The Risks of Cutting Corners in Due Diligence

Commercial real estate markets are highly competitive. When you’re an investor and finally find a promising building, it can be tempting to skip steps to secure an asset that looks like it could be a big moneymaker.

But appearances can be deceiving. The building could be structurally sound but located on top of an old toxic waste site. Or it could look like a bustling business centre filled with happy tenants, when in reality, many will soon be out the door, and the space soon to be filled with vacancies.

Due diligence allows you to uncover what’s hidden below surface appearances and reduce your financial, legal and liability risks so you start out on secure footing. Documenting due diligence also helps when applying for lender financing and pitching the property to co-investors.

Skipping over key due diligence steps can cause budget and schedule overruns and create headaches that didn’t need to happen. Instead of holding up your acquisition, the thoroughness of your due diligence process will actually determine your project’s success, both now and in the future.

What Exactly is Due Diligence?

Due diligence is the standard precautionary process of researching a potential investment before entering into a transaction or signing a contract in order to reduce the risk of financial losses and legal liabilities.

The four main types of due diligence are:

• Market
• Physical
• Financial
• Legal

Market Due Diligence

Market due diligence determines the property’s potential for future growth and profitability by comparing property values along with tenant rental and occupancy rates to those in the local area and by strategically analyzing the location with respect to factors such as current and future customer demographics, foot and auto traffic, competition, crime rate, etc.

Physical Due Diligence

Physical due diligence involves examining the physical condition of the building, property and any attendant structures and parking spaces in order to confirm compliance with building and permitting codes and identify any potential maintenance, repair or renovation issues. This is especially important since structural fixes, repair, or replacement of HVAC, electrical, plumbing, septic and other systems can be costly. In addition to the onsite inspections you’ll conduct, you’ll also want to do a detailed review of building insurance policies to see what, if any, past claims were filed so you can identify future property risks and liabilities.

Physical due diligence also allows you to confirm or challenge the property’s current valuation and better predict its potential resale value. If your building inspection team determines that various repairs, renovations or remediations are needed, you can either use the findings to negotiate a better price or walk away from the deal.

Financial Due Diligence

Financial due diligence involves evaluating the property’s past and present financial statements, cash flow projections, rent rolls, lease agreements and operating costs, as well as tenant payment histories and creditworthiness.

Legal Due Diligence

Legal due diligence involves reviewing the building’s title, survey, zoning, permits, insurance policies, property management, maintenance and other contracts, plus checking for liens, lawsuits, encumbrances or property tax issues.

You’ll also need to conduct a thorough Environmental Assessment of the property to identify the existence and scope of soil or groundwater contamination around or under the building (e.g., from pesticides, herbicides, petroleum or heavy metals), as well as confirming or ruling out the presence of toxic materials including mercury, lead paint, asbestos or mould. Because most lenders require an Environmental Assessment before loan approval, if you find environmental damage or contamination, you can make the complete remediation of the damage or contamination a condition of the sale or walk away from the deal entirely.

How Long Does Commercial Due Diligence Take?

Due diligence typically lasts anywhere from 30 to 90 days and usually occurs after both the seller and buyer sign a non-disclosure agreement (NDA) and a Letter of Intent (LOI). Although not a binding purchase offer, the Letter of Intent assures the seller of your willingness to eventually submit a bid, while the confidentiality agreement aims to protect financial data, tenant and supplier lists, intellectual property and any and all information communicated by either party during the due diligence process.

Once you sign the NDA and Letter of Intent, make sure your 30-90-day period begins only after the seller delivers the final set of documents required by your marketing, building inspection, finance and legal teams directly to you.

If you fail to gather all the information necessary during the due diligence period and it expires without both parties signing off on an extension, you’ll either go forward with the purchase or withdraw from the deal and forfeit any security deposit that was initially required.

Who Should Complete the Due Diligence?

Working with an experienced commercial real estate expert plus due diligence professionals, including building inspectors, engineers, architects, accountants, lawyers and environmental consultants, is crucial to uncovering information and expediting its analysis.

The Importance of Applying For Financing in Tandem with Conducting Due Diligence

Applying for financing in tandem with doing due diligence accomplishes three things. First, because the process of due diligence can require significant cash outlays, knowing you have enough funding to pay for it over the long run will lessen the temptation to cut corners. Second, it assures that you can satisfy lender requirements for information on items such as Environmental Assessments. Third, if due diligence reveals the need for significant repairs or renovations after you buy, you can roll those costs into the amount you ask for from your lender.

Don’t Cut Corners When it Comes to Due Diligence

Owning commercial real estate carries enough risks as it is. Doing due diligence, while sometimes costly and always more time-consuming than desired, protects you from unseen threats that could wreak havoc on your finances. Moreover, it provides a clearer understanding of a property’s strengths and weaknesses – and, ultimately – better assurance of its ability to generate future profits.