When making a real estate purchase, many details must be scrutinized. Failing to exercise proper care and planning prior to the completion of a transaction can be potentially catastrophic. That’s where due diligence comes into play.
Independently verifying all representations made by a prospective seller and uncovering relevant information that has not been disclosed but is important to the buyer can help you avoid expensive mistakes.
“Due diligence is a buyer’s investigation of an income-producing property during the sale process,” explains Marla Maloney, a senior vice president and principal with Colliers Turley Martin Tucker.
Smart Business spoke with Maloney about due diligence, common mistakes made during the process and the importance of a strong team of professionals.
How do you make the most of due diligence?
It is important to complete the physical inspection early in the process to ensure there is adequate time for inspectors to submit their reporting. If there is additional research that needs to take place, a structured timeline will allow the buyer to dig deeper. It is also important to manage the documentation flow so that there is time to review the materials.
How long does the due diligence process usually last?
Typically, the buyer and seller agree to a 30-day period. If the buyer finds significant deferred maintenance, if there is a hiccup with financing or if the seller is not diligent in handing over applicable materials leases, surveys, the last elevator inspection, contracts that are placed on the property for services, etc. the buyer will likely ask for an extension to have time to analyze and review the documentation as it relates to the property’s commitment.
What are some common mistakes that are made during the process?
There is so much exposure for buyers if they don’t fully understand the implications of code compliance and deferred maintenance. Let’s say a space has been vacant for a number of years. The previous tenant might not have been required to have a sprinkler system, but now it is mandatory. Maybe the building only has risers, it doesn’t have sprinklers on that floor, so the previous owner could have gotten away with it. However, if the code has evolved the new owner may no longer be grandfathered and may not be reflecting that cost in its pro forma, which could significantly affect the deal.
Sometimes, buyers assume unnecessary liabilities by failing to utilize professionals to complete their inspections. For example, a garage consultant should be hired to do core samplings of the parking garage. In the Midwest, there is a lot of deterioration of parking structures from deferred maintenance because of salt and chemicals that penetrate through the membrane into the actual structure of the garage. Perhaps on the outside it looks physically sound, but it could have a significant amount of deferred maintenance that will require the parking garage to be out of service for an extended period of time.
What type of research should be conducted in regards to current tenants?
It is important to examine leases and rent rolls as well as the payment history and creditworthiness of the existing tenants. It is a good idea to interview current tenants because you want to make sure they are happy and you can learn a lot about their future plans. A tenant may say it loves the building and its space, but the building is 100 percent leased and it is a growing company, so when the lease expires in two years, it will need an additional 10,000 square feet. The writing seems to be on the wall that the tenant will be relocating so you need to note this in your pro forma.
How can a company benefit from professionals when going through the due diligence process?
The benefits far outweigh the costs. Professionals understand and are aware of building codes. If you are engaging professionals, they can mitigate potential cost and help you understand the risks involved with the property.
Who should be on the professional team?
A real estate professional will act as a fiduciary on your behalf. An attorney will pore over the leases and identify the commitments that have previously been made to tenants. Due diligence includes an analysis of the incoming revenue stream. A tenant may be paying $22 per square foot in years one through three of its term, and in year four, the rent may go down. Without an attorney physically going through the documents this might have been overlooked. Also, in most cases, an environmental consultant, garage structural engineer, electrical engineer, mechanical engineer, surveyor, insurance broker and appraiser should be involved.
MARLA MALONEY is a senior vice president and principal at Colliers Turley Martin Tucker. Reach her at email@example.com or (314) 746-0342.