deliver clear title.   Perhaps the most important part of the title commitment from a due diligence perspective is “Schedule B” to the title policy.  Schedule B-I contains the requirements that must be met for the company to issue the policy and Schedule B-II lists the various exceptions to the title that the title company found when it performed its title search.  Common exceptions on Schedule B-II include

  • Easements
  • Rights-of-way
  • Restrictions or Covenants

By listing various items as exceptions, the title company is telling the insured buyer that these items are not covered by the title policy, and that the title company will not pay a claim or defend against a claim based on these excepted items.  In the due diligence context, Schedule B-II provides the buyer with a list of title issues that must be resolved prior to the purchase or they will be issues that the buyer will inherit upon taking ownership.  The buyer’s lawyer or the title company will also conduct a lien search and a search for any county or municipal code violations.  The buyer certainly does not want to inherit any such violations and should insist that any code violations or open permits be resolved prior to the closing.

Another key part of legal due diligence is the survey.  The buyer’s attorney should match the legal description in the proposed deed and in Schedule A to the title commitment to the actual representation of the land on the survey plan.  If the legal description uses metes and bounds, the lawyer must find the beginning point on the plan and follow the metes and bounds descriptions to ensure that they match and to ensure that the legal description “closes” (i.e., that there are no gaps in the description).  The attorney should locate on the survey plan all of the improvements, such as the buildings, parking areas, and drainage areas located on the land in question as well as such improvements on adjoining land.  The attorney should look out for possible encroachments by adjoining landowners on the property in question.  All of these issues need to identified and, if necessary, addressed with the seller prior to closing.

CONCLUSION

The level of due diligence will vary with the value of the project.  The more money is at stake, the more thorough the due diligence should be.  The lawyers at Blalock Walters have handled commercial real estate transactions of all shapes and sizes.  We stand ready to assist in all aspects of commercial real estate, from formation of the real estate holding company to financing to closing the deal.  If you have questions about commercial real estate, please call 941-748-0100 or email Matthew Lapointe at MLapointe@blalockwalters.com or Matthew Plummer at MPlummer@blalockwalters.com.