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Due-diligence process requires solid detective work

by  | Corporate
Posted:     Updated: Nov 25, 2015  11:29 ET
 
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Due diligence is generally defined as the process of researching and gathering information about a business transaction. In commercial real estate, the due diligence is focused on evaluating a property to make sure that you, the buyer, know exactly what you're getting as part of the transaction.Commercial Loan Application

As the prospective buyer of a property, the due-diligence process helps you determine whether the purchase of a property makes good business sense. It's like a detective story. You want to uncover the mystery behind the property and determine whether the real estate and its profit-making potential are what they seem.

The preliminaries

In a typical transaction, a buyer will make a formal offer on a piece of property that is contingent on completion of the due-diligence process. Often, buyers will put a deposit in escrow that can be applied to the purchase when the deal closes, or it goes back to the buyer if the buyer backs out of the deal by a specific date. The amount of time that the money is in escrow is the due-diligence, or inspection, period.

The process becomes formalized once you've made an offer to purchase a piece of commercial real estate, but due diligence often begins much earlier. Consulting with Realtors, attorneys and colleagues to learn about property values, rents, demographics and market dynamics are all part of the information gathering process.

Documentation

Once you decide an offer is in order, the next phase of the due-diligence process involves gathering and studying an extensive amount of information provided by the seller. How extensive is up to you, but the more information you have and the better you understand it, the better your chances of avoiding surprises at closing or, worse, after you've assumed ownership of the property.

Some of the basic information that you will want to obtain and evaluate as part the due diligence on any income-producing property includes the following:

  • The balance sheet and financial records for at least the three past years;
  • Monthly profit and loss statements for at least the past year;
  • Rent roll, including lease copies and payment history;
  • All existing loan documents, including closing statements, notes, deeds of trust, title policy, rate riders, etc.;
  • Utility and insurance bills as well as property-tax bills for at least the past two years;
  • A physical inventory of equipment and supplies; and
  • An estimate of operating costs, such as trash-collection contracts, management agreements and payroll records.

Gathering the information is, of course, only the beginning. There's plenty for you to study as you evaluate a potential deal, and it pays to be thorough. You're looking at the property's ability to make money, of course, but also on the lookout for red flags that might indicate the property is not everything it seems.

Pay particular attention to the leases, real estate investment site CREonline advises. Is the owner committed to making any concessions or property improvements? If so, have they been completed? Take a look at how long tenants have been in place. Is there a chance that the owner filled up the property recently with less-than-stellar tenants to improve the occupancy rate?

First-hand evaluation

Direct observation also is a crucial part of the due-diligence process. Look over the property in person, and talk to the seller about any concerns.

You also can dig a little deeper as part of the information-gathering process by employing a legal document known as a tenant estoppel certificate. The certificates, or affidavits, are designed to document the relationship between the existing landlord and tenants — and can help to expose any misunderstandings or conflicts in that relationship. Like much of the other information gathered in the due-diligence stage, estoppel certificates are often required as part of the documentation in a loan-approval process.

The estoppel certificates come into play late in the property-purchase process — after an initial look at documents makes the deal seem promising — but before the final sales agreement and closing of the sale.

Another later-in-the process consideration is environmental inspections and surveys. Standard environmental-site assessments can identify problems with asbestos or other property contamination. Extensive environmental inspections are normally necessary for properties transactions involving current or former sites of industrial facilities, gas stations or automobile dealerships. Less-extensive environmental inspections are often enough for deals involving multifamily dwellings that have not been exposed to possible groundwater contamination, such as pollution caused by underground tanks.

End game

The final due-diligence steps include activities generally associated with the closing of any property sale, including title searches, property-tax payment verifications and proof that any necessary licenses, permits and zoning variances are in order.

Once the detective work is over, you should have a feel for whether the property you're considering is a good buy, as will your partners, investors and prospective lenders.

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Bill Lewis is editor of Scotsman Guide Commercial Edition. Reach him at (800) 297-6061, or bill.lewis@scotsmanguide.com.

Topics: Commercial lending | Commercial underwriting
More by: Scotsman Guide Media

 

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Due-diligence process requires solid detective work

by Scotsman Guide Media | Corporate
Posted: Nov 25, 2015  11:27 ET    Updated: Nov 25, 2015  11:29 ET

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