In real estate investing, “due diligence” is an inquiry that investors and their advisors make into whether a property is a solid financial investment.
The due diligence period for most commercial triple net (NNN) investments is 30 days after the seller and buyer execute the purchase contract. At the end of this period, the buyer has two choices:
- Continue with the sale and close the contract
- Cancel the sale and receive back the earnest money from the title company.
To avoid arguments against the refund, the buyer should draft a sale contract that includes the language: “In the purchaser’s sole discretion, he or she may void the contract during the 30-day due diligence period for any reason by giving written notice to the title company. Receiving back earnest money does not require the approval of the seller.”
THE DUE DILIGENCE PROCESS
When they perform due diligence for a commercial real estate property, an investor and his advisors complete 4 basic processes:
- They examine features of the loan.
- Physically inspect the property.
- Review the lease and title reports for the property.
- Examine the seller’s books and records.
Below is a basic overview of each process.
If the investor decides to buy the asset and apply for financing, he should work with a broker to identify the best loan for the type of real estate he is acquiring. The loan amount, interest rate, fees, and terms of the loan should be compared against the projected income received from the investment property. If the loan does not make financial sense, the investor may CANCEL the sale!
The physical inspection should be scheduled weeks in advance. Depending on the characteristics of a building and how it will be used, a professional inspection engineer may need to provide an expert opinion on its condition. Regardless of whether an engineer is retained, the buyer must inspect the roof of the building, its HVAC system, parking lot, and general structure.
The building must also be evaluated for code compliance, including codes related to:
- The Disability Act.
- Environmental Protection Agency (EPA) regulations.
- And municipal regulations that impact the operation of businesses in the area.
Because code compliance can be a tedious affair, compliance officers should ideally determine the code readiness of the building.
It is important to remember that, because the tenant is responsible for providing building maintenance for a triple net lease property, the property owner may not have a good idea of whether the building is up to code, or whether its systems are in good working order. This is especially true if the buyer lives outside the area where the business is located.
LEASE REVIEW AND REPORTS
If the investment property is subject to a triple net lease, a real estate attorney should examine the terms of the lease. In addition, an updated title report and survey should be ordered and examined to grant a clear, insured title to the buyer. The report should expose any restrictions and easements, such as those involving lot size, building footprint, and setbacks of the property.
BOOKS AND RECORDS
Another aspect of due diligence is examining the seller’s books and records that display past income and expenses for the property. Ideally, the seller should provide records going back at least three years. Examining the sales history of the present tenant, and determining the responsibility of the landlord versus the tenant in paying for property expenses is crucial.
The purpose of due diligence is to increase the investor’s ability to make an informed decision. To this end, the processes performed in 30-day due diligence period that follows the initiation of financing are crucial for supplying the investor and his advisors with the information they need to move forward with the purchase, or cancel the sale and look for other investment real estate.