Due Diligence in Commercial Real Estate Transactions
Due Diligence in Commercial Real Estate Transactions
Due Diligence in Commercial Real Estate Transactions
ADVANCED
COMPLIANCE
INSIGHTS
DUE DILIGENCE IN
COMMERCIAL REAL
ESTATE TRANSACTIONS
“The acquisition of The outlook for commercial real estate in 2018 is best summed up in two words:
commercial real cautious optimism.
estate requires That’s the view of Heidi Learner, chief economist at Savills Studley, a leading commercial
intensive due real estate services firm. Broader market conditions appear favorable, thanks to sustained
diligence to uncover economic growth and rising employment figures. Additionally, the recent passage of the tax
key information that reform bill will likely have a significant impact on all major asset classes, including real estate.
may not be readily
While macroeconomic trends are encouraging, some lingering challenges remain. Tighter
apparent or available
enforcement of immigration law—and the prospect of new legislation that significantly
in evaluating the
reduces the flow of immigrant labor into the U.S.—could create greater labor shortages in the
value of a property
construction industry and dampen renter demand.
or portfolio.”
New tariffs issued by President Trump have created some uncertainty in the commercial real
estate market. Plus, there are concerns about the rising costs of building materials.
Despite these challenges, the overall outlook for commercial real estate is encouraging.
Collier’s International, in its 2018 Outlook on U.S. Property Markets, projects continued growth
this year following peak numbers in 2017.
The acquisition of commercial real estate requires intensive due diligence to uncover key
information that may not be readily apparent or available in evaluating the value of a
property or portfolio. Such hidden details can doom the financial merits of an otherwise
profitable deal, turning the transaction into a costly mistake.
There are essentially three types of investors engaged in acquiring commercial real estate.
Each is driven to make an acquisition for different objectives:
These different objectives alter the due diligence process and depth.
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This information is not intended to provide legal advice or serve as a substitute for legal research to address specific situations.
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DUE DILIGENCE IN COMMERCIAL REAL ESTATE TRANSACTIONS
Eager to engage in what appears to be a sure opportunity follows. For instance, the purchase of an income-producing
with little risk, inexperienced investors may jump in where property like an apartment building will require the investor
more seasoned buyers fear to tread. Certainly, less than to verify the existing tenant leases and examine each tenant’s
thorough due diligence by all investors may be a ticking time rental payment history. Otherwise, the investor cannot ensure
bomb, especially given concerns over a rising real estate the financial stability of the anticipated income stream. On
market. No investor can risk a costly surprise that rears its the other hand, the initial focus of a commercial real estate
head in the aftermath of a transaction’s closure. developer is on the intended use of a building and whether
or not the property can be permitted to achieve this intent.
WHAT IS DUE DILIGENCE FOR REAL ESTATE?
The chief aims of real estate due diligence are to thoroughly
inspect the fundamentals of the property, seller, financing, “Many jurisdictions have unique laws that
and compliance obligations to reduce and mitigate financial affect real estate transactions.”
uncertainties. The effort is not for the fainthearted.
Prospective buyers must scrupulously examine zoning
restrictions, potential liens, and possible encroachments on
the property. Existing structures must be fully inspected to Acquisitive parties should never engage in a commercial
discern needed repairs and their costs. They must determine real estate transaction without personally visiting, walking
whether or not they will absorb legacy liabilities from prior through, and inspecting the premises. During the walk-
owners’ legal and regulatory violations. If the property is through, buyers must analyze the property or building in
largely financed, they need to address their ongoing ability to terms of the intended use. Concerns that arise will affect the
make required payments to the lender. negotiations. For example, a property that a buyer plans to
turn into an office complex with ample parking may be hilly
Many sophisticated commercial real estate investors consider
and expensive to grade to accommodate the anticipated
it a best practice to commence detailed due diligence before
volume of vehicles.
the purchase contract is signed. The alternative is to carefully
lay out in the contract for sale the items of due diligence Given oft-disparate federal, state, and local environmental
that the buyer must undertake and the time this will take. regulations, investors also must ensure that a property or
This also serves to compel the seller to deliver required building complies with current rules and laws, and planned
documents on an expeditious basis. Certain findings may and potential ones in future. An example of this moving target
adversely affect the acquirer’s anticipated financial return, is environmental sustainability and liability. Investors need to
giving buyers a stronger hand in the transaction negotiations know that a particular regulation will phase in at a later date,
to ensure a fair and accurate property valuation, given the in some cases several years away.
risks that have been unearthed.
Before financing the transaction, lenders are likely to require
Given the vast array of documents in a commercial real estate an environmental suitability assessment. A best practice is to
transaction, it is important to prepare a due diligence checklist, undertake this evaluation anyway, irrespective of financing
marking off each item of concern once it has been addressed. issues. Recruit a reputable environmental engineering firm
Depending on the investor type and the entity’s financial to assess past uses of the building or property, in addition
objectives, this checklist can be quite long. Nevertheless, it to collecting evidence of possible contaminants like mold,
would be imprudent to close a deal before appreciating and lead, and asbestos, and the presence of underground storage
fully evaluating the risks against the rewards. tanks. What appears to be perfectly safe and legal in a visual
inspection can turn into a litigation minefield in the future,
GETTING THE BASICS DOWN since the investor will inherit these potential liabilities and be
required by law to eliminate the discovered problem.
Due diligence on a commercial real estate opportunity
begins with understanding the transaction’s objectives. Lastly, although sellers are legally required to provide
The investment goals in pursuing a commercial real estate certain disclosures on a property’s physical characteristics,
transaction serve as the foundation for the due diligence that such as easements, encumbrances, and other restrictions,
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This information is not intended to provide legal advice or serve as a substitute for legal research to address specific situations.
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DUE DILIGENCE IN COMMERCIAL REAL ESTATE TRANSACTIONS
it is prudent for the investor to personally review, validate smart tactic is to solicit documentation from the relevant
and check off each item. A best practice when acquiring municipality to ensure the current and anticipated use of the
commercial real estate is to never automatically assume the property is compliant with existing zoning regulations and
same degree of disclosures from the seller that exists when land use classifications. For buildings that are relatively new, a
buying residential property. Key differences exist. review of the certificates of occupancy can indicate compliance
with relevant property codes. With regard to the assessed
DIVERSE DOCUMENTS valuation of a property, this information can be obtained
New investors in commercial real estate should consider the through the tax certificates. The latter will also indicate the
value in retaining the assistance of a specialized commercial standing of property tax payments. As a precaution, buyers
real estate attorney. Numerous legal documents must be should consider reaching out to an outside zoning specialist
accessed, evaluated, and verified. At a minimum, these to independently confirm the received information is accurate
documents include the title, leases, zoning regulations, and up-to-date.
surveys, tax certificates, and the seller’s financial records and Be Aware of the Time Frame for City Approvals
operating statements. All documents should be listed in the
If problems are uncovered, or if the buyer plans on making
aforementioned checklist and stored initially in a VDR (virtual
any changes to the property, including its use, then additional
data room).
permits and business licenses may be required. Prospective
Title Searches and Property Descriptions property buyers need to be cognizant of time frame issues
Once escrow has been opened, the investor should order associated with city approvals. Depending on various factors,
a preliminary title report. The title will provide information it can take a month—or even years—before building permits
about the property, such as its current and past ownership are secured.
and the existence of liens, encumbrances, and easements. This means that it’s imperative to arrange meetings with local
Once these factors are understood, a best practice is to authorities to determine which approvals are necessary. This
undertake a professional survey of the property to corroborate includes planning and zoning, site plans, city council and
the particulars, as well as to confirm lot size, access roads, other approvals.
boundary lines, surface waters, rights of way, soil condition,
and possible property improvements and alterations. To Lease Payment History
verify the accuracy of the title, it is prudent to contract with For an income-producing property like an office building or
a title insurance company, which will commit to absorbing apartment complex, a thorough review of the lease payment
unanticipated financial losses due to possible title defects. history will shed light on the orderly and predictable flow of
rental income. Another best practice is to scrutinize the seller’s
Municipal Lien Searches for Florida Properties
financial records and operating statements—assuming these
Many jurisdictions have unique laws that affect real estate can be obtained—to discern gaps in lease payments.
transactions. Anyone who plans on purchasing property in
Florida should make sure to conduct a municipal lien search. ADA Compliance
In Florida—unlike most other U.S. states—unrecorded liens, A key item is to determine the compliance of an existing
fees and permit violations are attached to properties rather structure with the Americans with Disabilities Act. Each state
than individuals. has its own regulations regarding accessibility and needed
modifications to ensure compliance, in addition to the
Because of this, virtually all real estate transactions occurring
documents pertaining to these issues. The federal government
within the state of Florida must have a municipal lien search
has created a checklist helping investors understand the rules
conducted as part of the closing process. Florida property
prior to acquiring a building, property or undeveloped land.
buyers should be aware that a conventional title search will
not uncover issues found in a municipal lien search. All of these many documents are needed to rigorously evaluate
the risks of an investment versus its potential return. In each
Zoning and Property Codes
case, once the data in the document has been validated as
Investors also must ensure compliance with current zoning accurate or inaccurate, mark it off on the checklist and store
rules and property codes. With regard to the former, a it in the VDR. Compare the findings to the anticipated returns
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This information is not intended to provide legal advice or serve as a substitute for legal research to address specific situations.
© 2018 C T CORPORATION SYSTEM AND/OR ITS AFFILIATES. ALL RIGHTS RESERVED. PAGE 3 OF 4
DUE DILIGENCE IN COMMERCIAL REAL ESTATE TRANSACTIONS
or revenue streams that the transaction will produce. These of property, and integrity. Such insights will be useful in
details become ammunition in the negotiations to close the negotiating a fair deal, or making a determination to pass on
deal. Once the transaction has closed, transfer and store the prospect.
the documents for compliance purposes to a highly secure,
centralized platform that provides easy accessibility. CONCLUSION
Every real estate transaction is different and requires a
KNOW THE SELLER unique due diligence plan. Moving too quickly—and failing to
Due diligence extends beyond matters related to the property perform comprehensive due diligence—can create problems
being acquired. Before venturing into a commercial real estate for even the most experienced investors.
transaction, the standing, reputation, and track record of the
seller should be fully investigated and vetted. Not only may LEARN MORE
this indicate a less-than-scrupulous transacting partner, the Learn more about how CT can provide support for every
reputation of the current owner (and even occupants) may stage of the deal, from due diligence to closing, to ongoing
have a negative impact on future earnings. compliance.
Ask for and examine the seller’s tax returns, service contracts, Contact us at (844) 701-2064 (Toll-free U.S.) or visit
loan documents, past litigation history, and any other items www.ctcorporation.com.
that are related to the entity’s financial status, prior use
This information is not intended to provide legal advice or serve as a substitute for legal research to address specific situations.
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