What Is Due Diligence in Commercial Real Estate?

Commercial real estate is a competitive and oftentimes arduous process.  And while it is exciting when the parties finally agree on terms and price after tedious negotiations, this is just the beginning of the work that lies ahead of a commercial real estate buyer. One of the most important parts of a deal is the due diligence process, which is designed to not only ensure that the property may be used for the buyer’s intended purpose, but also to ferret out and expose any unexpected problems with the property. This phase can be time-consuming and difficult, but it is ignored at the buyer’s peril.

What Is Due Diligence?

Due diligence is a short period of time, typically between 30 and 60 days, during which commercial real estate investors can investigate all components of a pending purchase transaction.  Like other contractual provisions, the due diligence period can be negotiated, and a buyer should ensure it has given itself sufficient time to inspect the property. For example longer due diligence periods may be necessary where the buyer intends to develop the property or modify its’ existing use. Creating an investigation checklist can help buyers keep track of their due diligence.

Why Is Due Diligence Important?

Commercial real estate transactions are a risky business. However, due diligence can greatly reduce many risks by uncovering critical information before the buyer is obligated to close. Examples of information disclosed during the due diligence process include but are not limited to:

  • Title, zoning and survey matters, including judgment lien searches and easement agreements
  • Tenant and lease documents
  • Financial documents, including recent tax statements and utility bills
  • Insurance information
  • Property inspection reports
  • Governmental reviews, including licensing requirements and legal compliance matters
  • Declarations of covenants, conditions and restrictions for the property
  • A schedule of pending litigation that may affect the property or seller’s ability to convey the property

How to Conduct Due Diligence

It is essential for commercial real estate investors to be thorough when conducting due diligence. The process can seem daunting, but skimping on the details could be a financial disaster if it causes something critical to be missed.

Here are some suggested steps for buyers to take before completing a purchase:

  1. Shop around

Buyers should have a solid understanding of the market before committing to a property. This requires looking at many properties over many months and avoiding the urge to make an early offer out of excitement.

  1. Building inspection

A proper building inspection is essential to ensure that the structures on the property are fit for, or may be modified to fit, the buyer’s intended purpose and use, and that they are in good structural shape. The inspection should be conducted by a certified third party inspector or engineer who is local to the area and familiar with any climate- or region-specific construction issues. The building’s walls, roof, HVAC systems and fireproofing should all be assessed. If any repair needs are identified, a contractor should be hired to perform detailed cost estimates.

  1. Title search, property survey and title insurance

A title insurance company should be contacted to run an updated title search and issue a title report. A title report reveals a property’s ownership history, liens, encumbrances and easements. Some of these issues can also be revealed by looking at the land plat and physically walking the property. However, for the most thorough physical assessment of the property, it’s best to order a professional property survey which cross references the title report, and which can confirm the lot size, boundary lines, surface waters, access roads, rights of way, soil conditions and more.

  1. Zoning

The property’s zoning designation should be confirmed to make sure it can be used or modified as the buyer intends. The property’s zoning violation history, growth management agreements, covenant and public facilities agreements, proposed impact or linkage fees, assessments, exactions and pending zoning changes should also be reviewed for potential problems.

  1. Financing

Just like it pays to shop around for the perfect property, it pays to shop around for the best mortgage terms. To ensure they’re getting a fair deal, buyers should acquire multiple mortgage bids before choosing a lender. A good lender can also help with the due diligence process because it will conduct its own title search, inspections and appraisals of the property, providing the buyer with an additional layer of information.

  1. Environmental inspection

In any commercial real estate transaction, an environmental inspection is recommended.

  1. Property insurance

It is important to confirm that a property can be insured before it is purchased. This is particularly true of properties in areas prone to hurricanes, forest fires, earthquakes or other natural disasters. If a property can be insured, it is also important to make sure it is affordable. Therefore, it is recommended that buyers get bids from multiple insurance companies during the due diligence process.

  1. Review of leases and tenant information

Sellers are typically required to disclose all leases and legal contracts with tenants ahead of a sale. Buyers should carefully review these contracts for financial terms, including security deposits, rent rates and utilities. They should also look for any rate extensions or unexpected options hidden in the contract or the building’s marketing materials.

  1. Seller’s review

Depending on the purpose of the property, it may be prudent to look into the background of the seller during the due diligence process. For example, sellers with a history of safety violations, legal entanglements or bankruptcies could negatively impact a property’s value. In addition, some sellers may actually lack the authority to sell a property. Therefore, a seller’s authority to sell the property should be verified, and the seller’s recent tax returns, financial records, civil records and criminal records may also be required for review.

Is Legal Assistance Necessary?

Due diligence is a crucial part of a commercial real estate purchase. It can also be complex and time-consuming. As a result, it is necessary for buyers to contact a real estate attorney for help. The attorneys at Shein Phanse Adkins will assist with the process, review all legal documents and ensure that you’re properly informed about every element of the transaction before it takes place.

Give us a call at (480) 922.3933 to schedule a consultation on Commercial Due Diligence.