In the real estate investment market, “due diligence” refers to the care an investor takes in investigating the characteristics of a property before he buys it. Many types of properties (residential, industrial, retail, etc.) involve the same elements of due diligence, but there are also some variations from property to property.
Below is a general overview of the process of due diligence one should perform before making a real estate investment in a retail property.
PHYSICAL EVALUATION
The physical state of the property should be evaluated for two reasons: to assess potential maintenance costs for the tenant (assuming a triple net lease is used), and determine whether the condition of the property could negatively affect its operation. Key building areas to investigate when performing the evaluation are:
- the foundation,
- roof,
- HVAC system,
- electrical system,
- plumbing system,
- and building envelope (i.e. doors, windows, and walls).
TENANT QUALITY
The investor should ideally make an investment in real estate that a “creditworthy” tenant occupies. Creditworthy tenants, which have a solid credit rating from a trusted ratings organization, are often part of a national chain, and have access to public credit markets. A Standard & Poor (S&P) credit rating is the gold standard for assessing a tenant’s creditworthiness. Tenants that have a rating between B and A are considered investment worthy.
LEASE QUALITY
When commercial properties are purchased with a lease in place, the contract must be evaluated financially. Do escalation clauses favor the tenant and not the owner? If the lease will expire soon, what are lease rates for newly leased, similar properties in the same area? Does the tenant have a renewal option at the end of the lease? If so, what are the terms of the renewal? These are important questions to answer before purchasing a retail property.
MARKET AREA
The general area where it is situated can have a major impact on the success of a retail business. Working with a real estate investing specialist, you should assess the following elements of a business’ market to determine how they impact it finances: nearby traffic flow (vehicle and foot), population demographics for the general area, local household incomes and spending patterns, and parking lot size in relation to parking availability in the general area.
COMPETITION
Most businesses that occupy commercial properties have competitors in the general area. Having competition nearby isn’t always a bad thing, as long as it isn’t significantly better positioned in terms of traffic flow and parking, and as long as it doesn’t have prices and goods/services that draw customers away from surrounding retailers. For example, a Whole Foods located next to an old chain supermarket could present a real problem for the latter.
