Due diligence is rarely talked about because it takes back seat to sexier topics like raising money and finding, analyzing and negotiating commercial real estate deals. But I have found that more investors make more mistakes during due diligence than any other part of the commercial real estate investing process.
I had the pleasure of interviewing Brian Hennessey about this subject on a recent podcast. Brian’s been in commercial real estate for 31 years and just published The Due Diligence Handbook for Commercial Real Estate Investments. He’s done over 9 million square feet of sale transactions, and in the process, he’s learned some valuable lessons — in other words, he knows a little something about doing due diligence.
I wanted to share with you his 10 most common mistakes to avoid when purchasing commercial real estate.
The Top 10 Commercial Real Estate Due Diligence Mistakes
Mistake #1: Not Valuing the Property Correctly
Make sure you’re conservative in your underwriting of a deal. Do your homework! That means checking for sales comps and other available properties on the market. Contact the more active commercial brokers in the area and inquire about local property values and sale comparables. Then continue to adjust your valuation during the due diligence based on what you find.
Mistake #2: Not Understanding Your Lender’s Underwriting Requirements
Before you spend a lot of time, money, and energy conducting your due diligence, make sure you’ve had a preliminary discussion with some lenders about the amount of the loan they would consider putting on the property.
Today’s lenders are very conservative and look at many aspects of the property, such as physical condition, sale and lease comparables, leases in place, intended use, environmental issues, credit worthiness of purchaser, etc. Check with them before you get too far down the road with your due diligence to avoid surprises later.
Mistake #3: Not Checking if the Property Complies With All Current Municipal Building Codes
It’s a fairly common occurrence that a buyer finds out after purchasing a property that it doesn’t meet the compliance of building and/or ADA (handicap) codes. This comes up when the contractor goes to pull a permit from the city for intended improvements or when the city inspector comes out to check out the contractors work, discovering the infractions.
Be sure to keep an eye out for tenants whose space has been built out without a permit. It’s a good idea to have a contractor, architect, or space planner inspect the property to discuss any improvements and compliance during your due diligence period. You don’t want any costly surprises after the closing.
Mistake #4: Assuming There Are No issues Within Existing Tenant Leases
The leases can have many “trip wires,” such as cancellation provisions, contraction provisions, caps on pass-through expenses, and fixed option rents, just to name a few. You want to be aware of these provisions because if the tenant exercises them, it could put you in a bind and devalue the property. It’s important to have a competent real estate attorney read the leases if you are not familiar with commercial real estate leasing.
Mistake #5: Assuming Lenders Will Accept All Third Party Reports
Before hiring any third-party vendors to conduct an inspection and prepare a report, make sure that your lender approves them. This goes for the Property Condition Assessment, Environmental Reports, or any specialized reports, such as seismic or geological studies. Mistakenly having to pay two different vendors for the same report costs much more than time; it is very expensive.
Mistake #6: Trusting That the Seller and Their Representative Have Disclosed All Issues
You have to be a detective when performing your investigation/due diligence on a property you’re looking to purchase. Not all sellers are going to be forthcoming when it comes to disclosing the problems of their property.
Remember the Latin saying caveat emptor — let the buyer beware. Ask the hard questions and make sure you do that in writing, i.e. email them so you can keep track and record all correspondence in case you need to bring it to court one day. Always ask for backup receipts, lien releases, copies of paid invoices, etc. Remember, ASSUME NOTHING.
Mistake #7: Expecting the Closing Statement to Be Without Issues
Before you sign the final approval of the closing statement sent by the escrow officer, be sure you have scrutinized all the items listed, as well as those omitted. Many times a seller will load up items to be credited to themselves and “forget” items that should be credited to the buyer.
Some commonly overlooked items are letters of credit or Certificates of Deposit used as security from tenants that the landlord needs to assign to the new buyer, leasing commissions owed to brokers on leases that have recently been signed, tenant improvement allowances owed to tenants, and vendor billings that need to be prorated or paid in full prior to new ownership taking over.
Mistake #8: Not Checking Out the Competition
You need to — especially if you’re not familiar with the area. If you see rent specials or other concessions, you need to know they exist and why because they might affect your underwriting and valuation of the deal.
Mistake #9: Not Spending Time at the Property
Go there at different times of the day. You’re going to get a much better idea of what goes on there. That parking lot might be a hang-out for kids to party on the weekends. You get a chance to speak with the tenants. It might even change your mind about the property.
Mistake #10: Not Walking Each and Every Unit
Even if the seller doesn’t want to disrupt the tenants. For me, I want to see every one of them. You don’t know what they’re going to be hiding. Maybe one of the units has mold or fire issues. Insist on it.
Many new commercial real estate investors don’t know what they don’t know, and hopefully this list will help with that! Also make sure you follow your due diligence checklist and don’t cut corners.
So don’t underestimate the importance of due diligence. A deal you passed on is much better than a deal you did that you find out later is a big mistake.
Investors: What mistakes would you add to this list?
Let me know with a comment!