Due diligence can limit post-transaction surprises
Investors are always searching for new ways to identify opportunities in an evolving commercial real estate marketplace. In commercial property transactions, thorough due diligence helps reduce the risk of post-closing surprises. Buyers should avoid rushing into what appears to be a low-risk opportunity, especially given the range of issues that can surface in an unpredictable real estate market. A limited due diligence review can create a costly challenge after a transaction closes, making it important for every investor to understand exactly what they are acquiring before moving forward.
The acquisition of commercial real estate requires intensive due diligence to uncover key information that may not be readily apparent or available in evaluating the value of a property or portfolio. Such hidden details can doom the financial merits of an otherwise profitable deal, turning the transaction into a costly mistake.
There are essentially three types of investors engaged in acquiring commercial real estate. Each is driven to make an acquisition for different objectives:
- Investment Purposes
- Real Estate Development
- Business Operations (where the building will be occupied by the investor’s organization)
These different objectives alter the due diligence process and depth.
While this guide covers many of the critical areas of due diligence, it is not intended to serve as an exhaustive checklist. Every transaction carries unique risks that may require additional review beyond what's discussed here.
What is due diligence in real estate?
Due diligence in real estate is the process of investigating a property and its seller before closing a purchase. It helps buyers understand exactly what they're acquiring and identify any risks tied to the property or the transaction. In commercial deals, the purchase and sale agreement typically sets a specific due diligence period, during which the buyer can walk away from the deal if their review uncovers concerns.
The chief aims of real estate due diligence are to thoroughly inspect the fundamentals of the property, seller, financing, and compliance obligations to mitigate financial uncertainties. Prospective buyers must scrupulously examine zoning restrictions, potential liens, and possible encroachments on the property. Existing structures must be fully inspected to discern needed repairs and their costs. They must determine whether or not they will absorb legacy liabilities from prior owners’ legal and regulatory violations. If the property is largely financed, they need to assess their ongoing ability to make required payments to the lender.
Many sophisticated commercial real estate investors consider it a best practice to commence detailed due diligence before the purchase contract is signed. The alternative is to carefully lay out the specific items of due diligence in the purchase contract, along with the timeframe for completing them. This also compels the seller to deliver required documents promptly. Certain findings may adversely affect the acquirer's anticipated financial return. Uncovering these risks early strengthens the buyer's negotiating position, helping ensure the final purchase price accurately reflects the property's true condition.
Given the vast array of documents in a commercial real estate transaction, it is important to prepare a due diligence checklist, marking off each item of concern once it has been addressed. Depending on the investor type and the entity’s financial objectives, this checklist can be quite long. The specific items on that checklist will vary significantly by transaction, property type, and jurisdiction. Nevertheless, closing a deal before appreciating and fully evaluating the risks against the rewards would be shortsighted.
Tailoring due diligence to the deal
Due diligence on a commercial real estate opportunity begins with understanding the transaction’s objectives. The investment goals in pursuing a commercial real estate transaction serve as the foundation for the due diligence that follows.
For instance, the purchase of an income-producing property like an apartment building will require the investor to verify the existing tenant leases and examine each tenant’s rental payment history. Otherwise, the investor cannot ensure the financial stability of the anticipated income stream.
On the other hand, a commercial real estate developer's initial focus is on the building's intended use and whether the property can be permitted to accommodate it.
Physical inspection and environmental review
Buyers should never engage in a commercial real estate transaction without personally visiting, walking through, and inspecting the premises. During the walk-through, buyers must analyze the property or building in terms of the intended use. Concerns that arise will affect the negotiations. For example, a buyer may intend to convert a property into an office complex with ample parking. If the site is hilly, grading it to accommodate the anticipated volume of vehicles could be costly.
Given the often disparate federal, state, and local environmental regulations, investors must ensure that a property or building complies with current rules and laws. They also need to account for planned and potential regulations that may take effect in the future. An example of this moving target is environmental compliance standards (e.g., new emissions standards or updated stormwater management rules). Investors need to know whether a particular regulation will phase in at a later date, and in some cases years later.
One of the key drivers for buyers conducting environmental due diligence in real estate transactions is CERCLA. The Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) is a federal law that grants the EPA authority to track down parties connected to a contaminated property and require them to fund or carry out cleanup. Liability under the statute is broad. Current owners, prior owners, and those who arranged for or transported hazardous materials to a site can all be on the hook for remediation costs and damages, even if they had nothing to do with the original contamination.
Before financing the transaction, lenders are likely to require an environmental site assessment (ESA). A best practice is to undertake this evaluation anyway, irrespective of financing issues. Engage a reputable environmental engineering firm to assess past uses of the building or property, in addition to collecting evidence of possible contaminants like mold, lead, and asbestos, as well as any underground storage tanks. What appears to be perfectly safe and legal in a visual inspection can turn into a litigation minefield in the future, since the investor will inherit these potential liabilities and be required by law to eliminate the discovered problem.
Lastly, although sellers are legally required to provide certain disclosures on a property’s physical characteristics, such as easements, encumbrances, and other restrictions, it is prudent for the investor to personally review, validate, and check off each item. A best practice when acquiring commercial real estate is to never automatically assume the same degree of disclosures from the seller that exists when buying residential property. Key differences exist.
Diverse legal documents
Commercial real estate investors should consider the value in retaining the assistance of a specialized commercial real estate attorney. Numerous legal documents must be accessed, evaluated, and verified. Depending on the nature of the transaction, additional documents beyond those discussed below may also be required.
At a minimum, these documents include the title, leases, zoning regulations, surveys, tax certificates, and the seller’s financial records and operating statements. All documents should be listed in a due diligence checklist and stored initially in a secure, virtual data room.
Title searches and property descriptions
Once escrow has been opened, the investor should order a preliminary title report. The report will provide information about the property, such as its current and past ownership and the existence of recorded liens, encumbrances, and easements.
Once these factors are understood, a best practice is to commission an ALTA (American Land Title Association) survey of the property. This survey will verify boundary lines, surface waters, rights of way, existing improvements and alterations, lot size, and access roads.
To protect against unanticipated title issues, it is prudent to obtain title insurance. The title insurance company will commit to absorbing financial losses resulting from possible title defects that were not uncovered during the title commitment or survey process.
Municipal lien searches for Florida properties
Many jurisdictions have laws that affect real estate transactions in unexpected ways. Municipal lien laws for Florida properties are a prime example of how local jurisdictions introduce unique risks. Anyone purchasing property in Florida should make sure to conduct a municipal lien search during due diligence. Unlike most other states, Florida attaches certain debts and issues directly to the property, not the individual owner. These can include unpaid utilities, code violations, or expired permits.
Because of this, a municipal lien search is standard practice in virtually all real estate transactions occurring within the state of Florida. Property buyers should be aware that a conventional title search will not uncover these localized building and utility department issues.
Zoning and property codes
Investors also must ensure compliance with current zoning rules and property codes. A smart tactic is to solicit documentation from the relevant municipality confirming that the current and anticipated use of the property complies with existing zoning regulations and land use classifications. As a precaution, buyers should consider engaging an outside zoning specialist to independently verify that this information is accurate and up to date.
For buildings that are relatively new, reviewing the certificate of occupancy can help confirm compliance with relevant property codes, though this only reflects conditions at the time of issuance, so any subsequent renovations or changes in use should be checked separately. Tax certificates can provide the assessed valuation of the property as well as the standing of property tax payments.
Be aware of the time frame for city approvals
If problems are uncovered, or if the buyer plans on making any changes to the property, including its use, additional permits and business licenses may be required. Prospective property buyers need to be aware of the time frame associated with securing city approvals. Building permits can take anywhere from a month to several years to obtain, depending on various factors.
For this reason, it's important to arrange meetings with local authorities early on to determine which approvals are necessary. This may include planning and zoning approvals, site plan reviews, city council approvals, and other approvals.
Lease payment history
For an income-producing property like an office building or apartment complex, a thorough review of the lease payment history will shed light on the reliability of the income stream. It is also good practice to scrutinize the seller's financial records and operating statements, if these can be obtained, in order to identify any gaps in lease payments.
ADA compliance
A key item is to determine whether an existing structure complies with the Americans with Disabilities Act. While the ADA sets the federal baseline, each state has its own regulations regarding accessibility and the required documentation. The federal government has created a checklist to help investors understand the rules before acquiring a building or property.
All of these documents are needed to rigorously evaluate the risks of an investment versus its potential return. As each document is reviewed, the data should be validated as accurate or inaccurate, checked off on the master checklist, and stored in the virtual data room. These findings should then be compared against the anticipated returns or revenue streams the transaction is expected to produce, since such details can serve as leverage in deal negotiations. Once the transaction has closed, the documents should be transferred to a highly secure, centralized platform for long-term storage and compliance purposes, one that also offers easy accessibility.
Know the seller
Due diligence extends beyond matters related to the property itself. Before entering into a commercial real estate transaction, the standing, reputation, and track record of the seller should be fully investigated and vetted. This scrutiny can reveal a less-than-scrupulous transacting partner, and it can also flag reputational issues, whether tied to the current owner or the property's occupants, that could negatively affect future earnings.
Buyers should ask for and examine the seller's tax returns, service contracts, loan documents, litigation history, and any other records related to the entity's financial status, prior use of the property, and overall integrity. These insights will prove useful in negotiating a fair deal or in deciding whether to pass on the opportunity altogether.
Conclusion
Every real estate transaction is different and requires a unique due diligence plan. Moving too quickly and failing to perform comprehensive due diligence can create problems for even the most experienced investors.
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Learn more about how CT Corporation can provide support for every stage of a real estate transaction, from due diligence to closing to ongoing compliance. Contact a CT Corporation specialist today.