Due Diligence Mastery Lesson 2

Lesson Two: The Initial Stages of Due Diligence

The due diligence begins after you have selected the property you want to invest in and have begun the negotiations. It is important to be fully informed about the property and the requirements of the purchase before you go too far in the process!

2.1 Finding a Commercial Real Estate Attorney

Before you begin any transaction, you should make sure that you have your “team” together. One key person on your team is an attorney who understands commercial real estate. This attorney will be an important asset to you and you should feel comfortable in his or her abilities to negotiate and focus on the important issues. A strong attorney will help you to resolve issues and work through any potential problems creatively and he or she will find and point out any potential pitfalls of the deal.

The due diligence process does not just include the transaction itself, but also the people involved in the transaction. If you have not chosen a reputable real estate attorney, make sure that you do your due diligence on them before you choose them to represent you. You should ask the attorney for references, specific to the type of transaction you plan to work on with them and also about their past experiences. Taking the time to make sure you have a strong and competent attorney on your team will save you time, money, and headaches!

It is also important to remember that you get what you pay for! This means that the cheapest attorney does not always save you money in the long-run. You want to make sure that you have found an attorney that can help you, guide you, and point out potential issues and not just one who can prepare documents for you.

2.2 Beginning Due Diligence: During the Negotiations

When you begin the negotiations for the deal and start to work on the purchase and sales agreement, one of the first items you want to request is all of the leases and operating statements (year-to-date and also the past three years). However, many times the seller might be unwilling to provide this information until they have a signed agreement, but it never hurts to ask.

One of the main reasons for asking for the leases is to determine if there is anything in the leases that would prevent you from moving forward on the acquisition. When reviewing the leases, here are three areas to review:

  1. Look for any outstanding issues that may affect the leases, such as a cancellation/termination provision; buyout provision a reduction of space provision; or any other issues that could impact the “value” of the lease. Immediately address any major issues with the seller or their broker to find out if they are aware of any information that could shed further light on the issue(s)
  2. Confront the outstanding lease issues immediately and try to resolve them so as to not spend unnecessary time on a transaction that has unsolvable problems and issues. Time is better spent on “doable” deals.
  3. Ask to review all tenant files and correspondence. This will give an indication as to what issues are going on in the building, i.e. HVAC, plumbing, security, etc. and which tenants you need to be really speaking with. The ones who are writing the current landlord will most likely be forthcoming when it comes to telling you what’s “wrong” with the building. This will most likely be done during the time when you are at the building conducting the tenant interviews, after the purchase and sale agreement has been fully executed.

In addition to the leases and operating statements, you should also request all service contracts. Make sure you receive all the current service contracts that are in effect at the building. You may receive the following contracts:

  • Elevator Maintenance Contract
  • Roof Maintenance Contract
  • HVAC Maintenance Contract
  • Interior Plant Maintenance Contract
  • Landscape Maintenance
  • Piped in Music Service Agreement
  • Janitorial Service Contract
  • Parking Company Contract
  • Trash Removal Contract
  • Property Management Contract
  • Pest Control Service Agreement
  • Hazardous Waste Removal Service
  • Security Service Contract
  • Metal & Stone Maintenance Service Contract
  • Property Taxes Appeal / Property Tax Consult
  • Utilities Contract

Review carefully all service contracts in effect to make sure that they are cancelable with 30 or 60 days’ notice. Make special note of any that is self-renewing for long terms, such as one year or longer. If you come across any of these types of agreements, make sure that the seller understands that he/she will be responsible for any costs incurred for early termination or be prepared to live with them for the duration of the remaining term. You want to have the flexibility of bidding other outside vendors and replacing the old ones if you feel you can strike a better deal with another vendor. Be sure to note any special type of needed service contract, e.g. roof maintenance to comply with the warranty.

During the initial due diligence process, you should also ask for a list of all inventories from the seller. The items could include lighting and janitorial supplies; office furniture, equipment and supplies; tools and equipment; spare parts; motors; building plans; desktop and laptop computers etc. Make sure this list is provided and included in the purchase and sale agreement so both parties are aware of what is included in the sale.

During the due diligence process, you must verify that any equipment that is used as part of the operation of the property is listed, included and transferred at the close of escrow. Take photos of the inventory so that you can look to see if any of the equipment and/or supplies were moved out prior to the close of escrow. This happens often, especially when sellers have other properties in the area they own and can use them there.

Another key component of the due diligence process at the early stage is to review all mechanical systems. You need to address certain issues that you believe will impact the building from a physical, material or financial perspective that you discover with the third party investigative reports. You want to determine early on which items are going to be “deal breakers” and which ones you can negotiate on. Either way it’s important to figure them out as soon as possible; and if possible bring them up while negotiating the purchase and sale agreement, and make sure that the solutions to any issues negotiated are incorporated into the agreement so there are no “loose ends.” Any items left out will likely be forgotten or “overlooked.”

If that is not possible or issues or problems are discovered later in the due diligence process, make sure you are aware of the costs involved and how it will impact the financial analysis and be prepared to confront the seller properly “armed” with the right information; estimates for repair or replacement, etc., as applicable, so you can legitimately ask for a discount.

With mechanical system permits, make sure that all permits required for the operation of the property, such as elevators (annual and five-year load test); fire panel; fire/life safety; boiler; emergency generator, etc. are up to date and no outstanding violations exist.

2.3 Choosing a Lender

If you have decided to use traditional lenders for your financing, you must conduct due diligence to find the right lender.

Mortgage Brokers: You can choose to work with reputable mortgage brokers who come highly recommended. They will have a variety of lending institutions that they work with and will give you a number of choices that could work for your particular acquisition. It is best to let them know if you are planning to work with other brokers and ask that they submit a list to you of the lenders they are planning on going to so there is no duplicity among the brokers you’re using. It is best not to use more than a couple brokers at a time on a property so that they don’t step on each other with contacting the same lenders and create a lack of motivation due to excess competition.

Banks/Direct Lenders: You can also choose to go directly to a lending institution of your choice; either a bank, insurance company, credit union or other direct lenders. This could save you some money up front, such as loan points that would normally go to the mortgage broker. However, keep in mind that it does not always work that way and you will have to do your own shopping around and negotiating to make sure you’re getting the best possible deal out there. A good mortgage broker knows how to work the lenders and create competition amongst them in order to obtain the best pricing and terms for the loan.

Assignment:

In Lesson One, we noted that the seller may not be willing to provide much information without a signed purchase agreement, but now that you have signed the purchase agreement after your initial due diligence, you have the right to ask for more detailed reports. In Lesson Two, you learned about three main external reports. Discuss each report and what would be included in each report that would be important to an investor.

This assignment is your study guide to ensure you have learned these materials before you take the required quiz.