Commercial Real Estate Due Diligence and Things to Consider
Commercial real estate is a capital-rich investment opportunity in a fast-evolving industry. ‘Due diligence’ in real estate is the process of investigating all aspects of a CRE before the buyer signs on the dotted line. This is an essential process to undertake to avoid any post-transaction surprises.
Commercial real estate investments are one of the biggest investments of a person’s life. The buyer needs to be sure about investing in a property that has a good background and is free of risks. A superior level of research is required to play safe and investigate potential risks. That is where ‘due diligence’ comes into the scenario as a savior.
What is Due Diligence?
A little carelessness in commercial real estate investment often leads to a huge loss. Due diligence is cross-checking the property in and out before investing. This process goes on for 2 months after submitting a token of money to the seller. The investor hires a team of experts to get everything about the property he is going to purchase. Cross-checking the property through an expert’s eye ensures long-term benefits and omits any room for discrepancies.
Who are these experts?
These experts are commercial experts with titles such as engineers, interior designers, chartered accountants, lawyers, auditors, and investment-gurus.
How to reach these experts?
The investor can hire professionals through his personal network, internet, or a commercial real estate broker. A special note must be made about the knowledge, qualification, and work history of the professional. For example, a skin specialist cannot conduct heart surgery; a regular chartered accountant would not have the right skills on commercial real estate due diligence. Only a commercial, financial expert with work experience fits the role. A few pointers for finding such experts are given below:
- Looking for A Personal Referral: The investor can use his circle of networks to find the referral of professionals who can carry the series of investigations.
- Surfing the Web: The investor can browse the internet to find contacts of good commercial experts. The internet stays a good place to check their profiles, previous works, ratings, and testimonials.
- Reaching Out for a Commercial Real-Estate Broker: A commercial real estate broker can help the investor find commercial experts and recommend a contractor. A lot of time is saved on hiring a contractor since the contractor will have his own team of experts and look after the entire process.
The Areas of Due Diligence
There are three important areas to consider for due diligence. They are physical, financial, and legal due diligence.
Physical Due Diligence
Physical inspection is the core of commercial real estate due diligence. It confirms that the property is safe for investment and does not have any illegal structures. A team of engineers, interior designers, and auditors are required to carry out physical due diligence.
- Why Engineer? The engineer reviews the original construction plan and checks it against the physical structure. He confirms that there are no illegal or unauthorized structures inside the property and also ensures that the commercial building is safe. In case of any discrepancies, the engineer highlights the issues to the investor. This helps the investor to point out the issues to the seller for finding a solution. The investor may even reconsider investing in the property in case of extreme concerns.
- Why Interior Designer? The interior designers assist in adding value to the property. They might take a tour of the place and suggest changes for procuring higher profits from tenants. A property that looks good pays extra, doesn’t it? On the parallel, the investor may ask the interior designers to change the layout and renovate the property to suit the tenant’s expectations. For example, if a new tenant wants to open a café but the previous tenant used the space to run a boutique, the investor can ask the professional to transform the space according to the area of function.
- Why Physical Auditors? Auditors will conduct a series of physical evaluations to check the ambiance, damage, and property issues. The walls, ceiling, flooring, fire exit, water supply, washrooms, and so on would be evaluated. The auditors might also interview the existing tenants to determine the credibility of the property, look for major complaints, and note the tenants’ expectations for the investor’s benefit.
Financial Due Diligence
This step helps the investor find out financial risks before investing. The investor must procure every financial information from the seller. This information must be cross-checked against the official financial records minutely.
Factors like agreements of lease, inflow, and outflow of cash, financial receipts, tenant-related liabilities, or obligations need to be studied by a commercial, financial expert. This kind of verification further assists in obtaining an estimate of the real value of the property. The expert would double-check that the seller rightly represents facts pertaining to the cash flow and profit margin.
Legal Due Diligence
Legal Due Diligence can be a significant deal-maker or deal-breaker. A legal expert must conduct three major checks, -title, violation, and environmental checks.
- Title Check: Since the investor is spending an extensive amount of money, a title check must be done to avoid any unwanted issues or legal problems. In simple words, the title of the property means the complete ownership of the property. The investor must confirm that no third-party exists in the picture, and the property is authentic and rightly owned. A background check of the seller may be conducted to know if there are any court cases against the seller.
- Violation Check: A permit and violation check has to be carried out to ensure that there are no illegal encroachments or illegal uses of the property.
- Environmental Check: The legal expert should survey the property and surroundings to ensure that the property is not prone to environmental risks or cause environmental damage. If this step is missed, the investor might incur heavy losses in the future.
Commercial real estate investment is an expensive affair, and due diligence saves the investor from risks, helps him establish a budget, and makes way for higher profits and value-add opportunities. Therefore, the investor cannot neglect due diligence in the investment procedure at any cost.
CRE Due Diligence FAQs:
Before conducting due diligence on the property, the investor is invested in, he needs to supply the following information:
- The investor needs to supply ERF number and physical address and other vital details of the investment property itself
- Full Names, Personal details and ID numbers of the current owner or owners and the current lessee if there is any
- A copy of the current lease of the property
- Annual financial statements of the investor and all stakeholders involved if the property is owned by a business.
When an investor thinks of investing in commercial real estate property or if he plans to sell his commercial property to another buyer, due diligence should be conducted.
At the end of the Due diligence period, the investor needs to take a decision taking into consideration the relevant feedback that has been summed by the team of investigators. He needs to decide whether he wants to continue with the deal or if he wants to terminate it. There is a point in the contract which clearly states that if the seller refuses to extend the ‘Due Diligence Period’, the contract stands terminated thus the buyer needs to be take the decision in the prescribed amount of time. Normally, the investor does not possess the right to terminate the contract if due diligence is not done within the stipulated time period.
Normally the time of Due Diligence Period starts from the effective date of the beginning of the contract. It is stipulated in the form of the terms and conditions of the contract in which the agreed upon ending date of the due diligence period is specified. To begin with, the investor must negotiate the time period which would be appropriate enough to conduct all kinds of investigations and inquiries. Also, this time is quite beneficial for the investor to conduct appraisals, apply for relevant loans and discover the repairs which he would need to undertake after the acquisition of the property.
The fee is negotiable and is agreed upon by both the parties – buyer and seller. It is paid by the investor to the seller as a right to conduct ‘Due Diligence’. The fees may depend on certain factors like the general fee charged by servicemen as per the market rate, regular market for the property, number of days on the market, number of days that comprise the due diligence period, personal details and personal circumstances of the investor (buyer) and the current owner (seller) of the commercial real estate property.