6 Tips on Due Diligence for Commercial Real Estate

Discover 6 tips on due diligence for commercial real estate regarding physical, financial and legal due diligence that most investors often overlook. Armed with this crucial information, you can make intelligent investment decisions by avoiding the hidden pitfalls and know exactly what the risk are when buying a commercial property.

Due Diligence

Every commercial property has inherent risks and the risk is on you as the buyer, also known as Caveat Emptor. You can’t rely on anything that the Seller has told you nor should you ever make any assumptions. You need to you conduct a thorough analysis of the property and verify every aspect of the deal, aka “due diligence“, before you buy it. Due diligence for commercial real estate is broken up into 3 areas:

1. Physical Due Diligence: The physical review of the property includes building inspections and market research.
2. Financial Due Diligence: The financial review of the property includes examining profit and loss statements and leases for the property.
3. Legal Due Diligence: The legalities of the property like title, survey and land use / zoning.

The following 6 advanced tips will be grouped into one of these areas, but they will go beyond the typical steps most people already know about to help you uncover potential hidden problems. In previous trainings, we have shared tremendous wisdom in regards to the more well known due diligence steps, including:

• How to Inspect an Apartment Building
• Commercial Real Estate Deal Start to Finish
• 18 Commercial Real Estate Terms You Must Know

The following 6 tips will go beyond these basic due diligence steps that most real estate investors already conduct. The following are the insider secrets that the most experienced commercial investors apply to ensure they don’t make a rookie mistake when buying property.

Tip #1: Neighborhood Walkscore (Physical Due Diligence)

When buying multifamily, you need to find out how centrally located and accessible your property is to transit and other services. A website called walkscore.com is a great resource for this. Just type in the address and you can analyze the walkability, bus-ability, and bike-ability of your apartment building’s location. This has become an extremely important factor when doing due diligence on a potential property because many people work remotely and want to be able to walk, bike, or catch a bus to restaurants, stores, and other services. So, go to walkscore.com and rate your location as part of your due diligence.

Tip #2: Cell Service INSIDE the Building (Physical Due Diligence)

It is incredibly important that inside the building has strong cell service. In today’s world, everyone wants to always have good mobile service. While there are cell phone signal boosters, they can usually only increase the signal by one bar (or less). So if you have no bars inside the building you are looking to purchase, that could be a major issue.

Tip #3: Watch Out for a Property Tax Increase (Financial Due Diligence)

When you purchase a commercial property that has appreciated in value since the seller purchased it, the tax assessor will raise the property taxes to reflect the higher purchase price when you close. It is a huge mistake to base your financial projections on what the seller paid in property taxes. Therefore, part of your due diligence is to determine what that new property tax will be. Most brokers don’t include this critical information, so it’s on you to get that information yourself. Furthermore, you can dispute the new property assessment. We help our Proteges dispute property assessments and have been very successful in reducing them over the years.

Tip #4: Stress Test Your Net Operating Income (Financial Due Diligence)

Just a few years ago, rents were rising quickly. But those days are over, and now the trend is a slow and incremental increase. Which means you must test your net operating income and cashflow for unforeseen expenses and maybe even a potential economic downturn. Test it by decreasing the occupancy, increasing expenses, and applying other what-if scenarios into the deal to make sure it can withstand property expenses, any unforeseen expenses, or an economic downturn. Think negatively with your numbers to see if the property can handle a stressful time.

Tip #5: Investigate Zoning Details (Legal Due Diligence)

It’s essential that you know exactly what your property is zoned for as well as what land uses that zoning allows, as well as density and other factors. For example, let’s say you have a tenured Apartment Building that is zoned “commercial”. What happens if it burns down? Will the city allow you to rebuild an apartment building, which is technically multifamily residential? Usually, the answer is, “No”. You need to know precisely what you can and can’t do with the property. Investors often overlook this when analyzing a potential investment. They assume that if it’s an apartment building that they can rebuild another multifamily property on the same land. However, that isn’t always the case because you may not be grandfathered in if the city has changed the zoning laws. How do you find out with certainty about this? Hire an experienced local land use and zoning attorney.

Tip #6: Check for Rental Subsidy Programs (Legal Due Diligence)

Make sure you find out if the property is being subsidized. This is not Section 8, but a tax credit program like LITHTC (Low Income Housing Tax Credit) or Section 42. These programs subsidize your income with tax credits if you keep the rents lower than market rates. When you’re doing a deep analysis to get accurate financial information and you see a LIHTC or Section 42, beware because the restrictions in the program could interfere with any value-add plans you want to implement. Under a subsidized tax credit program, the rent upside potential of a deal can be deceiving because you won’t be able to get those low rents up as high or as quickly as you would like. If you see any kind of tax credit program, ask for the documents, and get a full understanding of the program. If your value-add plan is to raise the rents, do a cash-out refinance and pull that money out, that’s not happening right away under these tax credit programs. However, even if an attorney can review the LITHTC paperwork and explain to you what is in it, that doesn’t tell you the creative ways in which to work around those terms and make the deal work. This is one of the many examples of why having an experienced mentor is vital to your success.

Every Successful Commercial Real Estate Investor Has a Mentor

As you have discovered, even when you can identify these potential pitfalls, you still need to know what to do with what you learned from your extensive due diligence, such as when to walk away from the deal or when to renegotiate with the Seller. This is yet another reason why having a experienced commercial real estate coach is an invaluable asset to reaching your real estate goals. Every successful commercial real estate investor has a mentor. Get your mentor here:  https://www.commercialpropertyadvisors.com/protege-program/