CRE - Due Diligence
Due diligence is a critical component of the investment process. We have posted in the past about preliminary underwriting, which requires (at a minimum) some cursory due diligence to confirm that the asset is worth pursuing. However, this article will focus on the deeper dive due diligence generally performed once the LOI or the Purchase and Sale Agreement has been entered into, or at least exchanged.
For purposes of this post, we broke the due diligence process into three components, consisting of Physical, Business, and Legal. There are many factors and deal by deal scenarios that will dictate the depth and focus on each of the items summarized below. Such factors can include:
The asset's location (e.g., urban vs. suburban).
Age of the property.
Tenant type.
Lease structure.
Equity position.
See our previous post regarding investment objectives. What may seem like a negative for one type of investor may spell opportunity for another. For example, below-market occupancy could be negative for a core investor but a potential positive for a value-add investor. Due diligence is about asking the right questions. Accordingly, our list below focuses on the questions that the investor should consider. The ramifications of the answers may vary by objective and its related strategy.
The following is not an exhaustive list, and the investor should outsource many of the items listed below to third party experts (which may lead to better or more targeted questions).
Physical:
Structural Integrity & Building Envelope – foundation issues? Watertight or history of leaks? If relevant based on local laws are façade inspections up to date?
Mechanical, Electrical & Plumbing (MEP) – age and useful life remaining? Quality of maintenance? If the strategy includes a change in use (single-tenant to multi-tenant) – are the systems conducive to such a change? Does the building have adequate electrical service to accommodate higher density tenants? Does the property have redundancy in services – such as multiple water mains?
Vertical Transportation – elevators and escalators – how many and how old? Do they accommodate higher-density uses? Have they been upgraded, or if not, when will they be due for an upgrade, and at what cost?
Tech Infrastructure – particularly for older buildings – is there conduit space? Are there redundant service providers? Does the building need a DAS wireless solution to address connectivity?
Phase I (& II) – are there any environmental issues that need to be addressed?
Business (Operations and Financial):
Have you prepared a zero based financial analysis of income and expenses.? Using historicals is a great starting point, but have you verified the numbers and adjusted them to your management style and overall strategy? Are historical expenses based on the seller’s portfolio, that you cannot replicate, such as a blanket insurance policy that leads to reduced premiums (or a below market allocation to this asset)?
Service & Amenities – are they in line with market expectations? Is there room for expansion? What amenities do tenants expect in this sub-market?
Access to Transportation - what is the "walkability" of the property? Is there public transportation? Can the employees of your desired tenants get there?
Market Size & Competitive Analysis – what is this property's position in terms of its market?
Lease Structures – is the lease structure - NNN/ modified gross/ gross – conducive to your strategy? Does it match up with your cash flow underwriting in terms of tenant recoveries? See our previous article on lease structures.
Tenant Analysis. – what is the creditworthiness of the current tenants? Are they likely to stay? Do you need to factor in buyouts or relocation costs for office tenants? Do the tenants have special buildouts that are unique to them our would be costly to remove (who is responsible for the cost)?
Legal
Deal Documents - while not necessarily property-level due diligence, many of these documents determine the deal structure and tie back to the underwriting – particularly the loan document and the entity documents – which will spell out splits, hurdles, waterfalls, promote structures, etc.
Lease Abstracts – do the leases tie back to your underwriting – such as base years and recovery caps? Does your underwriting factor in below market renewal rights, expansion rights, and rights of first offer/refusal?
Tenant Estoppels – frequently required (as some % of tenants) by the lender – again, any discrepancies between the estoppels and leases? Any highlighted areas of concern – tenant complaints or claim of landlord default?
Survey & Title – confirming clear title – working with title company objections.
Easements – any existing easements or entitlements that restrict property use or subject the owner to additional costs or liabilities?
Zoning Status – is the property in compliance in terms of its current use? Does the use change, if any, require zoning approval or a variance?
Once you have the answers to these questions, you need to ask a few more to make sure you adjust your underwriting and decision process accordingly. For example, (i) does physical due diligence findings reconcile with the anticipated capital budget? (ii) do the operating expense recoveries allowed per the leases match the assumptions in the underwriting? (iii) do the loan documents require a cash sweep or other escrow that was not contemplated in your cash flow analysis – which may reduce your investor distributions?
Depending on the results of the due diligence (and the structure of your contract), there are three main ways to proceed – move forward on current terms, re-negotiate based on unexpected findings, or walk away. Walking away can be difficult, especially for the newer investor that fell in love with the deal – that is why a disciplined due diligence process with trustworthy professionals is critical.
This article is for general information, educational and entertainment purposes only. Establishing and implementing a strategy for a particular property encompasses many unique factors, and professional advice/services should be sought for that particular transaction or investment.
CRE Vertical Advisors, LLC focuses on implementing a comprehensive & consistent strategy across all aspects of the real estate vertical to best achieve investment objectives.