Physical due diligence
Physical due diligence is commonly noted as the largest blind spot to real estate investors prior to closing. While sometimes preliminary property condition details are shared with you, other times they are not. Regardless, the onus falls to the purchaser to examine the overall condition, compliance, and long-term suitability of the physical property itself, as well as the site on which it sits. After all, you are most likely buying the property for its long-term cash flow, it is only logical you will want to ensure the investment will be around to pay out.
Your goal is to rule out material defects, identify deferred maintenance, minimize short term capital expenditures and eliminate surprises. So, where do you start?
Bringing in certified consultants offer a professional, unbiased opinions on the current condition.
They will help to estimate future expenditures required to sustain the physical structure, make necessary improvements, and discern if all major mechanics are adhering to code and in good, working order. This may include any or all of the following professionals; a structural engineer, a roofer, an HVAC specialist, etc. In addition to confirming the capital budgets and agreed upon pricing reflects the work required, this also offers an opportunity to verify potential recent capital improvements made to the property, ensuring they were done in a satisfactory manner. These reports will highlight the presence and difference between preventive or predictive maintenance, and deferred maintenance. It is typically accepted any work not required within the first 24 months of acquisition is considered an ownership/operational expense. This may vary from project to project and is in contrast of work required sooner, which are considered deferred maintenance issue and may result in a price adjustment and negotiation.
Title & Survey Reports:
Partially physical, partially legal, an official American Land Title Association (ALTA) survey and a detailed title search are used to rule out any non-conforming issues with the property's current use or encumbrances against the title. The survey report will ensure an updated, accurate survey is on file and adhered to. The title search, subsequent title transfer, and title insurance policy are utilized to confirm and secure a clear title during the transition of ownership. Together these will outline all access rights, setbacks, zoning designations, liens, zoning restrictions, encroachments, and deeds. It will also uncover any potential easements or restrictions, or can even help uncover additional development upside. It is noteworthy, any potential issue or encumbrance placed against the property, or its title, stays with the property itself opposed to the controlling ownership at the time of any potential transgression.
Environmental issues may not be applicable for every real estate deal, but when relevant, they can prove a difficult obstacle to remedy. The vast majority of properties have a small likelihood of possessing historical environmental issues, however, for some property types (Gas Stations, Dry Cleaners, Nail Salons, etc.), that likelihood is drastically increased. When there is a potential history of contamination on a site or its adjacent parcels, a preliminary Environmental Site Assessment (ESA), or Phase I, may either be required or may already be on file. If a reasonable level of risk is determined, a Phase II may be required, at which point site samples are taken, including soil and groundwater testing. Remediation recommendations are made based on these results. This is a vital step prior to taking control of any property as environmental remediation can prove extremely costly and ultimately, challenge the entire feasibility of the acquisition.
Appraisal/Property Condition Report:
An Appraisal and a Property Condition Report (PCR), are third-party reports, often required by a lender to ensure the agreed upon valuation is appropriately supported. The determining factors include the overall physical condition on the property, both the in-place, as well as historical operations of the asset, and overall market fundamentals. These findings can serve as an audit to your own due diligence period as many of the reviewed items should have already been examined. Much like yourself, for a lender to be willing to put forward funds, the physical condition of the property must check out, the financial underwriting must not be deemed overly risky, and the suitability of the site itself must not be encumbered or contaminated.
Perhaps the most obvious portion of due diligence process, the physical due diligence period is as essential as any portion of the entire process as it is truly your time to ensure you are safeguarding your investors capital against foreseeable physical latent defects that will prove costly and affect your returns over your hold period.