Pitfalls of the Due Diligence Period.

For new real estate investors, your first investment is sort of like being a Chicago Cubs fan. You're committing to something that you think is a winner but if you're not careful there will be alot of disappointments in your future and it may take 108 years before you come out on top...

So you've found that ideal investment property, ran the numbers and decided to make an offer. Not so fast - there are some things you need to take into consideration based on the properties unique attributes that you might want to include as constraints of the offer.

Inspections:

When you are analyizing a financial investment such as a mutual fund, you're given a prospectus that describes the risks involved so that you can make an informed decision on whether to proceed with the investment and/or how much to invest. Just like a prospectus, an inspection report describes the risks involved with the physical property you are about to acquire. Having an inspection performed by a qualified commercial inspector is critical to assessing the state of your prospective investment. The inspection report will list any defects or deferred maintenance on the property such as outdated HVAC units, crumbling flatwork or an impaired roof. The older your property, the greater the need for an inspection. A 40+ year old property, for example, may require electrical upgrades. The results of these inspections and how you handle them are the critical path during your due diligence phase. You might choose to renegotiate part of the contract or expand on your financial projecttions to consider additional maintenance costs not originally considered before. You may need to call in additional inspectors for roof, plumbing or environmental.

My first commercial property was an 8-unit office/warehouse space with separate HVAC units for each suite. The property was an older property (over 30-years old) and the HVAC condensers were still original quality. I was able to go back to the seller and renogotiate the purchase price to include an allowance for condensers that should have been replaced at least twice in their lifetimes. This enabled me to set aside additional funds for the first few years to cover replacement if any of the units malfunctioned.

My second property was also an older building that had been remodeled. It originated as a Kentucky Fried Chicken restaurant and had been remodeled as a retail duplex. As I indicated earlier, Electrical and plumbing can easily be areas of concern on a property of this age. In fact, my insurance carrier for this property required evidence that these components of the building had been updated and brought up to code. A standard real estate inspector will cover a broad cross-section of a buildings components but typically will not go into detail in any one area. Working with my inspector, we brought in a Master grade plumber and electrician who were able to validate the systems as per my carrier's requirements. Knowing this now, I recommend that you check with your regular inspectors to find out whether they have a team of sub-specialty inspectors available should the need arise.

Environmental:

Before the acquision of my second property, I bid on a single tenant automotive facility which fell through in the end. Having grown up in a family that owned a Body Shop, I knew there could be environmental issues with automotive paint waste. Assuming you have a realtor worth their weight in gold, they can recommend inspectors who will evaluate the environmental conditions on a property. These reports come in two stages: a Phase I analsyis reviews the historical uses and ownerships of the subject property along with any reported environmental infractions within a certain radius of the subject property. A site visit is conducted to perform a visual inspection and note any potential concerns. This report also outlines any recommendations such as the need for a more complex Phase II analysis, or recommended corrective actions. A Phase II analysis goes into much greater detail focusing on specific conditions and advanced testing.

In my specific case, I paid for a Phase I analysis which confirmed my suspicion that twelve 55-gallon barrels of paint waste were leaking into the open ground. The inspection report recommended to remove the 12 barrels of waste and conduct a more advanced Phase II report with soil samples. What I've come to really like about commercial deals over residential deals (at least in Texas anyway) are how you can terminate a contract for any reason up to a certain date without much penalty or with a very insignificant amount of earnest money at stake. My earnest money in this case was an insignificant $100 for example. In my original offer, I attempted to include a contingency for the seller to pay for the Phase II inspection if the Phase I recommended it, but he wouldn't accept it. Normally, this would have been a red flag for me but the seller was the owner's brother who was terminally ill therefore he wasn't aware of the property conditions. I attempted to further negotiate with the seller to remove the waste prior to a Phase II inspection and assume responsibility for the results however the seller wouldn't budge stating it was the tenant's responsibility. This allowed me to back out of the deal with minimal costs incurred (I lost my $100 earnest money). Had I moved forward with the closing, I might have been stuck with a hefty environmental cleanup on my hands and possibly incur fines. With a copy of the Phase I in hand now, the seller was required to disclose this information so in a sense I felt justice had been served in the end.

Warranty Deeds and Title Insurance:

As my closing date for my second property was fast approaching, my realtor stayed on me to ensure I had reviewed all the Warranty Deeds and Title Insurance documents accordingly. During this review, I noticed several items that were concerning. First, the Warranty Deed carried with it a list of exceptions in a section titled "Reservations from and Exceptions to Conveyance". If you are just starting out in acquiring real estate, particularly Commercial properties, it would behoove you to understand exactly what all these documents mean that we normally take for granted at closing. The Warranty Deed is a guarantee that the deed to the property is free and clear. Sometimes they carry exceptions or restrictions with them, also known as restrictive covenants. For example the property may be part of a larger development (think homeowner's association restrictive covenenants) and there are limitations on what type of business can occupy the space. My particular property sits on the corner of what used to be a Safeway grocery store and to protect their image and brand, there are restrictions against liquor stores, bowling alleys, other grocery stores, and drive-in curb service eating establishments. As the property changed hands later, Kentucky Fried Chicken added in restrictions against any food service establishments serving chicken, pizza or Mexican food for 20-years (Tricon Global, now YUM! Brands owns KFC, Taco Bell, and Pizza Hut chains throughout the US). All of a sudden, my tenant list begins shrinking smaller and smaller really limiting who I can rent to. Fortunately, some of these Special Warranty Deed restrictions will expire cooinciding with the lease exprirations of my current tenants. This is a great example though of how you must know and understand all aspects of the property under consideration and how they are interrelated.

Another area of real estate we often take for granted are Mineral Rights. One would normally expect the property's mineral rights to transfer with the property. A Special Warranty Deed may accompany the property however in which those mineral rights were transferred to a third party along the way. There may not be much you can do to retain those mineral rights, but it helps to understand and avoid costly disputes later on down the line. The seller of this particular property owns 80+ rental properties and was obviously very experienced in these matters. This particular property sits on a popular Shale formation so the owner transferred the mineral rights to himself and retained the property in his LLC. He was able to subsequently sign a gas lease with a well known natural gas corporation thus creating an additional revenue stream from the property. He now retains those rights and revenue streams even after our deal has been consumated.

Leases, Estoppels and the Closing Statement:

Any discussion on pitfalls wouldn't be complete without a warning on Leases, Estoppels and reviewing the Closing Statement. During the due diligence phase of this newest property, I naturally reviewed each of the leases and the estoppels. During the acquisition of my first property, the lease review was straight forward - the tenants were responsible to me for their rent only. With this newest property however, the leases are Triple Net (NNN) and I had to educate my self quickly on the details of how NNN works. In my specific case, the tenants have a base rent that remains static for 5-years and a monthly Common Area Maintenance (CAM) charge that varies from year to year. This charge is made up of all utilities covered by the Landlord, maintenance fees such as landscaping, property management fees, Insurance and Property Taxes. Trying to understand how the previous owner calculated CAM was complicated by the fact that one of my tenants actually pays the electrical for the entire building and I'm responsible for seeking reimbursement from the other tenants. The CAM charge is really just an estimated amount then there is a reconciliation process that I have to go through at the end of year. Since I closed on the property in August and the owner had collected Property Taxes from the tenants for 8 months prior, it was important that the closing statement reflected the credit back to me for those 8 months. Unfortunately I wasn't aware of this arrangement and my realtor missed it. When the taxes came around a few months later, I was fortunatel enough for the statement to go to the previous owner who forwarded it to me. This opened up the door for me to ask him for reimbursement of the taxes at that time. Again - as an experienced investor himself he had been through this before and quickly reimbursed me for the appropriate amount. This could have turned out disasterous for me however to the tune of $4,500. Also during the review of the closing statement, I noticed the title company failed to take into consideration the CAM amounts and only prorated the rent amount. The day of closing I had to go back to the title company for a final adjustment.

Final Thoughts

As I reflect on the above, one thing that stands out as a common theme is the importance of relationships and building your team. You must ensure you have a solid team of professionals in place from your Realtor, Lendor and Title Company to the Inspector and Insurance broker. I built the initial relationships during my first closing but by using the same professionals on my second property, they were willing to assist when issues arose. These individuals go through the same exact scenarios every day of their professional life and they are there to help you solve problems and get the information you need to make a decisions. Those decisions though are ultimately up to you.