Planning to purchase or finance commercial or commercial Real Estate? Shopping Center? Office Building? Restaurant/Banquet property? Parking Lot? Storefront? Gas Station? Manufacturing facility? Warehouse? Logistics Terminal? healing Building? Nursing Home? Hotel/Motel? Pharmacy? Bank facility? Sports and Entertainment Arena? Other?
A Key to investing in commercial real estate is performing an adequate Due Diligence Investigation to assure you know all material facts to make a wise speculation decision and to intuit your foreseen, speculation yield.
The following checklists are designed to help you conduct a focused and meaningful Due Diligence Investigation.
Basic Due Diligence Concepts:
Commercial Real Estate transactions are Not similar to large home purchases.
Caveat Emptor: Let the Buyer beware.
Consumer security laws applicable to home purchases seldom apply to commercial real estate transactions. The rule that a Buyer must examine, judge, and test for himself, applies to the purchase of commercial real estate.
Due Diligence: "Such a quantum of prudence, activity, or assiduity, as is proper to be foreseen, from, and generally exercised by, a uncostly and thrifty [person] under the particular circumstances; not measured by any absolute standard, but depending upon the relative facts of the special case." Black's Law Dictionary; West Publishing Company.
Contractual representations and warranties are Not a substitute for Due Diligence.
Breach of representations and warranties = Litigation, time and money.
What Diligence Is Due?
The scope, intensity and focus of any due diligence investigation of commercial or commercial real estate depends upon the objectives of the party for whom the investigation is conducted. These objectives may vary depending upon whether the investigation is conducted for the advantage of (i) a Strategic Buyer (or long-term lessee); (ii) a Financial Buyer; (iii) a Developer; or (iv) a Lender.
If you are a Seller, understand that to close the transaction your Buyer (and its Lender) must address all issues material to its objective - some of which need facts only you, as Owner, can adequately provide.
General Objectives:
(i) A "Strategic Buyer" (or long-term lessee) is acquiring the property for its own use and must verify that the property is favorable for that intended use.
(ii) A "Financial Buyer" is acquiring the property for the foreseen, return on speculation generated by the property's revenue stream, and must conclude the amount, velocity and stamina of the revenue stream. A sophisticated Financial Buyer will likely intuit its yield based upon discounted cash-flows rather than the must less literal, capitalization rate ("cap rate"), and will need adequate financial facts to do so.
(iii) A "Developer" is seeking to add value by changing the character or use of the property - commonly with a short-term to intermediate-term exit strategy to arrange of the property; although, a Developer might plan to hold the property long term as Financial Buyer after improvement or redevelopment. The Developer must focus on whether the planned convert is character or use can be done in a cost-effective manner. A developer conducting due diligence will focus on issues sharp market demand, access, use and finances.
(iv) A "Lender" is seeking to build two basic lending criteria:
1. "Ability to Repay" - The capability of the property to generate adequate revenue to repay the loan on a timely basis; and
2. "Sufficiency of Collateral" - The objective disposal value of the collateral in the event of a loan default, to assure adequate funds to repay the loan, carrying costs and costs of collection in the event forced collection becomes necessary.
The number of diligent inquiry due to be expended (i.e. "Due Diligence") to study any particular commercial or commercial real estate project is the number of inquiry required to write back each of the following questions to the extent relevant to the objectives of the party conducting the investigation:
I. The Property:
1. Exactly what property does Purchaser believe it is acquiring?
(a) Land?
(b) Building?
(c) Fixtures?
(d) Other Improvements?
(e) Other Rights?
(f) The entire fee title interest together with all air possession and subterranean rights?
(g) All improvement rights?
2. What is Purchaser's planned use of the Property?
3. Does the physical health of the property permit use as planned?
(a) Commercially adequate access to collective streets and ways?
(b) adequate parking?
(c) Structural health of improvements?
(d) Environmental contamination?
(i) Innocent Purchaser defense vs. Exemption from liability
(ii) All thorough Inquiry
4. Is there any legal restriction to Purchaser's use of the property as planned?
(a) Zoning?
(b) hidden land use controls?
(c) Americans with Disabilities Act?
(d) Availability of licenses?
(i) Liquor license?
(ii) Entertainment license?
(iii) Outdoor dining license?
(iv) Drive through windows permitted?
(e) Other impediments?
5. How much does Purchaser expect to pay for the property?
6. Is there any health on or within the property that is likely to growth Purchaser's effective cost to acquire or use the Property?
(a) property owner's assessments?
(b) Real estate tax in line with value?
(c) special Assessment?
(d) Required user fees for needful amenities?
(i) Drainage?
(ii) Access?
(iii) Parking?
(iv) Other?
7. Any encroachments onto the Property, or from the property onto other lands?
8. Are there any encumbrances on the property that will not be cleared at Closing?
(a) Easements?
(b) Covenants Running with the Land?
(c) Liens or other financial servitudes?
(d) Leases?
9. Leases?
(a) security Deposits?
(b) Options to extend Term?
(c) Options to Purchase?
(d) possession of First Refusal?
(e) possession of First Offer?
(f) Maintenance Obligations?
(g) Duty on Landlord to furnish utilities?
(h) Real estate tax or Cam escrows?
(i) Delinquent rent?
(j) Pre-Paid rent?
(k) Tenant mix/use controls?
(l) Tenant exclusives?
(m) Tenant parking requirements?
(n) automated subordination of Lease to future mortgages?
(o) Other material Lease terms?
10. New Construction?
(a) Availability of building permits?
(b) Utilities?
(c) Npdes (National Pollutant discharge Elimination System) Permit?
(i) Phase 2 effective March 2003 - Permit required if earth is disturbed on one acre or more of land.
(ii) If applicable, Storm Water Pollution prevention Plan (Swppp) is required.
Ii. The Seller:
1. Who is the Seller?
(a) Individual?
(b) Trust?
(c) Partnership?
(d) Corporation?
(e) dinky Liability Company?
(f) Other legally existing entity?
2. If other than natural person, does jobber validly exist and is jobber in good standing?
3. Does the jobber own the Property?
4. Does jobber have authority to transport the Property?
(a) Board of Director Approvals?
(b) Shareholder or Member approval?
(c) Other consents?
(d) If foreign personel or entity, are any special requirements applicable?
(i) Qualification to do company in jurisdiction of Property?
(ii) Federal Tax Withholding?
(iii) Us Patriot Act compliance?
5. Who has authority to bind Seller?
6. Are sale proceeds adequate to pay off all liens?
Iii. The Purchaser:
1. Who is the Purchaser?
2. What is the Purchaser/Grantee's exact legal name?
3. If Purchaser/Grantee is an entity, has it been validly created and is it in good standing?
(a) Articles or Incorporation - Articles of Organization
(b) Certificate of Good Standing
4. Is Purchaser/Grantee authorized to own and operate the property and, if applicable, finance acquisition of the Property?
(a) Board of Director Approvals?
(b) Shareholder or Member approval?
(c) If foreign personel or entity, are any special requirements applicable?
(i) Qualification to do company in jurisdiction of the Property?
(ii) Us Patriot Act compliance?
(iii) Bank Secrecy Act/Anti-Money Laundering compliance?
5. Who is authorized to bind the Purchaser/Grantee?
Iv. Purchaser Financing:
A. company Terms Of The Loan:
What loan terms have the Purchaser, as Borrower, and its Lender agreed to?
(a) What is the number of the loan?
(b) What is the interest rate?
(c) What are the repayment terms?
(d) What is the collateral?
(i) commercial real estate only?
(ii) Real estate and personal property together?
(e) First lien? A junior lien?
(f) Is it a particular expand loan?
(g) A multiple expand loan?
(h) A building loan?
(i) If it is a multiple expand loan, can the needful be re-borrowed once repaid prior to maturity of the loan; production it, in effect, a revolving line of credit?
(j) Are there preserve requirements?
(i) Interest reserves?
(ii) heal reserves?
(iii) Real estate tax reserves?
(iv) guarnatee reserves?
(v) Environmental remediation reserves?
(vi) Other reserves?
(k) Are there requirements for Borrower to open company operating accounts with the Lender? If so, is the Borrower obligated to mouth minimum compensating balances?
(l) Is the Borrower required to pledge company accounts as additional collateral?
(m) Are there early repayment fees or yield maintenance requirements (each sometimes referred to as "pre-payment penalties")?
(n) Are there repayment blackout periods while which Borrower is not permitted to repay the loan?
(o) Is there a Loan Commitment fee or "good faith deposit" due upon Borrower's acceptance of the Loan Commitment?
(p) Is there a loan funding fee or loan brokerage fee or other loan fee due Lender or a loan broker at closing?
(q) What are the Borrower's expense repayment obligations to Lender? When are they due? What is the Borrower's promulgation to pay Lender's expenses if the loan does not close?
B. Documenting The commercial Real Estate Loan
Does Purchaser have all facts needful to comply with the Lender's loan closing requirements?
Not all loan documentation requirements may be known at the outset of a transaction, although most commercial real estate loan documentation requirements are fairly typical. Some required facts can be obtained only from the Seller. Yield of that facts to Purchaser for delivery to its lender must be required in the purchase contract.
As guidance to what a commercial real estate lender may require, the following sets forth a typical closing Checklist for a loan secured by commercial real estate.
Commercial Real Estate Loan closing Checklist
1. Promissory Note
2. Personal Guaranties (which may be full, partial, secured, unsecured, cost guaranties, collection guaranties or a collection of other types of guarantees as may be required by Lender).
3. Loan agreement (often incorporated into the Promissory Note and/or Mortgage in lieu of being a isolate document)
4. Mortgage [sometimes extensive to be a Mortgage, security agreement and Fixture Filing]
5. Assignment of Rents and Leases
6. security Agreement
7. Financing Statement (sometimes referred to as a "Ucc-1", or "Initial Filing")
8. Evidence of Borrower's Existence In Good Standing; including
(a) Certified copy of organizational documents of borrowing entity (including Articles of Incorporation, if Borrower is a corporation; Articles of assosication and written Operating Agreement, if Borrower is a dinky liability company; Certified copy of trust agreement with all amendments, if Borrower is a land trust or other trust; etc.)
(b) Certificate of Good Standing (if a corporation or Llc) or Certificate of Existence (if a dinky partnership) or Certificate of Qualification to Transact company (if Borrower is an entity doing company in a State other than its State of formation)
9. Evidence of Borrower's Authority to Borrow; including
(a) a Borrower's Certificate;
(b) Certified Resolutions
(c) Incumbency Certificate
10. Satisfactory Commitment for Title guarnatee (which will typically require, for diagnosis by the Lender, copies of all documents of record appearing on agenda B of the title commitment which are to remain after closing), with required commercial title guarnatee endorsements, often including:
(a) Affirmative Creditors possession Endorsement (extending coverage over policy exclusion 7 and policy exclusions 3(a) and 3(d) as they review to creditor's possession matters)
(b) Alta 3.1 Zoning Endorsement modified to contain parking
(c) Alta overall Endorsement 1
(d) Location Endorsement (street address)
(e) access Endorsement (vehicular access to collective streets and ways)
(f) Contiguity Endorsement (the insured land comprises a particular parcel with no gaps or gores)
(g) Pin Endorsement (insuring that the identified real estate tax permanent index numbers are the only applicable Pin numbers affecting the collateral and that they review solely to the real property comprising the collateral)
(h) Usury Endorsement (insuring that the loan does not violate any prohibitions against inordinate interest charges)
(i) other title guarnatee endorsements applicable to safe the intended use and value of the collateral, as may be considered upon review of the Commitment for Title guarnatee and seek or arising from the existence of special issues pertaining to the transaction or the Borrower.
11. Current Alta seek (3 sets), [typically ready in accordance with 2005 Minimum thorough detail for Alta/Acsm Land Title Surveys, certified to the lender, Buyer and the title insurer, together with items 1 through 4, 6, 7(a), 7(b)(1), 8 through 11(a) and 14 from the Surveyor's "Optional seek Responsibilities and Specifications" referred to as "Table A"].
12. Current Rent Roll
13. Certified copy of all Leases (3 sets)
14. Lessee Estoppel Certificates
15. Lessee Subordination, Non-Disturbance and Attornment Agreements [sometimes referred to plainly as "Sndas"].
16. Ucc, Judgment, Pending Litigation, Bankruptcy and Tax Lien quest Report
17. Assessment (must comply with Title Xi of Firrea (Financial Institutions Reform, saving and promulgation Act of 1989, as amended)
18. Environmental Site Assessment record (sometimes referred to as Environmental Phase I and/or Phase 2 Audit Reports)
19. Environmental Indemnity agreement (signed by Borrower and guarantors)
20. Site Improvements Inspection Report
21. Evidence of Hazard guarnatee naming Lender as the Mortgagee/Lender Loss Payee; and Liability guarnatee naming Lender as an "additional insured" (sometimes listed as plainly "Acord 27 and Acord 25, respectively)
22. Legal opinion of Borrower's Attorney
23. Credit Underwriting documents, such as signed tax returns, property operating statements, etc. As may be specified by Lender
24. Compliance agreement (sometimes also called an Errors and Omissions Agreement), whereby the Borrower agrees to correct, after closing, errors or omissions in loan documentation.
It is useful to come to be customary with the Lender's loan documentation requirements as early in the transaction as practical. The requirements will likely be set forth with some detail in the lender's Loan Commitment - which is typically much more detailed than most loan commitments issued in residential transactions.
Conducting the Due Diligence Investigation in a commercial real estate transaction can be time sharp and expensive in all events.
If the loan requirements cannot be satisfied, it is better to make that determination while the contractual "due diligence period" - which typically provides for a so-called "free out" - rather than at a later date when the earnest money may be at risk of forfeiture or when other liability for failure to close may attach.
Conclusion
Conducting an effective due diligence investigation in a commercial real estate transaction to seek all material facts and conditions affecting the property and the transaction is of needful importance.
Unlike owner occupied residential real estate, when a house can nearly all the time be occupied as the purchaser's home, commercial real estate acquired for company use or for speculation is impacted by numerous factors that may sway its use and value.
The existence of these factors and their sway on a Purchaser's capability to use the property for its intended use and on the Purchaser's projected speculation yield can only be discovered through diligent investigation and attention to detail.
The circumstances of each transaction will conclude what degree of diligence is required. The level of diligence required under the circumstances is the diligence that is due.
Exercise Due Diligence.
Cap rate or capitalization rate or just cap is the ratio of yearly rental earnings of the asset over the buy price. This estimate is often shown on industrial asset listings. So you must know this jargon if you want to spend in industrial real estate. It's ordinarily a estimate between 3% to 10%.
For those who spend in the stock market, cap rate is the equivalence of the inverse of P/E ratio. So a cap of 5% is equivalent to P/E ratio of 20. The main contrast is in real estate the earning is real while it's accounting earning in the stock shop where earning can be reinstated years down the road!
The higher the cap the higher rental earnings the asset produces and thus the less money you need for down payment. Experienced investors often look at the cap to screen out properties with low rental income. Some investors prefer properties with the cap that is higher than the interest rate they pay for the loan. That way they know they secure more from the tenants than they pay the bank.
When the asset has high vacancy rate, listing brokers often show proforma (or potential) cap instead to catch investors' attention. Let's use the following example to illustrate the point. A asset is listed for M and is 90% leased. It has gross leases with an actual gross earnings of K/year and K of yearly expense. Assuming the proforma earnings is 0K/year when it's 100% leased at higher shop rent. So 3 distinct listing brokers could display 3 distinct cap rates for the same property:
o The first broker may use Noi (Net Operating Income) of K/year (K of gross earnings less K of expenses) and thus the net Cap rate is 6%. This broker calculates the cap the way it should be.
o The second broker may use the gross earnings of K and so the gross Cap rate is 9%.
o The third broker may want to use the proforma earnings of 0K to get investors' attentiveness and thus the proforma Cap rate is 11%!
So as an investor, you need to know what cap, e.g. Net, gross or proforma the broker uses. Otherwise you may offer too much for the property. At the same time, when you tell your broker to look for properties with a unavoidable cap rate, make sure the broker knows what cap rate you have in mind.
The returns of a industrial asset venture come from 4 sources: appreciation, cash flow, i.e. Cap rate, depreciation (tax writeoffs), and necessary discount from your mortgage payments. If you spend in the "right" property, the biggest chunk of your venture return should come from appreciation. There is often a disagreement between cap rate and possible for strong appreciation. Properties that offer possible for strong appreciation, e.g. Newer properties or ones in good location tend to have lower cap rate. On the other hand, properties that are in poor condition, or have ground lease are much harder to sell. As a result, seeder will try to attract the buyers with a higher cap rate. If you see a asset with unusually high cap rate in California, e.g. More than 7%, you should ask yourself "what's wrong with this property?" Chances are you will find a compelling theorize why it is so high.
Is the asset with highest cap the "best" property? The short respond is no. If venture was that simple, you would not need an venture advisor. Cap rate should be one of the assorted other factors you think whether you should spend in a property. It should not be the only factor. Besides, you can enhance the cap by
o Increase the occupancy rate.
o Raise the rent when the current leases expire.
o Negotiate for leases with yearly rent increase.
o Improve the asset to attract more upscale tenants.
o Reduce the expenses not reimbursed by the tenants.
By doing so, you can growth the cap rate and consequently the value of your investment.
