1. Taking Shortcuts

It's just human nature to want to see a property you are purchasing as having more current or potential value than it might actually have. After all, you are the one who found this property for sale and had an inkling it was the right one. It just feels good to be positive at the getting-to-know-you phase. I know you will agree that it is much better to dig deeper into uncovering who this property really is, though.

Some buyers are prone to taking shortcuts with due diligence and my job is to shake them out of their downright laziness. Yes, you do need to try and get all the items on the due diligence list done. Many buyers seem to go after the easy ones with relish and lose steam on the difficult ones. And then, what do you know, they run out of time and are forced to make a hasty decision before they have uncovered all the facts.

Sometimes I have to twist my clients' arms to get them to do all the work it takes to evaluate the property based on facts rather than appearances and hearsay. Often they are already overwhelmed at gathering and evaluating over 40 items on the due diligence list, and then I give them even more items as we uncover discrepancies, most often related to the property financials and property condition report.

To safeguard my purchasing clients in determining the property's current and potential future income, I give them my Commercial Real Estate Purchase Evaluator Spreadsheet to fill out. You can find an example of this in Appendix A and a downloadable Excel version at my website: https://apartmentloanstore.com. After putting in the purchase price, down payment, and the property's income and expenses, this spreadsheet helps determine the property's current NOI and cap rate as well as the projected CCR and IRR over time. You will need to fill out a month-by-month pro forma first to project how the property will do over time. You can use my Seven-Year Month-by-Month Budget and Summary Spreadsheet; an example is shown in Appendix A and a downloadable Excel version is on my website. Of course you want to start by crunching the numbers accurately by uncovering the real numbers before they are entered into year 1 of this spreadsheet. Also be sure to do some market research to determine whether rents are at, above, or below market.

To safeguard against unknowns in the property's physical condition, I push my clients toward fully understanding all the major systems evaluated in the property condition report and getting bids on repairs that will stick to the wall.

2. Not Allowing Enough Time

It is surprising that many sellers and their real estate brokers would like the buyer to get all this reviewing done in 45 days or even less. Could this be because the more time they give the buyer, the more undesirables the buyer may discover? Possibly, but more likely it is because “time kills real estate deals” and they want to close quickly.

Short due diligence time periods often result in the buyer requesting an extension for more time because many items are still pending. Missing tenant estoppel certificates and zoning letters, and waiting for an ALTA survey to be completed, are common causes of delays. Sixty days is a much more reasonable period of time, but if the seller is highly cooperative, 45 days can work. For more complex commercial properties, such as senior assisted living, hospitality, and other commercial properties that are selling real estate with a business, 75 days is what you should insist on.

The harsh reality is that if you have not completed all of the important items on your due diligence list when the clock runs out, you have to either cancel the deal or own the property. At this time your earnest money deposit “goes hard”—meaning it is not refundable if you decide to bail. You can usually buy more time if you put more earnest money down that is nonrefundable. I can assure you that the most distressing experience in buying a commercial property is when a buyer knows they are running out of time on due diligence and has to make a hasty decision.

3. Not Includin a Due Diligence Checklist in the Purchase Contract

As the buyer, writing up the purchase and sale contract is your one chance to get the seller to agree to give you everything you need from them to conduct your due diligence. Always include a complete due diligence checklist as an exhibit at the end of the contract and make sure the seller initials it (see due diligence checklist in Encyclopedia Topic B, Due Diligence). The beginning of the purchase contract will include feasibility and inspection clauses that list many due diligence items, but the lists in these clauses will not be anywhere near as complete as your list. Your experienced buyer's commercial real estate broker and commercial real estate attorney can help you make sure the list is complete for the particular commercial property type.

4. Wasting Time on Small, Inconsequential Items

Okay, let's be realistic. It is unlikely that you will have the time to review every item on your due diligence list. Also, turning over one rock commonly leads to uncovering another that needs to be turned over. It is imperative that you prioritize your due diligence list from day one and make sure that you identify the really important items and those that take the longest to complete started first.

Wasting time on smaller, inconsequential items—like trying to get a copy of every utility bill for the past year—might mean that you run out of time to address the most essential tasks. Many items on your legal due diligence list, such as getting signed estoppel certificates from tenants and deciding what to do with restrictive easements, can take the longest to complete and need to be started early. You certainly do not want to leave clearing the title until the end, because it can take two months to clear problems up. Analyzing the property financials and having the property professionally inspected are obviously also very important. But engaging legal counsel to prepare lease summaries (for retail, office, and industrial properties) for you is equally important.

Unless the property is almost new and full of great tenants, it is unlikely that everything you investigate on your due diligence list will be to your liking. You might only have a matter of days prior to your deposit going hard to renegotiate the deal with the seller.

5. Trying to Negotiate the Price Down Too Soon

A property inspection report can be completed in less than two weeks after the purchase contract is signed. Sometimes the buyer has a knee-jerk reaction if a need for expensive repairs is discovered. They want to go after the seller immediately and demand that they pay for the repairs or drop the sales price accordingly.

I cannot emphasize enough that there should only be one negotiation about lowering the sales price with the seller. This should occur about a week before the due diligence period runs out. Have one negotiation about lowering the sales price or getting the seller to pay for repairs that also encompasses the financial negatives you have uncovered during due diligence.

At that time you can let the seller know that everything is going very well with your financing and that you'll be able to close on schedule. The seller in many cases will prefer to lower the sales price for the existing buyer instead of starting the whole process over with a new buyer who will discover the same derogatory items.

Negotiating with the seller piecemeal throughout the due diligence process will make them feel as if you are nickel-and-diming them. This will create a very unstable environment for all parties involved and will likely lead to the deal falling out. The following story illustrates this point.

6. Trying to Do It All Yourself

Conducting thorough due diligence is a daunting job. Use your commercial real estate advisory team and delegate as much as you can to them.

Your Commercial Real Estate Advisory Team

• Buyer's Real Estate Broker: Have your buyer's realtor get any items that you need from the seller that are not forthcoming from the listing agent, the seller, or the seller's property manager. You can let one of them get in the seller's face and be the bad cop. Remember, neither realtor will make a dime unless the deal closes, so they will want to assist you with this.
• Commercial Mortgage Broker or Lender: These professionals are experts at crunching the numbers and should be used to help you with financial due diligence. They are trained to find discrepancies between rent rolls and operating statements, and will share any concerns about the property appraising at the purchase price. They can also help you get financials that the seller hasn't provided by contacting the seller or seller's property manager for you.
• Property Manager: Even if you are planning on managing the property yourself, find a professional property manager to help you. They are experts at reviewing rents and expenses. They will let you know how much they think your rents can be increased and if there are any expenses missing on the seller's income and expense statements. They will also give you suggestions about how to run the property more lean and mean.
• Commercial Real Estate Attorney: Have your attorney review the leases, the preliminary title report, legal description, easements and encroachments, survey, and UCC and judgment liens. Their number-one job is to make sure the property has a clear title and can be used for your intended purposes.

7. Relying on the Seller's Numbers

I am not going to come out and say that sellers often lie to buyers. But since marketing flyers put the property's physical and financial condition in its best light, after doing their due diligence buyers might sometimes think they did. Quite often the buyer discovers the property's cap rate is lower than the marketing flyer led them to believe. When this happens the buyer's first thought may be that they are overpaying for the property. In most cases the seller has not intentionally tried to swindle the buyer but was in a rush and left out some expenses.

Another common occurrence is when the seller decides to enhance the net income of the property by transferring repair expenses into the capital improvement category. This lowers expenses and increases net operating income (NOI). Capital improvements are major property replacements that can't be counted as expenses on your taxes. These are improvements to the property that are taxable. Often your lender will request copies of the seller's Schedule Es, which show how the seller reported income and expenses on their personal taxes. Your lender might have heartburn if they find major discrepancies between the tax returns and income and expense statements.

It's also not unusual for the seller to compute the cap rate using gross rent from the rent roll, even though some tenants have not been paying rent because of delinquencies or rent concessions.

And the good news is that it is the buyer's job to uncover this. You need to verify all expenses listed on operating statements and look for expenses that might have been left out. Again, nobody can do a better job at being a sleuth than you. It's your financial future that is at stake.

8. Not Verifying Rent Collections

Would you buy a business that was priced based on reported sales even though some customers received but never paid for the product or service? Probably not. If you do not verify rent collections when doing your due diligence, you might be doing just that.

Should you pay full price for a property if there are some undesirable tenants paying the rent late or not paying at all? These kinds of tenant defaults are often not disclosed by the seller. At a minimum, this is something you need to know. Having to re-tenant after you own the property will cost you time and money.

Doing a collections verification report (Encyclopedia Topic B, Due Diligence) is a smart move if you find that income and expense statements show less rent collected than reported on the rent roll. This report uses the seller's operating account cash ledger or even bank statements to explain discrepancies between month-by-month rent rolls and corresponding income statements. You then follow this up by requesting an aged receivables report to identify the tenants who are not paying.

9. Ordering Third-Party Reports Yourself If You Will Need Financing

As the buyer it is your responsibility to conduct a physical and mechanical inspection of the property, and to see if there are any environmental concerns. If you are planning on financing the property, do not order these third-party reports yourself. Your lender will need these reports as well, and to eliminate the possibility of any collusion, the lender will not be able to use reports ordered by the buyer. So have your lender order all of the reports, including the property, environmental, seismic, and pest inspections, and any others needed. In most cases the lender's property inspection report will be more thorough. Believe me, you do not want to go through the shock of finding out what is wrong with the property from your property inspector only to have to go through the process a second time with the lender's property inspector, and be faced with paying for two reports to boot.

10. Not Reading Every Lease and Estoppel Certificate

Leases are complex and often difficult to understand. For office, retail, and industrial properties, have your experienced commercial real estate attorney review all the leases and estoppel certificates and prepare a summary for you. Be sure to verify that the square footage and the lease terms are the same as those listed on the rent roll. Look for any landlord obligations that will be passed on to you, such as incomplete tenant improvements that the seller has promised to pay for. Find out if the leases require your tenants to disclose their financial information. Your lender might require this.

11. Failing to Walk Every Unit or Space

This story says it all. My clients Tricia and her husband Rex were both CPAs—smart people who in 2013 purchased a large, 286-unit multifamily property just off the strip in Las Vegas that had been built in 1975. They did not have their own commercial real estate broker and worked with the listing agent. What they loved most about the property was that it was in a great location in great condition with well-manicured lawns. They were told that the property, which was 89% occupied, had been 100% remodeled in 2007 and had been outfitted with all new interiors, including kitchens, bathrooms, windows, doors, and roofs.

We required a property inspection report that was very thorough. The inspector even discovered a broken sewer line and electrical panels that were not to code. Also identified were over 40 health and safety issues, such as cracks in the walkways, rickety railings, broken windows, and dead fire alarms. Still, the report did show the property to be in good condition for its age.

But the inspection did not uncover the hoarder who lived in apartment 17D. She had lived there for 26 years. There were stacks of magazines, boxes, and junk going up to the ceiling, with narrow walkways to navigate through the mess. This should have been reported as a health, safety, and fire hazard. The inspection also did not reveal that 36 of the units had not been remodeled in 2007 and still had the original bathrooms and kitchens, complete with 1970s cabinets and countertops.

Neither the buyers, the listing broker, the property inspector, nor the appraiser walked all the units during the due diligence phase. The inspector should have gone through all 286 units (which would have taken weeks), but chose to take a shortcut. The buyers had nothing in writing that specifically stated which units were remodeled and to what extent. It cost the buyers just over $300,000 to bring those 36 units up to the level of the rest of the complex.

12. Not Responding Firmly to Seller's Pushback

All sellers have been buyers before they became sellers. Many are very helpful and accommodating and go the extra mile to get you everything requested. Some sellers forget what it was like when they had to gather all those due diligence items as a buyer.

Often your lender, your attorney, or an inspector will request additional information. Some of these items might not have been on the due diligence list the seller agreed to, and the seller or their property manager might just tell you that they gave you enough already or ignore the request.

This is where it really comes in handy to have your own commercial real estate broker representing you. Again, these realtors are on commission and only get paid if the deal closes. If you get pushback from the seller, have your realtor be the bad cop. The best approach is to work through the property manager and not try to make their life miserable but to ask them for help in getting the deal closed. If you do not have your own realtor then have your lender or mortgage broker ask the seller for help in getting the remaining items. If you are still not getting results and your money is close to going hard, request an extension based on items not provided by the seller at least a week in advance of the drop-dead date.

Guidelines for Calculating How Much You Need to Lower the Sales Price

Before you negotiate with the seller to lower the price, you will need to know exactly how much you are willing to pay for the property if they hardball you. This exercise will help you to determine the maximum amount you can pay for the property based on the minimum CCR you are willing to accept and the value-add opportunities you can implement.

1. Make a list of derogatory due diligence items. Make a list of all the problems you found with the property, both physical and financial. The list should include all necessary repairs and also any loss to the NOI based on inaccuracies given to you by the seller at the beginning. Next assign a cost to each of these and then total them up. Subtract this total cost from the agreed-upon sales price to come up with your lowball price.
2. Calculate the loss to your expected rate of return. Now take a look at what you expected the property to earn after the first full year before you did your due diligence. Subtract the total cost of the items from step 1 from the original annual earnings you expected to earn. Then calculate how much this has lowered your expected annual CCR.
3. Decide on your maximum sales price. When you go into negotiations with the seller, know ahead of time at what price point you will walk away based on your minimum acceptable first year annual CCR.
4. If your return on investment is lowered 10% or more, consider letting the property go. If the seller is not willing to budge on the sales price, consider letting the property go if your expected CCR was lowered by 10% or more. For example, if you were expecting an 8% CCR your first year, and now it has been reduced by 10%, you will now be getting a 7.2% CCR. If this is acceptable, then perhaps you won't want to risk losing the property for this amount. You can still act as if you are going to walk away, but in the end you won't. Finding another property to purchase and going through due diligence all over again might take more time and money and might not produce better results.
5. Value-add strategies might make this property worth more to you. You have likely come up with some value-add opportunities while doing due diligence. Create a three-year pro forma reflecting the increase in rents and perhaps lowering of expenses. Does this make the property worth buying and at what price? Be sure to weigh in the extra cash you will likely have to put in to implement these improvements. What will the property be worth at current cap rates in three years with the increased NOI? Now determine the most you are willing to pay for the property based on what it will be worth to you once these value-add strategies are implemented.

Coming Up with Your Pitch to Lower the Sales Price after Due Diligence

If you do not find much wrong with the property and decide that you want to lower the sales price after due diligence, the seller will consider this to be acting in bad faith. If you find significant negative changes in the profitability of the property or necessary expensive repairs after conducting due diligence, the seller will expect that you are going to try to renegotiate a lower sales price.

Eight-Step Pitch to the Seller to Lower the Sales Price

1. Prepare your pitch well. You want to be well prepared and write out a script for your pitch, or at a minimum have an outline. In most cases this pitch will be made by your buyer's realtor. But I can assure you that because your heart and soul are involved, you are the best one to make it. Your job is to convince the seller that the property is worth less than the agreed-upon price based on the facts uncovered by you and your commercial real estate advisory team. You should provide documentation to support your research whenever you can.
2. Start out by complimenting the seller. Keep in mind that the seller has likely been dreading the day when your diligence is completed and you will be asking them for a better deal. Why not start out by disarming them with some compliments? Tell them how professional and helpful their listing agent and property manager have been in getting you all the items needed. Tell them some items that you really love about the property.
3. Talk facts, not emotion, when making your points. Make sure your delivery is firm, but polite. Give the seller a list of repairs to remedy and associated costs. Back this up with a copy of your property inspection report. Show them why these numbers do not work, and point out that now that due diligence is complete, the return on your investment doesn't make sense and represents too large of a risk. Back this up by giving them a copy of your projections, showing them why the purchase price does not pencil. It's going to be difficult for the seller to argue with well-presented facts.
4. Support your pitch using advice from your expert team. Whenever possible quote advice and supporting data from your property manager, building contractor, buyer's real estate broker, lender, or attorney.
5. Offer to remove all contingencies. Offer to remove all contingencies—except that for financing if your loan has not been approved yet—if you can come to an agreement on a lower price.
6. Practice your script. Role-play your script with your spouse or a good friend. You want to come off as relaxed and confident in your delivery.
7. Deliver your pitch to the seller directly. It's okay if your real estate broker and the listing agent go with you to renegotiate the price with the seller. But your chances of a favorable outcome are greatly increased if you can present your situation to the seller directly. The best time to get to know the seller directly is at the beginning, when you are first making your offer or right after your offer is accepted. Your relationship with the seller will pay off the most when you need to renegotiate the purchase price after you have completed due diligence. If you can establish a friendship with the seller early on, you can establish the attitude that both of you need to win. The seller needs to get to know you as a reasonable person. When it is time to make your case as to why the sales price needs to be lowered, this will come through for you. After all, you are not making these things up. Your position is backed up by data. The listing broker knows that it is their job to be the bad cop and push back on behalf of the seller. If the seller is not present, you are likely going to hear this from the listing broker, “I talked with the seller and he sees no reason to lower the price and has several backup offers.”
8. Be willing to walk away. If you cannot negotiate a price reduction that makes the deal work for you, then thank everyone for their time and walk away. If they do not come back to you with a better offer the next day, you can always change your mind and accept their price.