Acquisition
Commercial Real Estate Due Diligence: An Ultimate Guide
Learn in this ultimate guide about commercial real estate due diligence about the various categories and timelines included in the process.
Before taking on a commercial real estate project, you must do your due diligence. This can involve assessing the property itself, the title, the seller, current leases and rent rolls, zoning and permit requirements, environmental risks and regulations, the deal’s financials, and more.
But how long should the due diligence period last and how much should it cover? This depends on the project type, scope, and other factors. Read on to learn what commercial real estate due diligence to perform on your next acquisition or development project.
What is Due Diligence?
Due diligence is the process of investigating and evaluating a property before completing a purchase of it. It involves thoroughly reviewing a property’s physical, legal, financial, and operational aspects to minimize investment risks, avoid costly setbacks, and estimate potential returns.
Due diligence findings can also help you negotiate a better acquisition deal. For example, if you discover a property needs a new roof or suffers from deferred maintenance, you can use this information to possibly negotiate a lower purchase price.
Alternatively, due diligence findings may steer you away from a project you deem infeasible or too risky, saving you money and headaches in the long run. In any case, due diligence is a vital step in any prospective property acquisition.
Types of Due Diligence
Due diligence can be broken down into the following types:
| Due diligence type | Description |
| Physical due diligence | This involves inspecting a property’s physical condition and structure for potential issues and obtaining any seller disclosures. |
| Financial and operational due diligence | This involves examining the property’s past performance, comparing different financing options and vendor contracts, and forecasting expected returns. |
| Legal due diligence | This involves running a title search, checking zoning regulations, and verifying any other property use restrictions. |
| Tenant due diligence | This involves reviewing the current tenant mix, their lease terms, and occupancy rates. |
| Market due diligence | This involves analyzing the local market, including comparable properties, average vacancy rates, and future developments. |
| Environmental due diligence | This involves assessing the property’s environmental restrictions and risks, e.g. via a Phase I Environmental Assessment. |
| Seller due diligence | This involves vetting the seller’s track record and reputation to help ensure a smooth transaction. |
Due Diligence: Raw Land
Raw land is undeveloped property that lacks buildings or infrastructure such as utilities and road access. As a result, it tends to involve more investment risk and require more due diligence than developed property (all else equal).
For example, raw land developers must assess the feasibility and cost of getting infrastructure to the land (including material, labor, and government approval costs). Required infrastructure may include adequate streets and parking plus access to electricity, water, sewage, drainage, gas, internet, and other utilities.
Furthermore, the land use must fit within the city’s General Plan. If not, you may need to apply for a General Plan amendment or rezoning. That’s on top of compliance with local building codes, environmental protection laws, traffic impact restrictions, and other potential regulations.
Given its scope, raw land due diligence can take 6 to 18 months or longer. Much depends on the developer’s relationship with government officials and whether the intended land use is already in the city’s General Plan.
Due Diligence: Developed Land
Developed land is property with infrastructure already in place. In other words, these are land lots with existing road and utility access that are partially or fully prepared for building.
As a result, developed land can offer a more streamlined due diligence process. However, it’s important to still investigate and confirm the status of completed infrastructure and zoning approvals. Just because a seller claims a site is construction-ready doesn’t mean there aren’t potential roadblocks ahead.
That said, expect due diligence on developed land to take at least 2 months (with at least another month for closing).
Due Diligence: Commercial Redevelopment – Structures
A redevelopment project involves building a new structure on a previously developed site—whether that’s demolishing an old building and replacing it with a new one or significantly renovating or adding to an existing structure.
Typically, redevelopment projects are driven by a changing market. For example, an old or poorly-performing hotel may make a great opportunity for a redevelopment project if consumer demand has shifted elsewhere, e.g. multifamily housing. This could not only increase the property’s value but revitalize the surrounding neighborhood, which is why local governments often offer incentives for redevelopment projects.
However, commercial redevelopment also has its unique challenges. For example, developers must carefully evaluate the existing structure’s condition. After all, many redevelopment projects involve outdated properties, so the risk of uncovering serious structural issues (especially after demolition) is greater. Furthermore, older properties registered as historic sites may come with extra red tape.
Meanwhile, if the intended land use differs from the original use, the redevelopment project may require rezoning, adding cost and complexity to the project. And while some infrastructure may already exist, it may need to be expanded or updated.
Bottom line: Redevelopment projects tend to be more complex. As a result, you should give yourself at least 6 months for due diligence, but don’t be surprised if it takes longer.
Due Diligence: Brownfields
According to the U.S. Environmental Protection Agency (EPA), a brownfield is a “property, the expansion, redevelopment, or reuse of which may be complicated by the presence or potential presence of a hazardous substance, pollutant, or contaminant.”
Typically, brownfields are previously developed and abandoned industrial sites, such as a former factory or mine. As a result, developing brownfields often requires significant cleanup and meeting strict environmental standards.
For example, the 1980 Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), aka Superfund, can hold property owners responsible for cleaning up contaminated sites even if they didn’t cause the contamination.
That said, as with redevelopment projects, governments (federal and local) have an interest in developing brownfields because it encourages sustainability and tends to improve property values. That’s why you may be able to offset cleanup costs with dedicated EPA grants.
To comply with environmental regulations, brownfield projects typically require conducting a Phase I, II, and III Environmental Site Assessment (ESA). These are standardized reports that assess a property’s potential environmental risks.
Due to brownfield projects’ extra environmental considerations, developers should expect to add at least 3 months to their typical due diligence.
Title & Lien Searches
The purpose of conducting a title and lien search is to identify a property’s legal owner and any potential claims or encumbrances on the property. For example, if the seller doesn’t actually own the property or it has an undisclosed mortgage, this is information you would want to know.
You may also want to get title insurance to protect you from potential claims against the property. This helps ensure you maintain ownership, no matter what issues arise after the fact.
Zoning and Land Use Compliance
As a developer, you must ensure a property’s intended use will comply with local zoning and land use regulations. If it will not, you may need to apply to have the area rezoned or move on.
Contact local city officials to confirm what zoning restrictions apply to the property and whether they can be adapted to meet your needs and goals.
Environmental Site Assessments
Environmental site assessments (ESAs) come in three progressive phases:
ESA Phase I: This is a historical review of a property to determine the possibility of any contamination. It involves an initial site survey and interviews with neighboring property owners and other relevant personnel to determine past property uses.
ESA Phase II: If a Phase I ESA concludes that contamination is possible, a Phase II ESA is conducted. This test confirms whether the property contains contamination and involves extensive investigation, including collecting soil and groundwater samples for lab testing.
ESA Phase III: If a Phase II ESA confirms the presence of contamination, a Phase III ESA is conducted. It delineates the volume of the contamination and its boundaries. From there, a remediation plan is drawn up detailing the amount of cleanup required and how long it will take.
Inspections & Surveys
Due diligence includes physical inspections. Before acquiring a property, hire a qualified property inspector or building engineer to assess the building’s structural integrity and pay attention to any deferred maintenance that could point to larger issues.
For raw land, hire a professional surveyor to identify the physical and legal boundaries of the property. Look out for any potential easements or encroachments.
Financial Analysis & Tenant Reviews
On top of conducting physical inspections, developers must assess a property’s current tenant mix and financial viability. This involves collecting rent rolls, screening and evaluating tenants, reviewing historical operating costs, running financial models, and more.
The goal is to ensure a project will be worth the investment. You would not want to develop a property only to realize that the cash flow will not cover the mortgage or that the resale price won’t justify the acquisition costs.
Working with other professionals (lawyers, environmental specialists, CRE agents)
Commercial real estate due diligence cannot be accomplished by one person. It requires a network of professionals, on whom you can rely for various tasks:
- Real estate attorneys
- Environmental specialists
- Property inspectors
- Architects
- Building engineers
- Title professionals
- City planning officials
- Appraisers
- Commercial lenders
By maintaining good relationships with CRE professionals, you can not only improve your due diligence process but cultivate sellers’ trust. After all, a buyer who wastes no time finding the right people for the job is more likely to build a strong reputation and win future business.
Due Diligence Checklist
Another part of being prepared for a potential acquisition is having a due diligence checklist. This can look different from one developer to the next, but here are some common components:
- Most recent title policy
- Most recent survey and topographic study
- Legal description of the property
- Zoning Compliance Certificate
- Declaration of covenants, conditions, and restrictions (CC&R)
- Environmental reports
- Past real estate tax bills
- Rent rolls and lease agreements
- Historical operating expenses
- Existing insurance policies
- Service contracts for property’s operation and maintenance
- All tenant security deposits
For a more comprehensive commercial real estate due diligence checklist, check out this one for raw land development by Stahl, Sewell, Chavarria, Friend & Cohen, LLP:
Frequently Asked Questions (FAQs)
What is included in commercial due diligence?
Commercial real estate due diligence includes evaluating the physical property, investigating the title, searching for potential liens, assessing the property’s past and projected financial performance, examining any environmental risks, and more.
What are due diligence documents in commercial real estate?
Due diligence documents in commercial real estate can include legal documents, financial documents, operational documents, appraisal and inspection documents, etc.—anything that provides insight into the property’s value and investment potential.
What do you look for in commercial due diligence?
Among other things, you look for potential title issues or liens, relevant zoning and land use regulations, historical operating costs and profitability, structural issues, environmental risks or liabilities, and local market risks.
What is the due diligence clause in a commercial contract?
The due diligence clause in a commercial real estate purchase agreement is a provision that grants the buyer a specified period to investigate a property before fully committing to a deal. Typically, the clause details the due diligence period’s length (e.g. 90 days) and scope (e.g. physical inspection, documents review, environmental assessments, etc.).
Conclusion
Ultimately, commercial real estate due diligence involves many moving parts and can take anywhere from two months to two years. But how much due diligence time should you aim for?
“As much time as the seller will give you,” Josh Green, Partner at Alchemy Design & Development, said.
After all, due diligence periods are negotiable. Many developers also make them contingent on the approval of building permits, site plans, rezoning applications, etc.
The key is to give yourself as much time for due diligence as the seller will allow and then have a due diligence checklist and professional network ready to go once you’re under contract so you don’t waste any time.
