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Commercial real estate investing offers the opportunity for investors to access a stable asset class that can offer significant financial returns. However, like any investment, investors must be careful of potential risks in a particular real estate deal. To mitigate these risks and maximize your investment return, it’s critical to conduct detailed and comprehensive due diligence.
Due diligence is the evaluation, investigation and analysis of a property and transaction before closing a potential deal. There are multiple aspects to due diligence, including financial, legal, tax, and others that will give you a complete overview of the property and proposed transaction. While this process may be intimidating to some investors, it’s essential to establish a structured approach when conducting due diligence for commercial real estate investments.
The goal of due diligence is to learn as much as possible about a potential investment property prior to deciding whether to proceed with the transaction. In any investment, there is a natural asymmetry between the buyer and seller. The seller, who currently owns the property, knows more about the property (including benefits and risks) than the buyer or investor. To reduce this asymmetry, investors not only tour the property and speak with the seller and broker, but also they evaluate financial, legal and other documents as part of detailed analysis.
Overall, investors want to make a fully informed decision before risking their capital, and they want to determine the property’s inherent value and potential for growth. Proper due diligence can help investors avoid potential liabilities, which can damage investment returns. By understanding the benefits and risks of any real estate investment upfront, investors can make more confident decisions about a commercial real estate investment. Leveraging the expertise of lawyers, accountants, brokers and independent consultants can help you evaluate a potential investment property during the due diligence process.
Let’s review several types of due diligence that, at a minimum, any commercial real estate investor should conduct:
Legal due diligence can include several areas. For example, you should confirm the property’s ownership, including title. Review the deed and make sure there are no liens or encumbrances that may adversely affect the property. You should also review any legal agreements related to the property, including any existing or pending litigation. The existence of liens or encumbrances doesn’t mean you shouldn’t invest in the property. However, having this information and understanding the legal and financial impact can help you make a more informed investment decision.
Like any investment, a shrewd commercial real estate investor will request and analyze all relevant financial documents. This includes, but is not limited to, the property’s historical financial statements. It’s critical to assess annual revenue sources, rental income, operating expenses, and cash flow. In addition to analyzing historical financial and operating performance, you will want to project the property’s net operating income (NOI). You also want to understand the current insurance policies and whether they adequately protect you as an investor.
As a corollary to financial due diligence, it’s imperative to understand any tax benefits or tax liabilities related to the property. Review property tax assessments to ensure they are accurate. If the property’s tax assessment is too high or low, this can materially impact the investment’s profitability.
Understand if the property is currently leased and the occupancy rate. Review all lease agreements so that you understand rental income, lease duration, renewal and escalation clauses, and all other key terms. Evaluate the tenant mix so you understand who is leasing your property. You will want to understand your tenant’s financial stability, their underlying business income and profitability, and their overall credibility.
Visit the property for detailed on-site inspections. Based on your budget, hire a supporting team, including experts to evaluate the property. Focus on structural issues, electrical, plumbing, HVAC, and other indications of wear and tear on the property. Property due diligence can help you understand how much capital expenditures you may need to invest following the purchase of the property and on an annual basis.
Commercial real estate due diligence should include an environmental assessment, which can be conducted by an independent, experienced third party. It’s critical for you to understand any potential liabilities that could result from environmental issues. For example, an environmental assessment could identify potential contamination or hazardous materials present on the property or in the surrounding areas. If there are environmental liabilities, you need to decide whether you want to proceed with the investment and, if so, which party is responsible for environmental remediation.
As an investor, you want to ensure that the prior owner has complied with all zoning laws and regulations. If you plan to develop the property, make sure you evaluate any restrictions that could impact your strategy.
While property due diligence is essential, it’s also paramount to evaluate the local commercial real estate market in which you plan to invest. Contact local commercial real estate brokers and other investors who are experienced in the specific market. Analyze market trends, vacancy rates, supply and demand, average rents, cap rates, and other data to make a fully informed decision. Overall, you want to determine whether your property is well-positioned for growth potential relative to competitor properties. You also may want to evaluate the specific location of your property, including visibility, proximity to other businesses like restaurants and amenities, the economic health and safety of the community, and other similar factors.
Shrewd commercial real estate investors conduct detailed due diligence on any potential property investment. By leveraging professional expertise and undergoing a comprehensive review, you can minimize risk, maximize returns, and make a fully informed investment decision. From legal and financial due diligence to tenant and lease analysis, the more information you can learn upfront, the more accurate your investment process will be. While due diligence isn’t full-proof, it can certainly help reduce information asymmetry and strengthen your position as an investor.
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