Due Diligence for Investments

Commercial Real Estate Toolkit

Due Diligence for Investments

When purchasing commercial real estate as an investment, in addition to obtaining third party reports discussed in prior articles, the buyer should use the due diligence period to acquire a complete understanding of how the property will perform from a financial perspective.  During this time, the buyer should obtain the leases and other agreements affecting the property, as well as historical income and expense information for the property.  When performing due diligence for investments, the buyer should do the following:

• Carefully read the leases and all amendments. A buyer should not assume that the seller’s marketing material includes all relevant information that a buyer should know about the leases. A buyer should review the provisions governing the landlord’s and tenant’s maintenance responsibilities and the provisions governing which expenses the tenant must pay or reimburse the landlord for. A buyer should be on the lookout for above market rents, operating expense leakage that tenants do not reimburse, options to renew, options to terminate, rights of first refusal, options to lease additional space, and options to purchase the property. The buyer should not assume that all of the leases have the same provisions. Each tenant may have negotiated unique terms that can impact the net income potential for the property.
• Review the seller’s existing service contracts, real estate taxes and historical financial statements. The existing service contracts will help the buyer understand who currently performs work on the property and how much they charge.  A buyer may be able to shop around for better pricing on the same services to increase profits. Although past performance is no guarantee of future results, a multi-year review of the seller’s historical expenses can give the buyer a general idea of what expenses to expect when operating the property in the future.  Be sure to review the current real estate taxes and assessments to determine if the taxes are temporarily low. An unexpected increase in real estate taxes shortly after purchasing a property may reduce net income substantially unless the property is fully occupied on net leases.        
• Interview experienced leasing brokers and property managers who work on similar properties in the area. In addition to finding the right leasing broker or property manager for the property, a buyer can use this opportunity to find information about rental rates, tenant incentives, taxes and operating expenses that are typical for comparable properties. Are the existing rents above or below market? Is vacancy in the building above or below average? Are the seller’s historical expenses too high or too low? These are important questions that a buyer should be able to answer before purchasing a property for investment purposes.   
• Meet with the existing tenants. While existing tenants may not always be forthcoming, a buyer might be surprised at the valuable information that tenant interviews may uncover. A tenant may disclose that it plans to move out, or that it needs to expand into vacant space in the building, or that the roof frequently leaks. Predicting the future income stream from the property becomes more reliable when the buyer has information about the future plans of the existing tenants.
• Create a forward looking financial model. A buyer should not assume that the seller’s marketing material includes accurate financial projections for the property.  The buyer can use the information gathered during due diligence to project the rental income that the leases will generate and the expenses that the owner will incur to a reasonable degree of accuracy.  The buyer should also anticipate that leasing vacant space and renewing existing tenants will have a cost in the form of periods with no rental payments, brokerage commissions, free rent, tenant improvement allowances and other incentives to lease.  Last but not least, be sure to include a reserve for capital expenditures to account for expenses that are not regularly occurring, such as replacement of the roof, HVAC equipment and the parking lot.
• Analyze recent sales comparables. A buyer should compare the subject sale to recent sales of similar properties nearby. A buyer should look at both the price paid per square foot as well as the capitalization rate for recent transactions.  The price per square foot is calculated by dividing the purchase price by the total square footage of space in the building. The capitalization rate is calculated based on the current annual net operating income divided by the purchase price.  A property with a secure or rising income stream will usually be sold at a lower cap rate than a property with an uncertain or declining income stream.            

By following the recommendations above, the buyer can determine during the due diligence period whether the contract purchase price is justified. If the buyer determines that the financial risk is too great or the return on investment will be too low, the buyer can terminate the contract or renegotiate the price before the end of the due diligence period.