Buying commercial real estate — either as an investment property or a new location for your business — is a big decision. Thorough due diligence into the asset is fundamental to the real estate acquisition process, both to confirm it’s a sound investment and expose potential risks.
Due diligence is the process to verify whether the deal you cut when you made your offer is the deal you are actually getting when you close on the property. In this article, we cover the real estate due diligence process for determining the property’s value (now and in the future), your offer price, and your ultimate decision to buy.
Understanding the property and its condition
When investing in commercial real estate, at a minimum, it’s important to familiarize yourself with the physical asset. Walk the site a few times, take note of any concerns, and ask the seller plenty of questions. Interviewing tenants can also be a great way to learn about the property, if appropriate and the seller will allow it.
Ideally, you will also want to review floor plans, unit descriptions, site plans, and architectural drawings. Walk each area of the property and verify that what you’re buying is represented on paper. Sometimes, a building may have been remodeled, but floor plans or other descriptions were inaccurately updated. Requesting an inventory of recent repairs to the building can confirm any major capital projects completed or uncover deferred maintenance costs on the horizon.
Most importantly, be sure to carefully review all contracts and other documents related to the property as part of your real estate due diligence checklist. Such a review includes everything from verifying appropriate municipal certificates and inspections to reading over vendor contracts, existing insurance policies, leases, easements, and any warranties or guarantees. Certain documents may encumber the property, which can prevent it from being financed by a bank or transferred to you as the buyer.
Examples of questions to ask before you buy commercial real estate:
- Are there any liens, leases, easement, municipal violations, or other issues that could encumber the property?
- Are all the site plans and architectural drawings updated to reflect the current state of the property?
- Does the property require significant capital investments, and if so, what’s the estimated cost?
Reviewing revenue and expenses
Much of the value of a commercial real estate investment is tied to its income: the associated leases. A thorough lease review is central to good due diligence. For a retail or office property, there may only be a few tenant leases to review and the terms will be for longer (for example, one to five tenants with terms between five to 15 years). Multifamily, as you can surmise, will have many leases to verify (hundreds, perhaps) and the terms are generally shorter (usually around one year). Other asset classes like hotels, senior living, or self-storage may utilize very different contracts or leases to generate income.
To obtain the general details of these leases, you will want to review the landlord or property manager’s tenant rent roll. A good rent roll should summarize key tenant lease terms: tenant names and contact information, rent payable, periodic rental rate increases, lease structure (e.g., triple net or gross), and term or duration of the lease, among other things. It’s good practice to verify the provided rent roll against the actual leases, especially when dealing with less sophisticated owners or operators. If there are numerous mistakes, omissions, or incongruent terms, you may have to review each lease further — which could take significant time depending on the property.
In addition to understanding how revenue is generated by tenants, you’ll also want to evaluate and verify any other sources of income. For retail or office properties, this could come from parking or concession sales. For multifamily properties, it could be pet rent, amenity fees, or many others. Changes in tenants, planned renovations, shifting consumer trends, or fluctuations in occupancy could affect the long-term viability of these other revenue streams.
Lastly, if there is any vacancy in your target property, be sure to determine if the vacant space is ready to be leased or will require improvements to be leased or marketed to new tenants. In the instance of a commercial property (versus residential), learn why the unit became vacant and think critically about potential new users for the space.
While reviewing and verifying sources of revenue is important, it’s equally necessary to identify your property’s expenses. A few areas for special attention include maintenance costs, utilities, insurance, and property taxes. Insurance costs and property taxes, two of the largest operating expenses, have been on the rise. It’s critical to forecast these accurately, as they’ll often be reassessed following a sale. Be sure to verify each item against seller-provided historical financial statements.
Examples of questions to ask before you buy commercial real estate:
- Who are the existing tenants, what are they paying, and how long is left on their leases?
- Are there any lease terms not reflected in the rent roll that may create added risk or cost to the buyer?
- Are there any other sources of income, and how viable are they moving forward?
- What is the current vacancy, does the space require improvement, and who might the user be for that vacant space?
- What are the projected property taxes and insurance costs for the property?
Evaluating the real estate market
While usually ascribed to home buying, the maxim “location, location, location” also applies to investments in commercial property. Much like understanding the property and its financial performance can be useful in determining its value and your offer price, the property’s submarket real estate data can help establish value and ensure long-term investment protection.
First, it’s important to identify the physical or social boundaries that establish the submarket, or neighborhood, for your property. Often, there are obvious lines of demarcation such as highways, rivers, or other geographical boundaries. Other times, it may be more subtle, such as school districts or municipal boundary lines.
Pricing can fluctuate significantly from submarket to submarket. Focusing on recent comparable sales in your submarket can help establish whether you are paying the right price for your property. For example, if Class A office buildings in the same submarket as your property recently sold for an average $300 per square foot, you can ascertain that a similar Class A office building would sell for approximately the same price per square foot.
Next, you will want to look at leases and determine if tenants are paying above or below the current average submarket rent for similar properties. Should one tenant decide to leave or seek renewal, you could have the possibility of gaining or losing revenue if you sign a new lease at the market rate. As discussed above, the value of your property is tied to its leases. Any deviation from market rates present the opportunity — or risk — for the value of your property to shift up or down in the future.
Examples of questions to ask before you buy commercial real estate:
- How well do I know the market and submarket the property is situated in?
- Is the price of the building commensurate with recent sales comparables in the market?
- Are the tenants’ rental rates above or below market value?
Hiring experts for inspections and reviews
Unless you’re a real estate expert, engineer, or attorney, it’s prudent to have the commercial real estate property you’re buying assessed by experienced third-party experts before you enter into any agreements with the seller.
Just like buying a home, you should have the asset inspected by experts who know what to look for when it comes to physical structure, environmental conditions, and zoning. At a minimum, you should engage engineers to assist with a property condition assessment, environmental site assessment, zoning analysis, and survey. If your property had a certain historical use such as dry-cleaning, automotive, or manufacturing, there could be recognized environmental concerns that necessitate additional environmental studies.
Legal review is also a key component of third-party analysis. Just as you’d rely on an attorney to assist in drafting your purchase agreement, you will also want to engage a lawyer to help identify any liabilities in existing leases or other property-related contracts, conduct a lien search, and review pertinent title issues or encumbrances.
All the real estate due diligence tasks described so far remain largely the same regardless of the type of property (e.g., residential, retail, office, industrial). However, there may be additional tasks, or the tasks may be more complicated, depending on the type of property you seek to acquire. Consider hiring a real estate consultant to help you determine the scope of the due diligence checklist needed for your property. With a scope tailored to your particular property, the consultant will manage the process of hiring and overseeing the required third-party experts who will perform the assessments.
Examples of questions to ask before you buy commercial real estate:
- What inspections and other evaluations are needed, in general and specific to the property?
- Which professionals should be hired to perform the assessments?
Real estate due diligence: A minor investment to avoid costly surprises
When it comes to real estate transactions, time is of the essence. Due diligence on a commercial real estate purchase should never be an afterthought. The due diligence process can be time consuming, and any delay could postpone your financing commitment, closing, or worse — put your deposit at risk. If you’re considering buying a commercial property — or have already started the process — download our real estate due diligence checklist below as a starting point.
While there is a cost associated with bringing in real estate due diligence consultants to assist, the cost of a thorough investigation is minor compared to the potential risks, and unexpected expenses, it can uncover or help you avoid. Furthermore, lenders will often require many aspects of due diligence discussed here in the normal course of obtaining debt financing.
As you can imagine, we’ve described but a few of the most common tasks on a real estate due diligence list related to all type of commercial real estate. This is a good place to start, but there are a number of items to consider before purchasing a commercial property. Contact us to learn more about our commercial real estate due diligence services.
