Performing your real estate due diligence
Article written based on New Jersey Law
Over the years, our firm has been engaged by a wide range of real estate buyers ranging from the first-time home buyer to the highly sophisticated organization looking to purchase a major commercial site. Regardless of the nature of the proposed acquisition, we advise each one to perform their real estate due diligence.
A thorough due diligence assessment process removes uncertainty from key decisions that must be made when analyzing the cost/benefit of any real estate transaction. A comprehensive inquiry should be designed to provide a buyer with clear pictures of where their strategies and decisions are taking them, or to put it simply - what it is they are buying.
Even though the term "due diligence" may seem daunting, it can be defined simply as "the responsibilities of a person or business to exercise proper care and planning prior to making any business decision, or entering into any business venture."
There are a multitude of details which must be considered when dealing with purchasing a parcel of real estate. Many of these details are easily overlooked. The function of due diligence is to independently verify all representations made by a prospective seller as well as to uncover pertinent facts which have not been disclosed but which are important to the buyer.
A multi-tenant property, either residential, office/retail or mixed use is the most complex for evaluation purposes. I have attempted to put together a detailed outline of what should be considered both by the novice, as well as the seasoned real estate professional in connection with performing real estate due diligence. Even in a high-performance real estate marketplace, astute investors and lenders know to look both ways before they leap.
After identifying a target property, due diligence starts during the contract negotiation stage. Unless the seller understands at the beginning of the process what document production and other information, will be required before the deal is closed, there is going to be automatic trouble in getting to the closing table. When a seller is presented with a thorough list of required due diligence items by a prospective purchaser, the seller can be overwhelmed. Many of the items that must be examined are personal and private, i.e., tax returns, and sellers are not usually comfortable with just "turning loose a box of documents."
Including a list of required due diligence items, therefore, is essential in the purchase agreement and it is expected that there will be some negotiation as to what will and will not make it to the final draft.
Ample time (at least 30 days AFTER the delivery of all documents) should be provided to complete due diligence. Agreements should state that the purchaser must give written notice that all due diligence is complete and satisfactory, or that there would be no further obligation to proceed with the transaction. Generally, due diligence should not be undertaken until after the contract is executed by all parties. Any time triggers should be tied to the delivery date of the LAST document supplied by the seller, with provisions for the extension of time based on the appearance of any non-disclosed material documentation. By requiring written acceptance of the due diligence items, control of the deal can be maintained.
PROCEEDING WITH DUE DILIGENCE - LEAVE NO STONE UNTURNED
Beyond the physical condition of the property (discussed below), there are a multitude of intangibles that have to be taken into account when evaluating a site for acquisition. Literally EVERY document concerning the land, building and its operation MUST be examined. This includes leases (with any and all extensions and modifications), notes and mortgages, (whether the buyers are assuming them or not), title policy, certificate of occupancy, New Jersey Department of Community Affairs (DCA) "green cards" insurance policy(s), ADA compliance, elevator maintenance contracts, tax history, licenses (in some jurisdictions), parking lot contracts, etc.
There are sophisticated companies that provide due diligence services. Several provide their clients with a detailed market analysis of income, operating expenses, vacancy rates, rental competition, sold comparables, on-market competition, and available sources of financing. They will also gain knowledge of the property and all internal and external factors likely to affect its economic health, now and in the future.
The benefit of having an independent evaluation ensures that an enlightened and clear assessment of a projects potential and pitfalls will be exposed. This is especially so if a buyer does not have sufficient experience in real estate investment to do a complete and thorough job. The detriment is usually the cost.
An evaluation of factors which an astute purchaser must consider includes:
(1) Cash flow projections;
(2) Appraisal, environmental and engineering reports;
(3) Sales and rental comparables;
(4) Market trends and property values; and
(5) Financing strategies and alternatives.
To accomplish these 5 broad evaluations, a buyer should request that the seller produce the following documentation. These are not exhaustive lists.
Financial statements
At least one year of monthly P & Ls (preferably two years)
Balance sheet (three years)
Rent roll including term, deposit and payment history
Tax returns - three years (five years preferred)
Insurance - policy, including all riders, risk assessments and disclosure affidavit for carrier
Existing loan documents including notes, deeds of trust, closing statements and title policy rate riders
All leases, entire copies plus any addendums or riders
All security deposit records
Any service contracts - trash, extermination, maintenance, management, commission agreements, union agreements, vending, billboard, pay telephone, etc. and any contract to be assumed by purchaser
Copies of all prior appraisals, engineering reports, environmental reports
Survey (as built), legal description, architectural and engineering plans and specifications
Payroll register, list of employees including name, position, wage rate and entitled benefits
Business licenses
Utility bills - water, sewer, gas, electric (at least two years of monthly statements) (or recap report from provider showing usage and cost)
Fire system inspection reports
Property tax bills for the past three years
Litigation history - details of any past or pending litigation (if none, then affidavit from owner)
Tax appeal status, if any
Department of Community Affairs (DCA) "green card" with prior inspection reports
When considering the external physical conditions of a target property, an informed purchaser is well advised to secure the services of a licensed inspection service. Depending on the nature of the physical attributes of the property, the following items should be considered:
Engineering inspection and survey
Environmental inspection and survey; key issues: asbestos, lead paint, testing of underground tanks, wetlands
Environmental Phase One
Environmental Phase Two Assessment/Subsurface Investigation if recommended by the Phase One inspection, which may include but are not limited to subsurface drilling and sampling, monitoring well installation and sampling, ground penetrating radar, and asbestos and lead sampling
Survey for abandoned underground storage tanks
Type of roof - consider number of layers of roofing material installed and identify evidence of damage
Assess leaks or moisture damage inside the structure (both roof and basement)
Drainage system should direct water ways from the structure
Availability of municipal water and sewer
External electrical connections and boxes
Condition of chimneys. If the chimneys are masonry, are there signs of loose mortar. If the chimneys are metal, are there signs of rust or corrosion
Cracks in sidewalks or driveways that are large enough to present a tripping hazard
Condition of any retaining walls. Signs of movement
Major cracks, bulges, or other visible signs of settlement in the foundation. Condition of the exterior surface of the foundation, especially at ground level
Has the septic tank been cleaned and inspected
Have handrails been installed where needed
When considering the internal conditions of a particular piece of improved real estate, one should consider the following items:
Are ground-fault breakers installed at bathrooms, kitchens, outside and other wet locations
Have modern garage door openers been installed that will reverse if someone becomes trapped underneath
Age of heating system - equipped with modern safety controls; also when it was last serviced
Signs of rust corrosion or scorching around heating unit
Sufficient source of outside air provided to the heating system
Condition of piping or ductwork
Test heating equipment for carbon monoxide production
Carbon monoxide alarms installed/tested
Smoke detectors installed/tested
Cracks or bulges at the interior finish surfaces
Do doors or windows bind in their openings, or are the openings out of square
Are interior floors level
Is there any earth/wood contact in the crawl space or basement
If there sufficient fireproof barrier to utility rooms and garage
Is there sufficient electrical service
Is structure insulated to typical standards
Was urea-formaldehyde or asbestos-containing insulation used
Property serviced by private water or sewer systems.
Water-potability test and a drawn-down test
Main water shut-off valve operational and accessible
Is there a main sewer clean-out
Is there sufficient water pressure
Age of water heater and properly installed temperature and pressure relief valve
One result of a thorough due diligence process is that when the time comes to present a deal to either partners, investors, lenders or another buyer, one will have the level of information and knowledge surrounding the property that gives a clear picture of a propertys financial and physical condition. This information enables others to make lending and investing decisions relative to the property in an informed manner. In addition, proper due diligence also reflects favorably upon a purchaser in the eyes of lenders and cuts down on time bringing the transaction to loan closing.
The most important result, however, is that the buyer will receive the benefit of the bargain made and paid for, without receiving very unpleasant and possibly fatal news after the closing. Once the purchase price is paid, absent certain limited circumstances, the property with all of its faults belongs to the buyer, and if it isnt worth what was paid, the buyer will have to live with the consequences.
The information you obtain in this article is not, nor is it intended to be, legal advice. You should consult an attorney for individual advice regarding your own situation.
About the Authour: Bruce E. Gudin, Esq. is a Partner with the firm of Levy, Ehrlich & Petriello, P.C. headquartered in Newark, New Jersey. He can be reached at (973) 643-0040, ext. 104 or by e-mail at Bruce@LEP-lawyers.com.