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.
By: Curtis Gabhart, CCIM
Here is a quick recap of some things I look for when doing a quick inspection of an apartment building or even a single family home and common issues I come across.
I like to do a quick review to the outside condition of the property in order to gain insight as to whether it warrants further consideration for purchase or investment.
Now, before getting into the details, let me summarize the most important factors regarding the physical condition of a property.
Some of the important visible considerations are:
- Reviewing the foundation and cement
- Checking the siding
- Reviewing the sprinkler systems
- Analyzing the quality of the landscaping
- Looking at the windows
- Looking at the roof
- Inspecting at the front door
- Looking at the gas meters
- Looking at the train gutters
- Reviewing the quality of the paint
- Looking at the overall neighborhood
When buying a property, whether it’s an apartment building or single-family house that you may plan on flipping, some of the concepts are going to be very similar, if not identical. With many investment properties, you will find an inside inspection is subject to an accepted offer. This means you will need to make some assumptions about the property before you submit your offer. This can prove difficult, especially when you’re not able to view the inside.
I’ll look from the ground up – I’ll start by looking at the ground and taking an overall look at the condition of the property to see what level of care has been maintained. As a general rule, if it’s a piece of shit on the outside, it’s probably a piece of shit on the inside. There have been a few exceptions where I’ve been pleasantly surprised when I got inside a property, but that’s exactly what they are – exceptions. I’d use this analogy as a general rule of thumb – if you see a car that looks junky on the outside, it probably just as junky on the inside.
Foundation – I’ll look at the foundation, all the cement on the ground near the foundation, and all landscaping near the foundation. I’m looking for things like sprinklers spraying on the building. I’ll then check if there is stucco peeling off the building, which can sometimes indicate moisture intrusion into the building. I’ll also check if the ground is sloping towards or away from the building; it should be sloping away from the building. If it’s sloping towards the building, it may indicate that a possibility of having a foundation or other problem that relates to water. If there’s cement, I’ll look for big cracks in the cement, which sometimes can indicate unstable soil or cracks in the foundation.
This could indicate further foundation issues
Landscaping – what is it going to cost me to improve the landscaping, what do I need to do to it, are there sprinkler systems, and are they automatic or non-automatic?
Building – what kind of siding is there? Is it stucco, brick, vinyl, wood? I pay close attention to the condition that it is in. If it’s wood, I will check for visible water or termite damage.
Eaves – Does the wood going into the eaves have damage? If there’s a lot of damage in the eaves, it very well could go into the attic rafters, which could be a lot more expensive. If it’s on the siding, what kind of siding is it? If it’s an old building, a lot of times replacing siding can get very expensive for two reasons:
the eaves is the part of the roof that meets or overhangs the walls of the building
- First is the fact that you may not be able to find that particular kind of siding anymore without having it specially milled.
- Second is anytime you pull something off an old building, you’re very likely to find unforeseen surprises. Because you can’t be certain of the magnitude of these surprises, it is safe to assume everything is going to cost you a little more than you think. Whatever you think the price is, assume it probably cost more than you originally estimated.
Windows- Are they new or old? If it’s an old building, are they wood sash or aluminum windows? Is that something that’s going to need to be replaced? Typically, the double-wood-hung windows that you see in houses or old apartment buildings are not in very good condition. With aluminum windows, I essentially just look at them and decide if I’m going to replace them or not. What you need to be aware of is in many areas where you replace these windows, there may be architecture review committees that require you to replace them with historical windows. This could prove to be very costly, especially if they are wood sash.
wood sash window
Building Corners – Does everything appear straight? If there’s siding, are the lines of the siding vertical or are they all straight? On the corners of the building, what does the wood look like? Is there stucco coming off?
Roof – Does the roof have something called a drip edge? This is a little metal edge that goes into the lip of the shingle roof. Are there rain gutters? If there are no rain gutters, water may not have been running away from the building. Because of this, I will spend more time thoroughly inspecting the foundation.
I look at the shingles of the roof; if there are many noticeable curved edges, it is likely on its last leg. Then, if I think I may need to replace the roof, I will look at how many layers of roofing there are. Typically, you don’t want to go past two or three layers of roofing. What that means is that if you replace a roof that has two or three layers, you need to put in your budget funds to tear off that existing roof before replacing it. You also will need reserves for unexpected issues when you pull of the old roof because you may need to repair the plywood underneath. Depending on how much work you do around the roof, you may have to re-sheet it.
re-sheeting a roof
Fence – Do I need to replace or paint it? Is the fence wood? Is it leaning, does it look like it’s on my property line, does it look I could add private yards for apartment units? Many times, you will find large open areas in the back of apartments that are shared. What we can do is put up a fence around the units and now each unit has their own backyard – a very inexpensive fix that not only can help you get higher rent but can reduce costs because you may not have as much landscaping to maintain
Paint (for older buildings) – If it’s pre-1978 and you have peeling paint, you’re probably going to want to get a lead-based paint test conducted. That’s going to tell you whether you’re going to need to do any kind of abatement or work on the property. If work is needed, you may need to use lead-based paint best practices, which can prove very costly. I usually recommend getting a test. Paint used in older buildings in San Diego is less likely to have lead in it compared to the east coast, where the weather is harsh and requires more durable paint. Most of the properties I have tested did not contain lead, but it is still important to get it tested.
If it is tested and comes back negative you do not need to follow lead based paint best practices. If you have a pre-1978 property and decide not get it tested, you still must work on it like it contains lead based paint – which is a good reason to get it tested in the first place.
peeling lead-based paint
Click here for information on lead-based paint best practices
Front Doors – Aesthetically, are they looking good? Are there any gaps? If I look at top of door, I will look for a little pie-shaped gap at the top. If this is present, it indicates there may be some settling in the property.
Meters – Is it gas or electric? Are there gas meters for all units? If the property runs on gas and there is one water heater, there should be gas meters for each unit and also for the building.If it’s a multi-unit building, I count how many individual meters there are. There should be as many individual meters as there are units, plus one additional one, which would be for the common area. If you’re missing a meter, you may have something called a bootleg property, which means one of the units may have been put in unpermitted (just something to look at). These are important things to note because in San Diego the tax assessor will charge for all the units, and state on the public website that it is X units, but that does not necessarily mean they are legal units.
Electrical – As far as electric meters go, I’m looking at what kind of panel it is. If it’s old, it could be something called knob and tube, which could indicate that I’m going to have to put a lot of money into upgrading the electrical. This will likely increase the interior costs as well. I then look at the circuit panel – is it updated? Then, I’m looking at how many amps each unit has. Ideally, you want 100 amps, but for many apartments, you’ll have between 30-50. Newer apartments should have 100.
Knob & Tube Wiring
I’m also looking at the type of panel; Murray Lampert typically have problems, so I want to check what kind of panel there is. Are there circuits in the units? Is there any room to add additional circuits if you want to add appliances or anything else inside the property? Is the inside of the panel painted? If so, it could indicate that the previous people who worked on the property weren’t doing things the proper way. This would lead me to believe other things were not done the proper way.
This is quite the mess!
I’m looking for bunches of electrical or cable lines running all over the place. We’ve bought properties where it looks like spaghetti running all over the building, and we’ve ended up having to rip it all off and start from scratch simply because it’s easier to do instead of trying to sort it all out.
Staircases – When I walk on the stairs, I make sure to walk very heavy. I’m looking to see if it seems squishy. Is termite damage visible, are the railings stable? In compliance with code, railing spacing should be about three and a half inches. For me, if I can make a fist or place my hand through the pickets of the railing, it is most likely not up to code and I’ll have to replace it depending on my insurance company and how bad it is. I look at the stairs to see if the tread rise and depth are consistent. It should be around 7” of rise and 11” of depth. If they are not to code they may need to be replaced.
Inconsistent stair depth
After An Inspection – Once the inspector gets into the property and finds things that I may not have found, do I decide not to buy the property? No, not at all. It just helps me to figure out what it’s going to cost to fix or if I even want to fix it, and what exactly I’m getting myself into. That’s what is critical about the inspection. You can make a well-informed decision on the property rather than going in blindly and being surprised later.
It is naïve to think you can figure out how to hit a certain number or certain profit, or how to stay within a tight budget, without being informed of all the problems. This is valuable while I’m negotiating in the beginning. If I’m coming in lower than the initial offer, I can right away talk to them about some of these problems, which, most likely, the owners already know about but haven’t disclosed yet or many times they had no idea there were these problems which make it easier to negotiate.
Keep in mind, none of this is 100%. These are just good rules of thumb when looking at a property. They have served me well to establish if an investment property warrants further investigating and analysis, and if so, what kind of offer to submit. This obviously isn’t everything. I depend on inspection in most cases. I will be posting an interior walk through an article in the weeks that follow. I’m interested to hear your story and what else you may look at when walking a property. Please share your take in the comments below.
**Disclaimer** – make sure you are walking the property with the consent of the current owner. Please keep in mind we are in the San Diego market and practices in your area may be different. I highly reccommend you get a building inspector to look at the property unless you are highly confident in your ability.
Curtis Gabhart, CCIM President Gabhart Investments, Inc.
Edited By Blake Imperl, our newest intern at Gabhart Investments. Check out his Linkedin page by clicking here.
Gabhart Investments, INC. (GII) is a privately held real-estate investment firm based in San Diego, California. We operate in a rapid paced project driven environment. The employees at Gabhart Investments, INC. (GII) are close-knit, highly qualified professionals, possessing the necessary competence to meet our clients’ goals. GII promotes ethical balance for continuous training, leadership, and teamwork. Since 2000, GII has acquired and converted multi-family properties into condominiums throughout San Diego County. The new real-estate market has presented us with many opportunities to take advantage of. Along with our equity partners, Gabhart began to grow its portfolio in, arguably, the strongest housing market in the country. Thus, we consistently generate superb risk-adjusted rates of return for our investors. In 2005, Gabhart’s private investment portfolio had transactions in excess of 40 million dollars. We intend to accelerate our business model by maintaining our focus within the purchasing and rehabilitation of bank owned real-estate property. Our additional services include consulting, brokerage, venture funding, development, construction management as well as property and asset management.
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How My Views on Commercial Real Estate Are Changing
By: Blake Imperl
As I am approaching the end of my first month as an intern at Gabhart Investments, I’d like to reflect on what I’ve learned, and what has changed thus far.
What I’ve Been Doing
Over the past few weeks, I have been spending a lot of time reading the material Curtis has provided me on Property Valuation & Investment Analysis. Although it is mainly an overview of the subject, it has proved to be some highly valuable content. This material essentially picked up where I left off in my Real Estate Investment Analysis class that I took last semester at San Diego State. I have been brushing up on subjects like tax benefits, 1031 exchanges, expenses, leverage, returns, evaluating cash flow, and much more. I still have a great deal of learning to do on these subjects, but it is exciting to see how what I’ve learned in the classroom correlates to real world applications. It is my intention to continue to read up on these subjects and ask as many questions as I can.
I’ve also been observing how Curtis and his team assemble marketing packages for commercial properties they are listing. I was doing things similar to this at my last internship at Realty National, so I’ve enjoyed seeing how this translates in the commercial arena
Commercial Real Estate Blog Posts
Another task I have taken on is the editing of Curtis’s blog posts. My first edit was a post on property walkthroughs. One tremendous benefit of doing this has been the information I’m learning is sticking much deeper than if I just glanced over it. It’s proved to be a great learning tool for me and I’ve even taken on the task of researching some of the topics I was curious about. Writing has always been a passion of mine, so getting the opportunity to revise and write some stuff has been great. I’m excited that I will get to continue to edit blog posts during my time here.
This past week I had a great learning opportunity with Curtis to do a walkthrough of a 13-unit apartment building in Fallbrook. I was able to learn about some of the things you should be looking for in a property, both on the interior and exterior. This was a neat real life application after reading Curtis’s article on property walkthroughs. This is certainly the kind of stuff you’d never learn in a class room.
13-Unit Apartment Building In Fallbrook
La Jolla Multi-Family Building
Another property we looked at was a 5 unit multi-family building in La Jolla. This was a very intriguing property because it had great bones, was less than a block to the beach and offered several routes for renovation. When walking the property, we looked at things like the condition of the floors, the bathrooms, kitchens, balconies, electrical, etc… It was far from move-in-ready, however, at the right price this could prove to be a great deal.
Curtis and Abe inspecting the condition of the upstairs balcony
the interior of the detached studio
Co-Star Lunch & Learns
In addition to the property walkthrough, I’ve also attended two Co-Star lunch and learns with Curtis and his assistant Dianne. The one that stood out to me was on the housing forecast over the next few years in San Diego County. I enjoyed this meeting because this is a real problem we will be tasked with fixing over the next decade. This past semester in my investment analysis class I did a great deal of research on this subject, so it was neat to hear the industry take on the issue.
Lastly, I have very much enjoyed the opportunity to pick Curtis’s brain. He’s always offering me valuable tips and knowledge about real estate and just life in general. Whether it be tips on client relations, listing properties, or even just financial management, I’ve been trying to act like a sponge of knowledge. He’s always honest about things and I respect that.
My views on real estate are growing stronger than ever and I’m excited all the learning opportunities that lie ahead. I am finding that the San Diego Commercial Real Estate Market contains more possibilities than I ever could have expected. Stay posted for my final update in August!
In a bit,
Intern, Gabhart Investments