5 Steps to Take When Conducting Due Diligence in Commercial Real Estate

Topic:  • By Annamarie Bjorklund and Chris Neumann • November 20, 2018 989 Views

5 Steps to Take When Conducting Due Diligence in Commercial Real Estate

After months of pursuing a commercial real estate property, it’s thrilling to finally be selected as the winning purchaser. However, the celebration is usually short-lived, as then the real work begins: settling on a price signals the start of the due diligence phase. The buyer now has a short period of time—usually 30 to 60 days—to uncover any unexpected issues with the property that may potentially yield post-acquisition surprises.

At Origin, we acquire many value-add opportunities, which means we spend money to support physical and/or operational improvements to enhance a building’s value. Our acquisitions team conducts a systematic and detailed cost evaluation before a bid is submitted to avoid any unexpected costs during our future hold period. We use the due diligence period to not only double check our numbers, but also to understand a property’s full potential.

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We leverage our local market knowledge and years of real estate expertise to solidify our business plan to add value to our investment. We document the property’s current condition and determine if we’re able to rework spaces, update amenities or enhance aspects of the building that will substantially improve our tenant’s living or working conditions. A business plan is then created to address these issues, as well as increase the property’s earnings, long-term value and the return-on-investment for our partners.

What Goes Into Origin’s Due Diligence Process?

The due diligence process gives a buyer full access to the property for a deeper understanding of the commercial real estate asset. Typically, the buyer and seller of a property will agree to a timeline for the buyer to obtain all information they feel relevant prior to ownership and negotiate an agreement to give the buyer access to the property while the Purchase and Sale Agreement (PSA) is being negotiated. The standard is a 60-day PSA that stipulates a 30-day due diligence period.

The buyer will typically be asked to deposit funds with the seller to confirm their intent to purchase the property. If the buyer uncovers any substantial new issues during the due diligence period, there’s a window of opportunity to discuss these items with the seller. However, buyers that value their underwriting acumen and deal-making reputation in the commercial real estate community will want to avoid adjusting the purchase price unless significant problems are discovered. If critical issues are uncovered, they need to be addressed in a timely fashion. Buyers should have their entire team engaged during the due diligence process, including lenders, general contractors, architects, and designers.

At Origin, our due diligence process goes above and beyond a standard procedure and generally can be separated into five categories of steps that can occur in any order: operational, financial, legal, physical and environmental.

Step 1: Operational Due Diligence

We ensure we have the best team possible and that the team is mobilized to execute on our business plan at the new property upon purchase. This work includes:

  • Vetting and hiring professionals. Selecting the right property manager to fulfill our vision and values is generally one of the first decisions that we make in our due diligence process. We interview the property’s existing management and leasing teams to measure their knowledge of the asset, their local market competence and their camaraderie with tenants. We also interview firms we’ve worked with in the past to ensure that our asset is being served by the best possible management and leasing teams, as our requirements extend beyond just operating the property efficiently.
  • Developing a marketing plan. We create a marketing plan to rebrand the property, which can mean revitalizing a community feel among tenants, improving the quality of tenants or improving a property to where it can compete with or exceed the performance of previously superior assets. We share our vision with the property manager and work with them to implement our strategies. We expect that this work, when done the right way, results in higher rents or a higher yield at sale.

Step 2: Financial Due Diligence

An essential due diligence step is to investigate a property’s cash flow to ensure that income and expenses match the seller’s representations and to determine if the property’s rent roll is sustainable. It takes the form of a series of audits:

  • Lease audits. Most PSAs require the seller of a commercial real estate investment to provide access to all leases for the property. Our team, in conjunction with our attorneys and other affiliated parties, compares actual hard-copy leases to the rent roll to measure accuracy. This can be an arduous process. For instance, lease audits involved more than 300 residential leases at The Fletcher Southlands, an Origin acquisition in Aurora, Colorado, and more than 60 commercial leases at Cherry Creek Plaza in Glendale, Colorado. We ensure that move-in and move-out dates, agreed-upon rents, renewal options, security deposits, and other additional charges and stipulations are consistent with what the seller has represented.
  • Contract audits. We perform a file audit to review existing service contracts. The property may have agreements in place with cable and internet providers, landscaping/snow removal services, office equipment services and technicians, and third-party maintenance providers. We study these contracts to better understand whether we would want to continue them as the new owner. If other available providers offer better services for a lower price, we identify when the current contracts can be altered or canceled. We recently implemented Google Fiber at 675 North Highland and Ellie Apartments in Austin, modifying the existing service contracts to enhance and provide best-in-class options for these properties.
  • Rent roll analysis. We analyze the timing of expirations and associated rollover schedules, as well as any termination, renewal, or relocation options that might be associated with a tenant. Some tenants might be entitled to special provisions within their lease, so it is important that we know about those prior to taking ownership. At multifamily communities, we ensure that existing leases are more heavily weighted to expire during high leasing season. By doing this, we allow ourselves an ability to increase rental rates on new leases while demand is higher than in other times of the year, and we open ourselves up to the broadest market possible to fill any vacancies.
  • Cost analysis. Analysis of historical operations provides valuable insight on what expenses we should expect to incur once we begin operating the property. When performing this type of analysis, we look to find areas to save money. For example: Is the property overpaying its staff? Can a more affordable insurance policy be implemented? Are owners paying for unnecessary items? It’s easy to assume that you can operate a property more efficiently than the previous owner. This is called “buyer’s bias” and isn’t always correct. At Origin, one way that we attempt to eliminate this bias is by examining how these properties operate relative to similar properties. Using the comparable properties that we underwrite and screen, we have an ever-growing database that we maintain to benchmark our prospective acquisitions on four distinct variables: geographic location, vintage, construction type (garden, mid-rise, high-rise) and, for multifamily, the number of units. We gauge properties across these different metrics to help prevent buyer’s bias and develop a realistic budget.
  • Market analysis. We perform a market study to estimate the future rents that we feel can be charged by studying similar properties’ location, unit finishes, amenities, and other variables. When we make a value-add investment in a multifamily property, we project a premium that we can charge over current rents after upgrading unit interiors, common areas, clubhouses and other amenities, and we consider how repositioning the asset will enhance its value at sale.

Step 3: Legal Due Diligence

Our legal team takes every step possible to ensure that we recognize our entitlements and obligations as owners, and make sure we take full advantage of the former and meet the latter during due diligence.

These include:

  • Title Transfer. The property’s title policy stipulates all collateral that falls under the owner’s authority. At Origin, we utilize both internal and external counsel to study the title policies of our prospective acquisitions; they ensure that no parties have a cloud on the policy that would affect our ownership.
  • Survey Report. When considering a new acquisition, we order a new survey of the property to make sure we have the most up-to-date information possible on a site. The report allows us to better understand the land parcel – in particular, any site access rights that adjacent landowners have, the boundaries of the lot and any required setbacks to consider in a development opportunity. When we purchased Atlanta’s Ellsworth Lofts in 2017, the survey helped identify a specific opportunity to develop vacant land on the site. We also confirm the site’s zoning designation, which is important in assessing development opportunities.

Step 4: Physical Due Diligence

Origin engages structural consultants during our due diligence review to understand any engineering implications before formally purchasing the property. The PSA offers us access to the property for more thorough inspections than we were able to conduct before negotiating our intent to purchase and allows us to obtain a range of reports to determine budgets.

This includes:

  • Examining the property’s condition. We have a certified engineer inspect the property’s current condition and review its original plans and specifications to determine whether the property was built according to code. The inspection also extends to “the bones” of the property to make sure they are structurally sound.
  • An appraiser will review the property’s historical operations, calculate a current rent roll and analyze the market’s fundamentals to determine whether our purchase price is appropriate for the property.
  • Engaging additional consultants. When specific concerns present themselves, Origin hires relevant consultants before formally purchasing the property. For example, we hire inspectors to estimate the roof’s useful life, so that we know whether to budget a replacement within our ownership period. On certain acquisitions, specific structural consultants evaluate the property’s interior and exterior and determine items for immediate or long-term repair. On a recent acquisition, our structural consultant recognized two concerns with the building’s façade that could indicate the potential for water intrusion during our hold period. The seller was not aware of these concerns, so by having this information we were able to address our concerns before proceeding.
  • Renovation budget. When contemplating the purchase of a multifamily value-add investment, for one example, we spend an extensive amount of time estimating costs to renovate unit interiors and transform common area amenities. A unit renovation budget might contain the expected costs to install new flooring, windows, lighting or cabinets, paint walls, replace countertops or more. Common area budgets might include the costs to upgrade a pool or clubhouse, remove walls, install new fitness equipment or replace windows. We receive competitive bids and engage construction management teams early in the process to avoid surprises. Our investment management and acquisitions teams work cohesively during this process to create and approve a comprehensive renovation budget before submitting an offer.
  • Plan for adaptive reuse and development. Properties with vacant land often carry a higher asking price given the added potential for development. Therefore, along with the survey produced as part of our legal due diligence, consultants can assist in determining the potential and cost of any development opportunities. For example, an office building that we recently purchased included an adjacent, vacant, one-acre parcel that had a marketed worth of “about $1 million.” However, a third-party engineering firm that we engaged determined that to develop the adjacent land, $750,000 in site costs would be necessary. Zoning review also guides the valuation of vacant land. When we purchased 675 North Highland, our consultants determined that developing the adjacent land as a four-story, 39-unit building with first-floor retail would best fit the demand in the area while maintaining compliance with the City of Atlanta’s zoning ordinance.

Step 5: Environmental Due Diligence

Environmental remediation can be a significant cost burden, which is why we identify any potential issues prior to obtaining ownership of the property. We analyze environmental compliance to uncover costly non-conforming uses or conditions that will limit the property’s intended use. This cost-benefit analysis is performed during our environmental diligence process to determine whether the project would be feasible. To alleviate the financial burden, municipalities frequently offer incentives to developers, most often in the form of a tax break.

To determine potential issues, we conduct the following assessments:

  • Environmental site assessment. In a preliminary Environmental Site Assessment (ESA), otherwise known as a Phase I report, a geologist determines the historical use of the property and its adjacent parcels, and the potential for any environmental contamination from past use. The state of the site and its underlying soil is important, as remediation steps can be significant and costly should any contamination be present.
  • Site tests. Depending on the geologist’s findings, a Phase II report might be recommended. The Phase II ESA will include actual soil and groundwater testing to determine if any of the concerns noted in the Phase I report are borne out. The Phase II will recommend steps to remediate the situation.

Future Success Starts with Due Diligence

Although the due diligence process only lasts two to three months, it’s a critical time in the investment’s lifecycle, as decisions made during this time can affect the property for many years ahead.  By going far beyond standard due diligence procedure, Origin sets operational priorities that can reduce expenses and speed the pace of value-add improvements. We remain laser-focused on maximizing the return on investment for our partners and assure a smooth path for the property when we are ready to sell.

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Annamarie Bjorklund and Chris Neumann