How to Do Due Diligence Before Acquiring a Commercial Property?

David Cohn
Mar 2, 2021
commercial real estate

Purchasing any commercial real estate requires a sizable investment, so you want to make sure that you're not buying a money pit.

Whether you're acquiring a facility for your growing business or investment property for your portfolio, the last thing you want is to inherit unknown risks.

Doing thorough due diligence is essential in ensuring that you are making a solid investment. In this blog, we talk about the considerations to look into in commercial real estate due diligence.

These considerations can help you determine a commercial property's current value and potential future value.

It can also help you strategize and determine a feasible offer price and ultimately help you decide if the property is worth purchasing or not.

Due diligence tip #1: Understand the real condition of the property

Walk the site several times—at different times of the day of the week—so that you can familiarize yourself with the characteristics of the physical asset.

During your visits, ask the seller whatever questions come to mind. It's also a good idea to talk to some tenants and note their concerns if you can do so by the seller.

This is a great way to familiarize yourself with the property you are interested in buying.

As you walk around the site, check if everything is accurately represented on the floor plans, site plans, architectural drawings, and unit descriptions.

Keep in mind that some structures may have undergone remodeling, but it did not accurately update their floor plans.

This is why it's a good idea to request an inventory of recent changes and repairs. It will give you a good grasp of maintenance work that may have been deferred and major capital projects that have been completed.

Another essential element to understanding the property's real condition is to review all contracts related to the asset carefully.

Verify vendor contracts, leases, easements, existing insurance policies, municipal certificates, guarantees, inspection documentation, etc. Check if the property has any encumbrances that may prevent it from being transferred to a buyer or financed by a bank.

Questions-to-ask: When investigating a commercial property's condition:

  • Do the architectural drawings and site plans accurately depict the current condition of the building?
  • Will the property require significant renovations and other capital investments? If yes, what's the estimated cost of these investments?
  • Are there any encumbrances and issues such as liens and municipal violations?

Due diligence tip #2: Analyzing revenue and expenses

You already know by now that the income generated by a real estate asset is a significant determinant of its value. Income, in this case, usually refers to associated leases. A detailed lease review is essential to due diligence.

If you're interested in buying an office or retail property, there's probably only a handful of tenant leases to look at—in many cases, no more than five. The terms will also be longer (usually anywhere from 5 to 15 years).

Multifamily commercial properties are a bit trickier because they involve many leases—sometimes in the hundreds—and with terms that are generally shorter (typically about one year). Other commercial asset classes such as self-storage and hotels may have completely different income-generating structures.

The best way to review a property's revenue is to ask the landlord for their tenant rent roll.

Any professionally managed property should have a fairly detailed rent roll that summarizes factors like tenant information and their corresponding rent payables, lease structure, regular rental rate increases, lease duration, terms, etc. Be sure to compare the rent roll to the actual leases. Watch out for any mistakes, incongruent terms, or omissions.

Some commercial properties have more than one source of income, so you will want to review those other sources as well.

For example, office and retail properties usually make money from concession sales and parking. Multifamily commercial real estate assets sometimes make money from things like amenity fees, pet rent, etc.

Do keep in mind that these secondary revenue streams' long-term viability can be affected by renovations, tenant turnover, shifting trends, and occupancy fluctuations.

It would be best to look at the property's expenses, among the areas that need special attention to require large outgoings, such as property taxes, insurance costs, utilities, and maintenance costs.

Proper due diligence means forecasting these expenses accurately. Look at the asset's historical financial statements to verify each item.

Questions-to-Ask: Assessing a property's income and expenditures:

  • Does the rent roll reflect all lease terms? If not, are there any discrepancies that may create additional costs or risks to you as a buyer?
  • What are the current tenants paying, and how long do they have left on their leases?
  • Are there vacancies on the property? Determine if those vacant spaces are ready to be rented out again immediately or need improvements to be lease-ready.
  • Who might the new tenants be for those vacant spaces?
  • If there are other sources of revenue, are they viable for the foreseeable future?
  • How much in insurance costs and property taxes will the property need to pay in the next few years?

Due diligence tip #3: Evaluating the submarket

The submarket of a commercial property refers to physical and social boundaries establishing its location and neighborhood.

Lines of demarcation include obvious geographical boundaries like rivers or highways and less obvious factors such as municipal boundary lines and school districts.

In some cases, the prices of commercial real estate in two submarkets that are right next to each other can be night and day, so you really want to be careful and make sure that you are paying a fair cost for the property you want to buy.

You can do this by analyzing recent comparable sales. If you're buying an office building, for example, you will want to check how much similar office buildings in the same submarket sold recently.

You'll also want to check the average submarket lease for comparable properties.

Do the current tenants pay above or below that average? This is important because should an underpaying tenant seek renewal or decide to leave, you have the opportunity to increase property revenue by signing the new lease at the current submarket rate.

Conversely, you may be forced to lower rental rates if it turns out that similar properties in the same submarket are renting for much less.

Questions-to-ask: When evaluating the submarket

  • Is the price of the commercial property proportionate with sales made recently in the submarket?
  • Do tenants pay above or below current average rental rates in the area?

Hiring professional inspectors

It's best to work with professional inspectors and engineers as the buildings to a physical structure, zoning, and environmental conditions. It also makes sense to have a lawyer help you spot any liabilities in contracts related to the property (including existing leases).

A lawyer can help you with a lien search and can look for encumbrances and other issues that may not be obvious. Due diligence requires some investment, but it can help you avoid expensive surprises later on.