Due Diligence When Buying Real Estate
Due diligence is generally defined as thorough research before signing a contract, especially one involving a purchase or sale. Within a real estate context, it usually refers to a stipulated period within a real estate contract for a buyer to investigate the property in question to ensure that they are satisfied with it before the purchase is finalized. However, long before any initial offer is made, properties considered for real estate investment should be assessed as thoroughly as possible using all publicly available information. This is known as preliminary due diligence, and can involve property visits, and/or discussions with brokers, and with your advisors, such as your attorney or financial advisor. Proper due diligence beforehand will save you considerable headaches afterwards.
The stipulated due diligence period includes your review of the seller’s documents and your own independent investigation. In this article, we will explore the due diligence period in real estate contracts, including 1) due diligence when buying commercial and residential real estate, 2) title review, 3) real estate surveying, 4) zoning, 5) property inspections, 6) environmental inspections, 7) real estate leases, and 8) real estate appraisals.
DUE DILIGENCE WHEN BUYING COMMERCIAL & RESIDENTIAL REAL ESTATE
One of the main reasons for preliminary due diligence is important in commercial and residential real estate transactions is so that the buyer can properly assess the property’s value to formulate an offer strategically. Many of the documents that allow you to explore a property’s net profitability are only available to the buyer after an offer has been made. However, fundamentally, when valuing commercial property, income production is critical. The key ratio to determine here is the Net Operating Income (NOI), which is equal to income minus operating expenses (not including taxes and interest), and should be one of the key factors in determining how much you are willing to pay for the property.
Commercial real estate
The primary reason critical reason due diligence for commercial real estate is so important is to ensure that the buyer knows exactly what he/she is purchasing. The stipulated period usually begins after the prospective purchaser has made an offer, the seller has accepted the offer pending the due diligence period, and the buyer has placed a down payment in an escrow account to be applied towards the purchase and lasts anywhere from 30 days to more than nine months. It should involve physical inspections of the real estate, an assessment of related-environmental conditions, a review of the title, zoning requirements, contracts, leases, and surveys, partially through a review of documents the seller provides. These should include copies of:
- The deed;
- Information on current tenants;
- Existing, actual uses of the property;
- Zoning documents indicating allowable uses of the property;
- Any seller inspections;
- Land and improvement surveys;
- Current title insurance;
- Other insurance;
- Any notice of pending legal and/or government action;
- Environmental assessments;
- Any special assessments or taxes;
- Copies of any property bills;
- Any service contracts;
- All construction plans in the seller’s possession; and
- Warranties for any construction.
Beyond the document review, the buyer should conduct an independent investigation. You can request that the seller conduct, and/or pay for some of the third-party assessments you may want to inspect, and negotiate them into the contract.
Residential real estate
Just like with commercial real estate, you should thoroughly assess the value of and market for a residential real estate property before making an offer. With residential real estate, there are fewer objective measures of valuation of property, especially single-family residences. If the family is a multifamily unit, review the income the property generated in tandem with property taxes, and utilities. With single-family residences, comps, real estate appraisals, and local real estate trends are your best bet for valuing the property.
The due diligence period for residential real estate purchases typically lasts 30 days, with 10 to 15 days to inspect. During this period, you should review:
- The deed and title review
- Surveying documents;
- Zoning documents;
- Property inspections;
- Property appraisals;
- Environmental assessments; and
- Insurance documents, and any other available documents.
Understanding Real Estate Investments: Due Diligence
The first thing is to review the title, which should be – unless you are buying a distressed property – clear of any liens or other claims against it. The title is the transferable right to the property, which you must ensure the seller actually has (and often mistaken with the deed, which is the document used to transfer the property to another). Typically, the seller makes sure they can convey a clear title before they put the property on the market. The title review period for commercial real estate purchases are similar, and involve reviewing all claims against the property – what is known as a title search. To protect yourself in case the title search misses a claim against the property, which then reveals itself after you’ve purchased the property, you will want to purchase title insurance, which makes the policyholder liable for such claims.
Commercial real estate title review
You will likely receive a document known as a PTR (Preliminary Title Report) from a title insurance company, which will include a description of the land, the type of estate, who has title to the estate, and any claims to the estate. When reviewing the title commitment, you should look for any Exceptions to or exclusions from the title, which will define any known claims to the property by others, such as by taxing agencies. PTRs may also list liens, restrictions, special assessments, and more. All should be carefully examined by your real estate attorney so that you are clear on what you are purchasing, what rights you will have, and what, if and, rights others, may have.
Residential real estate title review
A title insurance firm likewise conducts the residential title search. When you purchase a residential property using leverage, the lender typically wants you to purchase a clear title. When the title insurance company finds a claim, such as a lien against the property, the seller is informed and typically must redress it. Once a title is clear, the title insurance company issues a title commitment – a statement indicating that they will insure the property. The lender will then likely approve the mortgage. In the case of distressed properties, you may have to agree to satisfy existing liens (such as environmental, judgement or mechanics’ liens) at closing in order to receive a title commitment.
REAL ESTATE SURVEYING
Whatever property you plan to purchase, surveying allows you to see exactly what the land underlying the property is. You should know whether any nearby entity has an easement – a right pass through to any part of the land you plan to purchase, or whether there is an encroachment – a portion of someone else’s property intruding on what you plan to buy. There may also be other covenants – conditions and/or restrictions tied to the land, all of which are essential to know before making a purchase.
Commercial real estate surveying
Easements and restrictions can cause more headaches for a buyer than zoning regulations, particularly if you plan to renovate or expand the property. Look for a survey from ALTA – the American Land Title Association, which is prepared by a licensed surveyor in accordance with the Association’s standards. Typically, title insurers want to see the results of an ALTA survey before issuing a commitment. The survey will include information on encroachments on to the property you intend to purchase; encroachments the property you intend to purchase has on neighboring properties; and easements that affect the intended property.
Residential real estate surveying
Surveys should be current; many lenders will not honor one more than six months old. Most residential real estate purchasers obtain house location surveys, which are cheaper. However, the title insurance firms will not consider these surveys in coverage of encroachments and boundary line disputes. To get title insurance that covers these issues, you should also get an ALTA survey when purchasing residential real estate as an investment.
Zoning certifications are available from planning offices of the jurisdiction in which the property is located. The buyer should ensure that the building is currently in compliance with existing zoning regulations. Further, the buyer should learn of any planned zoning changes that may adversely affect their intended use of the property by speaking with representatives from the local zoning office.
Zoning for commercial real estate
Owners of commercial real estate property should ensure that the property currently complies with existing zoning regulations, especially if they plan renovations, development, or further expansion. Zoning also includes assessments, exactions, and impact fees – which can directly impact how much net income you can expect to generate. After you purchase the property, it is critical to keep abreast of developments in the city’s zoning plans.
Zoning for residential real estate
Residential zoning laws, like commercial ones, vary from city-to-city, and state-to-state. Knowing what they are and making sure that you and your tenants are in compliance is key. Tenants who decide to operate a home-based business in the apartment they lease from you, for example, may earn you a fine. It is likewise critical to keep abreast of zoning plans; a city deciding to develop commercial property could re-zone your property and pressure you to sell (though they cannot force you to do so). Know beforehand the applicable zoning laws and forecast what they may be during the time horizon you plan to hold the property.
All building inspections should be done by a certified third-party to ensure that the property is up to code, and structurally sound. Buyers should look for a current one or stipulate that one take place during the due diligence period.
Commercial real estate inspections
Inspections of commercial real estate will typically cover roofs, HVAC, electrical, heating, plumbing, and structure. They look at lifespans of these systems, which typically are, all other things held constant, 10 to 15 years for a roof, 40 to 60 years for plumbing, 50 years for electrical systems, 15 to 17 years for HVAC systems, and 70 to 100 years for the underlying structure. Commercial inspections average $0.10 per square foot. They will also typically include parking areas, among other areas of a commercial property.
Residential real estate inspections
These inspections cover the same areas as commercial real estate inspections, as well as pest infestation, chimney inspections, water quality, exteriors and interiors, and other areas. They typically start at $325.00, and should take at least two to three hours to ensure thoroughness. Time permitting, you should attend the home inspection with the inspector to ask questions and learn to spot issues with other properties you may purchase in the future.
Environmental inspections are critical, but are more of a significant issue for commercial properties whose owners and/or tenants may be purchasing environmentally harmful waste products in large quantities. The property you intend to buy may have suffered environmental damage from previous use, which may affect your intended use.
Commercial real estate environmental inspections
For commercial properties, environmental appraisals begin with a Phase I Environmental Report, which will indicate whether there are serious problems requiring remediation. These reports not only include appraisals from licensed third parties, they also include reviews of state and federal compliance agencies of the property in question. If there are, what typically follows is known as a Phase II investigation, which usually involves further testing.
Environmental assessments when buying residential real estate
Residential property purchases also involve environmental assessments, by licensed assessors selected by title insurance firms. While Phase I and Phase II assessments are not required, it is in your best interest to obtain the most thorough environmental assessment available to ensure you have full use of the property. In 2012, a New Jersey homeowner who did no pre-purchase environmental assessment was found liable for damage done to his neighbor’s property from an old oil tank on his property left there by the previous owner.
REAL ESTATE LEASES
As mentioned earlier, you should evaluate the income generated by the existing leases to valuate the property. However, you should also look at tenant files and credit-worthiness, as well as personally assess the condition of their leased space to corroborate the seller’s assessment of the property’s condition. Other documents you should evaluate in tandem with existing leases include existing loan documents; insurance documents, which may provide further information, and possibly a risk assessment from the insurer; and utility expenses and property taxes, as you are on the hook for them when the property is vacant.
Evaluating existing commercial real estate leases
Some experts suggest that you review the NOI for the preceding three years to properly project income. You should also review the previous period’s actual operating performance, rather than the pro forma statements, which may give you a misleading portrait of how well the property is doing. You should also thoroughly review the lease terms and periods, and tenant files, interviewing tenants directly if possible, as they will be yours to manage shortly. During the due diligence process, ask the seller to keep you abreast of any tenant problems that occur during the process to get a feel for any problem tenants.
Evaluating existing residential real estate leases
Beyond reviewing leases for income projections, review them for any clauses related to access of the leased space, renovations, and selling the property should you be interested in flipping it. Also, make sure that the seller informs you of any amendments they make to the lease during the due diligence period. And make sure the seller credits you for the tenants’ security deposit at closing.
REAL ESTATE APPRAISALS
One of the most critical aspects of the real estate purchasing process, real estate appraisals will be a key determinant in any assessment of the property’s value. This is what the seller used to determine their price, what lenders will use when determining how much they will lend, and what tax agencies will use when assessing taxes.
Commercial real estate appraisals
Commercial real estate appraisals assess the physical plant, zoning records, geo-demographic information, and comps to value a property. You will want to make sure the one the seller provides is current, and get one done yourself during the due diligence period to corroborate the one provided you by the seller. You will want to share with the appraiser the intended use of the appraisal and what it will be used for. Types include a fee simple interest – the value of property; a leased fee interest – the value of the property when leased; or a leasehold interest the value of a leas to a tenant. Commercial real estate appraisals can range from $2,000 to upwards of $3,000.
Residential real estate appraisals
Licensed residential real estate appraisers typically use the sales comparison approach – which emphasizes comps; the cost approach – which looks at the replacement cost of the property; or the income approach – to develop an initial opinion of value. You should be clear on the approach, date of valuation, and independence of the appraiser when reviewing the appraisal.