Is your Due Diligence, Diligent?
Investing in real estate sounds simple... find a property, buy it, collect rent. Right? Wrong.
There is a ton of work that needs to be done between the time that you make an offer and actually close on the deal. This period, referred to as due diligence, is your time to put in the hours gathering information to make sure that you’re getting a good deal. If you try to skim over it or just take things at face value and avoid digging in deeper, an investment that may seem like a sure thing could end up being a disastrous loss.
What is Due Diligence?
Due Diligence (DD) is defined as an investigation of a potential investment. This is a comprehensive, complex, and critical stage in any commercial real estate acquisition where no stone should be left unturned. Every aspect of the property should be inspected in detail, including the review of all documents and thorough inspections of the property, title, tenant relationships, and a multitude of other items, with the goal of identifying any red flags before proceeding with a purchase.
When is the Due Diligence period?
Initial due diligence can be performed before any type of offer is made, but it depends on the information that a seller is willing to provide upfront. Some sellers are more transparent than others. The more information a seller is willing to give you before the property goes under contract, the better. The more upfront due diligence that can be performed before being officially under contract, the better.
Some examples of up front information that is typically and willingly supplied by a seller could include rent rolls, profit and loss statements, a budget or proforma, and a list of recent improvements that were made to a property. All things that you would likely see in any ‘for sale’ listing.
Once the seller accepts an offer, the property is considered ‘under contract’, and the buyer will have a due diligence period that typically ranges from thirty to sixty days depending on the complexity of the property. The time period could be more or could be less.
During the due diligence period, a buyer will dive deeper into their research and find as much information as possible on the property to make sure that they know all there is to know before moving forward with the purchase. Think “home inspection” when purchasing a single- family home, but on a heavy dose of steroids. This is the time to do your homework on the property to make sure you know exactly what you are investing in.
The intricacies of Due Diligence.
The main goals of due diligence are to thoroughly inspect the fundamentals of the property. This includes the physical condition of the buildings(s), the seller, financing, and any compliance obligations to cut down on potential risks or any uncertainties that may be hiding.
This process requires a lot of hard work.
Buildings must be fully inspected by licensed professionals to look for any deferred maintenance issues or necessary repairs, and the associated cost implications. When investing in a property with in-place tenants, whether that be an office, industrial, self-storage, or multi-family asset, all tenant leases must be verified and examined to make sure tenants are actually paying rent.
Could you imagine buying a building that appears to be fully occupied and profitable, only to find out after you close that those tenants haven’t been paying rent, and this was missed all because the proper due diligence into the tenant leases wasn’t properly conducted? That would be a catastrophic hit to the investment’s cash flow, not to mention the money in legal fees that would need to be spent to evict the non-paying tenants, and the additional funds that would be needed to lease the building back up.
In addition to physical inspections and lease verifications, the financial performance of the property needs to be fully audited to ensure that it is financially performing to the level that has been represented.
A title report needs to be run, which will provide information about the property such as ownership history and whether any liens, encumbrances or easements exist. Once a title report is completed, it is always good practice to have a survey conducted by an engineering firm. If a lender is involved, they’re likely to demand a new survey is completed. Lenders will also demand that an environmental study is conducted to inspect past uses of the property and collect any evidence of possible contaminants such as mold, lead, asbestos, the presence of underground storage tanks, etc.
A property that may look to be safe and legal can turn into an environmental nightmare in the future that could include litigation, and the investor would be responsible by law to fix any issues once the property is under ownership.
It is also important to check with the local municipality to make sure that the building complies with local zoning laws, rules and ordinances.
To take things a step further, due diligence should also go beyond items related to the property itself and should also include digging into and fully vetting the seller. This may throw up some red flags regarding the seller’s integrity and reputation, which could have a negative impact on the investment.
Going through proper due diligence is not for the faint-of-heart and must be completed in an organized manner with a team of professionals. Due Diligence is too crucial for the success of an investment to be taken lightly.
3 Rules when setting out to perform a proper and thorough due diligence:
- Take As Much Time as Possible
When negotiating the terms of the purchase and sale agreement, the investor should always give itself the most amount of time possible to perform due diligence. While thirty to sixty days is standard in today’s market, it’s a good practice to aim for more time.
There are items to be completed that are within the buyer’s control such as physical inspections, the review of lease documents and financial information, etc.
However, there are items that need to be completed as part of due diligence that are outside a buyer’s control and must be completed by a third party. These items include surveys and environmental studies, and can include third party roof, electrical & mechanical reports as well.
At the time of this article, lead times for most third-party items are taking longer than usual due to labor shortages.
Any buyer should avoid backing itself into a corner and being forced to decide whether to proceed with a purchase of a property if it isn’t comfortable with the full completion of its due diligence. It’s also important to keep in mind that once a due diligence period is waived and a buyer proceeds to closing, typically the earnest money deposit becomes non-refundable, putting some serious money at risk.
- Put Together a Team of Experts
There are many intricate parts of the due diligence process that can’t be done by one person, or one group of investors. It is important to put together a team of experts who can tackle the various parts of due diligence in an organized fashion.
This team should include a real estate attorney to review all legal documents, title work, etc., a civil engineer or surveyor, an environmental consultant to conduct the environment study and property condition report, certified mechanical, electrical, and roof contractors to inspect the physical condition of the property and its buildings systems, and an investor may consider the involvement of an experienced property manager to assist with lease audits, financial review of the property, vetting of service contracts, and for budgeting purposes.
Having experts that are specialized in their individual fields assisting with due diligence efforts help to ensure that no stone is left unturned. Putting this team together before making an offer is in your absolute best interest and will allow you to use your full due diligence period for investigation rather than team building. Engaging a team like this to perform due diligence doesn’t come without a cost, which leads us to the next key element.
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NEVER Be “Cheap”
Every investor is looking for the best deal at the best price, but performing proper due diligence is not the time to be looking for a bargain or to cut corners to save a few dollars.
Attorneys, new surveys, environmental studies, etc. all cost money. Some may find it silly to spend thousands of dollars for due diligence efforts that might result in discovering reasons why an investor might back out of a deal and not proceed with the purchase at all, but to the contrary – this is money well spent.
Being cheap when it comes to due diligence could result in major unnecessary risk and increased liability. Read that again. Being cheap when it comes to due diligence could result in unnecessary risk and increased liability.
For example, the visual inspection of a boiler might look just fine with no obvious issues. What happens though when a couple of months after closing, the boiler completely fails, leaving the building without heat and displacing tenants?! Not fun.
If the proper due diligence was completed with a team of professionals, the corrosion inside of the boiler caused from old age that caused the failure would’ve been noticed.
Today, the lead time on a new boiler is a couple of months, and if it’s in the middle of winter and a boiler failure leaves a building and its tenants without heat, then the owner must either pick up the tab for costly alternative housing situations (hotels) or may be forced to let tenants out of their leases to find new places to live...with heat. These scenarios cost the investment dearly, and while insurance may help cover a portion of the costs, it may not cover everything.
This example could have been prevented by spending a little upfront money on a boiler inspection. Investors never regret spending money upfront on proper due diligence to prevent the loss of significant investment dollars later.
Our Due Diligence is complete. Now what?
Hopefully, the due diligence inspections found no red flags or issues.
If that’s the case, you can move forward with closing on the deal confidently – knowing that the property is a sound investment with no hidden issues.
If, however, due diligence did open your eyes to some concerns, such as a failing roof in need of replacement that the seller never disclosed, it could be time to renegotiate. Ask for whatever you need to make the deal happen. For example, an adjustment to the purchase price or a credit at closing will help accommodate the cost of a new roof. This isn’t always easy, especially if you’re dealing with an unreasonable seller, but it’s always worth the effort to ensure that you’re making a good investment.
What does our due diligence process look like?
The case study below gives a glimpse into a December 2021 acquisition of ours, which is 3-building, 72-unit multi-family community with 9,000 square feet of ground floor retail space.
In July 2021, we identified a multi-family portfolio in the Midtown neighborhood of Detroit that was for sale. We are experts in this market, and we know Midtown is one of most desirable areas of Detroit.
The location alone grabbed our attention from the start, and we scheduled a site visit to take a look for ourselves. From the site visit we determined that the main building looked to be well constructed, the two smaller buildings were renovated nicely, the retail tenants were full and mostly open for business (even during the pandemic), and the location couldn’t be beat. We also noticed some small things like dim lighting in hallways and cleanliness levels below our standard, items that were easy and cheap improvements that could be made quickly to improve the buildings.
After our visit we were also able to look at some basic financial information including current rent rolls and profit & loss statements to determine the in-place Net Operating Income (NOI). These are examples of some upfront due diligence items.
From the quick review of this upfront information, we learned that the in-place rents of all of the apartment units were approximately 20% below the market, and the retail tenants were 40% below the market. It doesn’t take a genius to figure out that there is a significant amount of value that can be created in a situation like this. For us, this meant that it was worth putting in an offer to hopefully get the building under contract so that we could perform detailed due diligence to make a final determination on if it was a property worth purchasing.
The negotiations went back-and-forth, but we agreed to terms with the Seller and proceeded to the Purchase Agreement. We were able to get the Seller to agree to allow us a thirty-day initial due diligence period, with the option to extend due diligence by another thirty days. Remember our 3 rules from earlier on? We “gave ourselves as much time as possible”.
Now the Work Begins
Let’s touch on our other 2 Rules...
Put together a team of experts.
Before the property was under contract, we were busy gathering costs and forming our team so we could be ready to perform due diligence once the contract was signed.
Our trusted property management team was geared up and ready to go to help us comb through 72 leases plus 9 retail tenant leases, audit financial statements, begin compiling our operating budget, check with the city to make sure there were no ordinances or code violations we needed to be aware of, and more.
Our project management and construction consultant’s role was to inspect the physical condition of the property from top-to-bottom. Our tax attorney was busy performing a tax analysis for us so we knew what the tax liability would be after we closed (In Michigan, the taxable value of a property uncaps upon a sale and could result in a major increase in taxes that need to be accounted for). A civil engineer was in place to survey the property. Our environmental consultant was ready to perform our Phase I condition reports and Property Condition Assessments (both lender required). Last but not least, our real estate attorney was already involved with the Purchase Agreement and was also there to assist with any title issues.
It’s a big team, but every individual played an important role for us. Oh yeah, and this all costs money. But how much? Not including legal fees, this due diligence effort cost about $45,000.
Every dollar was money well spent, especially because the Phase I came back a bit dirty showing higher than normal levels of sub soil gas. The building was built on a Brownfield site, meaning that the soil that used to be there was contaminated and the developer cleaned up the site by replacing the contaminated soil when the building was built. We knew all of this going into our due diligence, but the abnormal gas levels meant we had to conduct a Phase II environmental assessment that took a much deeper dive into the potential issue.
For the Phase II, it involved our environmental company drilling small holes through the foundation of the building in numerous spots to take samples of the sub-soil gas levels. Thankfully, the Phase II tests results were normal, and nothing further needed to be done. All clear, but what we avoided could have been either expensive, or well beyond that. If the results of the Phase II were unfavorable, the likely scenario would have been that a mitigation system needed to be installed throughout the building that would periodically suck the gases out of the foundation and exhaust them out of the building.
If that situation were to have occurred, we would have been forced into making a tough decision: try forcing the seller to pay for the mitigation system, pay for it ourselves, or decide it’s just too much and cancel the purchase contract.
All these scenarios are likely options, but the bigger potential issue we need to point out is... what if we didn’t spend the money to initially have the Phase I conducted? Yes, most all lenders are going to require the Phase I, but let’s hypothetically assume we weren’t required and chose not to do it.
Now let’s take it a step further and assume that we closed, we own the property, and at some time during our ownership tenants start getting sick because they’re inhaling gas thats being emitted from the soil the building sits on. Who do you think would be responsible for that? You guessed it; we would be. We won’t even get into the legal ramifications, public relations nightmare, etc. that could come from that. We think you get the point, but we’ll remind you anyways... “Don’t be Cheap!” when it comes to due diligence.
Do it right, do it completely, and never cut corners.
All in all, we were satisfied with the results of our due diligence. The process allowed us to learn the ins-and-outs of the property, establish our operating budget, schedule necessary improvements, and further formulate our business plan for the investment.
We closed in December 2021. We’re happy, our investors are happy, we have happy tenants, and the investment is performing well. All of this because we did what we needed to do by performing due diligence how it needs to be performed. Diligently.
Interested in learning more about how our Detroit-based investment company makes sure that our investor’s money is protected? Want to stack your portfolio so that it’s staged for growth? Let’s talk. Visit our website’s Contact Us page at, call us 313.312.8466 or send us an email info@investdynasty.com.
