How To Conduct Real Estate Due Diligence

Underwriting and due diligence is the most important part of the real estate investment process. Putting capital into the wrong investment can result not only in money lost but serious liability issues as well.

Underwriters put a tremendous amount of time, effort and knowledge into conducting property due diligence . . . before presenting an opportunity to  investors.

Here’s a quick overview of how to conduct real estate due diligence and underwriting.

Understanding Real Estate Underwriting

Underwriting is the process used to evaluate and determine the potential of various investment real estate opportunities. Underwriting that isn’t conducted properly creates below-market performance, expensive liability issues, and loss of capital for investors.

Good underwriters combine a boots-on-the-ground, big-picture approach for underwriting with sophisticated software modeling. They analyze a countless number of various data points, and both qualitative and quantitative factors to evaluate the risk-return potential of each prospective investment.

Detailed Due Diligence Steps

Once a potential investment has been identified, a lead underwriter is assigned to the property. The underwriter ensures that the property meets a stringent risk-return profile by performing an extensive and detailed analysis.

There are literally hundreds of data points used in a detailed due diligence process including:

Financials

  • Review last 3 years of tax bills
  • Capital expenditure (CapEx) review for last 3 years and current budget
  • Current month’s tenant improvements (TIs)
  • Schedule of tenant security deposits
  • Outstanding TIs and leasing commissions due
  • Utility records
  • Current invoices from service contract providers and utilities
  • Insurance quote review
  • Loss report from current insurance company for last 3 years

Building

  • Building and site plans including subcontractor warranties
  • Existing Phase I report
  • Insurance quote from 3 vendors
  • Property owner association (POA) document review, where applicable
  • Easement agreement review
  • Building service contracts, including leasing broker and property management companies
  • Maintenance and CapEx log review
  • Warranties
  • Property management agreement
  • Tenant contact list
  • Certificate of insurance
  • Copies of zoning and government permits, and written confirmation of code adherence
  • ALTA survey on file
  • Certificate of occupancy, improvements, and renovations for last 3 years
  • Current property condition reports
  • Copies of zoning reports
  • Warranties for all mechanical and structural systems such as HVACs, roof, and riser system
  • Notice of past, current, and pending litigation, citations or violations

Reports

  • Property condition assessment ordered
  • Phase I update ordered, if needed
  • UCC and judgment lien searches
  • Research any restrictive covenants, easements, and agreements

Comparables

  • Contact area brokers experienced in asset type being acquired
  • Obtain lease comparables – with both historical and current asking rents – for surrounding properties
  • Generate demographic information

Loan

  • Loan commitment letter from lender
  • Estoppels signed by tenants
  • Subordination and non-disturbance agreement (SNDA)
  • Property appraisal
  • Deed of trust/mortgage
  • Security agreement
  • Assignment of rents
  • Fixture filing
  • UCC-1
  • Contract assignments
  • Escrow closing instructions
  • Broker opinion of value
  • Partnership/LLC borrowing authorization
  • Corporate manager borrowing resolution
  • Signature authorization form
  • Primary and secondary lender commitments, if applicable
  • Lender loan documents
  • Budget and proforma review and approval

Title

  • Order title search from escrow
  • Order updated survey, if needed

Miscellaneous

  • Schedule site tour
  • Deposit earnest money
  • Register legal entity to hold property
  • Create operating agreement
  • Set up bank account for holding entity

Post Closing

  • Schedule and confirm property visit by asset management company and management committee member
  • Confirm all client-specific asset acquisition requirements are met
  • Notify in writing asset manager, property manager, and accounting firm of new ownership, when applicable

If at any point during this rigorous due diligence and underwriting process the underwriter decides that the property does not meet its requirements, they should not hesitate to walk away from the prospective deal.

How The New Tax Code Benefits Commercial Real Estate Investors

The Tax Cuts and Jobs Act of 2017 (TCJA) was the most substantial tax reform legislation enacted since 1986, when the Tax Reform Act of 1986 was passed to simplify the income tax code. Changes to the tax code by the TCJA are effective for tax years after December 31, 2017.

Here’s a quick overview of how the new tax code benefits commercial real estate investors.

Original Use Requirement Removed

The original use requirement for assets that were acquired and placed in service after September 27, 2017 was removed by the TCJA. Cost segregation studies can now be performed on newly acquired property and new construction to identify the personal property assets in the building and accelerate the depreciation.

Depreciation for Qualified Improvement Property

The definition of qualified improvement property was consolidated to make it eligible for bonus depreciation. Previously, improvements needed to be in qualifying leasehold, retail, or restaurant property. The TCJA changed that to allow for all improvements to the interior of commercial rental real estate – except for inside structural framework, elevators and escalators, and building enlargements – to be classified as improvement property.

On its website the IRS details section 179 and temporary bonus expensing for certain business property and assets.

Mortgage Interest

Commercial real estate investors are now able to deduct 100% of the mortgage interest paid on their commercial properties. However, for businesses with more than $25 million in gross revenues, the net interest expense deduction is now limited to 30% of earnings (before interest, depreciation, taxes, and amortization).

Pass-Through Taxation

Pass-through entities such as real estate partnerships and LLCs will now pay a top individual tax rate of 37%, with the pass-through business income eligible for a 20% deduction. The net effect of these changes is that the top tax rate on business income could be 29.6% compared to the previous top rate of 39.6%.

Historic Preservation and Rehabilitation Tax Credit

Developers renovating certified historic structures will still receive a 20% tax credit claimed over a five-year period. On the downside, the previous 10% credit for non-certified property constructed prior to 1936 was eliminated.

Like-Kind Exchanges

No change was made to section 1031 of the tax code. Commercial real estate investors can still benefit from using like-kind tax deferred exchanges to defer the payment of capital gains tax by selling an investment property and replacing it with another.

Impact on Multifamily Investments

While the TCJA provides several tax benefits to commercial real estate investors, homeowners didn’t benefit nearly as well.

While interest on existing mortgage debt of up to $1 million can still be deducted, interest can only be deducted on new mortgages of up to $750,000 and home equity loan deductions are no longer allowed. Deductions for state and local taxes are now capped at $10,000.

The reduction and elimination of these homeowner tax deductions makes owning a home more expensive in urban centers and high-tax states such as California. Multifamily real estate investors may benefit by offering alternative options to homeownership in central business districts, and by meeting the demand for housing as residents move from expensive city centers to more affordable suburban areas.

Top 5 Benefits of Investing in Real Estate as Part of a Portfolio

Investing in real estate is an excellent way to diversify your portfolio with a physical asset that generates income while simultaneously acting as a hedge against inflation. Due to consistent demand, real estate values also increase over time, increasing the potential for profit even more.

Industry experts list these top 5 benefits of having investment real estate in a portfolio:

#1 Passive Income and Increasing Values

The value of real estate keeps increasing for two reasons:

  • Rental rates, particularly in the multifamily housing sector, are continuing to rise due to demand.
  • As more investors look for quality real estate opportunities, increased bidding activity results in cap rate compression and increased values.

Income-producing real estate also generates passive cash flow month after month. Passive income can be used to pay off mortgage debt sooner, build equity faster, and leverage that equity to purchase more property.

#2 Tax Laws Are Real Estate Friendly

Current tax law is extremely friendly to real estate investors. Non-cash expenses such as depreciation allow investors to reduce the amount of taxable net income. When the time is right to sell, Section 1031 exchanges can be used to defer the payment of capital gains tax by relinquishing one investment property and acquiring another like-kind property.

#3 Hedge Against Inflation

Real estate investors are protected against the short-term and long-term effects of inflation. As prices increase, rents rise, and asset values grow.

According to the Census Bureau the average rate of inflation in the U.S. is about 3.2%, and at the average rate of inflation prices double every 20 years. But commercial real estate has more than outpaced the rate of inflation. In fact, over the past 10 years, average prices for office property, shopping centers, and large apartment buildings have more than doubled, according to the Federal Reserve Bank.

#4 Using Leverage Magnifies Returns

Positive leverage can be used to magnify the returns from investment real estate. Depending on the type of project, you can borrow between 50% and 90% of the property purchase price at interest rates that are lower than the anticipated annual return on the investment. Traditional portfolio components like stocks and bonds aren’t nearly as easy to use as collateral for financing.

#5 Variety of Investment Opportunities

Real estate provides a wide variety of opportunities to investors. Popular income-producing options include single-family rental housing, multifamily property, commercial buildings like offices and shopping centers, and vacant land.

It’s also possible to realize the benefits of investing in real estate without actually buying a property:

  • REITs: real estate investment trusts, real estate mutual funds, and real estate ETFs – or exchange traded funds – allow investors to buy shares of publicly-traded real estate funds.
  • Crowdfunding: online real estate investment platforms let investors buy fractional shares of institutional-quality office buildings, retail property, and multifamily projects.
  • Real estate partnerships: joint ventures with an experienced managing partner responsible for the hands-on, day-to-day operations of the investment works with passive investment partners who contribute money instead of their time while sharing in the profits and appreciation in value that the property generates.

Real estate niche analysis

real estate niche

If you’re a new agent or investor, focusing on a single real estate niche will help jump start your business. Or maybe you’ve been in the business for a while but feel like your real estate business plan needs a reboot.

Concentrating your efforts on a single real estate niche will help separate the good clients from the bad ones, and help choose the real estate investments that are right for you.

A real estate niche can be an asset class

One way of thinking about real estate niches is to look at the different types of real estate available. Real estate asset classes can be divided into four categories:

  • Residential
  • Commercial
  • Land
  • Special use

There are a lot of different types of real estate that go into each of these four asset classes. To fine-tune your real estate business plan and avoid real estate burnout, you’ll want to break down these big real estate niche asset classes into something smaller.

Small real estate niches make up bigger asset classes

The next steps is to break down the four big asset classes above into sub-classes or smaller real estate niches. Let’s use the commercial real estate asset class avoid as an example.

Some of the types of real estate and activities that fall into the commercial category are:

  • Retail
  • Office
  • Warehouse
  • Industrial
  • Single tenant or NNN
  • Apartment buildings
  • Leasing
  • Buying
  • Selling
  • Property management

You can probably think of more, but you get the idea. Now, let’s take the office real estate niche and break it down a little more.

Office real estate niches

The office real estate niche can be divided up a number of different ways:

  • Size of property – single or two levels, midsize, or high rise office building
  • By class of property – typical office building classes are A+, A, B, and C
  • By how the office building is used – medical, professional services, consumer-related services (such as banking, collections agencies, or telemarketing), and general office use
  • Location of property – central business district, suburban office markets, or mixed-use office/residential

Choosing the real estate niche that’s right for you

The types of tenants and the types of owners for each of these office niches are different.

For example, a Class A office building in a central business district will likely be owned by an institutional investor. The types of tenants in this type of building will be white collar and professional service businesses.

The demands and expectations of these property owners and tenants will be much different from the mom-and-pop bookkeeping firm renting space in a smaller office building in the suburbs.

Successfully choosing the real estate niche that’s right for you means understanding your own preferences, strengths, and weaknesses and selecting the best match that will lead to your real estate success.

Real estate burnout and how to avoid it

real estate burnout

Because real estate can be a 24/7 business it can easily lead to real estate burnout if you allow it to. Here are some of the best ways to avoid burning out in real estate while still being a six-figure earner.

Finding the work-life balance that works for you avoids real estate burnout

When you’re first starting out in real estate it might seem like you’re living to work. It’s true, in a highly competitive business like real estate there are dues to pay and hours to put in. But balancing work and play will make you more productive.

Three ways to balance your work life and avoid burning out are:

  • Take the same day off each week
  • Set the right expectations with clients upfront
  • Focus on a single real estate niche

Avoid real estate burnout by closing your office

Just because the real estate business can be 24/7 it doesn’t mean that you have to work around the clock, week in and week out. Closing your office one or two days a week means no phone calls, emails, or text messages.

These tips work even if you don’t have a physical office to close. Closing your office is as much mental as it is physical.

Avoid burning out by setting the right client expectations

Setting the right expectations with clients also helps agents void real estate burnout. If your office – or yourself, if you don’t have a physical office – is closed on Sundays or the weekends, let clients know right up front.

Many real estate agents are afraid do to this because they’re afraid of being seen as non-responsive. But in fact, the opposite is true. By letting customers and clients know that you have set business hours they’re much more likely to view you as the real estate professional that you really are.

Focusing on a single niche helps avoid real estate burnout

A lot of real estate agents, even those that have been in the real estate business for a while, believe that they have to be all things to all people. They figure the more they do, the more money they’ll make. Unfortunately this is one of the major factors in real estate burnout.

Focusing on a single real estate niche helps avoid burnout by concentrating your skills, knowledge, time and effort on what you’re best at. If you do that, the money – and the clients – will follow.

Five examples of real estate niches are:

  • Buyer representation
  • Commercial property management
  • Office leasing agent
  • Coworking office specialist
  • Multifamily sales specialist

 

Three Things To Know Before Signing A Commercial Lease

commercial lease

Negotiating and signing a commercial lease is much more complicated than a residential lease.

Here are three things to think about before signing a commercial lease.

Three Types Of A Commercial Lease

Every commercial lease is different, but they do fall into three general categories:

  1. Gross Leases – everything such as utilities, common area maintenance, and janitorial is included in the monthly rent
  2. Triple Net Lease – nothing extra is included in the rent
  3. Modified Gross Lease – some things are included in the monthly rent and some things are not

Landlord Expense Pass Throughs

The things that aren’t included in the base rent are items that can really add up.  Known as expense pass throughs, these charges can also surprise a lot of tenants.

CAM fees – or common area maintenance fees – are the tenant’s proportional share of the landlord expenses to maintain the common areas of a property.   CAM items can include routine charges for services such as:

  • Landscaping
  • Utilities
  • General repairs
  • Janitorial
  • Parking lot sweeping

Personal Liability

Landlords and real estate property managers always try to make a commercial lease as strong as possible.  If a tenant goes bad and stops paying the rent, the landlord will look for as many ways as possible to collect.

Unlike residential leases that are usually only one year in length, commercial real estate leases often have terms of between five and ten years.  While that can be good for a business initially, it can be a big problem for the owners if the business shuts down.

Until a replacement tenant can be found, the business owners can be held personally liable for the total amount of unpaid rent agreed to in the commercial lease contract.

 

Five Real Estate Rental Property Expenses Not To Forget

real estate rental property expenses

Here’s a list of five real estate rental property expenses not to forget about when calculating your ROI. They apply to whatever real estate niche you’re working in.

As a good real estate accountant or bookkeeper will say, ‘Report all of your income and expense as much as you can’.

Tenant Credit Reports

Checking the credit and background of prospective tenants is a must-do and one of the most important tips for a real estate landlord or property manager.

While the cost of running an individual report is small, the annual real estate expense for credit reports can really add up.  Especially if you have a large multi family property or several single family rental homes.

Leasing Fees

Surprisingly, many beginning real estate investors overlook expensing out the finder’s fee paid for leasing the rental property.

One reason this happens is that the leasing agent will collect the upfront monies from the tenant – such as the first month’s rent and security deposit – then remit to the owner this money less the leasing fee paid out of those upfront monies.

The landlord mistakenly only accounts for the money he or she actually receives instead of the gross income from the tenant.

Back Office Property Management Time

The time spent on little tasks like answering incoming phone calls, balancing the bank statement, and endorsing rental checks can really add up over the course of a year.

One way to account for this time spent managing your real estate investment is to use a stop watch or timer on your computer.  Then, log the minutes on a spreadsheet along with the date and a brief description of the task.

Onsite Property Management

Just as with the back office time, onsite property management time can add up as well.  It’s also one of the most overlooked real estate rental property expenses.

This category includes tasks such as driving by or walking the property, meeting a vendor onsite, and checking out the competition.

Market Research

Speaking of the competition, don’t forget to expense the time spent researching your market.

This can include things such as dues and subscriptions, property drive-bys, shopping the competition, and online research.

Common Real Estate Rental Property Expenses

Some of the most common expenses with a real estate investment property include:

Top FSBO Commercial Real Estate Tips

fsbo commercial real estate

FSBO commercial real estate is commercial real estate being sold by the owner.  It’s not that uncommon in the commercial real estate business.

That’s because – unlike residential real estate – most FSBO commercial real estate is owned by professional business people.  As a result, the investment group holding the real estate includes an attorney, high-net worth individual, or even real estate professionals.

Here are a few tips for buyers thinking about investing in for sale by owner commercial real estate.

Buyer Representation For FSBO Commercial Real Estate

More often that not, with FSBO commercial real estate, or any commercial real estate for that matter, a buyer is buying problems that the seller can’t handle.

That’s not necessarily a bad thing.  Sometimes commercial real estate owners don’t have enough capital to make repairs or upgrades.  Other times they lack the property management resources to find and keep great tenants.

Situations like these can be a good deal for the buyer, if the buyer has what the seller lacks.

But whatever the reason, buying FSBO commercial real estate means that you’re buying someone else’s problems.

That’s why it’s important to hire a buyer broker to represent you in a for sale by owner commercial real estate transaction.

Commercial Real Estate Due Diligence

Commercial real estate investors should always be sure to do their due diligence.  It doesn’t matter if the property is a FSBO or listed on the open market.

There’s a lot more due diligence when buying commercial real estate than when buying a residential property.  Some of the things commercial real estate buyers should always verify include:

  • Tenant leases, tenant quality, and historical rent payments
  • Current zoning and potential business restrictions
  • New competition coming to the market
  • Discover why the owner is really selling

 

How Do Real Estate Leasebacks Work?

real estate leasebacks

Real estate leasebacks can be a great arrangement for both buyers and sellers.  They also work well with both residential and commercial real estate transactions.

What Are Real Estate Leasebacks?

There are three main elements to a real estate leaseback that work with any real estate  niche:

  1. Seller finds a buyer who wants an income property
  2. Buyer buys the property, and the seller remains as a tenant
  3. Buyer gets consistent rental income, seller frees up equity for other uses

How To Structure Real Estate Leasebacks

Real estate leasebacks aren’t seller financing and they aren’t like a lease purchase.  That’s because the real estate has already changed hands.

The buyer needs to do its due diligence on the seller, who is going to become the tenant.  Just because the seller owns real estate doesn’t mean they will have the money to pay the rent after the sale closes.

That’s what’s known in the real estate business as being property rich and cash poor.

Before closing escrow both the buyer/landlord and seller/tenant should have a written lease agreement in place, credit reports and background checks done, with monies from the sale forwarded to the buyer to cover any deposits and upfront rents.

Potential Problems With Real Estate Leasebacks

Real estate leasebacks can be a win-win situation for both the buyer and the seller.  At least for the time when the seller is leasing back.

But what happens when the lease is up and the seller vacates?  Buyers can suddenly find themselves holding a property that is difficult to rent to a new tenant.

Problems can occur with real estate leasebacks when the property is unique or has special deed restrictions placed on the property by the seller.

For example, convenience store operators often do sale-leasebacks as part of their normal business strategy.

But they will also put restrictions on the deed to prohibit the property being used as another convenience store for several years after the lease expires.  The result is that the buyer will be unable to lease to another convenience store and may have difficulty finding another good tenant.

Real Estate Loan Scams

real estate loan scams

Whenever a real estate market heats up, real estate loan scams also rise.

Here are three common real estate loan scams to watch out for if you’re buying – or selling – real estate.

Seller Financing

Now, seller financing in and of itself isn’t a real estate loan scam.  But, this method of buying and selling real estate can be, if you’re not careful.

For buyers, seller financing can turn into a real estate loan scam if you pay the seller directly.  To protect yourself, always go through a independent third party such as an escrow company or attorney.  They will track payments received, the loan balance, and money disbursed to the seller.

For sellers, always remember that you are the bank, since you are carrying the note.  Sneaky buyers can turn seller financing into a real estate loan scam by providing you with bad credit information or selling the property to someone else without your knowledge.

Lease Purchase

Lease purchasing – real estate can also turn into a type of loan scam if you’re not careful to have everything in writing.  Also be sure to have written in your lease purchase contract what dollar amount or percentage of payment is applied toward the purchase price of the property.

Remember, a lease purchase agreement is different from a lease purchase option.  With an option, the tenant/buyer has the option to purchase at a predetermined price, but doesn’t have to.

Interest Only Mortgage As Real Estate Loan Scams

Using an interest only mortgage to buy real estate can also end up being a real estate loan scam if you’re not careful.

With an interest only mortgage, payments by the buyer only go toward interest and not principle.

In a real estate market where prices keep rising that’s OK.  But if the market suddenly drops, buyers can quickly find themselves upside down with negative equity on the property.