The process of selling commercial real estate can be the easy part. Difficulty comes knocking in the form of due diligence, the sometimes long investigative process done before the purchaser is legally bound to acquire the commercial property of interest. Choosing the right due diligence steps not only helps with the discovery of issues your purchasing client could face, but builds loyalty and eliminates extra hours of research.
As a commercial broker and appraiser with over 25 years of experience in the industry, I have helped clients with their due diligence for a variety of commercial property types, sizes, and budgets. Here is my process for a successful due diligence that saves time, identifies the concerns, and has clients coming back to work with you again.
1. Annual Profit & Losses
Analyze the past three years and current year-to-date financials using a spreadsheet to categorize the percent changes between each year. Depending on the type of property, you will be able to catch irregular expenses by analyzing line by line. Remember to look at the cost of insurance each year, taxes, and utilities.
2. Monthly Cash Flow Statements
Study the month-by-month cash flow statements for the past three years. This will allow you to know which tenants are paying on time and who has a reputation of paying late. These items do not show up on annual financials.
3. Study the Rent Roll
Make sure you look at multiple years of the property’s historic rent roll. Look for significant changes or rental modifications. This is a good cross-check for the lease analysis.
4. Analyze the Leases
This task can take the most amount of time. In many cases, items in the lease have been forgotten, like a lease cancellation clause with 90-day notice. These clauses can substantially impact the value of the property. If lease abstracts are provided, then verify each item. If they are not, create your own one-page lease abstract for each lease. Consider having your client hire an attorney to review leases and provide your client with the summary of the pertinent issues. This will also shift the responsibility to a third party.
5. Contact the City/Fire Department
Countless times, tenant improvements are constructed without a final occupancy permit or even a permit at all! Check to see if anything has been “red tagged” by the city. Verify all spaces and units have received a final occupancy permit. It’s better to find out that you are missing permits and $5,000 worth of work needs to be completed before your client buys the property.
6. Interview the Tenants
You can discover a lot about a property and any unknown issues by interviewing the tenants. Try to do this without the current owner or property management company with you in order to get information about any conflicts or issues the tenants have had with them. Ask the tenants the following questions:
How long do you plan on staying here?
Why did you locate your business at this center?
How has your relationship been with the property management company?
How has your relationship been with neighboring tenants?
7. Hire an Inspector/Contractor
I typically will have the client hire a local contractor (I don’t like typical “home inspectors”) to “inspect” the property. You want to rely on a professional that knows construction and can give you an unbiased assessment of the current condition of the property. I have yet to see a property without some hidden defects – even new properties.
8. Review All Capital Expenditures for Past 5 Years
Capital expenditures will give you insight into the work the current or previous owners have done to the commercial property. Analyzing these expenditures will help you determine if the owner has put any money into the property, if he or she chose “cheap” solutions to problems, or if problems were fixed correctly as the issues arised. Ask to see actual receipts and bids for all of the work the owner did and talk to the companies who completed the work. Then contact the companies who bid on the job but did not do the work. Ask them why their bid wasn’t chosen.
9. Complete a Market Survey
Make sure you have completed a detailed market survey of the current rental income as compared to the competition. Is the property above market? Why? If the leases are triple net, how do they compare to the completion? Make sure you look at access, exposure, and traffic counts to the comparables. Why will the subject property be competitive in the future? What new product is coming online to compete with the subject?
10. Everything Else
Other items to consider reviewing: Tax returns, balance sheets, title policies, insurance policies, current appraisal, loan documents, copies of all utility bills, current service contracts, deeds, current environmental reports, wetland reports, surveys, bank statements, litigation history, and mortgage estoppel letters.
At the end of the day, the goal is to verify all the information you receive from the seller. Make a request list up front in the purchase and sale agreement. Having a complete list of these items and letting your client know how you handle these things will give you a competitive advantage in representing buyers and sellers of commercial property. Some commercial brokers have even charged a fee to clients that they do not represent to do the due diligence for them. Due diligence can be difficult, long, and frustrating. But, when done right, you will help represent your clients well, eliminate problems quickly in the process, and gain a unique competitive advantage in the market.