Due Diligence Mastery Lesson 3

Lesson Three: Due Diligence: Signed Purchase Agreement

Congrats! You have a signed purchase agreement and now you can sit back and wait till closing. If only it were that easy. This is where the “real” due diligence begins since you have the right to request more information and reports. In this lesson, we will focus on the reports you should be looking for.

3.1 Third-Party Reports

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. Let’s discuss the key third-party reports you should be reviewing.

The first report is the Phase I & Phase II Environmental Reports. If there are any outstanding or alarming environmental or hazardous materials issues, you need to get resolution ASAP, such as a “no further action required” letter from the local governing authority handling those issues. The second report is the Property Condition Assessment Report. If there is a report available, it will give you an idea of which issues were outstanding when the current owners purchased the property as well as what has been fixed or upgraded since their ownership.

The third report is the Seismic/PML (Probable Maximum Loss) Report. If available, it will indicate if the property is located in an active seismic area and what, if any, damage was incurred in the last earthquake, as well as what the probable maximum loss would be in the event of another strong earthquake. A PML of between 18 to 20 is acceptable to most lenders, over that creates cause for concern. This would be applicable to property located in California particularly or any state that has any type of earthquake concern.

There are many other possible reports that could be generated, either as part of a report (such as the Property Condition Assessment Report), or as a totally individual specialized report; for example: structural, elevators, roof, air conditioning, ADA compliance, mold assessment, geological and any other aspect that could materially affect the property. Ask for and review any and all available existing third party reports that are in Seller’s possession.

When you have to order any type of third-party report, make sure you bid them out to two or three companies who are approved by the lender (without lender approval you may be forced to have report completed again by another vendor acceptable to lender). Also, make sure that whoever you choose is aware of any issues that are of concern to you, such as the elevators, HVAC, roof, etc. Let them know that you want them to pay special attention to those items you mention to them and to call you with their assessment of those issues when they are finished inspecting the property. This is important because there could be large expenses that will have to be dealt with once the property is bought and you want to be able to have the option of negotiating with the seller on those issues before your inspection period has expired and your money has gone “hard” (i.e. nonrefundable).

3.2 Conducting Tenant Interviews

Much information can come from the reports, but it is also important to talk to the tenants of the properties you are purchasing. Most of the time the seller will insist upon having their representative present during all tenant interviews. If so, tell them you do not want the property manager there because the tenants may feel intimidated, but if need be, you will agree to their broker representative attending the interviews. There are many things that can be found out about the building; its history and its current ownership, as well as what improvements can be made to enhance tenant relations and retention.

It is best to have a tenant questionnaire sent to the tenants ahead of time to prepare for the interview. This will allow them to think through some of the questions so that they may elaborate on them during your interview. It is important to find out if there are any outstanding issues that need to be resolved or any side agreements between the tenant and the landlord which may impact your purchase of the building. For example, “Does the landlord owe you any outstanding tenant improvement dollars or free rent?”; “Is there any litigation currently pending between you and the landlord at this time?”

Much can be uncovered during the interview in regards to their tenancy and experience in the building, as well as the submarket area in general. Many tenants will give you a wealth of information if you give them the right questions to respond to. For example:

  • “Tell me what your likes and dislikes are about this building.”
  • “Have you had any bad experiences in the building you can share?”
  • “How is the security in the building and in the surrounding area?”
  • “Have you had any problems with the HVAC or elevators?”
  • “Have you experienced any leakage from the windows when it rains?”
3.3 Conducting Other Interviews

In addition to interviewing the tenants, you should also take the time to talk to the property manager and the building engineer. When interviewing the property manager and building engineer, keep in mind they are representing the seller and do not want to say anything that might upset the transaction. Try to get them to understand (if they are with a third party management company) that if they are going to stay on with the building after the close of escrow, they are going to have to be forthcoming with information with you, “good, bad or ugly.” This will sometimes prompt them into telling you more about the issues and problems of the property and tenants.

In addition to the property manager and building engineers, you should also interview the current leasing broker. When interviewing the current leasing brokers of the building, find out what transactions (if any) are in progress and what the particulars are on each of them. Ask to see any pending lease proposals, activity reports, and/or transactions in progress reports. Ask them about what is happening in the submarket in terms of activity, pending deals and tenants who are in the market or about to start looking for space that you may be able to go after, should you have the available space to offer them. Also, find out what recommendations they have to improve the building or tenant relations. This will give you an indication as to how the current ownership handles the existing tenants and current leasing efforts. Let them know that you would consider keeping them on but that you want them to be completely candid with you in regards to the current ownership’s status with their tenants and the building issues (if any).

Finally, you should interview potential leasing brokers. It is important that you find out who the top leasing brokers are in the submarket that the property is located in. Call on the top two or three and ask to meet with them either in their offices or at the building, if possible. Find out what their impression is of the building; where it fits in the submarket against the competition; what the competitive set is; what they think the building needs for enhancement purposes; what their impression is of trying to do deals with the current ownership; what is going on in terms of transactions in the submarket; what tenants are looking for space; what the subject building can expect in lease terms, i.e. rental rates, tenant improvements, concessions, lease term, parking rates, brokerage commissions and incentives and any other pertinent information that can be gathered.

This is your big opportunity to gather as much information as possible on the subject building’s submarket from the people who help drive the market. Make sure you are optimizing your opportunity to get as much information as possible. Ask as many questions as you can in order to thoroughly familiarize yourself with the building and submarket you’re buying in. Ask if you can tour the competitive properties in the area with them so that they can point out the strengths and weaknesses of the subject property against the competition. This will give you an excellent perspective on how prospective tenants could view the building you’re looking to purchase.

3.4 Conducting Other Interviews

One of the best ways to find out more about the property, the tenants, and the area is to be present at the property. Spend time there and actually “self-learn” the investment you are about to make. There is much to be experienced and found out by spending time in and around the building. You will discover what the tenants are like; how the parking works in terms of availability and peak hours; what the surrounding area looks like in terms of activity and people, at different times. It’s important to check the property out at different times of the day in order to get a better feel for how it operates; i.e. Is the HVAC running after normal business hours or on weekends when it’s not supposed to? Is the building locked after normal hours or is the security for the building adequate? Is the lighting for the parking structure and around the property adequate and does it stay on 24/7 or does it operate at minimum standards after a certain hour, e.g., after 11PM?

Take time to discover any possible issues that could be occurring in and around the building such as: leaking from pipes, HVAC ducting, plumbing; cracks in the roofing, concrete, structure, glass; staining on carpeting, ceiling tiles; odors in and around common areas that could indicate the presence of mold and/or mildew; petroleum odor near the elevators, which could indicate leaking hydraulic fluid and any other peculiar smells that could indicate potential problems with the building.

You may be surprised at the different foot traffic that goes through the building. If the building is located in a major metropolitan area, you may get some vagrants coming in the building when it first opens, using the restrooms to clean up. If located near a school, you may get kids cutting through the parking structure or garage looking for a car with valuables in it. The point is that you want to be aware of what is going on in and around the building at different times of the day in case there is a potential problem that you might not have known about, had you not investigated.

3.5 Loan Negotiations

While you are busy looking through all of the reports, you also need to make sure that your loan approval process is moving forward. Once you have received the initial approval, they will send you a term sheet outlining the terms and conditions on which they will lend, (i.e. subject to a minimum appraisal amount; debt coverage ratio; future financial hurdles; review and approval of borrower’s financial statement, etc). You can be certain that this is just the beginning of negotiations for the final loan terms. Especially in today’s lending world, you can plan on negotiating all aspects of the loan right up to the very end when they are about to fund. For whatever reason, that has become acceptable practice in today’s lending environment.

Always take the approach that they are not the only lender out there and you would like to establish a business relationship with them to do more business, but not at any cost. Do not be afraid to negotiate the best possible terms and conditions for the loan. Always have an attorney who is competent in negotiating loan documents, review the loan docs and to fight for your best interests regarding carve outs, guarantees, liabilities, indemnifications, etc.

There are many other terms and conditions of the loan that must be carefully negotiated, such as reserves for tenant improvements, leasing commissions; capital improvements, financial reporting, etc.

Be sure to have the attorney (and the mortgage broker, if one is involved) review the loan agreement and promissory note and compare it against the fully executed term sheet to make absolutely sure that the terms and conditions are the same and no changes or additional stipulations have been added that can come back to haunt you later on. This is a crucial point because lenders will not cut you any slack when things start to go awry; especially if the loan has been sold to another entity. They will refer to the loan agreement and note that was signed off by the borrower. If people were not paying attention while negotiating the terms and conditions, there will be a lot of finger pointing to no avail. Better to scrutinize the paperwork BEFORE you sign.

In addition, always try to negotiate a one-time assumption at no cost to the new buyer especially if the loan has favorable terms. It will not cost you anything and it will enhance the assumption option for the buyer should they want to assume the loan and save money, usually one point of the loan balance.