What is Due Diligence in Commercial Real Estate?
When it comes to commercial real estate, true risk is what you don't or can't know. The greatest power a commercial real estate investor has is in the purchasing process is your due diligence. Due diligence can be some of the most financially impactful work you do, and more importantly — when done right — it can save you from purchasing the wrong asset.
If you're new to due diligence or are looking for more clarity on what the process is and what you should be looking for, this article will cover everything from what due diligence is to what you should look for as you complete due diligence for your next real estate asset.
What is Due Diligence in Commercial Real Estate?
In commercial real estate, due diligence is the process of deeply researching a property before you purchase it. It's a buyer's last chance to uncover as much as possible about the property before they make a decision to purchase. Also known as the free look or feasibility period, due diligence is negotiated between the buyer and the seller. A good due diligence negotiation will give the buyer ample time to investigate risks, without leaving the seller overly exposed to a buyer who can drop the purchase at very little cost.
How Long Does the Due Diligence Process Take?
The length of the due diligence period is decided when you enter into a Purchase and Sale Agreement. This is something you and your team of commercial real estate experts will work to negotiate. For example, if a zoning report takes 4-6 weeks in your area, you need to know that before you commit to a due diligence period that is shorter than that timeline.
At RENDR, when we're working with a commercial real estate client who is interested in a property, we bring our due diligence checklist directly to initial negotiations. This way, we can show the seller exactly what we are looking for and discuss exit clauses in very plain terms. For example, if we find asbestos, remediation would be a cost we would ask the seller to bear. We also tell the seller that the property will have to meet certain zoning or height requirements.
When Does Due Diligence Happen in the Purchasing Process?
Due diligence is the first thing that happens after the buyer and seller establish a purchase price. The due diligence period is often negotiated during initial purchase conversations and then stated in a Letter of Intent. It's important that due diligence happen early on in the purchase process so that neither the buyer's or the seller's time is wasted on a poor-fit property.
3 Key Elements of the Due Diligence Process When Purchasing Commercial Real Estate
When it comes to commercial real estate, there are some parts of due diligence that are standardized across the board. Things like permit violations, environmental reports, and unpaid rent are things that any seller should investigate before making a purchasing decision, as they're costs you will have to bear.
There are other parts of commercial real estate due diligence that are largely project-specific. Here's an example of one of those project-specific due diligence uncoverings in action:
Project Example: Riparian Rights
A previous RENDR client was interested in a property assemblage near a local river. Through the due diligence process, we discovered that riparian rights would require a 50-foot setback from the river's edge. This left us unable to match the density required in the pro forma. We advised our client to drop the purchase, which they did. A few miles up the road, a separate developer proposed a plan that was within 30 feet of the same river. That development is now being sued by the Sierra Club for encroaching on riparian rights.
This is a perfect example of why the due diligence process is so essential to making a purchasing decision that will be beneficial for you.
Though every property is different, here are three key elements of the due diligence process that every buyer should consider before making a purchasing decision.
01. Legal Due Diligence
Legal due diligence refers to any research or investigation you do on the legal aspects of the property. Common items include the title review, which looks for any financial burdens or easements on the property, as well as investigating zoning and allowable uses.
During the legal due diligence portion, you and your commercial real estate team are looking into any City or State requirements for affordable housing, rent control, and density, as well as any notices that are related to currently pending or past legal and governmental actions.
The purpose of legal due diligence is to ensure that the property you're considering purchasing can be acquired and used in the manner that you've intended, as quickly as possible. Any legal issues uncovered in the due diligence process should be brought to the seller for negotiations, though large legal issues, like the one found in the example above regarding riparian rights, could present reason enough to drop the purchase.
02. Financial Due Diligence
This portion of the due diligence process is focused on the financial feasibility of the property. Is this property capable of earning what you expect it will? If you plan to develop the property or complete renovations, do the finances line up to provide a return on that investment?
Financial due diligence is concerned with market supply and demand, and will likely focus on any relevant tax documentation, insurance costs, as well as tenant and lease matters. In addition to focusing on the property itself, your financial due diligence should take a close look at the market around you. Given the neighborhood, the building, and your plans for the property, does this real estate make financial sense to purchase? Are there any financial red flags you can uncover throughout the process?
03. Physical Due Diligence
Physical due diligence is concerned with evaluating the physical condition of the real estate you are purchasing. From environmental assessments to property inspections of key components like the roof, electrical, and plumbing systems, your goal through physical due diligence should be to accurately assess the condition of the property itself, as well as the land around it.
Is this property in suitable condition for what you've planned? Is the land around the property buildable? If there are significant issues, are these renovations that will fit your project's financing, or are they far beyond the scope of what you'd intended?
While due diligence is different for every property, it's important that you address each legal, financial, and physical due diligence to the best of your ability in the time you're given. This is your only chance to uncover as much as you can about your potential commercial real estate property before you make a final decision.
Are There Legal Requirements for Due Diligence in the State of California?
The State of California does not have a legal requirement regarding how much due diligence a buyer needs to perform when purchasing commercial real estate. That's why it's so important to consult with a professional valuation expert who is familiar with the market you're planning to purchase in. Commercial real estate is complex, and as you can see from what's outlined in this article, there's a lot to keep track of. It can help to have a dedicated team keeping track of your due diligence process and making helpful recommendations based on their experience in the area.
What Happens if I Don't Like the Results of my Commercial Real Estate Due Diligence Period?
Due diligence is designed to uncover as many red flags and problems associated with a commercial real estate property as possible. So what happens when you find something you don't like?
If you complete your due diligence process and find something unfavorable, you can walk away without consequence as long as you do so before the due diligence period ends.
It's on you and your team to negotiate an exit clause that makes this possible, but it is fairly standard for commercial real estate transactions to include this language. Again, the exact terms will be negotiated by you and the seller regarding how long you have for due diligence, and what constitutes a reasonable cause for walking away, but generally, as long as your exit clause is included, you can safely walk away within the limits of the due diligence period.
If you back out of the deal after the due diligence period ends, in most cases you will not get your Earnest Money Deposit back. That's why finding and including the right exit clause is so essential to your commercial real estate purchase process.
Who Can Help Me Facilitate Due Diligence in my Commercial Real Estate Transaction?
Due diligence is arguably one of the most important steps of the commercial real estate purchasing process. It's your only chance to see what you're working with before you make a large financial decision. Having help from trusted professionals is essential. From managing multiple inspection schedules to checking all of those important legal investigations off the list, it's a good idea to work with someone who knows your area and who has a history of completing in-depth commercial real estate evaluations.
If you're looking for expert real estate analysis in Santa Monica, Culver City, Venice, West Hollywood, Beverly Hills, or Century City, RENDR is here to help. As your commercial real estate valuation experts, we're here to help you maximize the potential of your properties — and that starts with thorough, comprehensive due diligence. For more information, get in touch with our team today.