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There is an overlooked art to due diligence in commercial real estate

Commentary

By OWEN ROUSE JR., Dolan Media Newswires

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Title and survey? Check.

Environmental report? Check. Reconciled operating statements, 12 months trailing? Check. Rent roll, certified by the seller? Check.

All of these items and many others are part of necessary due diligence associated with buying a property. Much of the drill is scripted and overseen by the legal talent on either side of transaction, with other activities performed by the buying entity in cooperation with the seller.

This exercise often involves (or at least should involve) an organized checklist with assigned responsibilities and deadlines for performance. Many legal documents required by the transaction may be driven by state law, local convention or accepted practices and are somewhat perfunctory.

With such organization by professionals, operating over a reasonable period of time, it is difficult to understand how some critical issues are missed during the due-diligence exercise which can lead to unpleasant outcome for real estate owners. Here are some suggestions for turning the science of due diligence into an art.

• Conduct tenant interviews in person. Conducting tenant interviews is a molecular-level exercise. What do those who pay rent think of their space, the owner and the management of the property?

Sit down face to face, not over the phone, and engage the principal (if possible) or the most senior person available. Encourage them to open up about what’s right and what’s wrong with their occupancy.

Many times the tenant will reveal the clue to their inner happiness or give a heads up to problems lurking around the corner that a new owner may want to address.

And don’t exclude a tenant from your interview list because they are too small or never seem to be around. Usually one of the tenants perceives themselves as the “mayor” of the property and acts accordingly. Don’t be surprised if it’s the smallest tenant. Taking the time to identify tenant concerns in advance ultimately will benefit you as the new owner.

• Visit the property with the consultants. You’ve hired an engineering firm to inspect the property and write a report on the physical condition of the property. Meet them on site to see who they are sending and have them walk you through their scope of work.

Follow them around and ask questions as they make their rounds. Visit vacant offices, vacant apartment units and the back of vacant retail bays. By delving deeper into an understanding of their observations in advance of their findings, a potential owner won’t be caught off guard on the results and can speak more clearly in any discussions related to their reports.

• Read, read, read. Read your leases, not just the abstracts. Foot the lease payments to the rent roll. Read the service contracts, not just the abstracts. Foot the costs to the budget or a ledger. Don’t assume that the abstract caught the relevant points of a document or that the translational arithmetic is correct. Double-check other people’s multiplication.

As fundamental as it sounds, issues such as cancellation rights, rights of first refusal or obscure landlord obligations can be embedded in a paragraph that otherwise would go unnoticed save for the diligence of the reader and have profound consequences if inherited unprepared.

• Visit the neighbors. Canvas the immediate neighborhood area of the property and speak with the merchants, neighbors etc. What do you hope to find? You’ll know it when you see or hear it.

Perhaps a traffic nightmare appears at certain times of the day. Perhaps another merchant is leaving and a less desirable one is scheduled to move in. Maybe a neighbor receives deliveries one day a week that impedes traffic. Maybe the property was built on an old cemetery! Take the time to find out. The insight you will gather will prove to be invaluable.

At the end of the day, successful investing begins with a foundation of well-researched risks, identified areas of concern and solutions to potential problems in advance of their occurrence.

Editor’s note: Rouse is senior vice president, director of capital markets at Manekin LLC in Columbia, Md. This article first appeared in The (Baltimore) Daily Record, which The Dolan Company also owns.

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