Commercial Real Estate Due Diligence
After having a great discussion during my last class on Commercial Real Estate Due Diligence, I wanted to take this opportunity to share with you some of the key takeaways. This article is intended mainly for apartments/multi-family, however many of the same principles will apply across different areas of commercial real estate. I’ll start with a brief overview, then dive into each topic a bit more, and finally leave you with my powerpoint presentation that gives an overview of the topics I covered in my class. It is my hope you will add many of these ideas to your property analysis toolkit.
What is Due Diligence?
Due Diligence is a necessary part of any real estate transaction.
- It is the process of examining a property, related documents, and procedures conducted by or for the potential lender or purchaser to reduce risk.
- Applying a consistent standard of inspection and investigation to determine whether actual conditions reflect the information represented.
- The process by which you confirm that all of the facts of a deal are as they have been represented to you by the seller.
Conducting proper due diligence can be the difference between turning a profit or suffering a financial loss in a real estate transaction.
If you’re new to commercial real estate transactions, I recommend that you consider bringing in someone with more knowledge. It’s OK to admit you need help. Getting help from an experienced commercial real estate broker can add a lot more money to your pocket and make the process much easier for all parties involved.
Start With Initial Due Diligence
Once you’ve found your target property, begin by requesting all of the information in the seller’s possession (expense reports, property records, profit and loss statements, etc…). Often you will find on smaller to mid-sized apartment buildings that owners do not keep detailed records. This means you will need to do a little more investigating to get the accurate expense numbers.
Talk to the current tenants about things that are wrong with the building. Ask how long have they been there, if they are happy with things, what’s the neighborhood like, etc.… Current tenants can be a tremendous resource for learning about a property. If there is a current property management company in place, ask the tenants how responsive they are to their needs. A lot of times it’s easier to keep the same management company in place for the first few months of acquisition if they are doing a good job. Talk with the maintenance people about matters not tended to or problems that will have to be fixed in the future. They are often going to be more honest than a seller would about the actual condition of the property.
Financial Due Diligence
- Review the profit and loss statements (P&L). Make sure you pay extra attention to any areas where significant gains or losses occurred and try to spot any discrepancies.
- Underwrite the property. Never take a seller and brokers provided pro forma at face value. Their numbers are usually a smaller look at the property and might not reflect how the financial performance of the property in a few years time.
- Look at rent and sales comparable in the area.
- Since your evaluation of the property will depend upon income today and tomorrow, the accuracy of the historical data, as well as the validity of projections, will significantly alter your potential financial return.
- Look into the rent roll and leases including the terms, deposits, and payment history.
- Be aware of handwritten changes to the leases
- Get written confirmation or an Estoppel Certificate from the tenants if you can’t read the document or if the statements are unclear.
Tenant Estoppel Certificate
- An Estoppel Certificate is a statement signed by the landlord and tenant that states that particular facts are correct, that there are no defaults, and that rent is paid on a specific
- Look for rent concessions
- Are the security deposits mentioned in the lease the same as those outlined in the rent roll? (This is usually a problem area)
- Cross check the rent roll against the income statement.
- Get a lease abstract. This is a summary of the essential financial, business and legal information that exists in a commercial real estate lease. It should bring to the reader’s attention any important lease provisions, financial obligations or other issues of importance.
- Always add your property management fees back into your expenses. Quite often, the current owner could be managing it and won’t factor that cost into their expenses, which could make the NOI appear higher than it would be if you bought it.
- Reconstruct the financials on your own… add things back like long-term capital improvements (HVAC, electrical, roof, cabinets)… then show how that would affect your financials as you spread those costs out over time.
- Recommend taking CCIM classes for understanding the financials and underwriting a property.
If you’re an expert in the location you’re interested in; you may still feel comfortable buying a property without the expense reports because you’re familiar with what expenses should look like. This is another reason why having an experienced broker could help because sometimes you will find properties that could be good deals but may lack proper financial reports.
Make sure you’re comfortable with the deal above all else.
Here is my quick financial due diligence checklist
Physical Due Diligence
- Walk every unit. It sounds like common sense but make sure you take a look at everything.
- Don’t trust the seller/broker to tell you the unit is in perfect condition.
- As you walk the units, I recommend using a “walkthrough sheet.” I have included a sample in my PowerPoint, which you can find at the end of this blog post. If you would like the full checklist, please let me know if the comments below.
- As you walk the units, assess the overall condition of them. Take inventory of things that need to be addressed, breaking it into what must be fixed and then a “wish list” of items you’d like to get to eventually.
- Look for any warning signs or safety concerns.
- Are there any tenant concerns? Things like hoarding, multiple pets, an excessive number of occupants, unapproved alterations, illegal activity, …
- Building inspectors are never a bad thing to have. Often you’ll get your money back in the deal.
Legal Due Diligence
Here are some necessary things you’ll need.
- Title inspection and survey
- Environmental inspection (typically paid for by the buyer)
- Inspection for building code violations. This is critical for understanding any potential hazards or areas that need immediate addressing.
- Checking to make sure that the property is in zoning code compliance
When using AIR Commercial Real Estate Forms
- Seller Mandatory Disclosure Statement (SMDS)
- Property Information Sheet (PIS)
- Tenant Estoppels (TEC)
- Commercial Property Owner’s Guide to Earthquake Safety (pre-1960 buildings)
AIR is a leading, member-owned real estate network. From contracts to networking and education, they’ve been helping commercial real estate professionals for years. Developed by top commercial real estate experts, AIR CRE Contracts are recognized as the industry standard, and the most efficient way to close a deal. I highly recommend you look into becoming a member as they offer over 50+ contracts that you can use and edit to your own needs. Learn more by clicking here.
When using CAR (California Association of Realtors) Residential Income Purchase Agreements
- Know Material Facts
- Seller property questionnaire (CAR Form SPQ) or Exempt Seller Disclosure (C.A.R. Form ESD) if TDS-Exempt
- Commercial Property Owner’s Guide to Earthquake Safety (Pre-1960 Buildings)
- Tenant Lease Agreements
- Tenant Estoppels (TEC) if agreed in the contract
- Survey, plans and engineering documents, if any, prepared on seller’s behalf or in seller’s possession.
- Permits and structural medication documents – if in seller’s possession
When using CAR Residential Income Purchase Agreement (cont’d)
- Lead-based paint pamphlet and form
- Applies only to residential property built before 1978
- Natural and Environmental Hazards
- Seller is required to disclose if the property is located in a special flood hazard area; potential flooding (inundation) area; very high fire hazard zone; state fire responsibility area; earthquake fault zone; seismic hazard zone; and (iii) disclose any other zone as required by law and provide any additional information needed for those zones. These are satisfied with an NHD Report.
- Withholding Taxes
- Seller shall deliver to the buyer or qualified substitute, an affidavit sufficient to comply with federal (FIRPTA) and California withholding law (C.A.R. Form AS or QS)
- Condominium/Planned Development Disclosures
- Seller has seven days (standard) after acceptance to disclose to the buyer whether the property is a condo minimum or if its located in a planned development or other common interest subdivision.
Click here to download the CAR Sales-Disclosure-Chart
The California Association of Realtors (CAR), is real estate trade association to develop and promote programs/services that enhance a member’s ability to conduct business with integrity and competency. They have many tools designed to help you thrive in your real estate career. From their zipForm transaction tools to their education courses and more, they are a great resource. Learn more by clicking here
Thank you for taking the time to read this article. I hope you found it helpful. As always, please leave any thoughts or comments below. We hope you will join us for our next class on “Don’t Take Cap Rates At Face Value” on Thursday, May 31st.
Stay up to date with all of our upcoming real estate classes by clicking here. We offer one class a month that covers relevant and important commercial real estate topics.
Curtis Gabhart and Gabhart Investments, Inc – 2018 All Rights Reserved
The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of Gabhart Investments, Inc. The material contained in articles that appear on gabhartinvestments.com is not intended to provide legal, tax or other professional advice or to substitute for the proper professional advice and/or commercial real estate due diligence. We urge you to consult a licensed real estate broker, attorney, tax professional or other appropriate professionals before taking any action in regard to matters discussed in any article or posting. The posting of an article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
The HARP2 program, combined with the $25B bank settlement (providing $20B in loan modifications), will save some underwater mortgages from foreclosure and help long-term market stabilization. However, part of the bank settlement requires banks to adopt standardized (and hopefully more efficient) servicing and foreclosure processing measures. I think better processing, combined with the sheer volume of underwater mortgages is going to keep the short sale floodgates open for quite some time.
According to researchers at CoreLogic, a leading analytics firm, 11.1 million or 22.8 percent of all residential properties in the United States were worth less than the amount their homeowners owed on the mortgages used to purchase them.
The federal government originally rolled out the HARP program in 2009 to help homeowners who were underwater or near underwater. However, the program was recently broadened to reach even more borrowers. Originally, HARP applied to 895,000 underwater borrowers; and now HARP II is expected to help up to double that amount. According to HUD, about 400,000 homeowners have taken advantage of the program since it launched in April 2012…that’s less than 4% of underwater mortgages.
HARP II allows underwater homeowners who are continuing to make payments to refinance their loan. The new program offers a number of advantages over the original HARP loans. First off, there is no loan-to-value or combined loan-to-value restriction on fixed-rate loans with terms of 30 years and under. In other words, it doesn’t matter how upside-down borrowers are on their mortgages. Previously, there was a cap that restricted borrowers who owed more than 125 percent of their home’s current worth from accessing the program. In addition, an appraisal may be waived if a value for the home can be automatically generated, and the borrower only needs to have a 620 FICO score.
There are three main components to qualifying for a HARP II refinance loan. The first requirement is that the loan must be owned by either Fannie Mae or Freddie Mac. Second, the loan must have been sold to Fannie or Freddie before June 1, 2009. Third, a HARP II refinance must benefit borrowers in at least one of four ways:
- Reduce the loan’s monthly principal and interest payment.
- Reduce the loan’s interest rate.
- Reduce the loan’s amortization term.
- Transition the loan to a more stable type of loan. (i.e. interest-only to fully-amortizing, adjustable-rate to fixed-rate, 30-year to 15-year).
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We attended this yearsÂ 12th Annual Residential Real Estate Conference at the University of San Diego and here is a quick summary of the event.
For both California and San Diego, the forecasts for 2012 are predictingÂ onlyÂ a slight decrease in the number of distressed homes and flat prices due to
- Low consumer confidence
- Tough credit qualificationsÂ
- Lack of hiring by employers.Â
We are not yet at a long term equilibrium in home ownership rates and many more “strategic” defaults are in the pipeline for the banks & a higher % of distressed inventory is selling as short sales vs. REO. This strategy is helping banks minimize their losses and are processing the short sales in half the time.
At GII We can attest to all of this through our deals. It appears that not only will our single-familyÂ renovate and sellÂ strategy fit the market conditions in 2012 it may be time to start buying and holding more properties.
Highlights from Fannie Mae chief economist Doug Duncan, PhD:
- New housing starts at long term rate for household formation by 2015
- 20% of us home values are underwater
- 0% growth in small business hiring in 2012
- 1.6% growth in US GDP in 2012
- Gdp is at prerecession levels but employment has not recovered and will remain at same level through 2012
- 75% of americans think economy is headed in wrong direction
- Reaching levels of historical % of ownership and rental properties
- Long term home ownership level expected to be 65%
Highlights from USD Assistant Professor Ryan Ratcliff, PhD:
- 12% unemployment rate in CA
- SD nonfarm unemployment increased 7%Â and has only declined 3%
- CA average resale home price down 5% year over year
- SD resaleÂ prices have only declined slightlyÂ year over year
- $100-300k is the price range of most distressed sales in 2011 in San Diego
- Best CA employment gains were in high tech and business services, worstÂ sectors wereÂ manufacturing and construction.
Highlights from USD Associate Professor Alan Gin, PhD:
- Best SD employment gains were in health care services, admin. and support services, real estate and hospitality (theme parks)
- SD gained 24k jobs in 2011
- SD unemployment rate dipped just below 10%
- Gin’s local consumer confidence indicator is down 2% in SD
- Job growth in SD expectedÂ to beÂ 15-20k inÂ 2012
- 5k home and multifamily units authorized in 2011 – up from 3k in 2009 and 3.5k in 2010
- 2.5k of the 5k in 2011 wereÂ multifamily (comprised mostly from a couple big projects – this is up 128% from last year
Burnham-Moores Center Presentation Slides
Presentations from the 12th Annual Residential Real Estate Conference,
December 13, 2011:
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