Due diligence and commercial transactions
“Due diligence” is a term often mentioned in connection with commercial real estate, but what does it mean?The term refers to the independent inspections and examinations undertaken by buyers, lenders and owners with respect to a certain commercial property, prior to the completion of a transaction, but after a purchase and sales agreement has been executed. The nature of the property and transaction will generally dictate what level of diligence is due. There are many areas that are covered by due diligence and many professionals who conduct the inspections and examinations. Here are just a few of the major due-diligence processes.• Physical inspection: ASTM International has promulgated standards for property condition assessments (PCAs) as well as property condition reports (PCRs). The assessment typically includes a walk-through by a qualified commercial real estate inspector (often someone with an engineering or commercial construction background), as well as interviews with people familiar with the property.The focus of the PCA is to determine whether there are physical deficiencies that need to be reported to the requesting party in the PCR.
Physical deficiencies include conspicuous defects or material deferred maintenance of a property’s material systems, components or equipment, as observed during the walk-through. The PCA walk-through is not intended to uncover deficiencies that can be remedied with routine maintenance, minor repairs or normal operating maintenance.• Environmental inspection: The most common environmental inspections are Phase 1 and Phase II environmental site assessments (ESAs). As with PCAs, there are ASTM International standards for both ESAs and the people who conduct them, and the EPA has rules as well.The purpose of the Phase I ESA is to identify any existing or potential contaminants. It requires that the person conducting the assessment also look at neighboring properties to determine whether there are any potential or existing external contamination sources. The ESA includes a site walk, interviews with persons familiar with the site and extensive reviews of public records, including local, state and federal environmental databases, and records from the Registry of Deeds. If existing or potential contamination is found, a Phase II assessment is required, during which samples are drawn from the land (and building) for further analysis. Phase II results more conclusively establish the presence of contaminants and whether further monitoring or remediation is required.• Financial analysis: With income-producing properties, a thorough review and analysis of all financial records is absolutely necessary, since the value of the property is often based on its net cash flow.Financial records include income and expense statements, rent rolls, tax returns, leases, tax bills, water and sewer bills, and any contracts with third-party providers of services used in the operation, maintenance or repair of the property. The financial analysis also might include a review of the existing insurance coverage as well as the need for reserves for future capital expenses or large repair and maintenance items.• Title search: While lenders always require title insurance, it’s important for the prospective property owner to know about all matters that affect the title to the property. These include covenants and restrictions, easements, options, rights of first refusal and encroachments. It’s also important to know the nature and extent of the interest being acquired, and whether the entity conveying title has the legal authority to do so.The title search also will reveal whether there are undischarged mortgages or liens that need to be cleared at closing. In some cases, items that are found during a title search may not concern the lender but may affect the buyer’s intended use of the property.• Zoning and planning review: Two of the more frequent questions I get as a commercial broker are is the property zoned to allow my business and how long will it take to get planning board review of my site plan?Generally, a prospective owner’s attorney will provide an opinion on the zoning issue, and will review the records of the local planning board to determine whether the property received all required approvals. If vacant undeveloped land is being purchased, it’s extremely important to know whether it’s zoned for the intended use, and to have a thorough understanding of the site plan review process in the municipality in which the land is located.• Feasibility analysis: Each prospective owner of real estate needs to confirm that the property can be used for his or her specific needs or business. In some cases, an existing building may need to be extensively renovated to accommodate the needs of the buyer.What will the costs be to complete the renovations, and will those costs be too much to justify the transaction? With vacant land, a determination has to be made as to how much of it can be developed, and how many square feet of building and parking can the site hold.
While due diligence is typically undertaken by a buyer, there is no reason a prospective seller cannot do the same in order to know ahead of time about any material issues with the property.
Dan Scanlon, JD, CCIM, is an adviser with Grubb & Ellis|Coldstream Real Estate Advisors Inc., Bedford. He can be reached at 603-206-9605 email@example.com.