Due Diligence: the key to a successful development?
By Zackary M. Flynn, Vice President, M&T Bank

A lender will take a somewhat different approach to some of these issues. A lender will be more concerned about confirming the value and understanding potential credit risks associated with the project and the principals. Those differences are outside the scope of this article, as are some issues unique to lenders, such as regulatory considerations and background investigations on the borrower and its principals. The investor’s staff, appraisers, engineers, counsel and other real estate advisors will handle most of the issues during the “due diligence.”  

Due diligence typically serves several purposes depending on the circumstances and the timing. It will affect the investor’s initial decision on whether to enter into a contract to acquire or develop a project. Later, it will affect whether the investor decides to proceed with the transaction on the terms negotiated, tries to renegotiate those pre-agreed terms or that the project is not worthy of further pursuit.  

During due diligence matters are identified that require representations or indemnities from the seller. Further possible breaches of those representations and warranties are also identified. Finally, it will help the investor control the pre-closing costs and obtain information the investor may need to manage the property post-closing.  

In developing any due diligence plan for an acquisition or financing, the investor will identify the categories of relevant information, and then set priorities. This article will attempt to identify the usual and not so usual categories and elements of due diligence for commercial real estate.  

In each case, the investor’s overall goal is to understand, value, and quantify any risks and opportunities relating to the project. To the extent that any particular due diligence will substantially assist the investor achieve one of these goals, the investor should emphasize that part of the process. Conversely, to the extent that the results of a particular exercise cannot materially help the investor understand, value, and define the risks of the project, then this particular stage of the due diligence becomes inefficient.  

A lender will take a somewhat different approach to some of these issues. A lender will be more concerned about confirming the value and understanding potential credit risks associated with the project and the principals. Those differences are outside the scope of this article, as are some issues unique to lenders, such as regulatory considerations and background investigations on the borrower and its principals.  

The investor’s staff, appraisers, engineers, counsel and other real estate advisors will handle most of the issues during the due diligence. Defining and coordinating those responsibilities early in the process can be just as important as defining the scope of the work to be conducted. The investor will need to manage and supervise its team so that they can collect organize, exchange, and understand the information in a timely and efficient manner.  

Typically, the investor will not undertake an extensive due diligence until the basic deal terms have been addressed and the investor has sufficient control to assure that if his diligence determines the project to be feasible, that he is properly positioned to complete the acquisition. The scope and nature of the due diligence will be reliant upon how the investor negotiates the business and financial terms of the larger transaction. The information obtained through due diligence will in turn affect the same negotiations, as well as the closing process. Thus, the investor must treat due diligence, and the process of defining its scope, as a dynamic and essential part of the larger transaction.  

Expectations and practices will vary with the circumstances, including price, risk tolerance, financial structure, participants reputation and the type of property. Due diligence for a fully tenanted office or retail project will vary greatly from due diligence for a vacant parcel of land or a development project. Residential, commercial, office, industrial, and hotel properties each raise their own issues.

I. Governmental and Developmental Issues  

Depending on the nature and location of the project, the investor’s plans for the project, and the governmental climate, the investor may investigate issues relating to local municipal issues and concerns and the requirements to obtain governmental approvals. A transaction may require approvals under laws governing such matters as density, onsite location of improvements, appearance, usage or operating matters generally. These will vary widely depending on the existing and intended use of the property.  

An investigation into the requirements for licenses and permits should be conducted.  

Issues regarding the transferability of licenses for liquor or healthcare facilities should also be researched.  

II. Legal Issues  

A zoning analysis, including compliance, appeal rights, and availability of unused development rights should be conducted. Any restrictions regarding the transferability of these rights should be addressed. At the outset, the investor will want to have its counsel receive and review copies of any legal related items. These items should include leases, service contracts, estoppel certificates, management contracts, utility agreements and deed restrictions. The level of review will vary depending on whether the contracts are cancelable, require termination payments, or are particularly important, unusual, or hard to replace. The investor will want to review leases to determine the amount of space they cover, their expiration and option terms, if any.  

III. Leases and Public Records Issues  

Because the value of commercial real estate is so dependant upon the actual and potential rental income of a project, and because leases often conceal a great deal of information, one must fully investigate the leases. Of extreme importance is a review of the rent roll for the project which should include a spreadsheet showing all tenants, rents, escalations, commencement dates/expiration dates, option terms, security deposits, and current tenant status. The status of security deposits, including their form, accessibility to them and their location are all items that should be investigated. The seller’s standard form of lease, including all exhibits should be thoroughly reviewed. Public records and other sources will also provide a great deal of critical information about the project. The investor or its counsel will want to review certificates of occupancy covering the entire building, any liens, judgements or bankruptcies (both for seller and major tenants). The survey should be reviewed for comparison against the appraisal, contract and deed description and the property title to see how the anticipated future use will affect the development of the project. A determination on any outstanding commission obligations for any leases previously signed should be made. Although estoppel certificates are primarily a closing issue, the investor’s due diligence may help identify timing problems with obtaining the estoppels and any terms of tenants’ leases that relate to or limit the delivery of estoppel certificates, particularly important when dealing with government occupied projects.  

IV. Financial Issues  

To fully understand the financial strength of the project, the investor should also review the appraisal, an audit of the operating expenses, any future payments of brokerage commissions due for existing leases in place, the operating budget for the current year and the seller’s budget for capital projects, as well as property financial statements for at least the last several years. Additionally, an analysis of future insurance coverage requirements, sales reports from percentage rent tenants, seller’s tax returns and underlying schedules for a comparison against their financial statements and an analysis of the financial condition of major tenants (and non-credit tenants) should be analyzed.  

V. Site Issues  

When contemplating the acquisition or development of a project, an investor should retain the services of an engineer or other qualified consultants to examine the physical condition of the property, including compliance with building, fire, zoning codes (including Americans with Disabilities Act), parking, environmental requirements and fire safety systems. Engineering issues will include the physical structure and major systems of the building, their age and the condition of the building systems and other components.  

An environmental assessment and asbestos analysis, including a “Phase I” report is a requisite during this process. The physical inspection, along with a review of the “as-built” plans and specifications should also determine the actual usable and rentable size of any existing structures at the project.  

VI. Tax Issues  

With any real estate transaction, an investor must also give careful consideration to a wide range of tax consequences. Tax issues are likely to address the status of any real estate tax appeals and any builtin increases in real estate taxes. A review of the actual real estate tax bills for the project for the last three years should be conducted.  

In certain jurisdictions, the availability of any tax abatement or incentive programs should also be investigated and verified.   Other areas that might warrant a review may include management files for possible claims or disputes, any plans for the transition of management and the possible retention of building management team and/ or selected employees.  

If the investor initiates the “due diligence” process utilizing the approach as detailed herein and tailors his approach to reflect the unique circumstances and issues that are important to that particular project, he should be able to foresee and prevent any potential long-term adverse consequences. When the “due diligence” process has a strong foundation and is implemented properly, the investor can focus on the broader issue of creating value in the project in ways that the seller and other investors may have overlooked. By doing so, the investor will create an aesthetically pleasing, functionally feasible and economically efficient project.  

Mr. Flynn, the Vice President of M&T Bank’s Commercial Real Estate Group, has been involved in the finance and development of commercial real estate since 1984, in Central PA since 1992. He holds a B.S. in Business Administration, concentration in Real Estate from Clarion University of Pennsylvania. He can be reached at 717 231-2657 or by e-mail at zflynn@mandtbank.com.

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