Now that your offer for a commercial property has been accepted, your purchase contract will specify that you have somewhere between 15-30 days due diligence period to investigate about the property. As a result of your investigations you will decide either to:
Cancel the purchase and get your full refund of your deposit. It's important to know that during this due diligence period you can cancel the transaction for any reasons and are not required to justify your reason with the seller.
Continue on with the transaction.
So it is important that you investigate thoroughly about the property. Once the due diligence period expires, you can only cancel the transaction if the loan if not approved. While your real estate advisor will assist you with the following tasks, you may want to know the whole process to make sure you understand what is going on.
Physical Inspection: This may be the first time you visit the property as it may be located far away from your home. You could either visit by yourself or make an appointment with the current property manager to show you around (if so, use this as an opportunity to meet and evaluate a potential property manager). It is very common that the seller does not want potential buyers to talk to existing tenants and let them know that the property is for sale. Refer to the articles "What 'Location' Means in Commercial Real Estate" and "Things to Consider When You Purchase a Commercial Property" written by the same author. You may want to plan ahead and have a list of things that you want to find out about the property and the method you use to get the information. You may need to be creative in your method of getting the information. For example: you may want to find out:
If the restaurant tenant is doing well by having lunch there.
If the Dry cleaner tenant plans to renew the lease by asking casually if the business is doing well.
You will get a lot of information by talking to the tenants (don't let them know the property is for sale) in the center without letting them know you could be their landlord.
Book & Records: Normally within 10 days the seller will provide you with information about:
Income and expenses: this includes rent, reimbursements from tenants from the last 2-3 years. Ideally the income should go up from year to year due to rent increase. If the income fluctuates from year to year, then it's a red flag that you need to understand the reason. You also want to know if the tenants pay rent on time or not. Regarding expenses, you want to make sure you receive property tax statements, trash bills, utilities bills, sweeping bills, and landscaping & maintenance contracts. In California, property taxes will be automatically adjusted based on the purchase price. They could be a much higher if the purchase price is much higher than the current assessed value. However, in many other states properties are re-assessed for property taxes purposes every few years and are not necessarily based on the purchase price. As a result, new property taxes may not increase as much as in California. The bottom line is you want to verify the Net Operating Income (Income after all expenses or NOI) is correct as advertised.
Leases: commercial leases are typically 20-40 pages long. However, they are often identical except the tenant name, unit, rent and lease terms. You will need to verify the rent, lease term are the same or better than the numbers in the rent roll. If the seller says that the leases are NNN, verify in the lease which expenses paid by the landlord are reimbursed by the tenants. You also want to find out who pays for property management fee and the repairs of roof and structure. Sometimes the listing broker advertises that leases are NNN but does not mention the landlord has to pay for those expenses or include these expenses when calculating NOI.
Property Inspection: There are 2 main reports for commercial properties.
Your advisor will order a property inspection report from a commercial property inspection company and provide you with a report. This report will assess the condition of the property including the description of the building, site drainage and paving, structural components, roof composition, parking lot and landscaping, cursory inspection of electrical systems, plumbing systems, heat/ventilation/AC systems, fire protection, and compliance to Americans with Disabilities Act (ADA). The report also provides a rough estimate to correct critical deficiencies. You should take time to read this property inspection report, talk to the property inspector if needed and let your advisor know if you want the seller to repair anything, preferably at seller's costs. As a rule of thumb, you would like all deficiencies related to health and safety, e.g. emergency exit light not working or exposed electrical wiring to be taken care of before close of escrow. The language in some of these inspection reports may sound very scary as property inspection companies try to limit their exposure to liabilities for not warning the buyers about some of the deficiencies.
The lender will order a "Phase I" or Environment Assessment Report. This report will tell you if the soil is contaminated or not. It also provides a list of contaminated sites within ½ miles from the property. The report could be several hundred pages long. You should at least read the summary which is 1-2 pages long to see if there are any recommendations and anything unusual. Normally there are 2 possibilities:
There is no evidence of contamination so there is nothing to worry about;
There is evidence of possible soil contamination, e.g. underground tank. The inspection may recommend a more expensive Phase II Report. This involves testing the water and soil to measure the level of contamination if any. If the level exceeds a certain governmental standards, the lender will most likely decline the loan.
Title & Survey: You will receive a title commitment which insures that you have a clear title to the property. It will tell you who owns the property so this owner should be the seller in the purchase contract. You should review the requirements and exceptions to the title insurance to make sure you are comfortable with them. The survey should tell you the lot size, foot print of the building, the number of parking spaces (is there enough parking spaces for tenants & customers?) and notes from the surveyor. You may want to read some of the notes to see if there is anything unusual, e.g. the roof may encroach the adjacent property.
Financing: your advisor should assist you with getting financing for the purchase by sending the loan application to several commercial lenders. Preferably you should receive a couple Letters of Intent (LOI) from commercial lenders stating
How much loan you can borrow
Interest rate
Terms
Loan fees
While the LOI's are not final loan approval, they give you a rough idea if you have enough money to close the transaction and what your cash flow will be. This in turn helps you decide if it makes investment sense to move forward. Once you complete all the above steps, you should have enough information to make a decision to move forward or cancel the transaction.
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