By Alfred Erdmann
Even in a “buyer’s market,” potential investors must be cautious when looking to purchase real estate. While there may be great investment opportunities available, there can be hidden dangers that drive the cost of owning real estate past the point of profitability.
This article discusses some key steps in the due diligence process to help protect yourself from the pitfalls inherent in real estate investing.
The natural first step in selecting a property is choosing the type and location of property in which you are interested.
This is a big step, and one that an experienced broker can help you accomplish. The right broker will have his/her finger on the pulse of the neighborhood and can advise you as to economic and social trends of the market.
Countless hours will likely be expended in visiting various potential sites. When viewing possible sites, pay attention to the physical condition of the property. What repairs, improvements, or upgrades might be necessary in the near future? Once you want to seriously consider a property, a formal engineering inspection should be performed on the property by a professional inspector.
With the property selected, you’ll want to review the financial information provided by the buyer.
The information should include historical financial statements, schedule of improvements, capital budgets and operating budgets.
Of course, the seller wants to present the property in the best possible light, so this information must be scrutinized and compared to other verifiable data.
If possible, obtain signed copies of tax returns for the past several years and compare the figures in the financial statements to what was reported in the returns.
Perhaps the single most important part of the due diligence process is the review of existing leases. Lease review goes well beyond comparing the base rents to the provided budgets. One should read the leases for renewal options and options to cancel, among other items.
When evaluating renewal options, consider whether the rents during the renewal term are fixed or at market (or percentage thereof).
With fixed rents, a comparison to projected market conditions during the renewal term should be made to determine the likelihood of the tenant exercising the option.
Some leases also contain cancellation options. Typically, such options come with penalty clauses, but with economic conditions such as they are now, the penalty may be less than the savings obtainable by terminating the lease. Clearly, this would have a negative effect on the property’s future cash flow.
In addition to leases, helpful information can often be found in tenant correspondence files. These files can offer insight into the relationships that exist between the landlord and the tenant, and about potential problems that have been encountered.
Examples include inability to pay rents timely, chronic or recurring mechanical issues with building systems, and intentions to renew, expand, contract, etc.
Assuming you have cleared these hurdles and you are willing to continue this arduous journey, there are two more key steps in evaluating leases.
The first is credit checks on tenants. It is vitally important to verify the credit worthiness of existing tenants. A lease with a tenant that cannot pay the rent is not worth the paper it’s written on.
The other key step is obtaining estoppel certificates from existing tenants. Matters to be addressed in the certificates include whether the lease has been assigned or amended, whether the landlord has complied with all requirements, whether there are any existing claims against the landlord, and whether any security deposit exists.
Most leases require that tenants provide such letters on request and in a relatively short period of time.
Of course, there are potential dangers that cannot be found in any lease or financial statement.
It is important to have an environmental Phase 1 study performed not only on the prospective property, but also adjacent properties. While the property you are looking at may be presently “clean,” contaminants can seep in from neighboring properties in the future. You want to review the zoning laws to ensure the property is within the law, but also to understand the options the property offers for expansion, conversion, etc.
It is possible that the property is not configured for its “best use.”
Inquire about any known plans for neighboring properties. Will a high-rise building be constructed on an empty lot that will obstruct your tenants’ views? Will a current property be converted into a direct competitor?
Finally, an important step in the due diligence process is to check local government records, often available online, for any building violations or liens.
This process may seem daunting, but it can be made easier if you have the right professionals to assist you. Real estate remains a solid investment choice, but only at the right price.
A thorough due diligence process is essential in determining that price.
Alfred Erdmann, CPA, is a partner at EisnerLubin LLP.