An essential part of real estate investing is the purchase of property for profit, but the risks involved may not be readily apparent. Buyers, lenders and sellers must identify the associated hazards and opportunities. It can also help if they understand the strengths and weaknesses of their position pursuant to deal-negotiation.
Conducting effective financial due diligence will help buyers and lenders structure a strategic transaction and avoid costly mistakes. Real estate purchases that look good on paper sometimes have hidden problems that are only brought to light when you plow below the surface.
Due diligence is basically the process of digging out any problems that may occur by doing your homework and scrutinizing every aspect of the real estate transaction. Moreover, it provides important data to identify future growth opportunities and post-acquisition strategies.
Due diligence can often be an expensive, time-consuming and complex. How well you perform the due diligence during a real estate purchase can be a key component of the investment’s future success. This article gives an overview of due diligence from the seller’s point of view, and outlines key tips you can use in your next investment.
Every property has individual and unusual features. Be ready to review your property with the buyer to conduct a thorough due diligence. Compile documents in a three-ring binder for easy review. Also, scan the information to create an electronic file for ease of transmission to interested parties.
The binder should contain all the necessary documents a potential buyer and lender will need during the evaluation period. This procedure will expedite the document-review process and wash out out likely problems. A due-diligence checklist of information that may satisfy a prospective purchaser’s needs includes:
- Bank statements (two years)
- Real property-tax invoices (two years)
- Rent roll including term and payment history
- Tax returns (three years)
- Insurance policy (including riders, risk assessments and carrier affidavit)
- Bank statements (12 months)
- Personal property
- Utility bills
- Income statements (current yield-to-date and last two full years, both detail and summary information)
- Occupancy reports (current yield-to-date and last two full years, both detail and summary information)
- Service agreements (cancellation rights/penalties)
- Environmental reports and surveys (phase one)
- Preliminary title report and legal description
- Site plan
- Lot size and zoning information
- Architectural drawings
- Narrative sections of the most recent appraisal
- Capital expenditures (detailed of last three years, current and planned)
- Government inspection reports (description and status of any violations)
- Licenses (description and name of licensed entity)
- Lease(s), sublease(s) and/or operating agreement(s)
- Natural hazard disclosure report
- Ground lease (if applicable)
- Key contracts
- Employment agreement
- Litigation-related documents
As with any real estate transaction, unnecessary holdups or information gaps cause deals to be delayed or cancelled. The potential buyer needs to be provided with all due-diligence info promptly and within the time frame documented in the purchase agreement. This will ensure the property doesn’t remain off market for an extended time in the event the buyer decides not to proceed with the transaction.
It’s useful to provide the buyer with a detailed checklist of documents provided. Include a short description of each item and the source of the information (public records, tax assessor, court, etc.), as well as contact information, such as e-mail addresses and phone numbers. In the event a document is excluded, provide an explanation. This procedure should prevent unnecessary delays during the buyer’s review period.
Remember, any errors in the information provided may cast doubt on the transaction and lead to greater reservations about the property. Increased uncertainty with the buyer may equate to further acquisition risk and negotiation, with a possibility of a reduced selling price or cancellation of the transaction. Make sure you’re prepared for questions and requests particular to your property.
A prudent and experienced investor will be looking for errors or lack of information. Unsurprisingly, inaccurate or incomplete disclosures result in the buyer spending more time evaluating the property. The additional review could exert downward pressure on property value as well as delay closing. Notwithstanding, with the lending market in partial paralysis, the buyer’s loan may be jeopardized in the process.
It’s always a sensible and practical policy for the seller to disclose all aspects of the property. Not doing so could lead to post-closing issues including but not limited to potential legal action.
Carefully walk the exterior of the building with a certified building inspector and note any unusual items in need of repair. If any construction deficiencies are detected, contact a professional who specializes in potential construction defects. Any construction that may not meet current building codes needs to be addressed and, if required, corrected.
Other general mechanical items that need to be examined include elevators, fire sprinklers, HVAC, security and telephone systems. Get a copy of the roof warranty to verify the remaining life. If the document isn’t available, have the roof professionally inspected.
Your due diligence should also include a thorough interior inspection. Look for any problems that will need to be fixed in the coming years. Watch for water or fire damage, or vector issues. Some fire departments will conduct a free inspection to verify the building meets current municipal codes. In short, leave no stone unturned.
The primary and most important result of a thorough due diligence is a smooth and uncomplicated inspection, financing and closing of the property. A secondary benefit will be your industry reputation. When you go to market with your next property, your track record will speak for itself, and investors will have a level of comfort with the information you provide. Finally, the seller and buyer should consult with legal and financial advisors to confirm due documentation is acceptable for either party.
Stephen Grossman is a senior vice president with NAI Capital Commercial Real Estate Services, Worldwide, and The Self Storage Investment Group in Newport Beach, Calif. He has been responsible for the sale of more than 850,000 buildable square feet of entitled self-storage land, and the sale or escrow of more than 3 million square feet of existing self-storage facilities. For more information, call 949.468.2394; e-mail [email protected].