The Due Diligence Handbook For Commercial Real Estate

1. Due diligence is crucial for successful commercial real estate investment

The whole purpose of the due diligence process is to discover the potential problems with a property, reveal any hidden profit potential, and to verify all information that you have obtained.

Importance of due diligence: Thorough due diligence is essential for making informed investment decisions in commercial real estate. It helps investors uncover potential issues, identify hidden value, and verify all information provided by sellers. By conducting comprehensive due diligence, investors can:

• Minimize risks associated with property acquisition
• Negotiate better terms based on discovered information
• Avoid costly surprises after closing
• Maximize the potential return on investment

Key components of due diligence:

• Physical property inspection
• Financial analysis and underwriting
• Legal and regulatory compliance review
• Market and competitive analysis
• Environmental assessment

2. Thoroughly review leases and operating expenses during negotiations

Review carefully all service contracts in effect to make sure that they are cancelable with 30 or 60-days' notice. Make special note of any that is self-renewing for long terms such as one year or longer.

Lease review: Carefully examining lease documents is critical to understanding the property's income potential and potential liabilities. Key aspects to review include:

• Rental rates and escalations
• Tenant improvement allowances
• Renewal and termination options
• Operating expense pass-throughs
• Special provisions or concessions

Operating expense analysis: Scrutinize historical operating expenses to identify:

• Trends in major expense categories
• Opportunities for cost reduction
• Unusual or one-time expenses
• Comparison to market benchmarks

By thoroughly reviewing leases and operating expenses, investors can better understand the property's financial performance and identify potential areas for improvement or negotiation.

3. Conduct comprehensive physical and mechanical inspections

I can usually tell very quickly how a building is being maintained by the way these various places are maintained; their cleanliness and orderliness, and how organized everything is.

Importance of inspections: Thorough physical and mechanical inspections are crucial for understanding the property's condition and potential future capital expenditures. Key areas to inspect include:

• Roof and building envelope
• HVAC systems
• Elevators
• Electrical systems
• Plumbing
• Fire and life safety systems

Inspection process:

1. Engage qualified professionals for specialized inspections
2. Review maintenance records and capital expenditure history
3. Identify deferred maintenance items
4. Estimate remaining useful life of major building systems
5. Develop a capital expenditure budget for necessary repairs and replacements

By conducting comprehensive inspections, investors can better understand the property's physical condition and plan for future capital needs.

4. Engage with tenants, property managers, and leasing brokers

Much can be uncovered during the interview regarding their tenancy and experience in the building, as well as the submarket area in general. Many tenants will give you a wealth of information, if you give them the right questions to respond to.

Tenant interviews: Engaging with existing tenants provides valuable insights into:

• Satisfaction with the property and management
• Plans for renewal or expansion
• Operational issues or concerns
• Market perception of the property

Property management discussions: Speaking with current property managers helps uncover:

• Day-to-day operational challenges
• Tenant relations and history
• Building systems performance
• Opportunities for improvement

Leasing broker engagement: Consulting with local leasing brokers provides:

• Market trends and rental rate information
• Competitive property analysis
• Tenant demand and preferences
• Leasing strategy recommendations

By engaging with these key stakeholders, investors gain a more comprehensive understanding of the property's strengths, weaknesses, and market position.

5. Scrutinize financial statements and underwriting assumptions

Underwriting is an ongoing process during your due diligence and beyond, until closing. Even then, you'll be looking back to see how accurate your analysis was during the time you own the property.

Financial statement analysis: Carefully review historical financial statements to:

• Verify income and expense trends
• Identify unusual or non-recurring items
• Assess the accuracy of reported information
• Compare performance to market benchmarks

Underwriting assumptions: Develop and critically evaluate key assumptions, including:

• Future rental rates and growth
• Vacancy and credit loss projections
• Operating expense inflation
• Capital expenditure requirements
• Exit cap rate and sales price

Sensitivity analysis: Conduct scenario and sensitivity analyses to understand:

• Impact of changes in key variables on returns
• Downside risks and potential mitigations
• Break-even points for critical assumptions

By scrutinizing financial statements and underwriting assumptions, investors can develop a more accurate projection of future performance and potential returns.

6. Address critical issues specific to different property types

Each property type has its unique qualities and issues that should be investigated or addressed.

Office properties:

• Tenant mix and industry diversification
• Parking ratios and accessibility
• Building efficiency and floor plate design
• Technology infrastructure and connectivity

Industrial properties:

• Ceiling heights and column spacing
• Loading dock configuration and truck access
• Power capacity and distribution
• Environmental considerations

Retail properties:

• Traffic counts and visibility
• Tenant sales performance
• Co-tenancy clauses and anchor tenant stability
• Parking ratios and site layout

Multifamily properties:

• Unit mix and amenities
• Rental rates compared to market
• Operational efficiency metrics
• Local demographic trends and demand drivers

By addressing property type-specific issues, investors can better understand the unique risks and opportunities associated with each asset class.

7. Finalize the transaction with careful attention to closing details

One of the most important items in due diligence is to properly review the closing statement prepared by escrow before finalizing the transaction. If you're not careful in scrutinizing it, it can cost you dearly.

Closing statement review: Carefully examine the closing statement to ensure:

• Accurate prorations of income and expenses
• Proper allocation of closing costs
• Inclusion of all agreed-upon credits and debits
• Verification of deposit amounts and loan proceeds

Final due diligence items:

• Review and approval of title insurance commitment
• Confirmation of property insurance coverage
• Execution of tenant estoppel certificates
• Completion of any outstanding third-party reports

Post-closing considerations:

• Transition of property management and leasing
• Communication with tenants regarding new ownership
• Implementation of planned operational improvements
• Execution of value-add strategies identified during due diligence

By paying careful attention to closing details and post-closing considerations, investors can ensure a smooth transaction and set the stage for successful property ownership.

Last updated: August 6, 2024