Due Diligence Real Estate Checklist: Steal Our CRE Process
Due diligence in real estate can be a bit of a drinking from the firehose kind of experience, especially when we are talking about commercial real estate.
When you purchase anything that requires a decent amount of capital whether it be your education, a car, a trip or even a mattress you should do your due diligence! What does this mean?–Research the university, test drive the car, look up your hotel on TripAdvisor, and lay on a few mattresses. It is a comprehensive appraisal of the asset in which you are investing to ensure it is what it claims to be and satisfies your needs.
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Due Diligence Real Estate Process: All You Need to Know
What does due diligence in real estate mean? Real estate due diligence definition: the reasonable steps taken by a person or company in order to satisfy a legal requirement, when purchasing or selling property. With respect to the perspective of the buyer specifically, it is referring to the critical process of vetting potential real estate property investment using a set of specific criteria. If you are considering buying any real estate property, this methodical process (you should have real estate due diligence checklist) is critical to ensure you’re purchasing a well-maintained and profitable investment.
We will focus on commercial properties in particular, as these are the types of investments that make up School of Whale’s real estate portfolio; however, the takeaways are relevant for any real estate investor.
What Does Due diligence Mean in Real Estate?
Real estate due diligence means thoroughly investigating the property (legal audit, review of the financials and physical inspection) before purchasing it. We will walk you through the real estate due diligence process for commercial real estate investing specifically.
A typical due diligence period for a commercial real estate property is between 30 and 60 days. This is called the due diligence period. This usually refers to the time after signing a contract that the buyer has to inspect the property and make a decision whether they want to move forward with the transaction or not.
In the case that you uncover something during this period that is a deal breaker, the buyer can back out. If you are not able to complete your thorough investigation prior to expiration of the due diligence period, then your deposit becomes non-refundable.
Residential vs Commercial Property Due Diligence: What is the Difference?
As we mentioned, regardless of commercial vs residential real estate, you should perform buyer due diligence. Commercial real estate due diligence, is more in depth than residential–Why?
Well, beyond the fact commercial properties are a larger investment, residential property buyers are also protected by the fact that, in most states, a seller must disclose known material defects that are not observable to the buyer. This does not apply in commercial real estate. So, it is a “Buyer Beware” transaction where the buyer is solely responsible for uncovering material facts and defects about the property to determine if it a profitable business venture…or not.
Our Commercial Real Estate Due Diligence Checklist
Given that commercial property value is high, you want to leave no stone unturned in your real estate due diligence process. It should be a methodical review of key documents and records, financial information and property upkeep. For this reason we have created a commercial real estate due diligence checklist. We suggest that you incorporate this checklist into the sale contract, so to require that the seller provide all necessary deliverables.
Legal documentation is the first step in our due diligence real estate checklist because this type of documentation covers the fundamentals. For example, if you discover that this property is not zoned for the purpose for which you are looking to use it, well then on to the next! Here we are able to identify potential deal breakers, so to not waste precious time, in a process that requires a lot of it. For legal you will need the following:
- Most recent Title Policy, Title Commitment and Title Insurance: The title is the right to ownership of real estate property. Unlike titles to other assets such as automobiles, CRE titles are not determined by a single document, but a collection of documents that prove ownership. It is not easy to determine exactly who owns a property. Thus, purchasing title insurance to protect yourself in the case someone claims rights to the property, is critical. The title commitment’s purpose of reviewing the title commitment is to have a clear idea of your title insurance coverage and ownership rights before moving any further into the process.
- ALTA survey: ALTA stands for the American Land Title Association. An ALTA survey is a detailed map that identifies the property boundaries, existing improvements of the property, utilities and any significant observations within the property. Title insurance companies and or lenders may require an ALTA survey to be performed. It helps reveal any critical discrepancies, such as boundary line disputes, encroachments or easements (the right to cross or use someone else’s land for a specific purpose) that you would otherwise not be aware of–all fundamentals for prospective buyer to know prior to purchase.
- Zoning Compliance Certificate: The Zoning Compliance Certificate ensures that your structure and property is correctly zoned for the intended business use and meets all provisions of the zoning rules and ordinances within the site area. Every municipality has different rules to obtain this certificate, but this is critical to ensure your investment property can be used for that in which you were planning.
- Declaration of covenants, conditions, restrictions, reservations and easements for the property: In the context of property and land use, a restrictive covenant is an agreement by the landowner to not do something on the property. For example, he or she may have agreed to not build any structure on the property over a specified height. Or maybe there is a covenant recorded against your prospective property that does not allow you to change the facade of the building. There are even covenants that prohibit commercial use. The scope and extent of possible restrictive covenants is vast and variable. How does this work with zoning? Generally speaking, if a covenant is less restrictive than an applicable zoning regulation, the zoning law prevails. If the covenant is more restrictive than the zoning regulation, then the covenant prevails over the zoning regulation. In short, it’s probably not going to work in your favor, so be informed before making the purchase.
Now that you have legally vetted your prospective commercial real estate investment and know that it is zoned appropriately for your intended use, and there are no restrictive covenants that are deal breakers, you need to determine that it is in fact a financially advantageous endeavor.
Which leads us to the next step of our real estate acquisition due diligence checklist. Here you need to gather the documentation that shows you the current cashflow, the current expenses beyond normal operating expenses like taxes, as well as ensure that when you acquire the property you are not taking on any unpaid debts. In doing so you need the following:
- Certified rent role: This is record of current leases and their current rent, previous rent, delinquencies, years of occupancy, lease start and end dates. This allow you to see the gross rental income generated by the investment property. Additionally, you should also ask for complete copy of each lease and each guaranty, along with any amendments. So that you are aware of all legally binding agreements that currently stand. Moreover, you should ask for a certification that there are no oral agreements between the current tenants and landlord.
- Accounting of all security deposits and any other amounts to which any tenant, vendor, or any other party may be entitled.
- A copy of the property taxes for the last three years; as well as, information on whether the property taxes will increase due to the property changing hands, transfer fees, and evidence that any sales taxes on the rental income have been paid in full.
- List of repairs and renovations including invoices and proof of payment.
- Take the time to explore the property to see if there are areas that you could improve to cut down on operating expenses in the future; for example, LED lighting. Take into account the upfront capital required to make these improvements and how it would improve net earnings in the long run.
- Create a preliminary budget showing gross revenue generated from rent, all expenses including and calculate a best case scenario net earnings and worst case scenario net earnings. Can you live with worst case fiscal scenario?
3. Physical Inspection
The last step of our real estate buyer due diligence is ensuring the property is in good condition! In doing so, you will need to ask for all of the seller’s third-party environmental and engineering reports or commission these assessments to be conducted. With respect to physical inspection, you will need the following:
- Phase 1 and Phase II Environmental Site Assessments: These assessments are to determine if there is any environmental contamination at the property.
- NFR letters: A No Further Remediation (NFR), or in some states it’s called a No Further Action letter, means that the property is either not environmentally contaminated or the contamination is contained to meet certain limits set by the state.
- Mold abatement reports
- Underground storage tank testing and closer reports
- Boring reports: refers to a geological test applied to the soil in order to determine how much weight that soil can take without the aid of any additional support structures.
- Termite studies
- Radon studies
Commercial real estate due diligence requires patience, grit and attention to detail. It is up to the buyer to discover any deal breakers that render the venture unviable. Contractually requiring that the documentation listed on our due diligence checklist will help ensure you are able to complete the thorough investigation within the due diligence period.
Commercial Real Estate Due Diligence FAQs
Can a seller back out during due diligence?
A seller cannot back out during the due diligence process. If a seller gets cold feet and want to back out of the contract they can be legally coerced to close anyway or be sued for financial damages.
How long does due diligence in real estate take?
A typical due diligence period for a commercial real estate property is between 30 and 60 days. This is called the due diligence period. This usually refers to the time after signing a contract that the buyer has to inspect the property and make a decision whether they want to move forward with the transaction or not. In the case that you uncover something during this period that is a deal breaker, the buyer can back out. If you are not able to complete your thorough investigation prior to expiration of the due diligence period, then your deposit becomes non-refundable.