Whether you’re purchasing your first home or if you’re a veteran when it comes to real estate and you’ve purchased multiple homes in the past, at some point, in each real estate transaction, you will encounter the term “Due Diligence. ”You’ll hear experts say to make sure to “do your due diligence” when buying property.
But, what does that mean exactly? When people say due diligence, what does it mean? And more importantly, why is it important to the real estate transaction?
Due diligence is generally defined as thorough research before signing a contract, especially one involving the purchase or sale of real estate. Due diligence means taking precaution, reviewing and analyzing documents, performing calculations, purchasing insurance, performing inspections, walking the property, and essentially doing your homework for the property BEFORE you actually enter into a binding real estate contract.
This due diligence period is typically known as preliminary due diligence, and it refers to a stipulated period prior to the execution of a real estate contract for a buyer to investigate the property in question to ensure that they are satisfied with it before proceeding to enter into a contract.
In New York some common considerations of the due diligence period prior to entering into contract is home, pest, and septic inspections, loan qualifications, repair negotiations, financial document exchanges, etc. Once there is an executed contract, due diligence continues with property surveys, bank appraisals, title search, loan commitment and again repair negotiation.
The buyer can choose to not proceed with a purchase for any or no reason at all BEFORE there is a fully executed contract. Should the buyer choose not to proceed with the transaction, the parties no longer have any obligation to each other. Be aware, if you fail to do the proper due diligence prior to contract signing, problems might arise that were preventable, and you may end up losing money.
In New York, as mentioned above, the due diligence period occurs in the days before a property goes under contract. In a fairly balanced market between buyers and sellers, the due diligence period typically lasts a couple of weeks, but in a tight seller’s market, buyers may agree to a shorter due diligence period, even as short as two to three days, to gain an edge over a competing offer,
Accordingly, the due diligence period is before the contract becomes binding. Generally, a contract is binding when both the buyer and seller have agreed to the terms, signed the contract, and the complete contract has been delivered to both parties. The date that this happens is oftentimes called the binding date, and it is commonly viewed as starting the beginning of all contingencies on the contract.
One of the primary reasons why preliminary due diligence is important in commercial and residential real estate transactions is so that the buyer can properly analyze the property’s value to create an offer strategically. Many of the documents that allow you to explore a property’s net profitability are only available to the buyer after an offer has been made. Accordingly, when valuing commercial property, income production is critical.
The key ratio to determine here is the Net Operating Income (NOI), which is equal to income minus operating expenses (not including taxes and interest), and should be one of the primary factors in determining how much you are willing to pay for the property. More importantly, in order to properly perform your investigation, you’ll need to go through a due diligence checklist.
The primary reason why due diligence for commercial real estate is so important is to ensure that the buyer knows exactly what they are purchasing. The stipulated period usually begins after the prospective purchaser has made an offer, the seller has accepted the offer pending the due diligence period, and the buyer has placed a down payment in an escrow account to be applied towards the purchase and typically lasts anywhere from 30 days to more than nine months.
Due diligence for commercial real estate oftentimes involve physical inspections of the real estate, an assessment of related-environmental conditions, a review of the title, zoning requirements, contracts, leases, and surveys, partially through a review of documents the seller provides.
A review of such documents may include:
Aside from the document review, the buyer should also conduct a thorough independent investigation. In fact, you can even ask that the seller conduct, and/or pay for some of the third-party assessments you may want to inspect, and even negotiate them into the contract.
As with commercial real estate, you should thoroughly assess the value of and market for a residential real estate property too before making an offer. With residential real estate, there are not as many objective measures of valuation of property, especially single-family residences.
If the family is a multifamily unit, review the income the property generated in tandem with property taxes and utilities. With single-family residences however, real estate appraisals, comps, and local real estate trends are the best way for valuing the property.
In New York the due diligence period for residential real estate purchases typically exists to inspect the property prior to contract. During this period, you’ll want to review:
First and foremost on the due diligence checklist, you need to review the title, which should be, unless you are buying a distressed property, clear of any liens or other claims against it. The title is the transferable legal right to the property, which you must ensure the seller actually has. The title is oftentimes mistaken with the deed, which is actually the document used to transfer the property to another. In general, the seller makes sure they can convey a clear title before they put the property on the market.
The title review period for commercial real estate purchases are similar, and involve reviewing all claims against the property with what is known as a title search. As a general rule, in order to protect yourself in case the title search misses a claim against the property, which then reveals itself after you’ve purchased the property, you will always want to purchase title insurance, which will then make the policyholder liable for such claims.
For commercial real estate, you will likely receive a document known as a PTR (Preliminary Title Report) from a title insurance company. A PTR will include a description of the land, the type of estate, who has title to the estate, and any claims to the estate. When reviewing the title report, you’ll want to look for any exceptions to or exclusions from the title, which will define any known claims to the property by others, such as by any taxing agencies.
PTRs also list liens, judgments, restrictions, special assessments, and more. All of these issues should be carefully scrutinized by an experienced real estate attorney so that you are clear on what you are purchasing, what rights you will have, and what rights, if any, will be given to anybody else.
Similarly, a title insurance firm will likewise conduct the residential title search. When you purchase a residential property using leverage, the lender will most likely mandate you to purchase title insurance. When the title insurance company finds a claim, such as a lien against the property, the seller is informed and typically must redress it.
Once a title is free and clear, the title insurance company issues a title commitment. A title commitment is a statement indicating that they will insure the property. The lender will then, in all likelihood, approve the mortgage, all else being equal. In the case of distressed properties, in order to receive a title commitment, you should consider agreeing to satisfy existing liens (such as environmental judgments or mechanics’ liens) at closing.
Being one of the most critical aspects of the real estate purchase process, real estate appraisals will be a key determinant in any assessment of the property’s value. This is what the seller used to determine their price, what lenders will use when determining how much they will lend, and what tax agencies will use when assessing taxes.
Commercial real estate appraisals assess the physical structure, zoning records, geo-demographic information, financial records, leases, and comps to value a property.
You will want to make sure the seller provides current and updated financial information to the appraiser. Commercial real estate appraisals generally range from $2,000 to upwards of $3,000.
Licensed residential real estate appraisers most often use the sales comparison approach – which emphasizes comps; the cost approach – which looks at the replacement cost of the property; or the income approach – to develop an initial opinion of value. You should be clear on the approach, date of valuation, and independence of the appraiser when reviewing the appraisal.
All building inspections should be done by a certified third-party to make certain that the property is up to code, but more importantly, structurally sound.
Inspections of commercial real estate will typically cover roofs, HVAC, electrical, heating, plumbing, and structure. Inspectors look at lifespans of these systems, which typically are, all other things held constant, 10 to 15 years for a roof, 40 to 60 years for plumbing, 50 years for electrical systems, 15 to 17 years for HVAC systems, and 70 to 100 years for the underlying structure. Commercial inspections will also typically include parking areas, among other areas of a commercial property.
These types of inspections cover the same areas as commercial real estate inspections, as well as pest infestation, chimney inspections, water quality, exteriors and interiors, and other areas. They generally start at $325.00, and should take at least two to three hours to ensure thoroughness. It is highly advisable that you attend the home inspection with the inspector to ask questions and learn to spot issues with other properties you may purchase in the future.
Surveying allows you to see specifically what the land underlying the property is. A typical example of this would be to determine whether or not a nearby property has an easement on your property. A easement is the right pass through to any part of the land you plan to purchase, or whether there is an encroachment – a portion of someone else’s property intruding on what you plan to buy.
Once there is an executed contract, due diligence continues with property surveys, bank appraisals, title search, loan commitment and again repair negotiation.
There may also be other covenants, which are conditions and/or restrictions tied to the land, all of which are essential to know before making a purchase.
If you plan to renovate or expand the property, surveying is of critical importance. You’ll want to look for a survey from ALT or the American Land Title Association, which is prepared by a licensed surveyor in accordance with the Association’s standards.
Oftentimes, title insurers want to see the results of an ALTA survey before issuing a commitment. The survey will include information on encroachments on to the property you intend to purchase; encroachments the property you intend to purchase has on neighboring properties; and easements that affect the intended property.
When dealing with residential real estate, the surveys should be the most recent as many lenders will not honor one more than six months old. Most residential real estate purchasers obtain house location surveys, which are less expensive.
However, the title insurance firms will not consider these surveys in coverage of encroachments and boundary line disputes. To get title insurance that covers these issues, you should also consider getting an ALTA survey when buying residential real estate as a potential investment.
As mentioned earlier in this blog, you should evaluate the income generated by the existing leases to evaluate the property. You should, however, also look at tenant files and credit-worthiness, as well as personally assess the condition of their leased space to corroborate the seller’s assessment of the property’s condition.
Other documents you should evaluate in tandem with existing leases include existing loan documents; insurance documents, which may provide further information, and possibly a risk assessment from the insurer, utility expenses and property taxes, as you are on the hook for them when the property is vacant.
Some experts recommend that you review the previous period’s actual operating performance, rather than the pro forma statements, which may give you a misleading portrait of how well the property is doing. You should also thoroughly review the lease terms and periods, and tenant files, interviewing tenants directly if possible, as they will be yours to manage shortly. During the due diligence process, ask the seller to keep you abreast of any tenant problems that occur during the process to get a feel for any problem tenants.
Beyond reviewing leases for income projections, you’ll want to review them for any clauses related to access of the leased space, renovations, and selling the property should you be interested in flipping it. In addition, make sure that the seller informs you of any amendments they make to the lease during the due diligence period. And make sure the seller credits you for the tenants’ security deposit at closing.
Zoning certifications are obtainable from planning offices of the jurisdiction in which the property is located. The buyer should make sure that the building is currently in compliance with existing zoning regulations. Furthermore, the buyer should learn of any planned zoning changes that may undermine their intended use of the property by speaking with representatives from the local zoning office.
Owners of commercial real estate property should make certain that the property currently complies with existing zoning regulations, especially if they plan renovations, development, or further expansion. Zoning can also address assessments, exactions, and impact fees, which can directly impact how much net income you can expect to generate. After you purchase the property, it is very important to keep abreast of developments in the city’s zoning plans.
Keeping abreast of your residential zoning laws is very important. Tenants who decide to operate a home-based business in the apartment they lease from you, for example, may cost you a hefty fine. It is likewise critical to keep abreast of zoning plans.
A city in New York, for example, deciding to develop commercial property could re-zone giving your property and land a larger opportunity for development.
Environmental inspections are also very important, especially for commercial properties whose owners and/or tenants may be purchasing environmentally harmful waste products in large quantities. The property you intend to buy may have sustained environmental damage from previous use, which may affect your intended useage,
For commercial properties, environmental appraisals begin with a Phase I Environmental Report, which will indicate whether there are serious problems requiring remediation. These reports not only include appraisals from licensed third parties, but they also include reviews of state and federal compliance agencies of the property in question. If there are such reviews, what typically follows is known as a Phase II investigation, which usually involves additional testing.
Residential property purchases also include environmental assessments, by licensed assessors selected by title insurance firms. While Phase I and Phase II assessments are not required, it is in your best interest to secure the most thorough environmental assessment available to ensure you have full use of the property.
Although proper due diligence is a lot of work, it is worth it and in the long run will help you determine if the property is what you actually want or whether you should purchase the property. Essentially, this is one of the most important stages of the real estate property buying process.
If you feel yourself overwhelmed with variety of tasks on the checklist, you need to consult a real estate lawyer who will take the time to explain the steps, take care of the paperwork and the title research, and go through the proper due diligence checklist.
At the Law Office of Yuriy Moshes, we assist clients who buy or sell property in the greater New York City area including all its boroughs (Manhattan, Brooklyn, Queens, the Bronx, and Staten Island) as well as Northern New Jersey, Long Island, and Upstate New York.