Commercial real estate purchase contracts usually include a due diligence or inspection period (Due Diligence Period). During the Due Diligence Period, the buyer should evaluate the real estate to confirm it is suitable for the buyer’s needs. Following are ten things which should be on every real estate buyer’s due diligence checklist.
The buyer should order a title commitment from a title company and should order a survey. A title commitment will show what liens, encumbrances, and restrictions are on the real estate. The survey should show the locations of any easements and identify any encroachments. Review of title and survey is highly specialized and should be done by buyer’s real estate attorney.
The buyer should verify that the real estate’s zoning permits the use that the buyer intends. Likewise, the buyer should review certificates of occupancy and confirm that permits were issued for the initial construction and major renovations.
Just because real estate is being used in a particular way does not mean that the real estate is zoned to allow for that use. Sometimes, owners change the use of a property without changing its zoning. More often, the zoning changes and the property’s use is “grandfathered” so it can continue after the zoning change.
If the property is operating under “grandfathered” zoning, the buyer may not be able to make changes to the property or rebuild after a casualty. If a previous owner did not obtain all required permits, the buyer may have to pay to bring the property into compliance after the closing.
The buyer should order a Phase I Environmental Site Assessment. The Phase I should reveal if there any “recognized environmental conditions” at the real estate. Also, the buyer should order inspections for mold and lead, asbestos, and radon as appropriate for the age and location of the property.
Many environmental concerns are not a “red light” for acquiring the real estate. Yet, they can result in increased maintenance and renovation costs for the buyer. Serious environmental concerns may make it difficult for the buyer to get a mortgage loan or to sell the real estate in the future.
Buyers should review every lease and confirm that the lease terms are what is listed on the rent roll. Also, buyers should compare the leases, the rent roll, financial records, and if possible, bank records, to confirm that rental revenue numbers are stated consistently.
Buyers also should walk through every rental unit and confirm that the tenants on the leases are actually occupying their units. For office, industrial, and retail properties, the buyer should get tenant estoppel certificates from major tenants, verifying their lease terms.
The buyer’s accountants or financial analyst should review detailed financial records. In addition to verifying rent income as part of the lease audit, the buyer should confirm that expenses are accurate. Taxes, utilities, and contract payments can be compared to the invoices.
Other expenses should be evaluated against local industry norms. For instance, if payroll is lower than expected, the owner might be performing services for which the buyer would have to pay after closing. Or, if maintenance expenses are lower than expected for a property of that type and age, the seller might not be maintaining the property
Buyers should read every service contract that is in effect at the property. Contract review is helpful in verifying financial statement accuracy. However, also, the buyer should determine which contracts can and cannot be cancelled after the closing.
Some contracts (typically for vending and laundry services) may provide for payment of a large up-front fee, followed by a small percentage of revenues. Since these contracts can stay with a property for as long as ten years, buyer should ask for seller to prorate the up-front fee if the buyer cannot cancel the contract.
Capital expenditure and maintenance history logs can provide additional verification of property expenses. Also, they can reveal information about the property and costs that the buyer might incur as owner.
For instance, repeat maintenance for a certain problem could be evidence of a construction issue which might need to be addressed. Low capital expenditures given the age and type of property could reveal that the seller has not updated the property.
A review of the seller’s litigation history can reveal much about the property and its reputation. A large number of evictions might be evidence of poor tenant screening. On the other hand, a large number of tenant lawsuits could indicate poor property management.
Buyers should have their insurance advisor review the insurance loss runs for the property. The buyer likely will “inherit” the property’s claims history. A history of excessive claims may result in higher-than-average insurance costs for the buyer. Rarely, a seller's claim history might prevent buyer from being able to get insurance altogether.
Properties built or renovated after 1991 must comply with the Americans with Disabilities Act . If the property is not in compliance, the buyer should require that the seller correct any potential violations.