Today’s show is about real estate due diligence and a little bit about the real estate closing process. Of course, we can’t cover the entire process in 20 minutes or less. I’ll tell you what -we’re going to make a stab at it. I believe that you’ll find at least one new thing that you did not know before about what’s necessary for commercial assets to be acquired, or closed, and the things that are required prior to that closing which we call the due diligence process.
[00:00:37] Due diligence, 10 years ago, was a 90-day to 120-day process. Today, that process is much shorter, particularly when there’s a lot of money in the market (too many dollars chasing too few properties). When there is a lot of money in the market people agree to a very short period to perform due diligence. It doesn’t matter if that commercial deal is $2.0M, $5.0M or $25 million dollars, the due diligence process, albeit so crucial, is much shorter than it was historically.
[00:01:06] Please remember for my podcast you can find our show notes on John Wilhoit.com. Go to the show notes on the podcast page and you will find a good handful of Spotlight Pages. It’s a single page you can download related to the topic at hand and it will go beyond just the show notes that you see here. Sometimes it will be a checklist, sometimes it will be other information or I may point you to other websites or other information that’s related to our topic so that you can go deeper into the subject matter.
[00:01:35] Today we’re talking about real estate due diligence and what’s required. Before anybody starts any due diligence, they need to negotiate a sales price. There must be a purchase contract and that purchase contract will outline what the parties have agreed to. With that purchase contract in hand you now have a reason to proceed with due diligence.
[00:01:58] With a purchase contract in hand, we’re presuming that there’s a deposit, or an earnest money deposit, that’s been placed in escrow and at that point it’s time to run- it’s time to go as fast as we can to get through our due diligence and make sure this is property we want to acquire for our portfolio.
[00:02:16] You must have your third party due diligence people, contractors and vendors, already engaged prior to signing that contract. These folks are busy like everybody else and just because you have a deal doesn’t mean they’re going to pull off their other work because you called them. We need to have these vendors aligned already. We need to know that they are available whether it’s for physical property due diligence (capital needs assessment), financial review- whatever part we’re asking other people to accomplish. They need to be in the loop prior to signing the contract so that we know they are ready to roll.
[00:02:58] There are two parts to the due diligence process; one is the business- which is the property, the rental income or the asset that we’re acquiring and how that business works; the financials and everything else to goes along with that.
Secondly, there’s the legal status of the property itself because unless title can transfer there’s no reason to go through all the pain, anguish and time to do the due diligence, right? We need to have the legal status in our sights and make sure the people selling the property have the right to do so. I know that sounds kind of silly but it does come up more often than you would think; that somebody is trying to sell an asset where everyone that’s on the sell side is not in agreement. And frankly, as a buyer it’s not our problem, unless it becomes our problem. We need to know the legal status of the property at the very front end of our due diligence process to assure ourselves that the people selling the asset have the right to do so and that everyone’s on the same page for proceeding. That said, now we can perform property due diligence which is all the things that are necessary to make sure we want to proceed with the purchase.
Number one- start with tenants and tenant lease files. We want to do some interviews of the tenants. We are looking to obtain an interview or estoppel of 100 percent of tenant in a commercial deal but not necessarily anywhere near that if it’s a residential deal. If it’s a commercial deal we’re looking for estoppels or estoppel certificates from all the commercial tenants confirming that what is in the lease file is true and correct and in order.
[00:04:42] We want to know everything we can about existing service contracts and any extended existing service contracts. An easy example is elevators- sometimes those contracts can run three to five years or longer and they’re very expensive. We want to know the status of those and what our cost are on those contracts.
[00:05:04] Title and survey. That’s legal but it’s still part of the front end of the due diligence process. We don’t want to get too deep in only to find out that there are blemishes on title or there’s some issue with the survey that will slow down or stop the process completely. We want to know who holds title, how it’s held and if it’s ready to go.
[00:05:26] Set up new bank accounts. This is not necessarily at the front end of the due diligence process but we want to be able to receive money from the day of closing. You don’t want to wait until one or two days before closing to have new bank accounts set up; start earlier.
[00:05:39] We also want to know about anticipated proration’s and any other adjustments that are coming to us in the closing process because that will affect the amount of money you, the buyer, bring closing. There should be a schedule of the security deposits and a schedule of any receivables or leasing commissions that are payable and any outstanding rent that’s due (not necessarily on the day of closing but for the next month).
[00:06:06] We want to know if there’s any bulk, or large payments, coming in thereafter (just after closing). Sometimes, in commercial deals, some tenants pay their rent once a month, of course, but there are transactions where rent is paid quarterly or annually and although that may seem a little bit unusual it does occur and we want to be aware and prepared for those events.
[00:06:29] Then there is the coordination of the closing documents. That requires a lot of people and we can’t take it for granted that everyone knows what to do and where show up for closing day. Any more, people are not all in the same room like they used to be. We have the opportunity for Docu-sign, which is electronic, and we also still use FedEx and all the other overnight services for getting documents back and forth. You need to know who’s in charge of coordinating that process. You can’t just presume there is an escrow agent. It may be an attorney or a law firm that’s coordinating the closing and it’s good to know who all the players are at the beginning and who has responsibility for coordinating the closing.
[00:07:20] With everything we’ve just talked about, with respect to the due diligence process, recognize that I didn’t mention anything about market survey, market analysis, identifying gross potential rents. Those are all things that we’re hoping you have accomplished long before making an offer on a property. If you don’t know your markets, then you shouldn’t be making offers on property so you’ll never get to the due diligence phase.
If you haven’t gone through the paces, as I have described them, with respect to demographics analysis, market analysis, submarket analysis, including reviewing comparable assets and competitive assets- all those things are long before we get to due diligence of the deal. And we don’t get to due diligence of the deal unless we’ve signed a contract for sale. In other words, unless we’re going to buy.
[00:08:10] I know we’re stuffing a lot of information into a very small amount of time so let me just take a few minutes here and identify the five core or five key areas that you need to focus on in real estate due diligence. Let me just cover those at a higher level.
[00:08:39] The first is tenant information having to do with leases and amendments, credit checks- all the things that should be in the lease file. What we want to see in our lease file review, more than anything else, is consistency in documentation and that it’s an order on the tenant information.
[00:08:57] Second is property operations. We want a rent roll and all the things that go with it. Please see my book How to Read a Rent Roll for a detailed level of information on how to accomplish rent roll analysis. There’s more to it than just looking at the numbers from a high level and determining NOI (net operating income) because there’s so many moving pieces which is why rent roll analysis is so very important.
[00:09:22] Third is the property itself or the physical characteristics. If it’s a commercial asset you’re going to want to have a capital needs assessment accomplished (CNA). Yes, it’s expensive. Yes, it’s worth and yes it’s necessary to have a CNA on a commercial asset. A CNA is important because we want to know what the useful life is of major systems and you can’t look at them with the naked eye and make that determination. Therefore, we need to have professionals come to ascertain capital needs.
[00:09:54] Next (fourth) on the list is title and survey. If it’s an older property we presume that it’s zoned correctly, but hey, the zoning may have changed so we can’t just make that presumption automatically, that the zoning is the same now, as it was when the property was built in the 60s 70s or 80s. With title and survey work we want to know where those (property) corners are. If there’s any overt blurring between property lines with neighbors on every side of the subject property. Sometimes things occur over time like weeds, but beyond weeds sometimes people build a corner of their building on your lot. And unless and until you check you don’t know that so it’s good to have the survey accomplished.
[00:10:39] And fifth, property ownership. We want to know as much as we can about the history of the asset which includes any environmental issues, including all existing debt that will be or should be removed in the transfer.
[00:10:53] That’s our short list and due diligence checklist; tenant information, property operations, physical property characteristics, which we will know more about through the capital needs assessment, a review of the title and zoning and of the survey. And lastly whatever we can find out about current and prior ownership that will give us a better feel about the history of that asset; information about where it’s been and where it is now can provide some insight for successful ownership going forward.
[00:11:28] As you’ve heard me say before, I always come at due diligence from the perspective that the money going into the deal is your money so therefore it’s a very important thing. Real estate due diligence is key to assuring capital preservation and quality investments. We do hope you take due diligence seriously. Take your time, do it right and bring people along with you that know more than you do in certain key aspects and areas so that the work is accomplished in a professional manner.
Thanks for listening today. This has been John Wilhoit on Real Estate.
John Wilhoit is a real estate professional specializing in residential asset management and property management. John has an undergraduate Degree in Business and a Master’s Degree in Urban Studies. Learn more about John here.