Due Diligence in Purchasing Real Estate

Due Diligence

The process one goes through in purchasing a piece of real estate is remarkably the same as the process one utilizes to determine a site’s highest and best use (http://www.dramatispersonae.org/HighestAndBestUse.htm) as well as the process used by Banks and other funders in determining their risks in lending to a proposed (or existing) project.

Duly Diligent

What are some of the key things one has to do or look at when acquiring real estate, financing real estate or determining a site’s highest and best use? In fact, I believe that the same process is invaluable for sellers of real estate as well as appraisers. I can’t believe how many sellers of real property do almost nothing to boost their case—many don’t bother to prepare a comprehensive sales and marketing package. You would think that real estate agents would be very good at it but many are horribly unprepared to sell property.

I have bought (and sold) hundreds of properties and I have had the rather frustrating experience of asking a real estate agent basic questions like: what is the zoning on the property; what’s the FSI (floor space index); what are the current rents and so forth and gotten … nothing.

Vacant Land

Real Estate is an industry where local knowledge is of paramount importance. Something that works well in Toronto and New York (say for the Reichman family of Olympia and York fame) may not work at all well in, say, London (at Canary Wharf, for example).Here are some of the things you should do or look at when buying vacant land:

What is the current zoning?
What is the current Official (or Master) Plan designation?
What types of uses are the adjacent lands being put to?
What is the local economic environment like and what direction is the neighborhood heading in economically speaking?
What is the crime rate like in the vicinity including petty crime such as vandalism and graffiti?
How can you add value to this piece of real estate—what type of uses are most in demand?
What is the competition like?
Are other developers doing projects if the area?
How are they doing with those projects?
Is it possible that competition in the area could actually boost your proposed uses much as fast food restaurants or petrol stations conglomerate together and feed off of each other (so to speak).
What kind of support are the neighbors likely going to give you for your proposed uses?
Have you talked to any of your neighbors?
What does your local councilor think of your project?
Have you walked the site and photographed it?
Is the local infrastructure sufficient to support your project (storm water outlet, sewer capacity, piped water supply, road capacity, power …)?
Are high speed Internet, cable and telephone service available?
Is public transit readily accessible?
Have you completed an economic feasibility study and rate of return calculation?
Does it meet your rate of return requirements?
How long will it take to get the project off the ground and realize this return?
Can you sustain the project if there are any delays?
Have you tested the economic feasibility of your project should there be any delays, cost over runs or changes in demand?
How can you tweak the project to either increase the benefits or decrease costs?
Have you spoken with city staff to gauge their level of support for your proposed uses?
Are there any wetlands on the property?
Is there any environmental contamination?
Are there any easements?
Does the Vendor have clear title?
Is there any litigation affecting the property?
Can you get title insurance (http://www.dramatispersonae.org/TitleInsuranceExplained.html)?
Is this a freehold acquisition or long term land lease?
Can you obtain financing?
Will the Vendor provide any financing (i.e., a VTB, Vendor Take Back mortgage)?
Can you get reasonably priced insurance?
Are there any heritage or archaeological constraints?
Have you met with officials from Provincial or State Ministries (environment, natural resources, transportation, agriculture, municipal affairs …)?
Are there any important natural resources on the property?
Are you purchasing riparian, subterranean and air rights too?
What are the setbacks and height limits affecting the property?
What are the building permit, development charge and other City, Province or State fees?
Have you had the property appraised by a professional appraiser?
Is the appraised value close to your proposed purchase price?
What are the property taxes?
Are there any noise sources close by such as rail road tracks, car washes or high intensity industrial uses?
Are there any dangerous or noxious uses in close proximity (such as abattoirs, fire works factories, pulp and paper mills, petro chemical plants …)?
Are there any streams, water courses, navigable water ways that impact of the proposed uses for the site?
Are there any short term or long term land leases (such as agricultural uses or parking uses) that impact the lands?
Can you get vacant possession of the lands?
Can you get vehicular access to the property, road cut permits or culvert permits?
Can you get full left in, left our access for vehicles?
If the property is being developed on private services, is there potable water on the site?
Can you install a septic system on the site?
Why is the Vendor selling?
Can you obtain a survey?
Does the survey show all easements, encroachments and rights-of-way?
Is the APS (Agreement of Purchase and Sale) subject to any excise fees (land transfer taxes, Goods and Services Taxes, VAT (Value Added Taxes) …)?
Are the property taxes up to date?
Is the property subject to power of sale conditions and rights of redemption?
Is the property subject to any rights of first refusal?
What did the Vendor originally pay for the lands?
What did neighboring lands sell for?

I am sure there are many more due diligence questions that we can come up with but this is a good start.

Buying real property is hard. Many, many people make mistakes in this business and, as a good friend of mine once told me (Barry G. Lett): “You make money when you buy real estate not when you sell it.” So getting it right the first time is pretty important.

Land and Buildings

When you buy real property that has existing buildings on it, you have just added more complexity. I tell my students that vacant land is more valuable than land under existing buildings. And I tell some of my clients that if they want to get full value for their properties, it is often best to pull down tired structures and create a vacant lot.

Why is this? Well, sometimes it is because people can’t visualize their own projects on a piece of land if there are other people’s buildings ‘in the way’. Humans are very territorial. That’s why residential real estate agents who sell a lot of homes tell their clients not to leave anything personal around so that prospective buyers can visualize themselves and their stuff in the home not the current occupants. Same thing in commercial real estate, I am afraid.

Also, when you build something on a piece of land, you have locked in all the options for the foreseeable future (a life of 30 to 60 years is typical for commercial projects these days). It’s just like when you buy a new car—you decide on the colour of the vehicle, engine size, whether it has a tow package, interior finishes, automatic or manual, etc. The moment you drive it off the lot, it devalues 15 to 30% overnight. If you drive it back to the dealer the next day because, say, you just lost your job, you can discover this for yourself.

There are the ‘restocking charge’ and the transaction costs to take into account but the biggest devaluation has taken place because you have locked in all the options, The person who next buys this vehicle might not like fire engine red or lemon yellow but they’ll take it for a reduced price…

Same thing in buildings—there are thousands of small changes in the local economy every year—so that a building built to meet one functional program (say, a roller disco rink) might not be suitable for a technology use a couple of years later when the disco craze dies. (I actually had this experience and the costs of retrofitting the building for a tech company after the roller disco place went bust were substantial.)

Most developers only think about form following function—they determine what the highest and best use is at one moment in time and then get an architect to wrap a form (i.e., a building) around those functions. But architects being the independent and stubborn people they are often disregard the developer anyway and design something that suits the site and the neighborhood—it grows organically from the ground in a way. So function follows form; that means that they intuitively understand that a building will probably see a multitude of uses in its life.

Think it can’t happen in residential construction? Think again. Imagine the computer cabling that a home like ours requires. Built if 1988, it had zero cabling for PCs. We now have five in our home and fishing the wire through walls and floors is hard and expensive.

Think about how many people work from home today or have home based business? It’s phenomenal.

Think about how many baby boomers are going to need elder care soon first for their parents and then for themselves. I think that we are building homes that are wrong for the times—the whole industry needs a rethink but that is not the subject matter here.

Here are some due diligence questions for structures:

Have you had the building inspected?
Do you plan to tear down the existing building?
Can you get a demolition permit?
Are you going to renovate, rehabilitate or add to an existing structure?
How is the wiring, plumbing, roof, foundation, structure, etc.?
Are there any leases in place?
Are they long term or short term?
What are the rents?
Are they net, net, net leases (i.e., does the tenant pay all operating costs)?
What operating costs will you have to pay?
Are the rents at, below or above market rents?
Which way is the rental market heading?
Who pays for major repairs such as structural repairs?
Who pays the property taxes?
Are there any inclusions or exclusions with the property (appliances, fixtures, etc.)?
Are there any environmental or bio hazards (e.g., asbestos insulation, ‘Legionnaires’ disease)?
How are the HVAC (Heating, Ventilation and Air Conditioning) systems?
Are your operating costs above, at or below the norm for this type of real property?
Can you reduce your operating costs—are there any environmentally sustainable practices that you can implement?
Are the tenants sound financially?

Buying existing buildings is a lot like buying existing businesses. It takes a great deal more due diligence and a different mind set than building from scratch. Some people are really good at buying existing property or existing businesses and turning them around.

Those folks are often really bad at creating a new project so I would say that the industry is split between operators and constructors. I have been much more involved in the latter and I know that the skill set to build from nothing is quite different from the skill set to be a good operator.

Both can add a lot of value—the constructor can see a project in his or her mind’s eye long before the first rivet is driven in steel. They have a natural feel for the local market and what will work and they see things before other’s do—they pioneer things.

A good operator can be creative too—they can see how it might be possible to add some ‘lipstick’ here and some makeup there and create a whole new ambience. They can differentiate their projects on style, panache, quality maintenance, clever redesign and use of space, etc. It isn’t just that they mop the floors better than their competition.