What Real Due Diligence Looks Like On Commercial Assets

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Investing in real estate comes in many different shapes and sizes. Most people focus primarily on residential real estate throughout their real estate investing journeys, which include single-family homes, condos, and small multifamily properties. Other investors choose to take the leap into investing in commercial real estate, which can be very intimidating at first.

Over the past few years, I became one of those investors who took the plunge into commercial real estate. My first deal was a 2,000-square-foot medical building, and my second was a much more intimidating 7,000-square-foot office condo unit.

After having bought, rented, and sold both of these properties, my biggest takeaway is that commercial real estate investing is very similar to residential real estate, with one big exception: the due diligence period, which provides a lot of possible ways to mess up.

Pursuing a Commercial Property

The process of buying a commercial property starts with standard market research and financial analysis. Before you even write an offer, consider the location you will be buying. When picking a location, you need to look at demographics, market trends, inventory, and demand.

Unlike residential investing, your options are quite broad when pursuing a commercial property. Property types include:

• Industrial
• Medical
• Multifamily
• Office
• Retail
• Self-storage

There are pros and cons to each of these different asset classes, and deeply understanding your market is critical to ensuring you pick the type of property that meets your budget and risk tolerance. 

In addition, the structure of leases on commercial properties is very different from residential leases. The biggest reason for this is that when buying a commercial property, your tenant will be a business compared to an individual, a couple, or a family.

Making the Offer

Once you identify the area where you want to invest and the type of property you would like to buy, and you find a specific property that meets your expectations, it’s time to make an offer.

Making an offer on a commercial property starts with an LOI (letter of intent). These LOIs are used to negotiate mutually agreeable terms with the buyer and seller, including the purchase price, earnest money deposit, and buyer contingencies. 

Often, the LOI will be passed back and forth several times before both parties agree on terms that meet their expectations. Once both parties agree, the deal is formalized with a purchase contract.

Navigating this phase and the next phase of the process will be more complex than you’re used to. Writing an LOI, submitting an offer, and entering due diligence should all be handled with the direction of a qualified commercial real estate broker and a real estate attorney.

Due Diligence (AKA Feasibility)

Much like a residential transaction, when both parties execute a purchase contract, the title company will open escrow. This starts the clock on your due diligence window, which in commercial transactions is more commonly referred to as your “feasibility” period.

The feasibility period in a commercial real estate transaction is a very important phase where you, the buyer, will conduct in-depth due diligence on the property, tenant, and financials to determine whether the deal meets your investment objectives. This window of time works similarly to your due diligence window on a residential transaction, but it is much more involved.

Your priorities during the feasibility period will include the following.

Inspecting the property

This sounds straightforward, and it is. You need to engage qualified inspectors to thoroughly inspect the subject property. Just like when buying a house, your inspector will inspect the physical condition of the building, look for structural issues, and review the state of the major systems like plumbing, electrical, and HVAC.

Reviewing financial records

The financial records of the property should all be made available to you as soon as you open escrow. This includes tax statements, lease agreements, P&L statements, and a balance sheet. This package should give you a better grasp of the property’s financial picture. 

Some owners aren’t the best at bookkeeping, so there might be some holes in the information provided to you. It will be up to you as the buyer to fill in the gaps and determine if the deal still meets your expectations from a financial standpoint.

Tenant interviews

If there is a tenant (or tenants) in place, ask your broker if it is customary to do a tenant interview in your market. This will help you get a better grasp on how the tenant feels about the building and their lease and whether they will be likely to renew when their lease expires.

Title report

You will receive a title report from the title company, and it is really important to review this report to understand if there are any encumbrances, liens, disputes, CC&Rs, or easements. Any of these items could affect your ownership or future property use.

Obtaining financing

By now, you should already have a few lenders lined up who would be willing to finance this deal. During your feasibility window, though, you will need to provide all of your financial documents to your lender and get final approval on your loan. The last thing you want as the buyer is to be a week away from closing only to have your financing fall apart.

Attorney review

Engage a real estate attorney early to help review all legal documents related to this transaction. They should be looking at the purchase agreement, contracts, lease agreements, and financial statements. Your attorney will ensure your legal interests as a buyer are protected.

Resale consideration

During this feasibility period, you should also consider the property’s potential for resale in the future. Talk with your broker about the market trends, appreciation potential, and factors that might influence the property’s future market value.

Closing on the Deal

Commercial real estate transactions, from start to finish, tend to drag out longer than residential transactions.

In my experience, I was given a 30-day feasibility window (compared to a 10-day due diligence window on my residential transactions), and then I was given 60 days after offer acceptance to close. That gave me plenty of time to complete my due diligence and get my financing in order prior to closing. 

The due diligence window can be overwhelming and make commercial transactions daunting, but it shouldn’t scare you away from doing a commercial deal. If you have some residential experience under your belt and the right team by your side, you’ll find the process to be pretty straightforward.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.