THE DUE DILIGENCE PROCESS PREPARATION IN REAL ESTATE TRANSACTIONS
In every conveyance of real estate, whether it be an apartment lease, a residential home purchase, a commercial business lease, the purchase of a strip mall or the purchase of a Manhattan skyscraper, the prospective purchaser or renter must conduct some level of due diligence toward investigating the quality, both physical and intangible, of the real estate they are being conveyed.
The foregoing list represents a progressive continuum dictating the depth to which that investigation should be conducted. An apartment renter, for instance, “kicks the tires” by walking into the apartment (usually with the salesperson in tow), looking in all of the rooms, turning some lights on and off and maybe checking the garbage disposal; the purchaser of the Manhattan skyscraper has a little more to do, not only because of the substantially larger investment he is making, but because of the permanence of the tenancy and substantial increase in potential liability to third parties using the property.
It is important, however, to remember that the foundational logic for conducting the property investigation at both ends of the continuum remains the same: you need to know the characteristics of the real estate being conveyed, so that you can adequately balance the risks and confirm that the superficial level of value represented by the purchase price or rental rate matches the reality of the condition of that real estate. The importance of keeping this in mind, especially in the larger transactions, is that every transaction is different and so must be viewed, not entirely through the lens of a Due Diligence Checklist, but as its own transaction, with its own unique potential pitfalls.
Preliminary Due Diligence
A great deal of the process of real estate inspection often begins before the offer to purchase real estate (or even a letter of intent outlining the terms of the proposed purchase) is signed, by visiting the site and having discussions with real estate brokers and sellers. This preliminary process should not be skipped or given abbreviated attention because it can be invaluable to establishing the informal connections necessary to obtain the information that will ultimately be sought. It can also point to some questions or investigative paths which might otherwise seem unfruitful, but which uniquely shed light on this transaction.
In addition to the obvious (contingency period length and access to information), during negotiation and drafting of the real estate sales contract, as it relates to the due diligence investigation, it is important to recognize the sticking points as to representations/warranties and provision of seller’s property-related information. Negative reaction on these issues by the seller often implies very telling red-flags related to property condition.
Review of Seller Documents
Once the real estate sales contract is signed, the race begins to garner the maximum amount of information, keeping cost efficiency in mind, but focusing on maximizing efficiency of time, as the investigatory period is invariably shorter than the purchaser would prefer. Assuming adequate document retention by the seller, a thorough review of their documents can save a great deal of time, effort and money that would otherwise be spent by purchaser procuring the same information.
Be sure to ask the seller for all documents and things the seller received (or should have asked for) during his due diligence process when he purchased the property (especially if acquired relatively recently). Such a list might include:
- Current tenant information
- All present uses of the real estate
- Any third party reports or inspections initiated by seller
- Any surveys of the land and improvements in seller’s possession
- Seller’s current policy of title insurance
- Any applicable condominium documents
- Notices of any pending or threatened litigation or governmental action relating to the real estate or seller
- Notices of any environmental conditions
- Notices of any new or special assessments or taxes
- Copies of all current bills for the property
- Service contracts
- Evidence of current zoning
- As-built plans and specifications
- All construction related documents including warranties
- Evidence of insurance.
You (or an agent on your behalf) should review each of these documents or items independently to identify the potential problem areas which require deeper investigation.
After receipt and review of the seller delivery documents, it is time for you to go beyond these documents into your own independent investigation of the condition of the real estate using what you have gleaned to this point to navigate the appropriate course of that investigation. CTE-VBMIS Group’s Due Diligence Checklist ( BELOW) is a great resource to guide you in your particular property investigation journey, but engaging a real estate consultant to help you in this process is highly recommended.
Your goal in the due diligence process is to make sure that the property you think you are getting is actually the property being conveyed. Remember, each transaction has its own unique set of obstacles and considerations, so give each purchase the unique respect it deserves. Armed with this information and guidance, you are well on your way to ensuring the purchase of a sound investment. Best of luck on your next purchase!
So you’ve signed the purchase contract and reviewed all of the seller-provided property information – now it’s time to dig into your own investigation of the property to make sure you are not buying a lemon…and the clock is ticking.
The following is a broad checklist of the information, reports and research you should obtain and conduct during the investigation period. It is important that you begin by determining the most efficient methods of organization and analysis of the (likely voluminous) information you receive (and pay for) to make a truly informed and timely “go/no-go” decision.
Title: As mentioned in our Due Diligence Process Article, your best resource in title inspection will be the title commitment. The focus of the
title inspection is mainly on the list of exceptions. Each of the recorded documents underlying the listed exceptions should be reviewed in detail. Consideration of the type and extent of title insurance to obtain can also be an important decision: Should you get an ALTA 2006 policy or CLTA 1990 policy? Standard coverage or extended? Are any endorsements necessary? These will all depend on the type of property being purchased.
Survey: In order to adequately evaluate the potential problems identified by the exceptions, each exception should be reviewed simultaneously with a current survey of the land and improvements. The survey allows you to visually understand where any easements or licenses burdening the real estate are actually located and whether the scope of use set forth in the recorded document is acceptable based on its location. The survey will also identify encroachments or physical uses not shown by the title commitment. Consideration of the type of survey to obtain is another important decision: Should ALTA standards be followed, or are the local/regional government agencies’ standards sufficient? Is an improvement location certificate sufficient or should you get a land survey plat? These, again, will depend on the type of property and nature of the transaction.
Building Inspection: Inspection of buildings on the property is essential to ensure sufficiency of construction considering the intended uses of the occupants and the surrounding geography and climate. Seller’s provision of as-built plans and specifications should be helpful here, but will not end the investigation. A current inspection should be done by a certified third party inspector qualified in the type of property to be inspected. The focus of that inspection should be primarily on structural components such as the walls, roof, HVAC units and the fire suppression system. Certain climates/regions will require more exacting inspections, so hiring a local inspector is a good idea. The inspector should also independently look for any regulatory or statutory violations.
Zoning: The zoning, subdivision and land use matters are an often overlooked, but critical, aspect of the investigation. Zoning designation should be confirmed and uses at the property verified to conform to the allowed uses. In addition to current violations (or potential violations considering purchaser’s intended use), it is important to look at all of the current agreements affecting the property such as growth management agreements, covenants or public facilities agreements, as well as any current or proposed fees (impact fees or linkage fees), exactions or assessments. Also look for a pending zoning change.
Financing: While not always necessary, lender financing is usually required to purchase real estate. In the context of due diligence, the lender can be somewhat of an experienced ally. The lender will conduct its own title and survey examinations and will require an appraisal of the property, which provides a great deal of history, as well as a rough measure against your agreed purchase price. In the case of assumption of financing, a little more research has to be done by the purchaser to determine the potential for additional fees or term renegotiation based on the assignment.
Environmental Inspection: There is certainly not enough room in this article to fairly treat the detailed items to be considered in an environmental inspection, but luckily there are third party inspectors who you can hire to do environmental impact assessments. The depth and breadth of an environmental investigation should be relative to the past, present and potential uses of the real estate. That is, a piece of land which has been, and will continue to be, a clothing retailer, is not nearly as concerning from an environmental aspect as a gas station.
Existing Leases: Finally, if assuming existing leases, a great deal of lease-related analysis is necessary. All attendant documentation, including the leases, communications, operating budgets, property service agreements as well as the creditworthiness of each tenant, should be scrutinized. You should conduct actual interviews with each of the tenants to determine the condition of the property in the Tenant’s opinion.
BRINGING IT ALL TOGETHER
As you know from the Due Diligence Process Article, the goal in any due diligence investigation is to make sure that the property you think you are getting is actually the property being conveyed. As you set out in your investigatory journey, we leave you with a couple of things to keep in mind: first, remember that, while patterns recur, each transaction has its own unique set of obstacles and considerations, and second, utilization of third parties in the process is critical to accuracy and cost efficiency. With that said it is best to have a Real Estate Consultant on YOUR side to ensure that these items are examined , reviewed and reported back to you while you can do what you do best.