In this post, we are going to be reviewing what is due diligence, what types of questions you should be asking during the due diligence period, and what documents you should be getting from the seller. I am not going to go over the entire due diligence checklist because that is a very long checklist. This is just a very brief overview of some of the items that you will need as you’re going through the due diligence report. In addition to what we will cover today, you’ll also need to be scheduling inspections (which we covered earlier on a couple of other podcasts). What we will be talking about today is just some of the basic items, typically you will have a very extensive list depending on the size of the property.
What is Due Diligence?
It’s a term that you will learn when you are buying your first commercial property, it happens after your offer was accepted and that means that you have a specific number of days to review all the documents that the seller has on the property, schedule all types of inspections and reports, compare rental rates that are ongoing in the market, as well as sales comparables to make sure that you are paying the right price for the property.
If you Google what is due diligence, Google says that due diligence is the “reasonable steps taken by a person in order to satisfy a legal document, especially in buying or selling something”. It’s a comprehensive appraisal of a business undertaken by you (the prospective buyer) to make sure that the assets and the liabilities are correct, and make sure that this is an actual good deal for you to purchase or not. You typically have, depending on the market, 15 days at the very, very minimum to do all of your due diligence, all the way to 30 days, 60 days, sometimes 90 days. If the deal is really, really complex, it can take six months, nine months, or even one year.
If you get in contract to purchase a property and you get 30 days to do your due diligence, and then you realize that you need more time because you were not given all of the paperwork on time, or that the seller took longer than expected to give you some off the actual paperwork, you can always ask for an extension, which is what we did on my first offer. It was an old, old movie theater that I talked about in a few of the podcasts, and we had to extend the due diligence twice by two weeks each time, so we had to extend it by another 30 days total because it was a very old building and it was taking a little bit of time to get responses from the city, as well as some of the inspections done. The seller was also taking a little bit of time to give us some of the required paperwork so it is always possible to get an extension, as needed.
What are some example items that you need to cover during the due diligence process?
Now that you know what due diligence is, let’s cover some of the items that you will need to get during that timeframe. Note that there is a ton of different things that you should be asking for, and depending on the asset class that you invest in, you are going to be getting a few more items, or different items than the ones I’m going to describe to you. What I’m going to go over today was for a retail property and a lot of these items could also be used for most purchases. With that in mind, let’s start with what you should be asking the real estate agent as soon as you get in contract to purchase a property:
– The number one thing you should know is who is going to escort everyone to the property, you will have contractors coming over to do inspections and some reports, so you need to know who will be helping these people get in the property.
– The seller’s agent should also provide you with a contact sheet for who is the escrow agent, who is the escrow officer, their phone numbers in case you need to get in contact with any one them.
– You are going to be asking for referrals for structural engineers, architects, roof inspectors and this could be from your own real estate agent because they are familiar with that city and they can refer you to the right people that they have used in the past.
– Sales comps for the area from your real estate agent, and this is for you to understand if you are paying a fair price for the property. How you determined that is by looking at the price per square feet. Prices can vary greatly based on location, so you need to take that into consideration as well. For instance, one of the sales comparables can be three blocks away from your property. However, if you have a property that sold on the main street, it’s definitely going to be more expensive than something that is outside of the main street, and your real estate agents will be able to help you with that.
– Lease comps for the area (also from your real estate agent), if you are purchasing a retail building or an office building, you want to know how much the leases are going forward in that area per square foot, since this will be part of your financial calculation as well.
– You are going to be confirming how many parking spaces there are in the property. For retail and for office you will want four parking spaces per 1000 square feet of property that you’re buying. This is just a standard number in the industry. If you’re buying an industrial building you can definitely have a lot less parking spaces because for an industrial building you will have a lot less people and employees going there per square foot, so that number changes if you are purchasing something that is an industrial building.
– If part of the property has been for lease for a while or some offices have been for lease and there have been a few people that reached out to try to lease it and get more information about renting that property, you want to ask for the contacts of all of these people so that you can follow up with them or so that your leasing agent can follow up with them. We’ll be following up with them in order to try to get some of these leases signed throughout the process, or after you close on the property.
– The title company will provide you a title report on the property showing if there are any liens on the property, and you should send that to an attorney to review. You will be in communication with the title company in order to follow up with any pending items on the title reports that should be removed from the title report prior to closing on that property.
– You’ll need a copy of all of the leases that have been signed for this property. If you’re buying an office building or a retail building, you really want to make sure that your read every single lease and all of the red lines. If you have two national tenants there for example, let’s say you have a Starbucks and you have a Chick-Filet, they will likely require the owner of the property to use their own leases, so Chick-Filet and Starbucks will give their own lease to the owner of the property and then they will negotiate from that. On the other hand, when you’re dealing with smaller tenants, you are the one who will be giving them your lease and then the negotiation will happen from there. So you really want to make sure that you have a copy of every single lease, and that you understand everything that is being said and that was redlined on these leases.
One of the most important things that you need to watch out for when you buy this property, is that the property taxes are going to go up. This cost needs to be accounted for you and for your tenants because in retail, your tenants will probably end up paying for that additional cost. However, a lot of national tenants negotiate their leases by having a clause that says that they will not pay any additional taxes if the property is sold at a higher price than the current owner has paid for (or that there’s a limit on the property tax increase). This is very important and can really damage a lot of financial calculations. This also goes for office leases where the owner is responsible for paying the taxes, it’s really important that you account for that tax increase cost in your financial analysis.
– A breakdown of every single expense that the property has, and for most of these expenses you will want a two year history of all of the bills. For example, you have electricity bills that you need to look at for the last two years and make sure that you understand by how much it has been going up yearly. You’ll also want to understand the maintenance costs over the last couple of years because some months are higher and some months are lower.
– You need to find out if there has been any deferred maintenance. Sometimes the roof will be pretty old and is going to be your responsibility to fix it, so you need to definitely make sure that you understand everything that has been deferred in order to add these things to your financial analysis.
– Find out if there are any issues with drainage on the property.
– Find out if there are any easement agreements. Easement agreements are basically an agreement between you and usually your neighbor to use your property so that their customer’s can get to their property, or vice versa. If there are any easement agreements, you also need to get a copy of that as well.
– Get a description and the model numbers for all HVAC units (heating, ventilation and air conditioning). Sometimes you’ll also need a two year history of their maintenance. Here you’re going to find out if you should also be changing some of these HVAC units or not.
– You will need to find out if the restrooms are ADA compliant or not (Americans with Disabilities Act), meaning all restrooms should be ADA compliant. Sometimes, if the property does not have an elevator and it has more than one floor, you might be required to put on elevator, but you will also have to check with the city. And if the city will require you to put an elevator after the property is sold, you are going to add this into your costs.
– Get a copy of all of the leasing commission documents for all of your leases. For commercial properties you’re going to have a leasing real estate agent who leases out the vacant units. There will be an agreement with that real estate company to lease those vacant units for you. So you need to know if you owe them any future commissions for existing leases or not. This is also for you to be able to put that in your financial document.
– Get a copy of all ADA work done or needed to be done. If they have made their restrooms ADA compliant, are their elevators ADA compliant or not.
– How often is the parking lot swept. Here you will understand how often is the property maintained, and if you need to increase that or decrease it and either way you go, you’re going to have to add or remove that in your financial calculations.
This is the very, very basic list of due diligence examples that you are going to have to request from the seller, from the seller’s real estate agent, you’re also going to be working with the title company and your attorney on all of these items. That is why typically a due diligence period takes at least 30 days and sometimes it can go to 60 days or a lot longer if the property is a lot bigger or more complicated. As you are walking through your first purchase, there will be more due diligence items that you are going to need to get at the end of the day. But this is a very good start, just so you can get a very good idea of what you will be working with in this super exciting journey!