ENCYCLOPEDIA TOPIC B
Due Diligence

Buyer's or Seller's Market: Are you buying or selling in an up or down market?

Recessions happen on average every six years. So up cycles are followed by flat cycles, which are often followed by down cycles. Is there any good reason to buy in a seller's market? Yes! But you need to work a lot harder to find properties that you can add value to without spending too much cash (see Chapter 7). In a seller's market, there is more demand than supply, resulting in a scarcity of decent properties. If you are selling in a seller's market, you are in the best place at the right time. You can get a good price just selling your property as is—even if you have too many vacancies or shorter-term leases. Let's say your property is a fixer-upper. In a seller's market, it will likely go for more than it is worth to someone who wants to renovate it in hope of raising rents.

In a buyer's market, there is more supply than demand. Now the buyer is in the best place at the right time and has a better selection of reasonably priced properties to choose from. But you might want to hold off on buying at the beginning of a recession; prices are likely to fall further. You won't know for sure that they've they hit rock bottom until they start going up again. If you are the seller, you better spruce the property up and get solid leases in place before putting it on the market. You might want to wait until it is a seller's market to sell. Is there any good reason to sell in a buyer's market? Of course! If you have found a larger property that is being sold at a great price, will give you much more income and depreciation, and you can 1031 exchange into it, buy it.

Cap/Capitalization Rate: Use the commercial appraisers method to calculate it accurately

The cap rate of the commercial investment property you are interested in buying is one of the most important metrics to investigate when doing your due diligence. Often listing real estate brokers put the property's financials in their best light by mixing in actual with projected numbers. Their goal is to demonstrate that the subject property is worth as much as the most expensive comparable properties with the lowest cap rates that have been sold. But this tactic is misleading. Your job is to figure out exactly what the subject property's cap rate is based on its actual NOI and sales price. The lower the cap rate, the more expensive the property is for its earnings. The higher the cap rate, the better a deal it is for the buyer. Computing an accurate cap rate for the property will give you the best indicator of its value. You can then compare this with other like properties that have sold or are for sale to determine if it is overpriced.

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Wouldn't you love to be able to determine a commercial property's cap rate that you are interested in buying accurately, using the same method a commercial appraiser does? This is the best way to determine value. You really can do this yourself.

Commercial Appraiser Method of Calculating Cap Rate

  1. Start out by determining the property's effective gross annual income. This includes current rents as showing on the rent roll, plus miscellaneous income, plus CAM (common area maintenance) reimbursements, less 5% or market vacancy (even if there is zero vacancy), less concessions and collection losses.
  2. Determine the property's total annual operating expenses based on the actual past 12-month trailing expenses (see list of expenses under expense checklist below) and make sure none are missing. Be sure to include something for off-site management—even if the seller is self-managing and you plan to do this too (use 5% if you do not have an estimate). Include something for capital improvements (see below) too.
  3. Subtract annual expenses from annual effective gross income to come up with the annual net operating income (NOI). Divide the NOI into the purchase price to get the subject property's cap rate.
  4. Ask your commercial real estate broker to provide you with the income and expenses of three to four comparable properties that have sold in the past year in the same market and their cap rates. They have data services they subscribe to, like CoStar and REIS, that can provide this.
  5. Average the cap rate of the subject property together with the cap rates of the comparable properties. This average will be a much more accurate representation of what the cap rate should be for the subject property. Once you have determined the cap rate, multiply this by the NOI of the property to come up with the property value. For example, if the cap rate is 7% and the property's NOI is $120,000, then the property value based on cap rate is $840,000.

Capital Improvement/Replacement Reserves/Cap-X: Try to understand what these are so you can put them on your pro forma

Understanding capital improvement reserves, also called Cap-X or replacement reserves, can be quite confusing. These reserves are for replacement of major items, such as roofing, windows, appliances, carpeting, cabinets, HVAC units, parking lot surfaces, or any item that will last for five years or more. When you own investment real estate, the IRS mandates that you first show these as income on your taxes since they are adding value, after which you can depreciate them. But they kind of seem like repairs, don't they? Most investment property owners think so. Most deduct costs for what should be classified as capital replacements as repairs so that they pay less tax. But when they want to refinance or sell the property—well, what do you know! These same items get taken out of the expense column and put into capital replacements. This lowers expenses and increases the net income, which lowers the subject property's cap rate, which raises its property value.

Can they have it both ways? The answer seems to be yes. Are they cooking the books? Actually not. The IRS is not known for cracking down on this, so it is acceptable. When analyzing property expenses for a property you are buying, be sure to add an expense line for a capital improvement reserve if the seller did not. This is because appraisers and lenders add $150–400 per unit per year to the operating expenses for capital replacements on multifamily, so you should too. Be sure to put Cap-X on your property budget pro forma. Also, if you plan on maintaining the property in good condition, you will be doing capital improvements over the years and should allow for this money. Ask your lender what they recommend you allow for replacement reserves based on the age and condition of the property.

Collections Verification Report: Everyone knows occupancy is important, but knowing if a property has rent collection problems is more important

Would you pay full price for a business whose gross sales were a major part of the value, but which never collected some revenue because some customers refused to pay? Verification of rent collections is verification of sales and is one of the most overlooked due diligence items for buyers of commercial real estate. Unpaid rent should show up as collection loss on the property's books. But often sellers just do not track this. If a property has quality professional management it will show up in an aged receivable report.

Everyone knows occupancy is important. But when buying a property, what's much more important to know is if the property has rent collection problems. Just because someone is on the rent roll doesn't mean they are paying rent. A collections verification analysis looks for discrepancies between month-by-month rent rolls and the corresponding month-by-month gross income from an annual profit and loss statement. Most importantly, it identifies which tenants are paying slowly and which are not paying at all. In other words, you need to know if you are buying a property that has some poor-quality tenants. Having to re-tenant will cost you time and money. In a seller's market, the selling price is seldom discounted for this. You can put this analysis on an Excel spreadsheet like underwriters do or just tally the results on paper.

Six-Step Collections Verification Analysis (This Is How My Underwriters Do It)

  1. Request a trailing 12-month report from the seller (the last 12 months of income and expenses shown month-by-month).
  2. Compare the gross annual income on the report with the annualized gross rents from a current rent roll. If for the last year the gross income on the annualized rent roll is much higher than the trailing 12-month report, you will need to investigate this discrepancy.
  3. Ask the seller why there is more gross income reported on the rent roll. Perhaps there was renovation of several units and tenants were vacated, or something else that explains why rent was not collected. If you are satisfied with the answer and can verify it, then you do not need to proceed further.
  4. Ask the seller for 12 months of rent rolls that correspond with the trailing 12-month report. Now compare each month's total gross rents with the 12-month report. You will be able to identify which months have problems with collections. Ask the seller to identify which tenants are paying slowly or not paying at all. You can also get this from an accounts receivable report for this period.
  5. If you still cannot verify actual collections, ask for the cash ledger from their accounting software (QuickBooks or the like) for the 12-month period being examined. This will show all cash in and all cash out. You want to focus on the cash in.
  6. If the cash ledger brings up more discrepancies you will need to request 4–12 months of bank statements from the property's operating account. This will give you the most accurate numbers on the actual rent collected during this period.

Commercial Property Purchase or Finance Evaluator: This spreadsheet tells you a property's current NOI and cap rate plus the projected CCR and IRR over time. Is it a good buy?

Wouldn't it be great if you had one spreadsheet that could tell you if the property you are purchasing is going to achieve your financial goals? What the actual cap rate and NOI are currently at, plus what your CCR is projected to be your first year and what your IRR will be in seven years when you plan to sell the property? A commercial property purchase evaluation spreadsheet does just that and more (see Appendix A to view samples for apartments and commercial properties). To get the Excel version that I give my clients to fill out, you can go to my website: https://apartmentloanstore.com.

Commercial Property Quick Analysis Calculator: Use this quick Excel calculator to determine whether the property you are interested in buying is a good buy

Evaluate many properties quickly for their value based on market cap rates and GRM with this Excel calculator. Just fill in the gross rental income, expenses, purchase price, down payment, and loan details (see Appendix A to view a sample for apartments and commercial properties). To get the editable Excel version for apartments and commercial properties, go to my website: https://apartmentloanstore.com.

Crime Rate Analysis: Are you serious? Someone was murdered in one of the apartments?

This one is so important, and so few buyers think about doing it. I am sure they would all like to know that it's not safe for them to be at the property after dark. Crime affects property value, appreciation, and how long your commercial property will take to resell, not to mention the impact on your mental health. Neighborhood crime rates in the United States can range from zero to over 300 incidents per month. Rogers Park, Chicago, the neighborhood I grew up in, is still a safe place today with an average of six crimes per month. Just a little farther to the northeast, East Chicago (which is actually in Indiana) has an average of 86 crimes per month. That's 14 times the crime rate in my old neighborhood.

Determining the crime rate in the neighborhood you are buying in is essential. This can be done free, and in a matter of minutes. Go to https://www.cityprotect.com, and simply find your location on the map. CityProtect compares data from over 1,000 law enforcement agencies. You can pay for a more detailed report at neighborhoodscout.com.

My client Jeff could not figure out at first why a C-minus apartment complex in St. Louis that he had an offer on had been on the market for over 11 months and had occupancy of 74%. Market occupancy was 89%. He found out that there were on average 130 thefts alone per month in the neighborhood and that someone had been murdered in one of the apartment units. Although the price was good, he took a pass.

Due Diligence Checklist: Be sure you give the seller a copy of this list at the beginning

Be sure to attach a due diligence checklist as an addendum to the sales contract and have the seller initial it at the bottom. Sorry, but this list has 49 items on it. It's really difficult to gather all of these items in 30 days; 45 days is more like it. Have your commercial real estate attorney review this list to see if anything is missing for your deal.

Financial Due Diligence

  • ___Current rent roll showing when leases begin and end, and for multifamily properties, identifying Section 8 tenants
  • ___Past 24 months of rent rolls if requested by buyer's lender
  • ___Last three years' income and expense statements (month-by-month format)
  • ___Trailing 12-month income and expense statement (month-by-month format)
  • ___Last three years' Schedule Es from seller's taxes on the property
  • ___Last five years' capital improvements and cost (annualized)
  • ___List of rent concessions for the last 12 months
  • ___Aged receivable report
  • ___Accounts payable report
  • ___List of outstanding tenant delinquencies and defaults
  • ___Payroll summary for on-site employees
  • ___Copy of last 12 months' utility bills
  • ___Most recent real estate tax bill
  • ___Accounting of ratio utility billing system (RUBS)
  • ___Management operating budget
  • ___List of any prepayments of rent
  • ___Accounting of all CAM reimbursements collected
  • ___Accounting of all rental deposits
  • ___Account ledger for RUBS

Physical, Mechanical, and Environmental Due Diligence

  • ___Building and site plans
  • ___Survey
  • ___Seismic report
  • ___Engineering report
  • ___Statement of structural alterations made by seller
  • ___Seller's phase 1 or phase 2 environmental report or environmental screening report
  • ___Copy of pest inspection report
  • ___Copy of radon gas report
  • ___Mold abatement report
  • ___Zoning compliance certificate
  • ___Certificate of occupancy
  • ___Parking compliancy verification

Operational Due Diligence

  • ___Copy of all leases with current amendments
  • ___Renewal options signed
  • ___Copies of intent to lease, signed
  • ___Tenant applications and credit reports
  • ___Tenant estoppel certificates
  • ___List of all personal property
  • ___Inventory list of supplies
  • ___Copy of all service contracts, including maintenance, pool, laundry, security, and pest control
  • ___Copy of off-site management contract
  • ___Copy of insurance policy
  • ___List of any pending litigation against the property
  • ___Insurance loss summary for the last three years

Legal Due Diligence (Your commercial real estate attorney will review these with you)

  • ___Preliminary title report
  • ___Property legal description
  • ___Basic or ALTA survey
  • ___Review of easements and encroachments
  • ___Tax, UCC, and judgment liens
  • ___Litigation filed against the property

Environmental Concerns: Be sure to ask the seller for a copy of their environmental report. If they have a loan, chances are they have one.

Savvy buyers of commercial real estate ask questions at the beginning about environmental concerns. The last thing they want is to spend their time dealing with the regulatory process involved with a property that may need cleanup. Unless the buyer of commercial real estate has negotiated with the seller ahead of time, the buyer can become totally liable for contamination on the property that occurred prior to the sale. Almost all lenders require an environmental assessment—anything from a simple screening report to a phase 1 report. If contamination is detected it is very unlikely that your lender will proceed with the loan. After all, the liability will be passed on to them if they take the property back in a foreclosure. If your loan is canceled because of this, you will have lost at least a month of your time doing due diligence on the property.

To be proactive, here is the best action to take. Prior to signing a purchase and sale agreement, ask the seller about any known environmental concerns. If they have a loan on the property, they will almost certainly have had to commission some level of environmental report. Ask them for a copy. If the seller discloses that there was contamination that has been mitigated, ask them for a copy of the closure letter from the pertinent federal, state, or local regulatory agency.

Estoppel Certificate or Letter: Be sure to get these to the tenants the day after signing the purchase contract. They can take a long time to come back.

As part of your due diligence when buying an office, retail, or industrial commercial property, it is important for you to review tenant estoppel certificates. Multifamily, hospitality, healthcare, and self-storage properties do not require them. The estoppel's purpose is to have the tenants state the terms of their leases and then certify that the information is true and correct. This is the only way you will know for sure that the leases you were provided have not been changed and are in good standing. Estoppel letters certify the beginning and end dates of the lease, options to renew, rent amount, security deposit amount, the date to which the rent has been paid, and any defaults by the tenant or the property owner. Be sure that your estoppel asks if there are any tenant improvements or repairs promised by the landlord, or if they have any claims against the landlord (see the next topic, Estoppel and Lease Review Checklists). If you are taking out a loan to buy the property, your lender will require tenant estoppels, so be sure to use them. Be sure that you mention in the purchase contract that you will be using your estoppel certificate and include a copy to be attached to the sales contract so that the seller is aware of this. Almost all commercial leases have a provision requiring the tenant to fill out and sign an estoppel letter for the property owner to give to a third party.

Estoppel and Lease Review Checklists: Be sure to go through this list when comparing estoppels with the leases

Comparing the estoppel certificates signed by the tenants with the leases is something your commercial real estate attorney will do for you. But I am including a checklist with some of the most important items (not claiming the list is complete) because it is so important for you as the buyer to understand this process and how important it is. After all, each lease represents a part of the income of the property you are buying, and you need to know that what is represented on the rent roll and the leases is what you thought you were buying. Again, only office, retail, and industrial properties require estoppels.

Estoppel Review Checklist

  • ___Compare the lease start and stop dates and rentable square footage with the rent roll to determine that there are no discrepancies.
  • ___Confirm that the description of the lease in the estoppel certificate is the same as what is showing on the lease.
  • ___Check the amount of current rent and security deposit.
  • ___Check as to the exact date the rent is paid through.
  • ___Check to see the date all common area charges, and if a net lease all pass-through charges (taxes, insurance, and maintenance), are paid through.
  • ___Check that there are no tenant defaults.
  • ___Check that there are no landlord defaults.
  • ___Confirm that there is no incomplete construction required by the landlord.
  • ___Confirm that all amendments, addenda, and agreements are represented.
  • ___Check lease extensions and purchase options.

Expense Checklist: Compare this list of expenses with the expenses the seller has given you for the property to make sure they haven't missed any

The main purpose of this list is for you to make sure that the seller has not missed reporting any expenses. An example of this is when sellers do not report property taxes and insurance on their income and expense statements because they pay these with their mortgage. Often sellers that do not have professional management lump many expenses together in a general category. An example is the repairs and maintenance category, where they might show one amount for everything instead of breaking out repairs, elevator maintenance, HVAC maintenance, landscaping, decorating, cleaning, and snow removal. If the seller has broad categories, ask them to break these into more detail.

Commercial Property Expense Checklist

  • ___Real estate taxes
  • ___Water and sewer
  • ___Pool maintenance
  • ___Insurance
  • ___Trash removal
  • ___Elevator maintenance
  • ___Licenses
  • ___Pest control
  • ___Parking lot maintenance
  • ___Ground lease
  • ___Building maintenance
  • ___Security
  • ___Electricity
  • ___Building repairs
  • ___Equipment leasing
  • ___Gas
  • ___Landscape maintenance
  • ___Audit expense
  • ___Resident manager
  • ___Payroll taxes
  • ___Association fees
  • ___Off-site manager
  • ___Telephone
  • ___Flood insurance
  • ___Advertising
  • ___Leasing commissions
  • ___Wind insurance
  • ___Supplies and cleaning
  • ___Professional fees
  • ___Tenant improvements
  • ___Employee benefits
  • ___Leasehold improvements
  • ___Internet and cable TV
  • ___Snow removal
  • ___Replacement reserves

Expenses, Variable and Fixed: Go after variable expenses with a vengeance to lower property expenses

One of the best methods of adding value to a commercial property is to lower variable expenses with a vengeance. They can be managed based on the property's ability to pay them. Some can even be eliminated. During the Great Recession I witnessed many multifamily property owners fire both their on-site and off-site property managers and take on these jobs themselves. This is an example of cutting a large variable expense. Variable expenses include off-site and on-site management, repairs and maintenance, cleaning expenses, and professional fees.

Fixed expenses are not easily changed and stay the same each month for about a year regardless of occupancy. These include property taxes, insurance, common area utilities, and trash removal.

Historical Financials: It is better to buy a commercial property that has a good, long operating history than one that does not

Would it not be better to buy a business that has three years or more of a strong operating history as shown on financials and tax returns rather than one that had failed and was resuscitated? As already mentioned, investing in commercial real estate is a business too. Be careful if you're buying a repositioned commercial property that might have been failing a year ago and now is for sale at a top market price. It might have just attained great occupancy, but it won't have any historical financials. Is it really worth as much as a similar property that can show proof of two years or more of success? It could be, if adequate screening was done on the tenants. If the property has been professionally managed there will be a file on each tenant and you should ask to review these. Strong historical financials show that the subject property is one that has good tenants and that people like to live or do business there.

Historical financials show the current year to date plus an additional three years of income and expense statements on the subject property. Be sure to request these in month-by-month format from the seller. This way you can track the history of the income and expenses. By the way, lenders much prefer to make loans on commercial investment properties that have strong historical financials. The ones that do not have these are highly scrutinized.

Loss to Lease Ratio: Wouldn't it be great to know what percentage of a property's rents are under market rate?

When evaluating a commercial property you are interested in buying or selling, check to see what the loss to lease ratio is, if any. When buying, this number can tell you how much of a value-add raising rents will be in the form of a percentage. When selling, it can tell you the percentage by which your rents are under market. The loss to lease ratio is the difference between what current rents are for a commercial property and what potential rents could be, based on market rents. In other words, how much is the property losing because of the rents being under market?

Let's use an example of a 10-unit apartment building where the units are all the same and rent for $1,000 per month. If market rents for like properties in the market support $1,100 per month, then there is a loss to lease of $100 per unit. Multiply this by 10 and you get $1,000; multiply $1,000 by 12 and you get an annual loss to lease of $12,000. Assuming that the total gross rental income of the property at 100% occupancy is $120,000 annually, then the loss to lease ratio is 10%. When figuring out the loss to lease ratio for office and retail properties you should use rent per square foot.

Market and Competition Analysis: This tells you how the subject property compares with its competitors in the market

If you were to start or buy a business, you would want to know the competition in your market. This is equally important when buying commercial real estate. It's best if you take a more hands-on approach. An experienced real estate broker who specializes in the property type you are purchasing can do a market analysis for you. For larger, more expensive properties you can order a feasibility report. Another alternative is to hire a consultant from Goodkin Consulting or Cushman & Wakefield, or to order a detailed report from a research firm such as CBRE, JLL, or CoStar. Follow the nine steps shown next to complete a modified market analysis yourself.

Nine-Step Market and Competition Analysis

  1. Geographically define your market. For larger metropolitan communities, look at the competition within 3–5 miles of your location. For smaller markets, look within 10 miles. For very small markets, you might have to use the entire county.
  1. Determine the vacancy rate in your market. You can call a local appraiser or talk with several commercial loan officers at banks in the area. They will have looked at many appraisals that have analyzed vacancy rates. Low vacancy rates will support your investment.
  2. Compare rent per square foot. For office, retail, and industrial properties, this will tell you if there is room to add value by raising rents. It will also tell you how the subject property compares with the competition. Ask your commercial real estate agent to help you find comparable properties.
  3. Compare rent per unit. For multifamily properties, find at least three comparable properties that are similar to the subject property in terms of age, condition, and number of units. Determine if there is room to raise rents on the subject property. You can look up apartment complexes online or ask your commercial real estate broker to provide you with comparables.
  4. Compare location and amenities with the competition. How does the subject property look compared to the competition? Does it have superior or inferior amenities? Does it have a workout room, or comfy outdoor areas? How is the landscaping? Is it older or newer? Do your competitors have more or less traffic? Why is this? What would you have to do to the subject property to give it a competitive edge in the market?
  5. Do a sales comparison report. Ask your commercial realtor to provide you with three comparable properties that have sold in the past year. Determine from this if the subject property is over- or underpriced.
  6. Do a market cap rate analysis. Ask your commercial real estate agent to get you the income and expenses from three properties similar to the subject property. Average the cap rate that these properties sold at with the subject property's cap rate. This market cap rate analysis will be a stronger indication of what the property is worth.
  7. Do a traffic count. For retail and office properties, higher traffic locations are more expensive. Spend 20 minutes at your site and at your strongest competitors' sites and literally count cars at different times of the day. You can also subscribe to Esri Demographics, which does traffic counts for more than a thousand locations in the United States.
  8. Check for new construction starts. Check for new construction starts with the city or the county building or planning department. You need to know if anyone is building a similar type of project near your location.

Millage Property Tax Rate: Have you checked with the county to see if property taxes are higher than what the seller is reporting?

Far too often buyers overlook the fact that their property taxes might be higher than what the seller has reported. They mistakenly use the amount on the seller's financials or last property tax bill when calculating expenses for after they buy the property. It's not that sellers are trying to mislead buyers on this. They are just reporting what they paid. But property taxes always seem to go up every year as the millage tax rate is increased. This is the amount per thousand dollars of property value that the property is taxed at based on current tax levies. I can't tell you how many loans I have worked on where I determined the property taxes were much higher than what the seller was reporting. Often the purchase price has had to be lowered.

To determine current property taxes, request a copy of the most recent property tax bill from the seller. Then do a search for millage tax rates on the county assessor's website. This is public information. Look up the current millage property tax rate for the type of property you are buying. Then multiply this by the property value shown on the tax bill. This should give you the most current taxes assessed on the property. Lastly, look up the property by the tax number on the website and see if the property value has been raised. If so, use this value or the current millage value you computed, whichever is higher

If the property you are purchasing is in California, property taxes are reassessed at the purchase price after a property is sold. This is quite a zinger. So be sure to use the current millage rate times the purchase price to determine what your new property taxes will be.

This conversation illustrates the point:

“Are you kidding me?” my client asked. “You're telling me that the property taxes are going up by $19,500 when the county reassesses the property? So I'm buying today based on the seller's property taxes and then once I own it my taxes will zoom up based on the purchase price?”

“Yes,” I answered. “In California they do that.”

“Well then,” he said, “that means I'm buying the property for a 4.7 cap instead of the 6 cap the listing agent said it was. That means I'm getting ripped off and the listing agent lied to me. Why would he put the seller's lower property taxes in the list of expenses and calculate a 6 cap? This is the only property I have identified in my 1031 exchange. What am I going to do?”

Mold Assessment Report: Don't forget to check for mold

If the property you are buying is older and in a damp climate, it is a good idea to order a mold assessment report, which will cost $250–400, as part of your due diligence. Commercial appraisers are trained to look for visual signs of mold in commercial properties. If found, it will be necessary to order a limited-scope mold assessment report. The inspector will conduct a visual inspection, collect samples in areas that are affected, and make recommendations for abating the mold. Usually poor ventilation is the culprit. Several types of mold produce mycotoxins, which are harmful when inhaled indoors. California requires owners to disclose the presence of mold in commercial properties to buyers and tenants.

Net Operating Income (NOI): This simple calculation is the most important one in commercial real estate

This simple math calculation is the most important number in commercial real estate. It is the foundation for determining everything related to a commercial property's financial condition, including CCR, cap rate, and its value. The NOI is simply the profit the property is earning before debt service. It is rental income minus expenses. But it is actually a bit more than that: gross rental income, less vacancy, less collection loss, less expenses = NOI.

Parking Ratio: Does the retail or office property you are buying meet the city's parking requirements?

If you are buying a retail or office property, check with the city to make sure there is adequate parking for each tenant based on their type of business as part of your due diligence. For a multitenant property, you will be adding the number of parking spaces required for each tenant together. Then confirm that the property has at least this number of spaces.

Here is how this can become a problem: Because tenants can change over the years, the current tenant might not have enough parking but has somehow gotten by with it. If the city discovers there is not enough parking after you own it they can make your life quite miserable. They can also require that a tenant move. For example, say a space that was once occupied by a shoe store became a coffee shop at some point. The city may have only required the shoe store to have one parking space for every 400 square feet in the tenant's space. For a food and beverage establishment it might require one space for every 200 square feet, however, which means that it requires twice as many spaces for the coffee shop as for the shoe store. Almost all multifamily properties have off-street parking space requirements. The good news is that the developers would not have gotten their certificate of occupancy (even if the property was rehabbed) if they did not meet the city's parking space requirement. This problem is rare and only occurs when the tenants have changed over to ones that require more parking spaces.

Preliminary Title Report: This is what you need to check out on the preliminary title report

Often buyers and sellers of commercial real estate fail to read the preliminary title report thoroughly. You would be surprised at how often a sale has to be delayed or fails to close due to not being able to get clear title on the property. Sellers sometimes do not know that there are mechanic liens, tax liens, or litigation showing on a title. If the preliminary title report is reviewed thoroughly at the beginning, this could have been avoided.

Be sure to have the listing agent pull a preliminary title report the day after the purchase contract is signed. This can take three or four days. You want to get started as early as possible. If there are problems with clearing the title, it can take several months to resolve. This is where it really pays to have a skilled commercial real estate attorney. They are experts at understanding the title report, comparing it with the survey, and watching out for your interests. A preliminary title report has information from the public record that tells the buyer who owns a property, its legal description, liens, easements, and encroachments.

Main Items to Check Out in the Title Report

  1. Who owns it? Is the seller's name on the purchase and sale agreement the same as it is on the preliminary title report? If not, find out why. It is hard to believe, but it does happen that someone who does not own the property will try to sell it. (See How I Learned the Hard Way to Read the Title Report box.)
  2. Is the property in foreclosure? Sometimes the seller does not disclose this, thinking they can sell the property and pay off the lender. If the foreclosure process has advanced to the point that the lender has received a court judgment awarding them the property, then the seller won't be able to get clear title. This will likely mean the purchase contract has to be extended. If this happens, maybe you can get the property for a better price, especially if you can buy it from the bank. Your time is worth money.
  3. Are there unworkable easements and/or encroachments? I have seen cases where a property really was landlocked, and the only access to it was through an easement that was being contested. I have also seen cases where the property that was being purchased was partially located on someone else's land. This is the definition of an encroachment.
  4. Are there liens that might be difficult to clear? If there are multiple loans, mechanic liens (liens from work done on the property that was not paid for), and back taxes, is the property being sold for enough to cover them all? Get assurances from the seller that clearing the liens will not be a problem. I had a loan approved on a property that failed to close because of liens on the property for past-due spousal and child support that were much more than the seller expected.
  5. Is the property in litigation? First, a property cannot be sold or financed when it is tied up in litigation. I lost a loan on a manufacturing plant that was owned by two partners. I knew my client needed the loan to buy his partner out. But he did not tell me that his partner was suing him. I found this out through the title report. Fortunately I did not start the loan. I told my client to come back when the lawsuit was settled.

Property Condition Checklist

Why not take charge of the physical condition of the property you are buying or selling from the beginning, by understanding what the property condition report covers? Here is a general list:

  • ___Structural framing
  • ___Pavement and curbs
  • ___Lighting
  • ___Building envelope
  • ___Drainage
  • ___Landscaping
  • ___Roofs
  • ___Fire suppression
  • ___Fencing
  • ___Foundation
  • ___Exterior finish
  • ___Fire and safety
  • ___Plumbing
  • ___Interior finish
  • ___Regulatory compliance
  • ___Electrical
  • ___Boilers
  • ___Common areas
  • ___HVAC
  • ___Signage
  • ___Elevators
  • ___Windows and doors
  • ___ADA accessibility
  • ___Stairways
  • ___Data and phone
  • ___Mold
  • ___Wood-boring insect damage

Radon Gas Report: Radon gas is the second-leading cause of lung cancer in the United States. Does your property have it?

As part of your due diligence, don't forget to test for radon gas. Radon is a radioactive gas that is in rocks and soil and can be under commercial properties in almost every state. With poor ventilation it can build up to dangerous levels. It is the second main cause of lung cancer in the United States after cigarette smoking. A radon gas inspector will place a testing kit in each unit or space and retrieve it in a few days for analysis. If the result is below 4 pCi/L, the property is okay. If higher, they will come back and do a second test. Mitigation usually consists of increasing ventilation. Many lenders require a radon gas report for states that are known to have high levels of radon gas. The western states have the highest incidence.

Rent Comparable Report: Are the rents at or above market rents? Is there room to raise rents?

A rent comparable report compares the rent from three to six similar properties with the subject property. The purpose of the report is to determine if the subject property rents are at market, below market, or above market. When buying or selling a commercial property, this report will tell you if there is a value-add opportunity to increase rents.

A commercial real estate broker that wants to represent you will do a rent comparable report for free. If they are not going to represent you, they will charge a small fee. They will not only know some rent comparables themselves, but their companies will likely be members of Costar or REIS, which are market research companies that have current market rents. Property management companies are another excellent source for market rents. Banks and commercial mortgage brokers have access to recent appraisals, which will have this data too.

Seismic Report/Seismic Risk Assessment: Is the building you are buying at risk of collapsing in an earthquake?

Is the property you are buying in an earthquake zone? If so, it's important to assess the building's structural risk for earthquake. Ask the seller what has been done to retrofit the building for earthquakes and for a copy of his seismic report. If he financed the property in an earthquake zone he will likely have one. Search online for “FEMA seismic map” to find locations in the United States that are prone to earthquakes. A seismic report estimates the percentage of a building that could be lost in the event of an earthquake by calculating the probable maximum loss. The report evaluates the seismic risk as a percentage of the building's potential loss. A loss of 20% or higher is considered high risk. “Tuck-under parking,” where parking is on the bottom level and apartments or shops are above it is considered very high risk. Most buildings that are at risk can be retrofitted seismically.

Stabilized Occupancy: This is when the property is at market occupancy

“Is the property stabilized?” or “When will the property be stabilized?” are questions that come up a lot in commercial real estate. A property is considered to have stabilized occupancy when it is leased up to market occupancy. Newly built or rehabbed properties can take six months or more to achieve stabilized occupancy. A brand new apartment building might have only 40% occupancy after the first three months, but be expected to reach stabilized occupancy in another four months when it achieves a market occupancy rate of 95%. Properties that do not have stabilized occupancy have lower NOIs and are worth less than ones with stabilized occupancy. Commercial appraisals for properties being rehabbed or newly constructed will have two values—a lower, as-completed value and a higher stabilized value.

Survey, ALTA: This survey will show absolutely everything about how the property is laid out

When buying a commercial property there is no better way to see what you are buying than through an ALTA survey of the property. Not only does it show you accurately where all the property lines, rights of way, and buildings are, but it will also show all walkways, roads, paving, parking, storm drainage, landscaping, and utilities. Just as important, it shows all easements and encroachments, and the zoning and flood-zone classifications. Keep in mind that title reports only provide a legal description of easements, which is usually hard to comprehend. An ALTA survey shows you exactly where it is located.

The seller of the property you are buying might only have a simple boundary survey, which is often acceptable to community banks that can go and see the property easily. Lenders that are out of the area will often require an ALTA survey, which is much more expensive.

Tenant Rollover Risk: Is the property at risk for many vacancies at the same time?

When making a decision to buy a commercial property, it is essential to assess the tenant rollover risk. This is the risk associated with leases that are expiring. For office, retail, and industrial properties, the tenant rollover risk is high if many leases are expiring at about the same time soon or at some other time in the future, or also, if they are month to month. A property with a majority of leases with terms of five years or more remaining has a relatively low tenant rollover risk. A property that has 20% or more of the total square footage of the leases expiring in one year has a high tenant rollover risk.

Steps to Determine Tenant Rollover Risk

  1. For each year, make a list of each lease that is expiring and the amount of square footage that each of these tenants occupies.
  2. Sum the amount of square footage for the expiring leases for that year.
  3. Divide that total by the property's total rentable square footage. This will give you a percentage of the property's rollover risk for each year.

Your job is to identify time periods in the future that are at an unacceptable risk level for tenant rollover. An example would be a strip mall that has 60,000 rentable square feet with two leases totaling 10,500 square feet expiring in the first year of ownership:

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Title and Survey Objection Letter: If there are problems with the title report, your commercial real estate attorney will write this letter

When buying a commercial property, most buyers just assume that everything will be okay with the title commitment and survey. Always assume a problem may exist and have your commercial real estate attorney review these items shortly after signing the purchase contract. If your attorney finds any title defects, such as restrictive easements, encroachments, or any agreements that restrict your use of the property, they will prepare a title objection letter on your behalf. This will be given to the buyer's and seller's real estate brokers, the seller, the title company, and the surveyor. This letter needs to be issued well before your due diligence period is up, as defects can take several weeks to a month or longer to remedy. In most cases the seller will extend the purchase contract to accommodate the estimated time it will take to correct the title defects.

Trailing 12-Month Report (T-12): Your lender will require this. Ask the seller for it early on.

What you really need to know when buying a commercial investment property is how the property has been performing over the 12 months previous to your signing the purchase contract. A T-12 report does just that. It shows income and expenses month by month, starting with the month preceding the contract and looking back for 12 months. You need this to be in month-by-month format so you can look for monthly discrepancies in rental income and expenses. When purchasing a commercial property, the seller and/or listing agent will most often provide the past calendar year's income and expenses for the property in the marketing flyer. This does not give you an accurate representation of how the property has done recently—especially if you're buying the property early in the current year. Be sure to request a T-12 report from the seller as early as possible and make sure it is included on your due diligence list for property financials. Most lenders require a T-12. To view a sample of a T-12 report go to Appendix A. For an Excel copy that can be filled out, go to my website at: https://apartmentloanstore.com.

Transfer Tax: Check to see if the city or county is going to charge this tax; fortunately, most do not

A transfer tax can be charged by municipalities, counties, or states when real estate is sold to another party. This is really a charge for changing the deed from one owner to another. In a seller's market, most often the buyer pays this tax. The cost can be anywhere from 1 dollar for every 1,000 dollars of value to 2% or more of the purchase price. These states do not allow transfer taxes: Mississippi, Missouri, New Mexico, North Dakota, and Wyoming.

Vacancy Rate: Physical, Economic, and Market

  • Physical Vacancy Rate: The physical vacancy rate applies to multifamily, mobile home park, or self-storage properties. It is the number of vacant units divided by the total number of units. For office and retail properties, the physical vacancy rate is the square footage that is vacant divided by the total leasable square footage.
  • Economic Vacancy Rate: When you buy a property you should be looking at the economic vacancy rate, not the physical vacancy rate that is showing on the rent roll. The economic vacancy rate is determined by looking at actual gross rental income from rents collected as shown on income and expense statements. For example, you could be told that a property has a 6% vacancy rate, but in looking at rent collected you might find its economic vacancy rate is 9%. Economic vacancy rate is what lenders really look at; they're interested in vacancy based on actual rents collected, not based on rent rolls. To determine the annual economic vacancy rate, take the total annual gross rental income collected from the property as shown on the operating statement for the past 12 months. Now divide that amount by the gross potential income as if the property were 100% occupied during the same time period.
  • Market Vacancy Rate: The market vacancy rate is the average vacancy rate for the subject property type in a submarket. This is an indicator of supply and demand in this market. You can determine market vacancy rate through a quick call to a commercial appraiser or local lender. If the subject property has a 12% vacancy rate and market vacancy is at 7%, then this is an excellent opportunity to reposition the property. Your goal would be to get the property to a market vacancy rate or better.

Wood-Destroying Insect Report: If you live in a state that has wood-eating insects, you should order this report as a precaution

As part of your due diligence, you will need to order a wood-boring insect report if your building inspector finds signs of termites and other wood-boring insects, including carpenter ants and wood-destroying beetles. The report will identify the location of the infestation, the extent of the damage, and the cost to remedy it. Alabama, California, Hawaii, Florida, Louisiana, Texas, Mississippi, Georgia, and South Carolina have the highest incidence of wood-boring insects.

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