In the earlier section, “Making do diligence a team effort,” we break down the due diligence process into three specialized parts: physical, financial, and legal.
In this section, we discuss the must-dos of each aspect.
The simple checklists that we provide in this section are going to be your very best friends when it comes to not missing a single step of your due diligence. The items on each of these checklists are to be asked for and obtained within your due diligence period. And remember that sometimes the most obvious things are the easiest to overlook. So don’t just read through the lists and think that you can remember everything on them. Instead, use the lists we’ve created as a template for your checklists that you can tweak and improve over time. Check them off as you complete them. We know from personal experience that you become sharper, if not more at ease with due diligence, as you examine more properties.
Physical due diligence checklist
When investors think of physical due diligence, they often only think of an actual walk-through of the property with an inspector. Walk-throughs are a part of physical due diligence, but only a tiny part of it. You have quite a bit more to think about and do. For instance, ask the seller for the following items:
• Site plans and specifications: This group of documents includes all the construction documents, building plans and schematics, floor plans, and land use documents. These docs provide a road map of the property’s inspection for when it was first built, how it was built, and for what purpose.
• Photos of the property: Photos of the exteriors, interiors, and the surrounding land and structures should be taken. Digital aerial photography is widely available and aids in showing the placement of property within neighborhoods and in between highways. Having photos allows you to start putting together the pieces of the puzzle and knowing what’s in your vicinity can only help you in determining what obstacles you may be facing now or in the future.
•A structural inspection: Inspect the walls, roofs, and foundation and make sure safety implements are in place for earthquakes, flooding, or hurricanes depending on where the property is located. This inspection counts as the exterior and interior inspection. Allow a professional inspection company to guide you in this inspection.
•An interior systems inspection: Inspect the interior of the property for wear and tear, including items such as doors, doorways, windows, and weatherproofing. Then inquire about the age of the roof, and any building code violations, and ensure the building meets ADA standards.
•A mechanical and electrical inspection: Make sure that every mechanical and electrical system is inspected. Such systems include heating, ventilation, air conditioning, plumbing systems, and all electrical power systems and controls.
•A list of capital improvements performed: Obtain receipts and documentation of any capital improvements that were made over the last five years. This documentation will help with the clarity and assessment of the physical inspection and allow you to project when parts of the property may need repairing or replacement within the next few years.
•A pest inspection: On some types of buildings, an inspection for pests, such as termites, may take place. Most apartment buildings have this inspection done as part of a lender requirement. If termites are found, the building is chemically treated.
Financial due diligence checklist
The financial aspect of due diligence focuses on why you’re buying the property. It helps ensure that you make money by verifying the seller's records of the property’s financial performance. To perform thorough financial due diligence, be sure to obtain the following from the seller:
•Income and expense statements: These statements show what the seller has collected in income from the tenants as well as what the owner spent in operating the property. You should at least obtain annual income and expense statements for the past three years. Also, get all of last year’s monthly profit and loss statements and review the balance sheet for the past three years. These documents can be obtained from the seller. After you have all this information, complete your financial evaluation of the property to ensure that it produces the type of returns that you expect or desire.
•Rent rolls: A rent roll is essentially an attendance sheet for all the tenants. It displays the tenant name, unit space or square footage, amount of rent paid, move-in date, lease expiration date, and security deposit. When you have the rent roll, verify the rent amounts with those given on the lease agreements. Also, add the total income of the rent rolls and compare that with the income and expense statement amount. If you notice any discrepancy here, put up a red flag and investigate further.
•Tax returns: Obtain the property’s tax returns for the past three years. If there’s a single owner, you need to review only that return. If the property is operating under a partnership agreement, you need to get every partner’s tax return for the property. Add up all the income and expenses shown on the tax returns. These numbers should match those from the property’s income and expense statements. If they don’t, ask yourself a question: “Which would you believe? The IRS tax returns or documents that the seller produced?” Crunch your numbers again and see whether the property still produces an acceptable return for you. If the discrepancy is in your favor, that’s okay, but if it’s not, you may have to renegotiate the terms of the deal to meet your objectives.
•Lease agreements: A lease agreement can be a complex legal document. We suggest allowing someone who has expertise with that type of lease to do the auditing for you. If all the leases are the same, such as in an apartment building, have an attorney review the first few to make sure that they’re valid. For every other category of commercial real estate, we suggest verifying the leases by using an estoppel letter. This letter confirms that the lease is true and accurate and is the only agreement that’s made between the tenant and the owner.
Pay strict attention to the expiration of the leases of each tenant. What if a good portion of the tenant leases expire next year? Do you have the financial strength to carry the property while it’s being filled up again (which can take several months)? For the tenants that have upcoming expirations, do you have the right to renegotiate the leases even if you aren’t the owner yet?