Consumers tend to throw around the phrase due diligence with an all-purpose meaning. Most commonly, due diligence is performed when buying a business or investing in stock. For a business, due diligence may include a comprehensive investigation into the revenues, expenses and contracts. If investing in a stock, it may mean reading annual reports and 10-K statements.
When investing in real estate, due diligence is a key aspect of a successful transaction – and it carries with it a specific meaning and process.
According to Black’s Law Dictionary, due diligence can be defined as follows: “Such a measure of prudence, activity, or assiduity, as is properly to be expected from, and ordinarily exercised by, a reasonable and prudent man under the particular circumstances; not measured by any absolute standard, but depending on the relative facts of the special case.”
In terms of commercial real estate, what does that mean? Let’s address the matter with regard to three key issues: (1) what is the planned-for outcome in purchasing the property; (2) what does one need to know in order to execute the transaction to achieve that outcome – discovery of the material facts and conditions, i.e., the relative facts of the special case; and (3) who should perform the due diligence to ensure that you satisfactorily get the answers to #2.
Starting with the End in Mind
Commercial real estate transactions may have a variety of different buyer types and therefore different requirements as far as outcomes. Someone purchasing with the intention of using the property, for example, is going to have different requirements from an investor who is seeking a revenue stream. While developers may have some of the same characteristics as investors – even to the extent of holding some of the properties – their objective will require an understanding of the potential for return on investment once they’ve performed their development magic.
Each of these buyer types will have different due diligence requirements as they go through the process. They will also be dependent on a number of issues specific to the property, such as land, rights and improvements, as well as the physical building or buildings being acquired.
Crunching the Numbers
In addition to a wide array of details, the due diligence process in commercial real estate begins with a baseline business understanding of the market itself, not just the property. Is there a demand for the products or services provided by the intended purchase? Do the potential revenues justify the acquisition? This will not only require looking at the current state of the market, but the history and projected future.
The next items to be addressed are specific to the property. These include but are not restricted to the physical condition of the structure, traffic and the availability of vehicular access and parking, utilities, environmental concerns, and Americans with Disabilities Act compliance/accessibility, to name a few.
A review of the following issues should be a part of any commercial transaction:
- financial feasibility (are the revenue and expenses presented representative of the actual revenue and expenses that the buyer should expect; are there opportunities to add value, or is there downside risk; what is/are the exit strategy(ies));
- zoning laws, to ensure compliance with planning and zoning ordinances and future planned uses;
- private land use controls;
- licensing requirements;
- title review;
- survey review;
- flood plain review;
- water rights review;
- an examination of easements, encroachments, covenants, conditions and restrictions (CCRs); and
- a review of liens and encumbrances, including leases, and a determination of how each will impact the current and future uses, and actual and potential income stream.
At the risk of oversimplifying, the buyer (and its lender, if any) needs assurance that the property meets with its financial goals and objectives, and that the property will physically meet its goals and objectives for its occupancy, or its tenants occupancy.
Creating a Due Diligence Plan
Finally, we come to the question of who is best suited to perform due diligence. An experienced buyer, who has gone through numerous transactions in the commercial realm, may have a good idea of the level of detail required to make a proper assessment on a vanilla deal. On the other hand, a novice buyer or a complex transaction will warrant the involvement not just of the commercial real estate broker, but legal and financial advisors with specialized knowledge.
Acquisition of a commercial property includes a lot more moving parts than the average residential purchase. The reasonable, prudent buyer will enlist the appropriate level of expert help. Properly executed, due diligence may be expensive; but in very real terms, it can be far more expensive if you fail to do it correctly and don’t get the answers you need.