Due diligence: The first step in a property acquisition

Asset managers understand the variety of factors that contribute to the profitability of owning and operating a successful property, which can make them invaluable participants in the acquisition process. This process begins with a valuation of a property known as preliminary due diligence, which is the first and most important step in the purchase of commercial real estate.

Through the process of due diligence, all aspects of a prop­erty are examined, and its value is determined. Poor due diligence can affect the financial interests of a new owner. Nothing short of full, comprehensive, and verifiable due diligence should satisfy any buyer when purchasing real estate.

Due Diligence regarding Income and Expense

Verification of rental income and operational expenses is of para­mount importance to any buyer. A buyer must be certain that he or she can maintain the income that the property has historically generated. The expense side of the operating statement must have verifiable costs, be complete, and include each monthly expense that the building incurs.

The operating statement should also include major capital expenses that the property will require in the future, such as replacing roofing or floor coverings. These major expense items occur at different times and should be budgeted through a reserve account. There are certain line items that should be found on every operating statement. Other items may be required, but these are determined by the type of property, its age, or other distinguish­ing characteristics.

Net income, less total operating expenses, results in net operat­ing income (NOI). NOI is usually calculated before the monthly debt service amount, or monthly mortgage payment, is applied. While calculat­ing NOI is relatively simple, attention to the details comprising it is essential. The buyer must be assured that the income represented can be collected and that the expenses are all-inclusive, accurate, and not understated.

A buyer may be basing his or her investment decision primarily on the property’s performance. If the seller’s accounting is inaccurate, the buyer cannot make an objective purchase decision. Thus, a buyer must recreate an operating statement for the property based on experience and research, rather than simply relying on the statement provided by the seller.

Due Diligence regarding Environmental Issues

The environmental condition of a property is a critical area of con­cern for the buyer. Federal regulatory law states that any environ­mental problems associated with a property can be the responsibility of the current property owner, regardless of whether or not that owner created the problems. Lenders will not provide loans of any significance for commercial properties or multifamily residential properties unless a Phase I environmental site assessment (ESA) has been completed and provided to them for review. Prudent buy­ers require the completion of this report, whether or not a lender is involved.

A Phase I ESA identifies existing environmental problems. Completed by a firm specializing in environmental analysis, this report:

  • Provides information on the presence of any environmental problems at a property
  • Identifies specific problems and comments on their severity
  • Quantifies financial implications
  • Addresses the need for any immediate reclamation or cleanup

A Phase II ESA describes the means necessary to accomplish the cleanup, and it often provides estimates of the cleanup cost. These reports are a part of standard operating procedures for buyers, and are mandated by federal regulatory law. They should not be over­looked in any purchase transaction.

Due Diligence regarding the Physical Plant

The physical plant is the actual building, any ancillary properties (for example, parking structures), and the common areas (areas used by all tenants and their guests).

For example, suppose that a buyer is purchasing a 250,000-square-foot multiuse commercial property that is 90 percent office space and 10 percent retail space. A six-story underground parking structure is located beneath the five buildings composing the complex. The buildings are separated at street level by brick walkways and landscaping. The physical plant begins at the roof of each of the five buildings and ends at the low­est level of parking. It includes all structures and all systems within, such as HVAC systems, windows, elevators, carpet and floor coverings, lights, doors, landscaping, sprinkler systems, and fixtures in the exterior common area.

During due diligence, the condition of each aspect of the physical plant is analyzed to determine the cost of repairing or replacing anything that is in disrepair or is nonoperational. Often, the costs of repair or replacement are negotiable and may be applied against the purchase price.

Due Diligence regarding Title Issues

The first step in verifying issues of property title is hiring a title company to complete an exhaustive title search and to provide a preliminary report. The preliminary report will show any clouds on the title. An example of a cloud is a mechanic’s lien, or a lien that offers tradesmen the priority of payment for work and materials expended on the property. Unless this lien is removed prior to clos­ing, the lender will not make the loan, because the tradesmen by law will have priority for payment over the lender.

The preliminary title report should give an accurate legal description of the property, which should be identical to the legal description in the purchase and sale agreement. If it is not, the buyer could be buy­ing something other than what the seller is representing. This report should also supply information on any permitted exceptions to title, including items such as:

  • Utility easements
    The utility company has the right to cross the property to perform services.
  • Special assessments
    Special assessments are typically required by cities for street or other public improvements.
  • Encroachments
    Encroachments involve instances where an adjacent property intrudes within the subject property’s legally defined space.
  • Property taxes
    This includes showing last year’s tax amount, the amount paid, and any delinquent or outstanding prop­erty taxes due.

Due Diligence regarding Property Survey

A new property survey is obtained in nearly every commercial real estate transaction. The survey shows the boundaries of the property and where the footprint of the building is on the land being pur­chased. It will also show where utility easements cross or intersect the property.

For instance, the local power company may have an easement across a corner of the property where underground power lines are buried. The power company maintains a right to inspect and improve the underground lines, whether or not a structure is located above them. With the easement, the power company has the right to access the lines by any means necessary, including demolishing a part, or all, of the building. Similarly, water compa­nies, gas utilities, and other public companies may have easements, and the survey will indicate this.

It is essential that the buyer understands where the easements are, as they can have a dramatic effect on the property—especially if the holder of the easement needs to access the power, water, or gas lines. The lender has an equal interest in knowing where easements are and often requires the buyer to engage, and pay for, a property survey. Further, the funding for a loan often depends on the lend­er’s acceptance of the survey.

Due Diligence regarding Legal Issues

Due diligence typically involves legal issues, including the develop­ment of preliminary settlement documents. The first draft of the final purchase and sale agreement should be written only when due diligence proves beneficial to the buyer. Often, in commercial transactions, the purchase agreement evolves into a series of docu­ments (including representations, warranties, and affidavits) that the buyer, seller, or lender may require.

Another issue to pursue during legal due diligence is verifying the legality of the buying entity. Many investors create single-asset enti­ties that take title to the investment property at closing. The entities are typically in the form of a limited liability company (LLC), a partnership, a joint venture, a trust, or a corporation.

The inves­tor should consult with an attorney, a tax consultant, and a lender before choosing the type of entity that will hold the title of the property. Each entity has specific legal liabilities and tax ramifica­tions for the person creating and managing the entity. Deciding what type of entity will take title should be made as early in the acquisition process as possible, since receiving state approval for a newly formed entity can be a protracted process.

This article is adapted from BOMI International’s Asset Management, part of the RPA and FMA designation programs. More information regarding this course or BOMI International’s new High-Performance Sustainable Buildings credential (BOMI-HP™) is available by calling 1-800-235-2664. Visit BOMI International’s website, www.bomi.org.