Conducting due diligence properly on a commercial investment property not only helps you avoid costly mistakes, but it also improves your skills as a commercial real estate investor.
While years ago the due diligence period stretched to nearly a month, today serious investors may have less than two weeks to examine all the documents and perform inspections between signing the Letter of Intent and the closing.
Mistake #1: Assuming Lenders Will Accept 3rd Party Reports
Banks and private lenders may have specific companies designated as acceptable for providing inspections, surveys, and other assessments.
Save time and money by checking with your lender to see if they have a list of approved vendors before you start the due diligence process.
Mistake #2: Trusting Sellers To Disclose All Problems With The Property
In an ideal world, sellers would disclose all problems with the property before prospective buyers even sign a letter of intent. Unfortunately, not all sellers are eager to reveal of the issues of a property, which is why you must do a thorough inspection of everything – even if the seller “thinks” there might not be an issue.
Furthermore, you should keep asking any questions in writing regarding the property, and make sure to keep a hard copy of your conversations just in case.
Related problems that also occur are inspections and reports provided by the seller fail to disclose a serious problem with the property.
In these instances, the problem may have been the responsibility of the seller or the issue may be so severe that it might be almost impossible to resell the property to another party.
On the other hand, if these problems are found before closing, the buyer will be able to negotiate a reduced price.
Mistake #3: Assuming A Property Is Code Compliant
Have an architect or contractor inspect the investment property beforehand to see if it meets all ADA and building codes. This is much better than finding out- as many owners have- that the property is not a code compliant when a city inspector comes to check your completed renovations.
Mistake #4: Skimping On A Business And Legal Review Of The Property
Business and legal reviews should uncover a wealth of information that if not thoroughly explored, could leave you open to lawsuits from tenants, neighboring property owners, and vendors.
Another important factor, unrelated business taxable income (UBTI) is defined by the IRS as, “ the Gross Income derived from any unrelated trade or business regularly conducted by the exempt organization, less the deductions directly connected with carrying on the trade or business.”
In simple terms, these are monies generated by a non-profit foundation through taxable activities.
It’s important that all of these issues be addressed before the closing. Even if the contract makes the seller responsible for any issues or if a seller has dissolved or sold all assets beforehand, the buyer will have no recourse in addressing any future problems.
Mistake #5: Not Checking Tenant Leases Carefully
Checking tenant leases may take up a significant amount of the time you have allotted to due diligence.
However, considering the number of potential minefields (fixed option rents, cancellation clauses, caps on pass-through expenses, etc) can not only cause serious cash flow problems but can also devalue the property.
Doing your due diligence is one of the most basic tenets of commercial real estate. Keep in mind that this is not a conclusive list of all the due diligence issues that may arise, although a due diligence checklist will help you avoid the most mistakes.
Your best bet is to use a team of professionals experienced in commercial real estate, including a broker and attorney, to help you successfully navigate the process.