An investor's Guide to Commercial Real Estate Due Diligence

Real Estate Due Diligence:

  • Real estate due diligence is essential for determining the profitability of a property.

  • Investors complete due diligence to confirm the facts and details of the property.

  • Types of Real Estate Due Diligence:

    • There are various categories of real estate due diligence, including analyzing the location and understanding contracts.

    • Other categories include estimating after-repair value, conducting property inspections, and reviewing financial and legal matters.

  • Analyzing the Location as Part of Due Diligence:

    • The crime rate, population and business growth, school ratings, and occupancy rate are important factors to consider when analyzing the location.

    • High crime rates, low population growth, poor school ratings, and high inventory can negatively impact the profitability of a rental property.

  • Estimating After Repair Value (ARV):

    • Knowing the ARV is crucial in determining the success of a property.

    • Investors can calculate the ARV by adding the purchase price and value-added through renovation and subtracting the estimated repair cost.

    • The ARV can also help determine the maximum purchase target and loan amount.

  • The Importance of a Pro Forma Report:

    • A pro forma report provides rental income and expense history, which is vital for investors.

    • Net operating income from the pro forma report is used in calculations like cap rate, cash-on-cash return, and ROI.

    • Investors should verify the accuracy of the pro forma report to avoid making detrimental investment decisions.

  • Dangers of Pro Forma Reports:

    • Pro forma reports provided by sellers may contain inflated values or missing expenses.

    • Investors should research the local market to verify vacancy rates and be cautious of optimistic appreciation assumptions.

  • Estimating Renovation Costs:

    • Knowing the neighborhood, touring the property, noting problem areas, organizing repairs into categories, and determining rehab costs are steps to estimate renovation costs.

    • Investors should ensure that renovations align with the neighborhood and projected rental rates.

    • Breaking repairs into categories and collaborating with contractors can provide rough estimates of materials and labor costs.

  • Understanding Contracts and Sales Timelines:

    • Understanding the timeline is essential during the due diligence process.

    • Residential property sales contracts typically have a 30-day window to close, while multi-family properties have a 60-day window.

    • Investors should use the limited time wisely and negotiate an extended inspection period if needed.

    Completing Property Inspections:

    • Thoroughly inspecting the property helps investors understand its condition.

    • Inspecting the overall physical condition, checking for hazardous substances, verifying square footage, and evaluating major systems are important steps.

    • Specialized inspections for lead, asbestos, radon, and termites may also be necessary.

  • Termites and Environmental Surveys:

    • Termites can cause significant damage and should be promptly addressed.

    • An environmental survey may be necessary for multi-family or commercial properties.

  • Financial Due Diligence:

    • Investors should review financial documents carefully.

    • Important documents include the rent roll, T-12 operating statement, delinquency report, and list of capital improvements.

  • Reviewing Existing Leases:

    • Investors should examine lease details such as lease type, rental rate, security deposit, late fees, pet policies, utility information, and addendums.

    • Understanding the terms of existing leases is crucial for planning necessary actions.

  • Verifying Legal Matters:

    • Consulting a legal professional is advisable for checking legal matters.

    • Examples of legal considerations include HOA restrictions, property use restrictions, and title and tax searches.