A due diligence checklist for buying commercial real estate has ten checks: the financial records, property management, the building’s condition, an estoppel certificate on the tenants, a site visit, an appraisal, insurance, the agreements in place, the existing loan, and the closing statement. Complete every one before you sign.
There is no doubt that due diligence is crucial in business dealings. Considering the US commercial real estate market is worth more than $1 trillion, you can expect stiff competition, so you must carry out due diligence before formalizing any real estate deal.
Like every massive investment, compile a commercial real estate checklist and follow it religiously. Failure to stick to the checklist may result in colossal losses, time wastage, and costly litigation.
A due diligence checklist for commercial real estate lets you check all the facts about a property before purchasing it. In the process, you can assess the nature of the deal and the state of the property before signing on the dotted line.
What is on a commercial real estate due diligence checklist?
When buying commercial real estate, these are the factors you should consider lest you make a regrettable investment mistake:
- the financial state of the company
- property management
- condition of the property
- information about the tenants
- site visit reports
- lease agreements in place
- insurance of the property
The due diligence checklist addresses these factors in totality and is thus a must-have:
1. What financial records should the seller provide?
Financial information enables you to identify liabilities and weigh the possible returns after purchase. While newly built commercial real estate cannot always provide the required information, for other potential investments, the property agent should at least provide:
- Income and expense statements of the last three years
- Copies of audited financial statements for the past three years
- History of receivables for the past 18 months
- Information on the cost of leasing the property for five years
- Real estate tax bills for the last three years
- 5-year history of capital expenditure
- Budget of the current year and the following year
- A list of all unfunded capital projects in progress
- The general ledger for the current year
- The cost of tenants’ electricity bills, and
- Copies of tenants’ recovery schedules such as common area maintenance (CAM) tax billing
2. Check Management of the Property
Commercial properties have people who oversee the operations within the building. Property management has extra costs that you will need to look into.
Some of the operational costs of commercial buildings that you should check include 2-year utility bills and employees’ salaries. Therefore, you need to look at the list of employees and contracts on service, utility, and maintenance.
Request your agent to share the property management agreements and the list of personal properties and equipment.
3. Confirm the State of the Property
There’s no way around it–repairing, upgrading, and maintaining commercial properties is costly. Knowing the state of the property and the existing preventive maintenance program will protect you from false representation and unforeseen mandatory repair costs.
During the inspection, request the site plan, occupancy certifications, licenses, permits, architectural plans, and specifications. You should also confirm if the property management has embraced safety measures and the property fits the description provided.
4. Ask for an Estoppel Certificate
Commercial real estate agents keep a portfolio of their tenants. Agreements, credit information, security deposit, and lease abstracts are some of the information you can get in an estoppel certificate.
Knowing your potential tenants’ profiles and payment history is a good start. After all, once you own the property, you will be dealing with them frequently.
Verifying information about the tenants will enable you to identify anticipated challenges and address them.
5. Schedule a Site Visit
Site visits confirm if the property meets the description provided and the standards set. In addition, it allows you to interview the tenants to verify uncertainties like the property’s security and cleanliness.
For tall buildings, check if elevators are available and functional. Take note if the facility complies with the Americans with Disabilities Act (ADA) standards.
You can request experts to assess the structural and environmental condition of the property and its mechanical, electrical and plumbing (MEP). The assessment will enable them to make a reliable report for your perusal.
6. How is a commercial property appraised?
Appraisals are assessments done to determine the value of a commercial property. The assessment involves researching the property’s zoning, ownership, and ADA compliance of the property.
It also consists of comparing compiled sales, costs, and rents analysis of similar properties to determine the value of a property. From the appraisal provided, you will decide whether to buy the property or not.
7. Ascertain the Insurance of the Property
Good insurance goes a long way in compensating property owners in case of loss or damage. Understanding the underlying documentation and legal description of a property’s insurance enables you to assess the risks.
From an existing title report, you will learn about historical and pending litigation. It will help you determine the insurer’s reliability in safeguarding your property.
Remember to request an ALTA survey to know the insured property’s existing covenants, boundaries, and easements.
8. Go through the Agreements in Place
Sale agreements safeguard the parties’ interests with regard to the ownership of a commercial property. Going against such agreements may attract legal suits, and you risk losing the property.
Apart from tenant leases, general contracts, and amendments, you should check:
- Parking agreements,
- Brokerage commission agreements,
- Tenants’ lease agreements,
- Property management agreements,
- Contracts for service, utility and maintenance,
- Exclusive brokerage agreements, and
- Loan agreements.
You can seek the clarity and counsel of your legal representative when examining the agreements.
9. Look at the State of the Existing Loan
Loans are liabilities: if a loan goes into default, you risk losing your investment through auction. By checking existing loan agreements, you will weigh potential risks and act accordingly.
Take note of the primary lender’s commitment by checking the promissory note and fixture filings. If the loan was an authorized partnership borrowing, request a resolution to avoid future disputes.
10. Assess the Closing Statement
After buying a commercial property, the last thing you want is to deal with litigation arising from undefined roles. It is crucial to seek closure on who will handle outlined financial responsibilities.
A closing statement comes in handy by listing all profits and liabilities. The statement clearly defines the roles of each party, highlighting whoever is in charge of a particular proceeding.
Final Remarks
Once you have completed your due diligence, you can decide whether to buy the property or not. It is the essence of following the due diligence checklist. The checklist involves site visits and assessing contracts, financial information, and insurance positions.
While the process may be tiresome and costly, it is worth it. After all, it is better to lose some coins in preliminary investigations instead of blowing up millions of dollars on a poor investment.
Every time you buy a commercial property, make sure you carry this checklist. It will save you a ton of money and provide peace of mind. Remember, failure to do due diligence is the precursor to bad investment decisions.
Frequently asked questions
What are red flags in due diligence?
On a commercial purchase, watch for a building that does not match its description, repairs nobody disclosed and a weak preventive maintenance program. Check the title report for past and pending litigation, the existing loan for default risk, and whether the property meets ADA standards. Missing financial records deserve questions too: only newly built property has a reason not to supply three years of statements.
What is an estoppel certificate?
An estoppel certificate is a record of the tenants in a commercial building. It covers each tenant’s agreement, credit information, security deposit and a lease abstract. Asking for one before you buy tells you who you will be dealing with and how they pay, so you can spot tenant problems before they become yours.
What is an ALTA survey?
An ALTA survey shows a commercial property’s boundaries, easements and existing covenants. Request one during due diligence alongside the title report, which lists historical and pending litigation. Together they tell you what the insurance covers and what legal limits come with the land before you commit to the purchase.
Why is due diligence important when buying commercial real estate?
It lets you check every fact about a property before you commit, so you can judge the deal and the building’s condition before you sign. Skipping steps can lead to large losses, wasted time and costly litigation. The checks cost time and money up front, but losing a little on preliminary investigation beats losing millions on a poor purchase.
