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Due Diligence: Physical & Legal Conditions

by Ray Alcorn   

Investigating an income property is a lot like a detective story. You're never quite sure if 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.

Part 1 of this series discussed Financial due diligence, Part 2 covered Operations. This article addresses the third category, the legal standing and physical condition 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 whether the seller supplies an existing title policy. It is relatively inexpensive and it provides an update for the existing report.

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 called "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. The gold standard is a survey drawn to "ALTA" standards. The acronym stands for the American Land Title Association. An ALTA survey is prepared in conjunction with a title report and shows any easements, encroachments, or other burdens on title.

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.

Phase I Environmental Reports are the minimum standard for most lenders. Based on the findings, a conclusion will indicate 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 issue.

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. First 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 works to the owner's advantage.

If the previous report is available and has a finding of "clean" or "no further action (NFA)," then get 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.

Get a zoning certification from the planning office of the appropriate jurisdiction. The current zoning compliance can usually be verified with a phone call--and it is essential. Do not accept anyone'’s opinion or belief about zoning compliance. Make the call personally.

Also read the zoning district regulations, usually online. 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.

Look for maximum density requirements, development standards, and other information that may indicate the property can be expanded or eligible for a change of use.

The Building/Engineering Report is the commercial property equivalent of the home inspection. The inspector will test the property systems, evaluate structural components, and note any deferred maintenance. Depending on the property type, additional inspections may be required for HVAC systems, Fire Suppression Systems, Elevators, Boilers, health permits or other licensing.

If you're not familiar with building systems, you'll 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

Don't think that by hiring professionals, the full extent of property condition is known. The pros are human, too, and even the most experienced veterans make mistakes, 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 astonished to see a huge pothole in the pavement that everyone had missed.

How could that happen?

Simple. During business hours the lot was full, and the cars hid the pothole. Which just goes to show we'll never get it perfect.

About the Author:

ray alcornRay Alcorn is the CEO of Park Commercial Real Estate Inc., a real estate acquisition and development firm headquartered in Blacksburg, Virginia. In a career spanning three decades, through all types of economic conditions, he has been involved with the acquisition, sale, development, financing, and leasing of commercial property transactions valued over $250,000,000.

Ray is a renowned expert in commercial real estate with experience in apartments, office buildings, shopping centers, mobile home parks and hotels.

Ray generously shares his wealth of knowledge and experience in dozens of articles about commercial real estate.

Ray is the author of The Dealmakers Guide to Commercial Real Estate, THE definitive work on commercial real estate investing.

His book provides real-world information written by a true dealmaker, including how to identify opportunities, determine value, and how to structure deals for maximum returns. It is an invaluable resource for creating and building wealth in commercial properties of all types.

 
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