What Is Due Diligence In Real Estate?

In real estate, due diligence investigating facts about the physical and financial condition of the property includes reviewing environmental factors, researching zoning and permits, ordering inspections, and analyzing financial documents.

By Douglas Wade, Attorney

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Table of Contents

1. What is the importance of due diligence in real estate?

2. What does due diligence in real estate entails?

3. Establishing the Fundamentals of Due Diligence in Real Estate

4. Documentation Involved in Due Diligence in Real Estate

5. Understanding the Seller

6. Conclusion

What is the importance of due diligence in real estate?

Due diligence in real estate is vital because thorough investigation and research can help mitigate unexpected issues after a transaction.

In a rapidly changing commercial real estate market, investors, both seasoned and new, are actively seeking innovative strategies to maximize opportunities. Experienced investors in commercial properties leave no stone unturned in order to minimize the likelihood of unpleasant surprises after a transaction. Novice investors should adopt the same approach and avoid rushing into deals, considering the multitude of risks involved.

Due diligence in real estate is used to unearth crucial information that might not be immediately evident or accessible when assessing the property’s worth or portfolio. Overlooking such concealed details could jeopardize the financial viability of an otherwise lucrative deal, transforming it into a costly error.

There are essentially three categories of investors involved in procuring commercial real estate, each with distinct objectives:

Investment Objectives
Real Estate Development
Business Operations (where the investor’s organization will occupy the building)

These differing aims influence the extent and nature of due diligence in real estate.

Inexperienced investors, enticed by what appears to be a guaranteed opportunity with minimal risk, might enter where more experienced buyers hesitate. Undoubtedly, incomplete due diligence in real estate from any investor could lead to potential issues, particularly in light of concerns about an escalating real estate market. No investor can afford the risk of an expensive surprise emerging after a transaction is finalized. If you’re a real estate investor that has been bamboozled, please contact our California business ligation lawyer in Los Angeles for a free consultation.

What does due diligence in real estate entails?

Due diligence in real estate involves a comprehensive examination of the seller, property, compliance commitments, and financing to minimize financial uncertainties. It is a rigorous process that requires thoroughness. Prospective buyers must meticulously scrutinize factors like potential liens, zoning restrictions, and any potential encroachments on the property. They need to conduct a detailed assessment of existing structures to identify necessary repairs and associated costs. Additionally, they must determine if they will inherit any regulatory or legal liabilities from prior owners. In cases where the property is largely financed, they must assess their capacity to meet ongoing payments to the lender.

Experienced commercial investors often initiate detailed due diligence in real estate even before signing the purchase contract. Alternatively, they may stipulate in the contract the specific due diligence activities the buyer must undertake and the allotted time frame. This not only compels the seller to promptly provide necessary documents but also empowers the buyer if any significant issues are uncovered, allowing for a fair and accurate property valuation.

Given the extensive range of documents involved in a commercial real estate transaction, it is crucial to have a due diligence in real estate checklist. Each concern should be marked off once addressed. Depending on the investor’s type and financial objectives, this checklist can be quite extensive. Nonetheless, it would be unwise to finalize a deal without a thorough understanding and evaluation of the risks in relation to the potential rewards.

Establishing the Fundamentals of Due Diligence in Real Estate

The initial step in conducting due diligence in real estate is comprehending a transaction’s objectives. These investment objectives set the groundwork for the subsequent due diligence in real estate process. For example, if the goal is to acquire a revenue-generating property like an apartment complex, the investor must verify existing tenant leases and examine their rental payment history to ensure the stability of the expected income stream. Conversely, a commercial real estate developer’s primary focus lies in assessing the intended use of the building and whether the property can obtain the necessary permits for that purpose.

It is imperative for parties considering a commercial real estate transaction to personally visit, inspect, and walk through the premises. During this walkthrough, buyers should evaluate the property in terms of its intended use, as any concerns discovered will impact negotiations. For instance, a property slated to become an office complex with ample parking may present challenges if it is on uneven terrain, requiring costly grading to accommodate the anticipated volume of vehicles.

Given the often varying local, state, and federal environmental regulations, investors must use due diligence in real estate to also ensure that the building or property complies with current and potential future laws and rules. Environmental liability and sustainability serve as a prime example of this evolving landscape, with regulations sometimes phasing in years down the line.

Lenders typically require an environmental suitability assessment before financing a transaction. However, it is advisable to undertake this evaluation regardless of financing concerns. Engage a reputable environmental engineering firm to assess past uses of the building or property and identify possible contaminants like mold, asbestos, lead, and the presence of underground storage tanks. What may seem legal and safe in a visual inspection can lead to legal complications in the future, as the investor will inherit these potential liabilities and be legally obligated to address any discovered issues.

Lastly, while sellers are obligated by law to provide specific disclosures regarding a property’s physical characteristics, such as encumbrances, easements, and other restrictions, it is prudent for the investor to personally review, validate, and verify each item as a part of due diligence in real estate. When acquiring commercial real estate, it is a best practice not to automatically assume the same level of disclosures from the seller as one might expect when purchasing residential property, as there are notable differences.

Documentation Involved in Due Diligence in Real Estate

For those entering the realm of commercial real estate, it is advisable to consider enlisting the expertise of a specialized commercial real estate attorney. There are a multitude of legal documents that require access, assessment, and verification. These include, at a minimum, the title, tax certificates, zoning regulations, leases, surveys, and the seller’s financial records and operating statements. All these documents should be enumerated in the previously mentioned checklist and initially stored in a virtual data repository as a part of due diligence in real estate.

Title Investigations and Property Descriptions

After opening escrow, it is recommended that the investor procure a preliminary title report as part of the due diligence in real estate. This report furnishes information about the property, such as its previous and current ownership, as well as the presence of liens, easements, and encumbrances. Once these details are understood, a prudent approach is to commission a professional survey of the property to substantiate the particulars, including lot size, boundary demarcations, access routes, rights of way, surface water features, soil conditions, and potential property modifications and enhancements. To validate the accuracy of the title, it is wise to engage a title insurance company, which undertakes to cover unforeseen financial losses arising from potential title defects.

Municipal Lien Searches for Florida Properties

Different jurisdictions have distinct laws impacting real estate transactions. Those intending to purchase property in Florida should ensure they conduct a municipal lien search as part of due diligence in real estate. In Florida, in contrast to most other U.S. states, unrecorded fees, liens, and permit infractions are linked to properties rather than individuals.

Due to this distinction, nearly all real estate transactions taking place within the state of Florida necessitate a municipal lien search as part of the closing process. Prospective buyers of Florida properties should be aware that a conventional title search will not bring to light the issues uncovered in a municipal lien search.

Zoning and Property Regulations

Investors must also verify adherence to current zoning regulations and property codes as part of due diligence in real estate. Concerning the former, a prudent strategy is to request documentation from the relevant municipality to confirm that the present and anticipated use of the property aligns with the existing zoning regulations and land use classifications. For recently constructed buildings, an examination of the certificates of occupancy can provide assurance of compliance with pertinent property codes. In terms of the assessed value of a property, this data can be obtained via tax certificates, which will also indicate the status of property tax payments. To exercise due diligence in real estate, buyers may consider consulting an external zoning specialist to independently verify the accuracy and currency of the received information.

Mindful of City Approval Timelines

If any issues arise, or if the buyer intends to make alterations to the property, including its usage, additional business licenses and permits may be necessary as part of due diligence in real estate. Prospective property purchasers should be mindful of the timeframes associated with city approvals. Depending on various factors, obtaining building permits can take anywhere from a month to several years.

This underscores the importance of scheduling meetings with local authorities to ascertain which approvals are requisite. This encompasses planning and zoning, site plans, city council, and other necessary approvals.

Lease Payment History

For an income-generating property such as an office building or apartment complex, a comprehensive examination of the lease payment history provides insights into the regular and dependable flow of rental income. It is also advisable to meticulously inspect the seller’s financial records and operating statements, if available, to identify any gaps in lease payments as part of due diligence in real estate.

ADA Compliance

A crucial aspect of due diligence in real estate is assessing the adherence of an existing structure to the Americans with Disabilities Act. Each state has its own set of regulations governing accessibility and necessary modifications to ensure compliance. Relevant documents pertaining to these matters should be reviewed. The federal government has established a checklist to assist investors in understanding the regulations prior to acquiring property, a building, or undeveloped land.

All of these numerous documents are essential for a thorough assessment of the investment’s risks in relation to its potential returns. After validating the accuracy or inaccuracy of the information in each document, mark it off on the checklist and store it in the VDR. Compare the findings with the projected returns or revenue streams that the transaction is expected to generate. These details serve as valuable negotiation points when finalizing the deal. After the transaction is completed, transfer and securely store the documents for compliance purposes in a highly secure, centralized platform that offers easy accessibility.

Understanding the Seller

Conducting due diligence in real estate transactions entails more than just assessing the property itself. Before engaging in such a transaction, it is crucial to thoroughly investigate and evaluate the reputation, standing, and track record of the seller. This not only helps identify any potential unscrupulous behavior on the part of the transacting partner but also recognizes that the current owner (and even occupants) may have a detrimental influence on future earnings.

Request and scrutinize the seller’s tax returns, loan documents, service contracts, past litigation history, and any other relevant items related to the entity’s prior property use, financial status, and overall integrity. These insights will prove valuable in negotiations, aiding in the determination of whether to proceed with the opportunity or pass on it.

Conclusion

Each transaction is unique and necessitates a tailored due diligence in real estate strategy. Rushing the process and neglecting comprehensive due diligence can lead to complications, even for the most seasoned investors.

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