Physical and Legal Conditions
Investigating an income property is a lot like a detective story. You’re never quite sure what you’re seeing is the whole truth, or even relevant to solving the case. We wade through reams of facts in search of bits of information that, when considered as a whole, point to the right conclusion.
In that sense, due diligence for an income property might seem to be a similar task. As we collect mounds of data from our own inquiries, review third-party reports from knowledgeable experts we have to ask ourselves which facts have relevance and which can be disregarded.
In a previous article we discussed financial due diligence, the first of the three categories of due diligence. This article addresses the second category, operational matters pertaining to collecting and analyzing the various issues surrounding the physical and legal standing of the property.
Legal and Physical Information
The deed, title report, and survey, are often combined into one document—the title report. I always order a title report for a property independent of whatever the seller may supply. The reason is simple: It is relatively inexpensive, ordering the report now saves time later, and it provides the deed references for my own investigations.
The title binder (a preliminary commitment to issue a title policy) will reference and copy the deed, and list all known encumbrances on the title to the property. Pay attention to the section noted as “Exceptions”, as those are the matters the title company is not insuring against. It is customary and expected for the report to except matters of zoning, easements of record (listed by recording instrument) and any known encroachments and covenants. But a report that, for example, excludes “all matters of survey” is a major red flag.
The survey is one of the most important documents in real estate. Most sellers will have some sort of survey, but its quality may not be sufficient. Many lenders require a survey drawn to “ALTA” standards. The acronym stands for the American Land Title Association, which developed comprehensive minimum standards in 1999 for the completion of commercial property surveys, and are prepared in conjunction with a title report. Any easements, encroachments or other burdens on title will be shown on an ALTA survey.
I strongly recommend that any buyer obtain a detailed and accurate field survey of the property. Encroachments and other matters of survey can hide potential liability, and the sooner you know about it the better.
Third Party Reports and Inspections
Standard third-party reports required by lenders and owners are the appraisal, environmental, zoning compliance, and building/engineering reports. These reports are usually not ordered until all other due diligence has been examined and accepted. They are prepared at the buyer’s expense, so there is no reason to incur the cost if problems are found in the financial or operational conditions.
The seller may have an existing appraisal and be willing to share it; however don’t be surprised if the answer to a request for a copy is “no”. In most cases the property or the market will have changed in the interim, and the value may not be relevant. If you do get a copy of an old appraisal, it can be of some help in gathering market information and establishing the competitive set for the subject property.
If you are getting a new loan for the property the lender will order a new appraisal, usually from a list of approved firms, with your input. Do not order the appraisal yourself, as this will violate several underwriting regulations.
Phase I Environmental Reports are the minimum standard for most lenders. Based on the findings, a conclusion will be offered as to whether or not any further action is recommended. For a site with suspected contamination, a Phase II report with sampling may be required. A site with confirmed contamination from a prior user, or with an environmental risk identified in a Phase II project, will require a Phase III environmental report, remediation and ongoing monitoring. Once closed, an “NFA” (No Further Action) letter is issued. This is a key document for any site with an environmental problem.
An important note about the use of environmental reports prepared for the previous owner: it offers no evidence of performing adequate due diligence (important when establishing liability) for you as a buyer. The report plainly states that it is for the use of the original parties only and not to be relied upon by others [emphasis added]. That means you will not be able to use the report to establish that you performed proper due diligence to avoid liability for any problems found after closing, even if pre-existing.
There are two solutions to this issue. First, and most obvious, is to commission a new report. Standard Phase 1 fees range from a low of around $1,250 to a high of $2,500. Competition among engineering firms has worked to the owner’s advantage in lowering costs.
If the previous report is available and has a finding of “clean” or “no further action (NFA),” then your attorney (and lender) may approve the use of a less detailed report known as a Transaction Screen. This is a review of the property conditions brought down-to-date from the previous report. A transaction screen usually costs a few hundred dollars and does not have to be completed by the same firm that prepared the original report. Most importantly the transaction screen qualifies as adequate due diligence in any future dispute.
Except in the most severe cases, environmental problems do not spell the automatic death of a deal.
A zoning certification should be obtained from the municipal jurisdiction, usually the planning or zoning office. The current zoning compliance can usually be verified with a phone call to the appropriate office, and it is essential. Do not accept anyone’s statement about zoning compliance. Make the call personally.
Land-use ordinances are the rules of the road in real estate. Without knowledge of how they affect the property you are essentially sitting down to a poker game and asking someone else to tell you what cards you have and how much to bet. Make a point to be familiar with the zoning ordinance for every piece of property to be acquired.
The Building/Engineering Report is the commercial property equivalent of the home inspection, but not required by all lenders. The inspector will test the systems in the property, evaluate the structural components and note any deferred maintenance or deficiencies. Depending on the property type, additional inspections may be required for HVAC systems, Fire Suppression Systems, Elevators, Boilers, and any required health permit.
If you’re not familiar with building systems, you will want to commission an independent inspection. Many HVAC contractors will conduct an inspection and give a written report for a nominal fee. It doesn’t take but one blown HVAC compressor to eat up an entire year’s capital improvement budget.
Leave No Stones Unturned
Investors should be wary of thinking that by hiring professionals the full extent of property condition is known. The pros are human too, and mistakes are made by the most experienced veterans, including this author.
A couple of years ago we had an office building under contract for which we had completed all the above inspections, accepted the property, and set the closing date. One evening I had to meet the surveyor to get a corner remarked. It was the first time I had been on the property after business hours, and as I walked through the parking lot I was astounded to see a huge pothole in the pavement that everyone had missed.
How could that happen?
Simple really, and patently obvious; during business hours the lot was full, and the cars hid the pothole. Which goes to show we’ll never get it perfect.