Commercial Real Estate Blog

This is the fourth article of a seven part series I will be writing to help guide commercial real estate buyers successfully through all of the steps involved in the purchase of commercial property.

As I stated in the previous article in this series, due diligence is the process of verifying all of the statements of facts and potential downfalls of a property you are considering purchasing. Proper due diligence is not a simple matter and normally takes weeks or sometimes a few months to accomplish. Legal due diligence is extensive and requires experts to perform the research for you.  In this article I will cover the Physical and Financial processes of due diligence.

Physical Due Diligence

This is more than just a simple walk through of the property with a building inspector.  A walk through is only one part of the physical due diligence you should complete.  Here is some information you should be getting from the seller with regards to physical due diligence.

•    Site Plans and Specifications:  This group of documents includes all the construction documents, building plans and schematics, floor plans, and land use documents.  These documents provide a road map of the property inspection with regards to when it was first built how it was built, and what its original purpose was.

•    Photos of the property:  You should take photos of the exteriors, interiors, and the surrounding land and structures.  Also getting aerial photographs of the site will help.  This process has become much easier with web services such as those provided by Google Earth.  Having these photos allows you to start putting together the pieces of the puzzle and knowing what other structures are in the same vicinity as your property can help you determine any restrictions you may face in the future with regards to expansion.

•    Structural Inspection:  Have a professional contractor or building inspector look at the walls, roof and foundation of the building.  They should make sure all of the electrical and plumbing aspects of the building are up to code along with the types of building materials used, etc and whether or not these structures will need repairs.

•    Interior Systems Inspection:  Here you are looking for wear and tear on items such as doors, doorways, windows and weatherproofing.  Also find out the age of the roof and the history of any maintenance issues inside the property.

•    Mechanical and Electrical Inspection:  These include the heating and air conditioning units, plumbing systems, elevators, loading dock lifts and any other electrically powered aspect of the structure.

•    Capital Improvements:  Obtain documentation from the seller of any capital improvements that were made to the property, specifically over the last five years.  This will let you know what items have already been recently addressed and allow you to focus on those items most likely to break down or need upgrading in the future.

•    Pest Inspection:  Have a termite inspection done at the very least.  Especially when dealing with residential structures such as apartment buildings.

The whole purpose of the physical due diligence inspections is to try and determine the costs involved in upgrading and maintaining the building in the future.  You want to make a list of short term projects and long term projects the building will need and then factor these into your costs when determining how much to pay for the building.  If during your physical due diligence you discover something that significantly impacts the value of the building then you can either back out of the deal or approach the seller with this information and attempt to renegotiate.

Financial Due Diligence

The financial aspects of due diligence focuses on what the property's financial condition is like.  It is used to determine whether or not the building is currently showing a profit and if not, what actions you can take to make it profitable.

•    Income and Expense Statements:  By far this is the most important part of financial due diligence.  These statements show what the seller has collected in income from the tenants as well as what the owner spent in operating the property.  You should at least obtain annual income and expense statements for the past five years.  Also get all of the previous 24 months quarterly profit and loss statements to see if there is a seasonal aspect to the properties cash flow.

•    Rent Rolls:  A rent roll is a list of all of the units/tenants in a property and how much each is paying in monthly rent.  It displays the tenant’s name, unit space, price per square foot, total amount of rent paid, move in date, lease terms and expiration date and if they have given any security deposit.  Once you obtain this information, make sure the rent amounts stated on the reports actually match those shown on the leases and then compare all of this information with the income and expense statements you received.  If you notice anything does not add up then immediately contact the seller for clarification.

•    Tax Returns:  This may be harder to obtain as most sellers do not wish to disclose their tax returns to strangers.  However this information is essential in determining if the income and expenses shown on the tax return match those on the reports you were given.  If they don't then either the seller has been misstating his income or some other mistake has occurred.

•    Lease Agreements:  A lease agreement can be a complex legal document or it can be one piece of paper.  You should have an attorney review all of the lease agreements on the property to determine what rights the tenants have as well as your rights to either terminate the leases or raise rents.  You should also use an estoppel letter to verify the leases.  This is a request for information letter that you would send to the tenants to ask them to provide information regarding their lease to determine if the copy you were given is true and accurate and represents all of the agreements between the seller and the tenant.

•    Utility Bills:  This includes costs for electricity, gas, water, sewer, trash, telephone, cable and internet services. You need to obtain and verify all utilities bills for the last 2 years and make sure they add up to what was listed on the expense statement to ensure the property’s net income is correct.

•    Property Tax Bills: Again this is information that should be listed on the expense reports but you want to verify with the taxing authority.

•    Omitted Expenses: It’s not uncommon for sellers to omit certain expenses from the income statement to make it seem like the property’s net income is higher than it actually is, and thus worth more. You need to take the time to check if any expenses have not been listed on the expense statement. Things like landscaping costs, management fees, advertising costs and general maintenance costs are all things that are commonly “forgotten” on expense statements.

Financial due diligence is critical in determining whether you are buying a property with a positive cash flow or one that is going to cost you money to own every month.

Don't miss part five of this series where I will be discussing Mortgages and Financing Options for Commercial Real Estate. Please leave your questions or comments!

Disclaimer: Nothing stated in this article should be taken as the giving of legal advice.  As always, you should check with a licensed, competent real estate attorney who specializes in your field when unsure of how to proceed.