What is Due Diligence?

What is Due Diligence?

What is Due Diligence?
Due diligence is the period that starts once the deal is under contract and continues until all inspection contingencies are fulfilled when purchasing a commercial real estate asset. This time frame can range from 15 to 60 days, and these are some of the most common timeframes you’ll see for due diligence in a transaction. In my opinion, the faster, the better. If you want to buy the asset, get in there, complete your inspections, and close the deal—don’t waste time. This is typically better for the seller as well, because it gives them time to cure any defects if that is part of your contract. It also allows them to move on to their secondary offer faster if your contingencies aren’t met.

What Should You Look for in the Due Diligence Period?
Look for everything you can possibly discover. Primarily, you want to identify reasons not to close on the asset you have under contract. You should already love the deal, or you shouldn’t have it under contract in the first place. Your initial underwriting should be solid, so now it’s time to find anything you can that was not known or disclosed by the broker. Some brokers will provide a seller’s disclosure statement outlining any known defects; others may require you to rely on your own inspection teams. Keep in mind that some brokers or sellers may attempt to hide things so that you can’t find them or might miss them. This could include manipulating photos in the offering package, quickly filling vacant units before listing to inflate the rent roll, or covering up damage to hide major issues.

Major Things to Look for and Schedule During the Due Diligence Period:

1. Unit Inspections
   Inspect every single unit—don’t skip any. The one you miss could have all the problems.
2. Plumbing Systems
   Make sure everything is up to code and check for water damage. Older buildings may have plumbing systems that are prone to leaking and could need replacing soon. If you don’t check thoroughly, you could be in for major problems down the road.
3. Electric Systems
   Are you on breakers or fuses? Does the building have old aluminum wiring? If so, good luck getting insurance. And when it comes to insurance, get your quotes during due diligence. If you wait until after, you may not have enough time before closing, or you may find you can’t get insurance at all in today’s market.
4. Exterior Issues
   Look for problems with siding, gutters, and roofs. Drainage issues are common and can cause structural damage, basement leaks, or mold. I am currently working through a property with this issue. It’s not a big deal as long as you’re okay with it. You can ask the seller to fix it, pay for the repairs, or escrow the money for you to do it yourself. They might even reduce the price at closing. Never make it your problem—you don’t own the property yet. If it’s a big enough issue or you can’t justify the purchase without it fixed, walk away. Sometimes, the deals you don’t do are the best decisions you’ll make.
5. Lease Audit
   Now is the time to thoroughly review all lease documents. You want to know the economic vacancy rate, occupancy rate, and who’s on the actual leases. Are they real people? Where do they work? How long have they been there? Sellers or managers often inflate occupancy just before selling, so you’ll want to look for that. Also, verify the income and ensure it matches the rent roll. You can cross-check this with the profit and loss (P&L) statement or the trailing twelve-month (T12) financials, or even tax returns. If things don’t add up, start asking questions.
6. Capital Expenditures (CapEx)
   This is the time to get bids and cost estimates for any improvements or repairs you plan to make. For a well-maintained property, this could be minimal, but if you’re rehabbing the property to increase its value, it could be significant—perhaps even more than your down payment. Know what you’ll need to spend upfront. The due diligence period is when you gather all this information, so you understand the financials when you close.
7. Environmental Inspections
   Don’t buy a property without conducting an environmental inspection unless you know the full history of the land. Even then, it’s best to get one. If an environmental issue arises three years after you close and you didn’t conduct the inspection, guess what? You’re responsible, and you’ll bear all the costs. Issues could include fuel or oil contamination, buried tanks, or contaminated soil. An Environmental Site Assessment (ESA) Phase I should cover you, and if any issues are found, you may need to conduct a Phase II, which includes soil boring samples and further analysis. If there’s an issue, it’s not your problem until you close—but once you do, it becomes your responsibility.

Final Thoughts:
Property due diligence can save you hundreds of thousands or even millions of dollars, and prevent you from facing major headaches down the road. Skipping due diligence could eat into your profits if you miss something important. Third-party management teams can assist, but you should still familiarize yourself with all the key areas and check every box before the due diligence period ends. If it’s your first time, make sure you allocate enough time to learn the process and get all the right crews in place so you don’t miss anything.

A rookie mistake would be nitpicking every small issue (like every scratch on the wall) or highlighting every minor maintenance item. That will annoy sellers and could ruin your chances of closing the deal. Every property needs maintenance, and owning rentals is about keeping them in good shape. Focus on the serious issues that affect value, longevity, or the property’s ability to operate. Deferred maintenance can also indicate a tired landlord or a property management company that needs to be replaced or motivated.

Inspections and due diligence are all out-of-pocket expenses and considered at-risk money. There’s no insurance, title coverage, or income to reimburse you. If the deal doesn’t close, the money is gone. I wouldn’t spend the money unless I was confident in the deal and truly loved it. These expenses can range from tens of thousands to hundreds of thousands of dollars, depending on the asset. Don’t inspect the property before you do your due diligence! Find the deal, love it, underwrite it, and get it under contract. If it’s a good deal, it’s worth investing time and money into the inspections and possibly renegotiating the repairs before closing.

It’s your job to find the problems and identify why not to buy the property. Do your due diligence thoroughly—and don’t skip anything!