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Due Diligence and Risk Assessment – Real estate investment property

March 25, 2022 General

In acquiring an income producing property, it is important to understand what risks are associated with the investment before you close.  Experienced buyers typically conduct their own due diligence in order to identify and assess the risks involved, typically within a negotiated “due diligence period”, which often gives the buyers the right to terminate the contract without a penalty if they are not satisfied with the result of the investigations.  The appropriate scope of any due diligence depends upon the specific property, but it would typically include physical inspections of all structural components of the existing  improvements on the property, with particular attention to the items that can be costly to repair or replace, such as the mechanicals, roofing, septic, etc., as well as determining the feasibility and cost of any contemplated renovations. 

It is important to note that any application for a new building permit can generate a review of all existing code compliance issues, including those which are not related to the contemplated work.  Primary examples of these include ADA compliance and the discovery of prior work which was not completed with a proper permit.  These are issues that should be researched prior to closing to the extent possible.  Discussions with municipal planning and zoning staff may also be appropriate to determine if any proposed renovations or a proposed change in use of the property will require any local or state approvals. 

Most would agree that researching a property’s environmental history and status is one of the most important investigations a buyer can do, as environmental issues can seriously impact the value, financing, use and marketability of a property.  More importantly, environmental remediation expenses are often quite significant, and taking on clean-up responsibility can create long-term liability.  If there is any history of environmental issues, or if the existing or prior uses of the property could create environmental risks, hiring a licensed environmental professional (LEP) to investigate and identify the status is critical.  

If the property is to remain partially or fully occupied after the closing, a careful review of any and all leases is essential, focusing particularly upon the duration of the remaining lease term(s), scheduled rent adjustments, landlord responsibilities with regard to issues such as maintenance, repairs, property taxes, and insurance.  Each tenant’s payment history and copies of any personal guaranty for each lease are also important.  Upon request, most sellers will provide copies of recent income and expense reports for a property it seeks to sell, and it is usually best to include a contract provision which requires that the information be supplied.  This can help identify any issues which are inconsistent with a buyer’s expectations, such as an unreliable stream of income, or maintenance or utility costs which are disproportionate to market rates for these items. 

The due diligence period should also be used to begin pursuing any financing you may need for the acquisition, even if you have a separate financing contingency which would give you extra time to secure financing.  If a buyer is not seeking financing, it is incumbent upon them to use the due diligence period to perform its own evaluation as to the financial risks associated with the property, which typically includes consideration of the credit risks associated with each tenant, potential losses due to vacancies, market changes, and other factors.  In most situations, it is also advisable to have your attorney order a title search during the due diligence period, and to discuss with your counsel and whether or not a survey is required and/or advisable.  It is also prudent to contact your insurance agent to determine if there are any particular underwriting issues in connection with insuring the property.  While each transaction is unique, these basic investigations will be worth the effort in most situations.   An experienced attorney can help you identify any other issues to research with regard to any property you wish to consider. While a lengthy due diligence checklist can seem daunting, engaging an attorney at the outset can help keep the process on track, allowing you to focus on analyzing the information to determine if the investment is right for you.