In Part 3 of Canadian Real Estate Wealth’s commercial investing series, Mark David reports on how to conduct due diligence when investing in commercial properties.
The best kind of property investor is an informed one, and the more knowledge they have, the better their situation will be. Neil Warshafsky, a top commercial broker with Royal LePage Real Estate Services Ltd, echoes that statement.
“A serious due diligence exercise is integral to the success of investing in real estate,” says Warshafsky.”
Performing due diligence not only arms prospective buyers with the necessary knowledge about what they would like to
acquire but is also vital to helping them identify certain issues that may present them with difficulties later on.
Warshafsky explains: “It is highly recommended that all buyers complete a responsible research and analysis in advance of firming up of a purchase. Due diligence will serve to identify any concerns that may affect the viability of the investment.
Such concerns may be financial constraints, which could reduce the value, legal issues, environmental and a host of other issues, which may reduce the interest in the property, hence value.”
A STEP-BY-STEP PROCESS
STEP 1 – Initial Review
“Typically, an initial review of the property and all background material that is available from the seller for review by the buyer is performed by the buyer and any advisors that they feel would be in a position to confer the best feedback,” says Warshafsky.
First-time commercial investors should focus their attention on the following criteria before engaging in the purchase process.
This includes any background information about the area the property is located in. Examples include property values, vacancy rates, and key demographics (especially applicable if the chosen property will be used as a retail outlet).
- Type of property
What type of commercial property is best and offers the greatest chance of good returns (retail, industrial, office space, etc.).
- Ownership history
This includes when the property was built, who previously rented it, and whether or not any extensive renovations were made by the previous owner(s).
- Background information on the seller
This includes whether or not they have a proven track record.
- Long-term cash flow potential
STEP 2 – Legal and Financial Matters
Legal matters are an important part of any real estate acquisition, however large or small. First-time buyers may encounter difficulties in this area, so it is best for them to have all the information they need before pursuing a deal. “The buyer would likely engage its lawyer to complete a review of the leases, along with the balance of the legal matters, which may affect the real property,” Warshafsky explains. “[The buyer’s] accountant may review the income statement and the financial issues.”
Both residential and commercial real estate deals are bound by legal issues, and there are many differences between the two. “Commercial real estate is much more complex than residential, as it has its own nuances and mode of doing business,” says
Warshafsky. “Each type of commercial real estate investment has its complexities.
Simply put, office buildings have different measurement standards from industrial o retail properties. Issues like ownership, lease histories, and zoning may also prove to be a thorn in a prospective owner’s side if they are not properly reviewed prior to closing the deal. “You must complete a careful review of all leases, offers to lease and any other contracts which can serve to bind the property and affect the bundle of rights that the owner may enjoy,” says Warshafsky. “Issues such as rights of way, easements and other legal rights which may affect the real property should be reviewed. Municipal concerns should be looked into as the zoning and by-laws are constantly changing and may affect the value and use of the property.”
Also important are the legal ramifications of commercial tenancies. “There are different legal issues in the lease form for each type of tenancy,” Warshafsky says. “HST is applied against rent and all expenses including realty taxes. In essence,it is more complicated for real estate ownership. Concerns over encumbrances and other financial debt should be reviewed and addressed.”
Warshafsky adds that “one must be experienced in the understanding of leases, legal ownership, environmental concerns, and
a myriad of other factors.”
STEP 3 – Structural Analysis
“Typically, a soil test is conducted to determine the stability, compaction and nature of the soil,” says Warshafsky. “A review is completed of the foundation and walls to determine the structural soundness of the building. Normally, these tests will yield a result as to the structural integrity.” Following these three steps will allow buyers to learn as much as they can about the property before the deal goes through and the final signature is scrawled on the contract.
“This process affords the buyer with the time to identify any concerns that may affect his buying decision and whether the contract that was negotiated properly reflects the value of the asset being acquired,” Warshafsky says of the steps of the due diligence process.
How much due diligence is enough?
“The simple answer is that one can continually search for answers and keep on asking questions, and the due diligence process could conceivably continue for an infinite period,” says Warshafsky. Commercial investors tend to focus their due diligence on four specific areas of concern when on the lookout for new property acquisition opportunities. “These pillars of concern would be broadly classified as follows: legal, financial, environmental and physical,” Warshafsky clarifies. “If these areas of concern are found to be satisfactory, many buyers would typically move forward with the contemplated acquisition.”
Informed investors will generally perform the correct amount of due diligence, usually paying attention to these four factors. However, some investors, especially first-timers, might overanalyze these and other factors, a habit that has resulted in the death of many a deal. “Many investors, especially first-time buyers, can become paralyzed due to overanalyzing what should be simple concerns and overemphasizing these issues,” says Warshafsky. “Accordingly, they may focus too much on one particular [aspect] and ultimately convince themselves to not proceed with the contemplated purchases.” Warshafsky adds that it is fairly typical
with less experienced buyers and those who have very little risk tolerance. “They are unable to quantify the concern and address
it through many possible solutions, and the matter may get in the way of their intended purchase, he says.”