Due Diligence is a legal contract term which affords the buyer to inspect a property and run appropriate financial modeling to determine if a transaction is worth the price being paid.
When purchasing really expensive assets there is a lot of things that are unknown to the buyer while the buyer is still prospective. The seller doesn’t disclose everything about the thing she is selling. In popular parlance, people sell you all the beautiful things about what you are purchasing but the due diligence shows all the “warts” about a project.
If you’re lucky, what you buy is what you get and everything is sunshine and rainbows. If not, the due diligence period gives you time to evaluate a transaction and get out of the contract.
Let’s talk about contracts.
Contracts are agreements between individuals to do something in exchange for something. You may remember the playground in grade school where promises were made and broken? In the real world, contracts are enforced by a higher power, the government. The government’s purpose among other purposes is to enforce contracts between private individuals. There’s no “oops, sorry” moments in contracts in business. You make a promise, you break a promise, you can be compelled to fulfill the promise by the government.
This act of being compelled to fulfill a promise is called “Specific Performance”.
So if you enter into a contract without a due diligence clause you can, in theory, be compelled to buy it even if you find out things about it along the way to the closing table which you did not know and which change the value of the property (lower).
Because as humans, we aren’t clairvoyant, we build escape hatches into contracts to exit on the way to the closing table, often but not always, without losing money.
Types of Due Diligence Periods.
A contract is a negotiation and you can ask for whatever timeframe you want to complete your due diligence regarding a property. You can and should also specifically list out what kinds of due diligence you will be doing. There are four main types of due diligence:
Financial – Under the financial due diligence category we find a professional appraisal of the property. As entrepreneurs we know our business but we may not know everything about market rates for properties we are purchasing to run our business. A professional appraisal fills in the gaps with a third party. Commercial property appraisals cost more than residential but are well worth the money when it comes to valuing property types that are unique to the market. Financial due diligence with commercial properties also covers what the renter contracts terms and conditions are. The rent roles and the history of payments by renters. The interest rate the buyer can be expected to pay when obtaining a loan.
Physical – The physical part of due diligence is an inspection of what you are physically purchasing. This is done by assessors who double check the property boundaries. There’s also an inspection called a PCA in the industry. PCA stands for Property Condition Assessment and is a very in-depth inspection of property which goes so far as to explain the expected life of the mechanical features of a property and the costs to replace them. They are very helpful in showing depreciated assets and deferred maintenance. A good example of this would be an HVAC system that is 29 years old. If the service life of a HVAC unit is 30 years, the value of the unit is 1/30th of what a new replacement unit would cost. These hidden costs aren’t captured in an appraisal. They are, however, very real costs and affect the underlying value of an asset.
Economic – As an economics major, this is my favorite due diligence. The concept is if any of the things we find in our due diligence period don’t add up to our making money, or better yet, making enough money on this deal to make the risk worth it, then we are out with no harm or foul. It’s a get out of jail free card.
Environmental – You’re on an environmental website so you knew this was coming. Environmental due diligence allows you the appropriate amount of time to make sure there’s nothing going on in the soil or groundwater which started either on the property or on a neighboring property. Environmental contamination is often very expensive to remedy. In addition, the contamination comes with the property. You are in effect potentially purchasing an environmental nightmare but nobody can see underground, you need a consultant to tell you if there’s an environmental risk you are taking by purchasing the property. In effect, environmental risk is financial risk coming at you from a different direction.
How environmental consultants protect you from environmental risk.
The Phase 1 Environmental Site Assessment is the industry standard product that protects commercial real estate buyer from environmental risk. This is, as it sounds like, a preliminary report which consultants in the environmental industry perform inside the due diligence period before you sign for a loan and purchase the property. All of your due diligence needs to be run concurrently to fit inside the typical 30 days between signing a contract to purchase and being at the closing table.
I can tell you from the personal experience of doing one thousand projects last year, don’t wait when commissioning your environmental consultant. People call us all the time at the last minute. We’re awfully fast doing what we need to do to get projects done compared to our industry. Our fastest turnaround is 5 business days, our normal turn is 10 business days. But if we find Recognized Environmental Concerns (REC)s as the industry calls them. We are the most likely thing that will blow up your deal. So getting our part done early keeps you from spending money on your other due diligence just to have us come by at the end and blow up your deal.
If you need a Phase 1 Environmental Site Assessment during your environmental due diligence period, give A3 Environmental Consultants a call. We’ll get your project done with the utmost in confidentiality, we’ll meet or exceed ASTM Standard E1527-13 on any sort of commercial or industrial property. Our reports meet the requirements of all lenders and government agencies such as the Small Business Administration (SBA), Housing and Urban Development (HUD) and the United States Department of Agriculture (USDA). A3 Environmental Consultants can be reached at (888) 405-1742 or by email at Info@A3E.com.