July 16, 2022

JF2874: Commercial Due Diligence Pt. 1 | Beyond Multifamily ft. Ash Patel


The Beyond Multifamily series is hosted by non-residential commercial real estate investor and Best Ever Show host, Ash Patel. Ash’s goal for this series is to introduce you to the world of non-residential commercial real estate investing and teach you how to look at and underwrite different commercial asset classes.

In this episode, Ash lays out his top tips for conducting commercial real estate due diligence that leads to taking down great deals.

 

1. Create a checklist for your due diligence items. 

Your checklist should include due diligence prior to contract signing, due diligence in contract signing, and tasks that must be immediately completed before and after closing. 

 

2. Google the property address. 

This way, you can learn if the property is listed on the market, which will impact the amount of time you have to close.

 

3. Find out everything you can about the seller.

Conduct your own research to learn what other properties they own, why they are selling their current property, and what kind of pain points they have that you could potentially address for them.

 

4. Check if your property is on a floodplain.

Go to the FEMA website and find out if your property is in a flood zone. Any lender can also immediately find this information for you. 

 

5. Negotiate as close to 60 days of due diligence as possible.

If you're raising capital for the deal, you may need extra time in the event of a tricky lending situation. Ideally, you want to have a 30-day closing after the 60-day due diligence period.

 

6. Write down that due diligence will begin only when all requested items are received.

This discourages the seller from dragging their feet when it comes to providing you with important documents. 

 

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7. Include provisions in the contract that allow for extensions.

If situations arise that are out of your control, having the option to request additional extensions without losing your initial earnest money is key. If necessary, pay for these extensions.

 

8. Be thorough when it comes to financial requests.

Ask for three years of P&Ls, three years of tax returns, five years of CapEx records, copies of the roof/HVAC/mechanical warranties, a copy of the current insurance policy, any and all service contracts, rent rolls, and estoppel. 

 

9. Ask for the property management company contract.

You’ll need to know about any cancellation policies or obligations that are included with it. 

 

10. Talk to the zoning and planning office in the municipality where the property is located. 

Learn about any zoning ordinances that affect your property, what the acceptable uses are, and if there is anything in the works for the area. Find out if they have any potential tenants for your vacancies, and if there are any easements or property line disputes. Ask if there are any current violations, get a list of previous violations, and see if there are any open permits within the city. Also, make sure to call ahead before bringing a potential tenant to the office.

 

11. Check fire extinguishers and sprinklers.

If your building doesn’t have sprinklers, find out if you need to install them, or what kind of change of use would require you to install them. Make sure all fire extinguishers are tagged and up to date.

 

12. Reach out to the city council.

Determine whether the council seems divided or unified. A divided city council indicates that this is a place where things don’t get done.

 

13. Get on the city’s local Facebook page.

Find where the locals are venting and having discussions that will help you learn about the town’s vibe, level of crime, job losses, and what kind of businesses residents are interested in. 

 

14. Read the area’s local newspaper.

Viewing the comments at the bottom of certain articles can also help you understand the area.

 

15. Contact the local police department.

Ask about the amount of crime at the property you are interested in, and ask what you can do to help them. Make sure you write down their contact information for future reference.

 

16. Purchase a property condition report.

If you’re unable to conduct an in-person inspection, you can pay for a property condition report for $5K–$10K. Make sure to get a sample report from the company beforehand to make sure it will be thorough. 

 

17. Call a local roofing company for an estimate.

Make sure you pay the company for their work to ensure they do a thorough job in a timely manner.

 

18. Determine when it’s appropriate to bring your lender in, and when you should order the appraisal.

If you bring in lenders too early, you might be wasting their time. You should only bring them in once you are fairly certain that you're going to move forward with closing the deal.

 

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TRANSCRIPT

Ash Patel: Hello, Best Ever listeners. Welcome to the best real estate investing advice ever show. I'm Ash Patel and this is an episode of Beyond Multifamily, where we dive into topics other than multifamily investing. Today we're going to talk about commercial real estate and the due diligence behind taking down great deals. The first thing I want everyone to understand is you have to have a checklist for your due diligence items. I've done this in the past where I have not used my checklist and items were forgotten. No matter how great of a deal you think you're getting into, these little things on your checklist can be absolute game-changers.

Your checklist should start from due diligence prior to contract signing, due diligence in contract signing, and then tasks that you have to do immediately pre and post closing. We will dive into a fair number of those today. One of the first things I do if a property is presented to me as off market is google the address. If you google the address, and it starts showing up on LoopNet, Crexy, Redfin, Zillow, you know it's not off-market; there's already been a lot of eyes on it. So take that for what you will, just know that timing is probably not of the essence, because it's already on the market.

One of my due diligence items is I try to find out everything I can about the seller, and not just from the broker or the listing realtor; do your own research and find out everything you can. Does he or she owned dozens of strip malls, and could you possibly get more deals from them? Is this an estate sale, where they just want the cash and they want this over quickly, because there's infighting amongst siblings? Find out if this was a recent divorce and they really don't care about the price as well, they just want this done quickly. So whatever information you can find, will help you. And if you remember from my Beyond Multifamily episode where we talked about addressing pain points and finding solutions for them, let's see what kind of solutions you can find to affect the sale either at a better price or more in favor of your terms, or just overall making it a win-win.

I want to talk about checking if your property is in a floodplain. This ended up burning me one time. And I'll tell you the story. So every real estate contract that I've done with residential realtors, even though they're for commercial buildings, they use the residential MLS form. And on that form, I'm so used to just signing it, because they're all

standard. Well, this one particular form, it stated -- the seller to the best of their knowledge acknowledges that this is not in a floodplain. It did not say "Seller hereby warrants this is not in a floodplain." Well, it turns out this was an office building, there was no water anywhere around there. However, there was a small creek where when it rains, it has the potential of flooding. So this property was now in a flood zone. And I ended up walking away from a $5,000 earnest deposit. Not a huge deal... I walked away because this wasn't a great deal, but I was either past my contingency period, or I waived all contingencies, and therefore ended up losing, luckily, only $5,000.

So Best Ever listeners lesson learn, go to the FEMA website and find out if your property is in a flood zone. You can call any lender and they'll immediately look it up for you as well. There's different levels of flood zones - 100-year, 20-year, whatever it is, but find out if it's a red flag for your lender. And all of my purchase and sale agreements or PSAs or purchase contracts - I like to put down I want 60 days of due diligence. And currently, appraisers are very backed up, so I typically try to blame them for that. I tell them "Look, we'd love to close earlier, but appraisals are four to six weeks out right now, so we need that extra time." Whatever pushback you get, negotiate as close to 60 days due diligence as possible. And if you're raising capital for the deal, you may need extra time. If there's a tricky lending situation, you may need extra time. So try to have a 30-day closing after the 60-day due diligence.

What I also like to do is write down that due diligence starts once all of my due diligence requested items are received. This make sure that if the seller is dragging their feet in providing documents to you, they're not eating up your precious time.

Finally, if there are situations that arise out of your control, you would want additional extensions without losing your initial earnest money. Pay for those extensions if you have to. So write down, if you're 65, 75, 85, 90 days in, you should be okay with having your earnest money go hard. And if you need additional time, put down another 20k, 30k, 40k, 50k if you need to, just to keep the deal alive, and make sure you don't lose your earnest money.

A good example of this is we have a lender who normally just signs off on whatever loans that we do. However, on this one instance, it was, I believe, a $7 million strip mall - he decided he's got some free time, he's going to fly out and check this place out. Well, he discovered there was some underground tanks in the parking lot. So now the loan was not going to get approved, and we needed to do a phase two environmental study... So this would have killed the deal. We had $200,000 in total earnest money out, and we potentially would have lost that. Because we were smart in writing our PSA and we had a number of provisions that lead us out of the contract or gave us extensions, we were able to use that and not lose our earnest money.

When it comes to financial requests, you should have this already in your checklist. We would love to have three years of P&L's, three years of tax returns, five years of any CapEx, meaning five years of any major repairs, roof, parking lot, exterior, HVAC mechanicals. We want a copy of their current insurance policy. We want all of their service contracts, if any; obviously rent rolls... Something called estoppels, which in commercial real estate is where the tenant signs off saying yes, these are the terms of my lease. There is no additional leases that have not been given to us. This is what I've been paying. I have not missed the rent payment in X number of months, and whatever other information that either you or your lender requires... But these need to be signed by the tenant and the seller. You also want to make sure you have copies of any warranties for the roof, HVAC, any mechanicals.

If there's a property management company involved, make sure you have the contract, whatever cancellation policies or obligations are included with that... If your property has sprinklers, or an elevator, or a fire suppression system in a commercial kitchen, make sure you have service records, make sure everything is up to date and signed off on.

Now, let's dive into some of those nuances that I've learned over time. When you buy commercial real estate - and

Best Ever listeners, you know me by now, when I say commercial real estate, I mean non-residential commercial real estate. So when you buy commercial real estate, you always have to talk to the zoning and planning office in whatever municipality you're buying in. And why is that? There are all kinds of weird zoning ordinances that your property can fall under.

I once had a property that was a 15,000 square-foot single-tenant retail building, and for whatever reason, because this was under special zoning, anytime I had a tenant, they would have to get approval from the City Council. The reason for this was the previous owner that built this property only had 28 parking spots for 15,000 square feet; he built it to be an Ace Hardware, and for whatever reason, he thought he only needed a very limited amount of parking. The zoning and planning commission approved it, but they moved this property into a special zoning designation, where forever after, anytime a tenant wants to sign a lease, they have to get approval from the city council, because there's such limited parking there.

And this story has a couple twists and turns and lessons learned. So when I told the tenant, "We have to go together to the city and fill out this application", "No problem", what I should have done is given the city a heads up because I brought the tenant down there, and I introduced him and I said, "Hey, I'm really excited. This gentleman is going to sign a five-year lease for this property, build a great business in there." And the person behind the counter said, "Oh, what kind of business are you going to put in there?" and the guy said a high-end thrift store. The guy behind the counter says "Oh, no..." And my heart drops. He says, "For whatever reason, we've never had a thrift store be able to stay in business in this town." And my blood pressure's boiling, I'm cringing inside, and I'm thinking it took me months to negotiate this lease, to land this tenant, convince him that this was the right spot, get all of the signage up to par for him... And here, this individual is going to kill my deal.

Luckily, my tenant was great. We walked out of there, and he said, "Ash, I can't believe you're so calm. You should have reached over and killed that guy." And thankfully, he was understanding that whatever this gentleman said was inappropriate, and took it with a grain of salt. Nonetheless, I called the mayor and had it dealt with later on. But what I should have done is I should have called ahead of time, and I should have said hey, "I'm going to bring a potential tenant to the office, for whatever reason. Will you do me a favor and talk about some of the great things in this city, and explain why he's got a great chance of success?"

Break: [00:13:01.05] to [00:14:48.08]

Ash Patel: I've had meetings with city managers and mayors when I've had high-profile tenants, very nice steakhouses or high-end retail shops... And I do this meeting because I want the city to be very welcoming to this tenant, and let them know they're there for whatever they need, and they'll support them as much as possible. And this is also a great time to ask for tax abatements, any grants... You'll be amazed at how many times that there's a facade grant available. Or if it's in an entertainment district, there is a matching grant available for anything. But if you don't ask, you're never going to know about these things.

A lot of cities also have a significant amount of leeway. We've had tenants go in front of a city manager, and the city manager agreed to pay for all of their cooking equipment. And that's not written in any brochure. It's just a conversation where you bring your tenant to the city, and make both sides feel good about renting your building. But do your homework and make sure you let everybody know what your intentions are, and what your expectation of their roles are. While you're talking to zoning, you want to find out what the acceptable uses are. And again, a lot of this is fairly standard, but it's amazing how many nuances there are from municipality to municipality. So at certain times, there could be a zoning ordinance where a certain type of business is just not allowed in a downtown area, or a suburban downtown.

So you want to find out what the acceptable uses are. You want to find out if there's any current issues with that property, or that area. Find out from zoning, what they would like to see there. What kind of tenant would you like to see? What does this town need? And this way, it becomes more of a conversation. You're getting their input, you're building rapport, versus just asking them questions. This is also a great time to find out if there's anything in the works for that area. Are there any master plans? Is there any revitalization district? What's the future of this area look like? And zoning people I think are a lot like us real estate people. They just don't have a lot of people that want to listen to their stories. So if you can get them talking, you should be able to find out a wealth of information on this area.

While you're talking to zoning, also find out if they have any potential tenants for the vacancies that you have. And hopefully you've got some vacancies, because we're buying value-add commercial real estate, and zoning and the city council are typically the people that are aware of either tenants that they want to recruit, or tenants that have asked, but just haven't found the right space.

This is also a good time to find out if there's any easements, property line disputes, or just the overall vibe of the area. You'll be able to tell. If you can do these meetings in person, let them know ahead of time that you're coming and would love a quick sit down. If you can't do it in person, don't just call them randomly. Set up a time to talk to the people and see if they can line up as many members of their staff or council as possible... And it's amazing how you can get the vibe of this area.

There's also other items like find out if there's any current violations, get a list of previous violations. See if there's any open permits with the city. If your building doesn't have sprinklers, find out if you're good, if you're grandfathered; what kind of change of use would trigger having to install sprinklers. While we're on that, whether you do your property tours in person, or you have a third party do it, one of the things you definitely want to check is if all of your fire extinguishers are tagged up to date. It's just one of those things that gives you an overall idea of if this landlord is proactive or reactive. If they're four, five years expired, not good. You just know that it was an absentee property manager or landlord. If they're current - awesome. Kudos to that landlord. Hopefully, everything else is in tip top shape as well.

I also want you to reach out to people on the city council, and you want to find out if the council is cohesive, or if they're split. In my opinion, Best Ever listeners, every city council is either divided or they're working together. I've been to city council meetings in numerous different locations where there's a lot of infighting, a lot of passive aggressiveness at the meetings... And these are towns that things are just stagnant and nothing gets done. And you can find this out by either attending a city council meeting in-person, or watching it, if they record it. Look for that subtle, passive-aggressive talk, where they're questioning motions, they're rolling eyes, and overall they're just not having a great time. And then if you look at other really progressive areas where a lot of businesses are coming in, downtowns are being revitalized, go to one of those city council meetings... You'll be amazed, it actually appears as if everybody in the city council is friends with each other, and they're smiling, they're laughing, they're making jokes, there's banter with people in the audience or people at the microphone, and it's just a completely different vibe. And I'm telling you, these are the areas where things are booming.

If you find out that there is a divided city council -- and what I ask in these phone interviews, or meetings, or whatever, if I get a city council person on the phone, or a city manager, I will literally ask them, if the council is divided, if it's two sides, or if they're cohesive. And if they give you an answer of anything less than "Listen, this city council's awesome. We get things done", you need to start diving deeper, digging in, and asking more questions... Because again, a divided city council is just places where things don't get done.

Another thing that I want you to do is whatever town you're buying property in, get onto that local Facebook page, and find the Facebook page that doesn't have a lot of rules, it's the one that people talk freely on... Whether it's under a marketplace ad, or garage sale ad... Whatever town it is, find the one where all of the locals are out there, they're venting, they're having discussions... And it's amazing how you will find out the vibe of that town, you'll find out if crime is rampant, drug use, job losses, you'll find out what restaurants people want to see... If there's a Taco Bell opening, you'll hear people "Oh, no, not another fast food restaurant. I would love to have a breakfast place. This town really needs a coffee shop" and again, it's amazing how much you find out.

But not just get on there... A lot of these pages are private, so you may have to ask for access. And when you do that, if you let them know you're looking at buying property or you've got a deal under contract, they'll usually let you in to those private sites. And once you're in, I want you to interact with residents and say, "I'm looking at buying this strip mall. I'm looking at buying this office building. What's your guys' opinion? What would make it better? Is there a lot of crime in this area? What stores would you guys like to see?" And now you're kind of capturing hearts and minds and you're connecting with people, so that later on, once you do purchase the property and you ask for their help, "Hey, small town in USA, I need a tenant to fill an office vacancy", or "I've got a 4,000 square-foot retail building. Do you guys have anybody that you would recommend, anybody that is looking to open a business in this strip mall or in this office building?" And you'll be amazed at how the locals will already know of you because of that, and they'll try to help you. And if you need more help, ask for help, but give a finder's fee. "A $1,000 finder's fee for somebody that finds me a tenant for this property", and you'll be amazed at how many times that post gets shared.

Another way to get the local vibe is find out what local newspaper is in that area, and read the paper. Read the comments after certain articles. Again, this just helps you understand the area that you're buying your property into. Especially important if we buy a property sight unseen, we definitely need this information.

Another due diligence item that a lot of people probably don't do is contact the local police department. Ask them if there's a lot of crime at this property that you're looking to buy. Ask them what you can do to help them. What I always tell them is "We're going to immediately improve the exterior lighting. Every property we buy, we light up like a Christmas tree", and they're usually very grateful for that. But have that conversation, build that rapport, write down their contact info, so if there ever is a problem, you can know who to reach out to.

One of the things that you can do in lieu of an inspection is a property condition report. There are companies that -- it could be five to $10,000, but they will dissect whatever building you're looking at and they will give you a very in-depth report of all of the mechanicals, exterior, parking lot, signage, any foundation issues, [unintelligible 00:24:35.09] paint, you name it, and it'll be in this property condition report. Get a sample report from this company before you sign that document and agree to pay $5,000 or $10,000, because you want to make sure it's as thorough as you expect.

When it comes to roofs, I would consider calling a local roofing company and paying them to get an estimate. And I almost insist on paying them, because if it's something that they agree to give you an estimate for free, they may drag their feet, they may half-ass the report... But if it's something that you're paying for, they usually do a little bit better job, and they'll find whatever issues that roof has. And you can use that to go back to the seller and retrade the price, or get an allowance at closing.

During this due diligence process, you also have to identify when it's appropriate to bring your lender in, and when they should order the appraisal. Here's why these are important - one, you don't want to bring lenders in too early, because if you show them a lot of deals and have them underwrite it, you don't end up closing on every one of these deals, you've kind of wasted their time. If this happens infrequently - not a problem. They almost would respect you for walking away from certain deals. But you want to make sure that you have a pretty good knowledge that you're going to move forward with closing this deal when you bring the lender in, let them do a preliminary underwriting, they'll let you know that they're good to go, and at some point, they have to order the appraisal, and appraisals could be anywhere from $2,500 and up for commercial properties... And once they order that appraisal, you're on the hook for that cost, whether you close on the property or not.

Best Ever listeners, I've talked a lot more than I anticipated, and there's a lot of materials still to get through, so we'll likely do a part two on due diligence. But if you enjoyed this episode, please share it with somebody that you think can benefit from it. Please follow us, like, subscribe, and have a Best Ever day!

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