The importance of performing due diligence prior to purchasing commercial real estate
An important step in the commercial real estate buying process is performing ‘due diligence‘. In commercial real estate, the due diligence process varies greatly from that in the residential home buying process. In home buying, the goals of each buyer are typically quite similar and thanks to well defined contracts and consumer protection laws, the due diligence steps that home buyers take are well defined and common between most properties.
In commercial real estate however, buyers are assumed to be more sophisticated and the phrase “Buyer beware” should be taken seriously. In addition, the goals and needs of each buyer vary more than they do in the home buying process, meaning that the details of the due diligence process are unique to each buyer. While the details are unique, they will usually fall into some common categories which are discussed below:
Due diligence varies by type of buyer
Your reason for buying a property will be one of the main factors in deciding which due diligence steps are most important. As a buyer, you will typically fall into one of three categories:
Additionally, you will likely need to work with lenders to fund your purchase. The lender will have their own view of the due diligence process, which we discuss below.
Here you will find information regarding the due diligence process from the owner-user perspective (see our Investor due diligence article in our Investor Center for details regarding the due diligence process from the investor perspective).
Owner-user due diligence
If you are in this category, you are an owner-user purchasing the property for your own use. Therefore, you need to make sure that the property will meet your needs and play the appropriate role in achieving your overall business goals. Most buyers entering into a purchase contract expect that the property will meet their needs. However, verifying this can be expensive and time consuming. You will want to enter into some type of agreement with the seller before spending large amounts of money on this process. This may mean that you’ll want to enter into a formal purchase contract, or come to an initial agreement of terms via a Letter of Intent (LOI).
The process of ensuring that a property will meet your specific needs typically includes the following steps:
Confirming the physical characteristics of the property
This means a variety of things. You will want to confirm such aspects as the amount of land you’re purchasing, the square footage of buildings and which fixtures and equipment might be included in the sale. This involves performing physical inspections to verify the number, quality and condition of each of these. Depending on current and proposed uses, this might mean measuring spaces, counting parking spaces or hiring professionals to complete engineering studies, or to inspect roofs and other structures located within the property boundaries.
Conducting a legal review
A legal review includes issues related both to the property itself and the business that plans to occupy it. You will want to verify if there are any easements, encroachments or other limitations to ownership of the property. You will also want to verify zoning and check with city, county or other municipality to ensure that the planned use of the property will be allowed. You might need to obtain special licenses and permits, or at least feel comfortable that you will be able to obtain them with no problems, before making a final commitment to purchase the property.
Even though, or especially because, you plan to occupy the property, you might need to review any current leases in place and speak with current tenants. This is both to verify that you will be able to occupy the space within your required time frame and also to evaluate if any co-occupants are a good fit if your intention is not to be the sole occupant of the property.
Financial and market review
As an owner-user, you’ll want to make sure the property makes financial sense. This requires understanding the costs of ownership, which includes taxes, insurance and maintenance costs, all of which vary from property to property. For many businesses, this may also mean verifying the property fits within their business plans. Is the property located in an area with the proper demographics, proximity to customers,and proximity to competing or complementary businesses? How does the price, costs and business income for this property compare to a different property? How does purchasing compare to leasing? If problems are found during other parts of the due diligence process, how much will it cost to overcome those problems? The financial review will continue throughout the purchase process, providing you with the information you need to decide whether to continue with the purchase all the way through to closing.
Lender due diligence
For owner-user properties, a lender is primarily concerned with two things:
- Buyer ability to repay the loan
- Market value of the collateral (the property)
These interests cause the lender to be interested in the entire due diligence process. The will want to know the due diligence steps that you are taking and the results of those steps. Lenders oftentimes have their own specific requirements with regards to the due diligence process because they have a vested interest in the market value of the property (the value for which they can sell it on the open market) in the unfortunate case of default by the buyer. These requirements typically include:
- Appraisal/valuation: A licensed appraiser, or possibly even a real estate broker, will provide a formal appraisal or broker opinion of value (BOV) regarding the amount at which the property should sell on the open market.
- Environmental study: Lenders are particularly concerned about the possibility they could end up owning a property that has environmental issues. EPA rules can hold any owner responsible for these problems even if they did not cause them. Therefore, the lender will often require a Phase 1 or Phase 2 environmental study even if the buyer is not concerned about these issues.
- Financial review: For the owner-user property, the financial review will focus on the buyer’s financial condition. Similar to the buyer, issues such as taxes, maintenance costs and any existing leases will be a factor will be important to the lender.
Additionally, the lender’s requirements and loan terms may vary from property to property. Therefore you will want to review the lender’s terms as part of your own due diligence.