Buyers: Do your Due Diligence
Commercial property transactions are much more complicated than residential ones and require a great deal more due diligence than a residential transaction. Both require inspections of the structures, mechanical systems and surveys, but commercial properties also require environmental, municipal and tenancy research and knowledge. Some of this can be quite involved and it is important to work with professionals that have a solid understanding of the pitfalls and consequences of different scenarios and can guide a buyer successfully through the process. Below is a brief summary of some issues to help you better understand potential problems that can be avoided.
Municipalities can have numerous requirements for a developing or using a property that can be very costly. A property that seems like a good value might not be as good once you factor in some of these hidden costs. I am working on one property right now that is a vacant development property. Through discussions with the township and Michigan Department of Transportation (MDOT), it has been determined that depending on how much traffic the site generates, MDOT may require a turn line to be installed on the highway. This could cost anywhere from $200,000-$500,000 for the new owner to absorb. Another property I was involved with was being evaluated by a restaurant that was looking for a location. By checking with the Department of Public works, we determined that an additional 20 water and sewer benefits were going to need to be purchased, in order to turn the property into a 200 seat restaurant. This was going to result in a cost of over $100,000 to the buyer, that he was not aware of previously.
Site work & environmental studies are extremely important for development property. They can uncover the potential for tens or hundreds of thousands of dollars of work that may need to be completed. Geotechnical site work on another property I was involved with showed that the earth on a site was too soft to support a building. The site was going to require $30,000 worth of fill in order to make it stable enough for a new building. The environmental studies showed levels of arsenic from old farming operations that had to either be removed or blended with other soils to lower the concentration before building could commence. Another site had contamination from previous use as an industrial site. There was a cleanup that cost hundreds of thousands of dollars, but the buyer was able to procure Brownfield funds that covered the cost of the clean up and some site work. By knowing what to look for, and how to resolve the issues, the buyer was protected from future unknown liability and decreased their development costs.
Even an investor buying a leased property with no contamination in a new building and no structural issues or permits needed, has a number of due diligence items that should be researched. Two of these involve researching the market rent for the property and researching the strength of the tenant. A ten year lease at a high rate is only good if the tenant will still be in business in 10 years. If the tenant is not credit rated, and the tenant leaves, it is important to know you can lease the space to a new tenant for the same rent. Rents are often increased to cover the cost of the tenant’s build out. If a new tenant is needed, either the rent will decrease or a new build out may be required.
Another issue is a property may have low lease rates for current tenants and a higher asking rate on vacant space. Find out if the higher rate is really the current market, or vacancy may increase if rates start rising in the building. Also, some tenants, such as non-profits, may show that are paying market value for their rent, but they are getting donations from the landlord to offset their rent. If financing is coming from the existing landlord, they may not be able to afford the space if the landlord stops making a donation after he sells the building.
These are just a few of the issues I have run into over the past couple years. Each purchase is different and depending on the use, there is a complete set of due diligence that should be done. Make sure that you work with surveyors, environmental companies, lawyers, and real estate professionals that know all the parts of this process before you buy a property and then you can be sure that you are not in for any hidden surprises.