Table of Contents
Introduction to Commercial Real Estate Due Diligence
In the realm of commercial real estate, due diligence plays a pivotal role before finalizing any acquisition, development, disposition, or lending deal. Investors undertake a meticulous vetting process during commercial real estate due diligence to align the deal with their risk-return profile and uncover any potential issues. This exhaustive investigation encompasses property assessment, financial analysis, zoning compliance, and a thorough review of other investment criteria, forming a solid foundation for a data-driven capital deployment decision.
Initiating the Commercial Real Estate Due Diligence Checklist
A crucial initial step in any commercial real estate transaction is the completion of a commercial real estate due diligence checklist. This crucial process scrutinizes every aspect that could pose a challenge in the future, including the legal status of the property, as well as the condition of its foundation and fixtures.
Understanding Due Diligence in Commercial Real Estate
What is Due Diligence in Commercial Real Estate?
It’s an in-depth, comprehensive review conducted during the later stages of a deal, designed to help investment teams identify all possible risks before the deal’s closure. Utilizing a thorough commercial real estate due diligence checklist is key for investors to spot financial and other significant red flags, ensuring the deal matches their ideal risk profile before signing a contract.
In the commercial real estate sector, due diligence is a critical practice. It involves extensive inspections and legal research to confirm that both the building and its title are free from issues before agreeing to ownership. This step is vital to prevent future complications and investigate any potential problems that might arise.
Duration of the Commercial Real Estate Due Diligence Period
How Long Does the Commercial Real Estate Due Diligence Period Last?
The commercial real estate due diligence phase usually commences upon mutual approval of the Purchase and Sale Agreement (PSA) by both buyer and seller. The length of the commercial real estate due diligence period can vary, influenced by factors such as the buyer’s efficiency, the deal’s complexity, and other variables. Typically, due diligence starts right after the purchasing contract is signed, on the condition that the building must pass all inspections, failing which the contract becomes void, releasing you from any obligation to buy. It’s possible, however, to negotiate due diligence completion before signing the purchasing contract, with the seller potentially requesting confidentiality in return.
The PSA often outlines the timeframe allocated for due diligence, which generally spans 30-90 days. It’s common for buyers to obtain a “free look” period, granting them exclusive rights to purchase the asset until this duration expires.
Starting with a Preliminary Checklist
In the preliminary stage of commercial real estate due diligence, deal teams diligently inspect various factors like regulations, tax implications, and other profitability constraints, as well as collect all essential due diligence documents. Early identification of issues enables investors to avoid unprofitable deals before committing significant time.
During your preliminary commercial real estate due diligence process, consider reviewing the following:
- Current title policy and other related commercial real estate due diligence documents.
- Development and construction plans, including as-built, architectural, engineering, and any other relevant plans.
- Property condition report.
- All government-issued documentation related to the building, such as permits, occupancy certificates, warranties, government notices, special assessments, code violations, and unexpired guarantees.
- Property tax bills from the past three years, including special assessments and incentives.
- Energy and utility bills from the previous two years.
- All pertinent environmental and energy reports, potentially involving site consultants.
- Capital expenditures.
- Documentation of any personal property on the land.
- Calculating costs for identified issues to ascertain total expenses.
After completing these preliminary steps, investors typically gain sufficient insight into the property to assess if it aligns with their risk profile. Properties that clear this phase of the commercial real estate due diligence process and meet other criteria are then considered for a more detailed evaluation.
Site Underwriting Commercial Real Estate Due Diligence Checklist
As part of the deal lifecycle, investors engage in the site underwriting process during commercial real estate due diligence. This stage is the final chance for investors to thoroughly vet the property and gather all necessary information. The site underwriting process, involving an in-depth examination of the property’s legal and financial standings, often includes multiple parties and may take a month or more to complete.
While underwriting the property, ensure the following items are reviewed in each category:
Financial & Insurance:
- Recent or past property appraisals.
- Current insurance policies and filed claims.
- Up-to-date rent roll, including tenant expenses like security deposits, real estate taxes, and CAM billings.
- Service contract reviews for potential cancellation penalties.
- Demographic research and analysis of the surrounding area.
- Competitive market analysis.
- Comparison of selling price with similar deal comps.
- Lease financial comparisons with similar deals.
- Year-over-year cash flow analysis.
Title, Zoning & Surveys:
- ALTA (American Land Title Association) survey and other topographical surveys.
- Zoning compliance certificates.
- Current property liens.
- Encroachments from neighboring properties.
- Review of legalities affecting property use, such as covenants, conditions, restrictions, reservations, and easements.
- Interviews with local municipal authorities.
- Pending and ongoing litigation impacting future ownership.
- Review of the property’s legal description.
- Letter of intent and client authorization letter.
- Purchase contract review.
- Site inspections for market location, accessibility, and identification of unknown variables.
- CAM (common area maintenance) recommendations for tenant contributions.
- Pro forma information review.
- Current tenant leases and abstracts, including amendments.
- Tenant profiles, including credit ratings.
- SNDAs (subordination non-disturbance and attornment agreements), unless it’s a multifamily unit.
- Tenant sales reports, aged receivables, and security deposit lists.
- Interviews with current tenants.
After completing this comprehensive list, investors typically have all the necessary information to make a final decision on the deal’s risk and return profile before closing. While detailed and thorough underwriting may extend the process duration, the meticulous analysis of risks usually proves beneficial. Documenting these details enhances the credibility of deal teams when presenting opportunities to investors.
Synchronizing Financing and Due Diligence in Commercial Real Estate
Applying for Financing and Conducting Due Diligence In Tandem
The initiation of the commercial real estate due diligence period often aligns with the early phases of securing financing. This strategic timing allows potential buyers to proceed with a purchase decision informed by the due diligence (DD) findings, instead of waiting on financing approval.
In fact, prospective lenders frequently have their own set of requirements for borrowers that intertwine with due diligence activities. By applying for financing while simultaneously conducting commercial real estate due diligence, buyers are positioned to proactively meet lender demands. These may include the submission of particular environmental reports or other specific information from the commercial real estate due diligence checklist. Lender requests often involve details directly linked to the due diligence checklist, emphasizing the importance of thorough and comprehensive due diligence work.
Conclusion: The Vital Role of Due Diligence in Commercial Real Estate
In conclusion, the Commercial Real Estate Due Diligence Checklist is an indispensable tool in the world of real estate investing. It ensures that all potential risks are assessed and managed before finalizing a deal. Due diligence covers a wide array of areas, from financial and legal aspects to property and tenant evaluation. This thorough process not only aligns investment decisions with the investor’s risk profile but also paves the way for successful and informed property acquisition. Remember, in commercial real estate, the value of due diligence cannot be overstated — it is the bedrock upon which savvy investment decisions are made.
FAQs About Commercial Real Estate Due Diligence Checklists
What is the main purpose of a Commercial Real Estate Due Diligence Checklist?
- The main purpose is to identify and analyze potential risks and issues in a real estate transaction, ensuring that the investment aligns with the investor’s risk-return profile.
How long does the due diligence process typically take in commercial real estate?
- The due diligence process in commercial real estate typically lasts between 30 to 90 days, depending on various factors like the complexity of the deal and the efficiency of the buyer’s due diligence process.
What are some key components of the due diligence checklist?
- Key components include financial and insurance reviews, title and zoning checks, legal evaluations, property inspections, and tenant/leasing analysis.
Can the due diligence process impact the financing of a commercial real estate deal?
- Yes, the due diligence process can significantly impact financing, as lenders may have specific requirements that are addressed during due diligence.
Is it possible to negotiate the due diligence period?
- Yes, the duration and specifics of the due diligence period can often be negotiated as part of the Purchase and Sale Agreement (PSA).
What happens if issues are found during the due diligence process?
- If significant issues are discovered, it can lead to renegotiations, price adjustments, or in some cases, termination of the deal.
Who is involved in the commercial real estate due diligence process?
- The process typically involves a range of professionals, including real estate agents, lawyers, accountants, and environmental consultants, among others.