Top 9 Due Diligence Contingencies in Commercial Real Estate Transactions
Written by Mark Hulsey
Every real estate investment professional understands the “money is made on the buy.” It’s about nailing it at the acquisition phase which is often focused on the purchase price and for good reason. But we’ve come to learn over the years that the sales price is only as good as the due diligence the transaction must stand up to.
Before managing the due diligence contingency process, a quality commercial broker needs to understand how to properly negotiate due diligence within the sales contract. If a due diligence item becomes a requirement during the contingency period and it’s not addressed in the sales contract, it can kill the deal. All parties to the transaction need to clearly understand the needed due diligence that must occur within specified timeframes. It’s not uncommon for us to meet a commercial property owner who does not know what a Phase I or ALTA Survey is, much less have a copy in their file from when they purchased the building. Due diligence is not the most thrilling thing to talk about amidst the excitement of buying a building.
At RE/MAX Results Commercial Group, our brokers understand the hard work starts after the sales contract is signed. Effective due diligence management is critical to every deal and it begins upon the delivery of the purchase sales agreement. Escrow is opened, the title commitment ordered, property investigation studies are ordered and we’re working on price quotes for all of the due diligence resources required. That’s just the beginning. Due diligence is expensive and can be time-intensive. However, failing to do proper due diligence can be far more expensive.
Before I go into the Top 9 Most Common Due Diligence Items, let’s discuss a few key points. First, it’s important to know that if the property sale is going to have debt put in-place, then the buyer’s lender is going to be critical in determining what due diligence items will be required for their underwriting team. Second, each product category within commercial real estate has different due diligence requirements. Managing the due diligence process for a 50 unit apartment building is very different than a 65 acre land site zoned I2. Working through due diligence on a net-lease investment (NNN) is very different than a standard commercial deal.
Bear in mind, the world of commercial real estate due diligence is enormous. The more you learn, the more you realize you have to learn. It’s nearly impossible to do this subject justice by discussing only the most common due diligence items, when each discipline within the due diligence spectrum is a deep specialty in and of itself. Regardless, the following items are the most common everyday due diligence issues we address with nearly every commercial investment property sale.
Now, let’s get down to the countdown.
1. Review of all property documents in the Seller’s possession
First things first, every buyer needs to start with the documents that the seller currently has in their file including the survey, leases, title policy, notices from the city, etc. Not only is the information contained within these materials critical, but knowing what actual documents the Seller has in their possession is essential. For example, if there’s no need to order an ALTA survey when one exists in the file, that saves time and money for everyone.
2. Income/Expense, Lease & Estoppel Certificate Approval
For commercial investment assets, it’s all about the numbers and the quality of tenant in addition to their term. We need the real numbers to complete the financial underwriting and confirm assumptions made during the negotiation sales process. Rent rolls, Schedule E’s, P&L’s, Balance Sheets. Understanding every detail of every lease is essential. Here too, one poorly written or negotiated lease can easily cost the deal. After all, the purchaser is buying the leases, the income and the liability that comes with it. We work closely with real property attorneys for the lease review process.
3. Physical Assessment Report
This is the property inspection report which may include a single commercial building inspector going through the property top to bottom. Or, it may include taking through a series of building specialists for their respective opinions on building systems like the roof, HVAC, parking lot, or structural issues. Often during the physical assessment building inspection period, architects and contractors will also review the site for verification of usable square footage and to outline the capital improvement costs & project timelines. On most commercial transactions during the physical inspection period, we are looking for deal-killers big problems, not the leaky faucet in the restroom.
4. Environmental Studies: Phase I & Phase II
This is getting more complicated every day. As new laws are passed that have an impact on building owners regarding environmental issues, buyers and their lenders are challenged to find the balance between comprehensive environmental studies and not overreaching and spending tens of thousands of dollars on something that may not be 100% required now or later. This is a moving target in every deal and environmental risks need to be understood on a case by case basis. Plus, not all commercial transactions require a Phase I or Phase II. On smaller transactions, say $500,000 or less, where there are no known red flags for environmental issues, many lenders will only require a Seller Environmental Questionnaire.
Depending upon the type of property, the buyer’s intentions for the property , or lender involvement will often dictate if a survey is needed. Then it’s a matter of determining the type of survey (ALTA versus Certified; Standard Boundary) and the additional endorsements that may be required as part of the transaction. This is where an experienced real property attorney working with a first-rate title company can make the transaction smooth and simple for all parties.
6. Zoning Use Verification
While it’s rather simple in most commercial transactions to verify if the Buyer’s intended use will meet the current permitted zoning requirements, but sadly this actually falls between the cracks in some transactions. That’s the epitome of due diligence failure by the real estate broker. If the property’s use does not fall under a permitted use, then a Conditional Use Permit, CUP, is required or even possibly a re-zoning request. Most of the time, rezoning is not a practical solution, but that is determined by working closely with the municipality’s zoning department which is usually very cooperative in providing zoning & use direction.
7. Property Compliance Verification
It’s essential for every buyer of any property to fully understand if the building is fully compliant with all governing jurisdictions. What’s that mean? Does the building have a current Certificate of Occupancy? When is the next inspection date? What about outstanding items that need addressing before the sale? Rental License in-place? Is a Point of Sale inspection required by the municipality? Did the Seller have the proper permits pulled for the work completion? Have all permits been closed prior to closing? If these questions are not answered before the sale is completed, the consequences can be very expensive for the buyer.
As we all know, if there are title issues, there’s no closing. Title issues must be cured. Sometimes it’s fast and simple. Sometimes, it’s complicated and litigious. Regardless, it starts with the title commitment immediately following the delivery of the fully executed purchase sales contract. The title commitment will tell the story. As with most specialized areas of real estate, title is a world in and of itself. It requires title experts and legal guidance. The real estate broker needs to have a clear understanding if a title policy can be put in-place or not. This is not something that can wait until a few days before closing to take seriously. Title issues can delay closings for weeks or months, if it doesn’t kill the deal completely.
9. Lender Underwriting & Appraisal Approval
Usually, this is the last and final due diligence contingency that must be removed after all other due diligence work is complete. The lender has done all of the back-room work, the appraisal is complete, and the loan committee has provided their final loan approval. The deal is now clear-to-close and often times the lender’s Written Statement is delivered notifying all parties the transaction can be closed and funded. In every transaction involving a lender, the broker will always be working closely to know what the lender needs for all of their underwriting requirements and the associated timelines. Good communication is imperative between all parties to be sure all the i’s are dotted and t’s crossed. Last thing you want to find out is that the lender needs a Phase I and it’s only a week until closing.
While there are a number of similarities between residential and commercial real estate due diligence, commercial deals are generally much more due diligence intensive. Commercial brokerages must have the systems & tools in-place for accurate due diligence project management. The due diligence process does not have to be difficult or challenging, just properly managed on behalf of both the buyer and seller.