There are two words to apply to commercial real estate purchase contracts: Buyer beware. With sophisticated sellers and sellers’ agents working to leverage the best deal for the property, buyers must approach commercial real estate purchases with eyes wide open.
Due diligence is a period of time starting after a proper purchase agreement is executed and continues until the escrow opening. It is the prospective buyers’ window of opportunity to uncover what they actually are buying, to climb out of that window to renegotiate or walk away from the deal.
“Purchasing commercial property is not always, ‘What you see is what you get,’” says Terry Coyne, executive vice president, Grubb & Ellis. “The whole point of due diligence is time to uncover the unknown.”
Smart Business spoke with Coyne about maximizing due diligence to help ensure costly problems don’t arise after finalizing a commercial real estate purchase.
What elements of a commercial building purchase are part of due diligence?
There are three separate columns of due diligence, including physical, financial and title. Physical due diligence is the obvious inspection of all physical components of the building, including any components that are in the earth or built on the site. This includes the roof, the structure and anything that relates to environmental issues, such as Phase 1 environmental reports.
The big items here are environmental concerns and the roof. If you don’t do an inspection on the roof, it might cost you $4 a foot, which on a large building could be an enormous amount of money.
Financial due diligence involves getting a loan and primarily includes the appraisal and the credit quality of the buyer. The credit quality of the buyer is extremely important, so make sure the appraiser you select is informed and has the required knowledge about the specific asset class so the appraised understands what the values are. You don’t want a residential appraiser doing a commercial appraisal, or an industrial appraiser assessing an office building.
Due diligence on the title includes a survey that will show the physical location of the property and any encroachments and easements, and a title report which would show you all the issues on the title relating to the quality of the deed.
How has due diligence for property buyers changed in the last decade?
The appraisal process and aspects of environmental due diligence are stricter today because of the Dodd-Frank Act. The changes mean you can’t talk to your appraiser and the bank can’t talk to your appraiser – the appraiser has to be independent. You run the risk that your appraiser may not be fully informed as he or she could be, because of a lack of interaction with the bank or the buyer. In the past, buyers could communicate openly with their appraiser to share information, ensuring they were fully informed.
Environmental aspects of due diligence are constantly in flux. Asbestos and PCBs were a critical topic years ago, but now they are more understood and expenses to deal with them are much more controllable.
The big question today is black mold. The presence of black mold is not the end of the world, but it’s something to be aware of, since there is a cost for remediation if it’s discovered in your building.
What are the most important aspects of due diligence?
Former Secretary of Defense Donald Rumsfeld coined a term applicable when you are told buyer beware: ‘the unknown unknowns.’ The unknown unknowns of due diligence are things you can’t see, including title concerns and environmental issues. It’s the things you can’t see below ground or on a sheet of paper.
As far as the title is concerned, easements are the biggest worry because they have an impact on the property value. If you don’t perform a survey, you may later discover an easement that runs right across your parking lot or alongside your building. All of a sudden you find out you can’t use these areas the way you had planned because your next-door neighbor has an easement to drive over your property or use your land for oil and gas drilling.
On the environmental side, you don’t want to discover after the sale the presence of an underground oil storage tank, or that you’re downstream from a paper mill that used to dump chemicals in the water, and now they are leaching onto your property.
What happens if due diligence reveals problems?
You have three choices. The first is to get an extension of time to understand it better. Second, you can get a reduction in price. The third choice is to walk away.
It all depends where you are in the process. If it’s bad, you walk away, but it’s not often that deals die.
If it’s manageable, you get more time. If you’re interested and it’s just a question of money, then you ask for a price reduction.
How can buyers best protect themselves when acquiring commercial property?
Talk to your broker or your attorney before starting the process so you can make a fully informed decision. You can obtain a lot of free information from people in the business to help you understand the risks. Commercial contracts are sold as-is – buyer beware.
There are sophisticated parties on both sides of these transactions — you want to make sure you have protection. It’s hard to go back and sue someone on a commercial transaction when things were fully disclosed.
Terry Coyne is executive vice president, Grubb & Ellis. Reach him at (216) 453-3001 or Terry.Coyne@Grubb-Ellis.com.
Insights Real Estate is brought to you by Grubb & Ellis