Due Diligence for Acquisitions

By Matthew Crocker

Due diligence is the critical phase of investigatory work that determines whether or not your deal can move to the next phase, be it approvals or zoning phase in land development or the closing period for an acquisition. This critical period, while negotiated as part of the purchase and sales agreement, can often be compressed. Buyers will have an enormity of information to gather and analyze prior to the expiration of this period. The essential element of this period expiring is typically centered around a posted deposit becoming nonrefundable. It will be money well spent to engage a set of professionals who can not only meet your timeline, but provide valuable guidance during the analysis of this information.

Investors pursuing financing for a purchase will have to meet requirements by lenders or equity partners. It is important to use the due diligence period to make a thorough determination and establish the highest level of confidence in the purchase. Once the deal is closed, the buyer has to live with the purchase.

The purchase and sales agreement should include an exhaustive list of potential items a seller may possess, when these materials should be turned over, and how they should be delivered. This period, typically three business days, is adequate time for a seller to turn over these materials considering the property is listed for sale.

Let’s explore the due diligence period for an acquisition of an existing building and where to focus efforts during this limited period. Due diligence professionals include those providing property condition assessments, environmental site assessments, title examinations, survey examinations and updating, zoning verifications, building and hazardous materials collection and analysis, and building systems analysis.

Property Condition Assessment (PCA): The PCA is a visual examination of the property which is complemented with information provided by the seller via questionnaire. Further, previous reports and other due diligence materials provided by the seller will be examined. These assessments can typically be completed in 15 days or as quickly as 10 days, which may come at a premium.

These reports will be logically structured but can be over 100 pages depending on the age and complexity of the property and the number of issues identified during the assessment. These assessments will range in price from $3,500 to $10,000 depending on the property type, complexity, and size. It is important to remember to disclose to the professional whether you are pursuing financing and/or equity partners to ensure the report meets these standards.

Phase I Environmental Site Assessment (ESA): The environmental site assessment involves both a site survey and research of databases to determine any past or existing environmental concerns. This assessment is also complemented by disclosure of any known issues by the property owner. Further, the assessor will review any pertinent due diligence materials provided by the seller as part of the purchase and sales agreement.

These assessments can be completed within the same time period as the PCA and typically cost $2,000 to $2,500. These reports are again logically structured and typically much shorter than the PCA, although this depends on the number of issues encountered, which will depend on the past use of the property.

Phase II ESA: This assessment is only completed should a Phase I ESA result trigger this requirement. This assessment is typically focused on a specific issue such as an existing hazardous condition, like an identified spill which may lead to groundwater concerns. While the requirement for these assessments is typically limited, it remains a possibility. These assessments will be more extensive and time consuming and cost significantly more than the Phase I ESA. It is vital to get out ahead of any issue that may trigger this requirement to determine if completing the assessment can be accomplished within the agreed upon due diligence period.

Title Examination: Buyers need a title commitment, which is a future promise to provide a title insurance policy upon closing. Title examination complexity and period will depend largely on the availability of property records held by the county recorder of deeds. Record keeping varies by county.

The title company hires a researcher to search available records. This may require the researcher to visit the county property record repository to pull records manually and make photocopies for the title company. Title companies typically require examinations to go as far back as the 1950s, but this will depend on the county searched and the number of times a property has transferred. Once the researcher compiles all pertinent records, they are turned over to the title company for examination.

At the conclusion of the examination, the title company will issue a commitment based on its findings. It is critical the Schedule B of the title commitment is thoroughly examined for exclusions and issues concerning the commitment. While it costs the title company the fees for the researcher and internal examination time, the title company cannot charge a fee for a title commitment. Title policies fall under the purview of insurance and therefore fees cannot be charged to establish a policy, but only for the policy itself at the time the policy is bound.

Zoning Verification: It is critical to have a professional review the zoning of the property, any existing or potential future conflicts, and conformity with current zoning ordinances. Unfortunately, this is often overlooked. While this is typically not an issue for the property, there are times when zoning may have been changed and the property falls into a non-conforming use category (some refer to this as “grandfathered”). The zoning of the property conflicts with the use and therefore the property is governed under the non-conforming use regulations of the zoning ordinance.

One issue that can threaten a non-conforming property is periods of abandonment. If the property is considered abandoned for a consecutive 6-month period, the “grandfathered” use could be disqualified from future use and the owner forced to redevelop the property to a conforming use. One example would be if a buyer purchases an industrial building that has been abandoned for over six months and is forced by the municipality to redevelop the property to a conforming use, say retail.

These examinations are typically inexpensive, $1,500 to $2,500, but should be reviewed by a land use attorney who is familiar with the zoning history of the municipality. This is an enormous assumption that has the potential to bury a successful acquisition.

Building and Hazardous Material Assessment: These are additional assessments that may not be required by the Phase II ESA, but the buyer will want to get a handle on. The best example is asbestos containing materials (ACMs). These materials can still be found in buildings of certain vintages, for example in insulation and roofing materials. If the plan is to use the building without alteration, then ACMs may pose little if any issue. If the plan involves any level of renovation requiring demolition of areas of the building that contain ACMs, there are special mitigation procedures that need to be followed to contain the release of these materials. This could add unanticipated costs to renovations. These costs should be quantified to ensure the investment is not compromised by a required additional cost. This assessment and report can cost between $1,500 to $5,000 depending on the number of samples taken.

Building Systems Analysis: These assessments are completed by specialized vendors in each building category. The following systems to consider assessing are HVAC, plumbing, electrical, fire sprinkler, roof, and utility connections. These vendors can be paid by the hour, but some, such as roofers, perform these types of inspections so regularly they establish a flat fee, which is around $2,500.

Looking at the listed systems above, let’s review some pertinent points of each:

• The air handlers of the HVAC system should be assessed for age, maintenance history, and remaining service life. Further, it is a good idea to ask the tenants their level of comfort to assess if the system is performing well during the peak seasons of summer and winter. Replacing air handlers can reach well into the tens of thousands of dollars, so it is a good idea to have a handle on when replacing them will be necessary during the holding period of the property.
• Plumbing should be assessed to ensure all fixtures have adequate water supply pressure and that there are no issues with underground sewer connections.
• The electrical system should be reviewed for its code compliance and, if time and budget permit, an infrared scan of all building electrical panels should be completed. These scans can run from $5,000 to $15,000 based on the number of panels being scanned. The report should categorize each panel based on the level of immediacy of repair. Electrical repairs could reach into the high tens of thousands of dollars. It is rare that owners make scanning the electrical system a priority, so it is likely several years have passed since the system was thoroughly evaluated.
• The fire sprinkler system is a system that can pose a significant issue in the operation of a building, specifically in warehouses. This system should be evaluated by a fire sprinkler engineer or NICET certified fire sprinkler vendor. When it comes to storage, many older systems (those built in between the 1970s and into the 1990s) may only be adequate for minimal storage heights depending on what is being stored in the building. If the building is restricted to minimal storage height and there is no existing racking storage system with in-rack sprinklers installed, then the clear height storage of the warehouse will be for nothing. Further, fire sprinkler heads are required to be tested for performance at 50-year intervals. If the testing reveals the heads are not performing to standard, all of the heads will need to be replaced which could cost $0.50 per square foot. The cost to replace or upgrade a system to a modern standard is between $2 to $3 per square foot. Evaluating the performance of the system and its adequacy for the intended use is critical to incorporate into the capital plan during the holding period. While it may not be an overwhelming capital cost, the tenant disruption and coordination issues could prove significant.
• Roofs are significant systems that reach the top of the list during due diligence. The cost to replace a roof can reach up to $7 per square foot. This cost raises the concern of any owner because it is a significant capital cost. It is best to have a roofing professional complete a visual roofing inspection along with taking coring samples. It is crucial to figure out the age of the roof, any warranty period remaining, and whether or not the roof on the building is an overlay on the original roof. By code, roofs can only be overlaid once, meaning there is a maximum of two roofing systems that can be in place at one time. This is why the core sample is so important because there is a large dollar difference ($3 per square foot versus up to $7 per square foot) between overlaying a new roof and ripping out an existing roof and replacing it completely.
• Utility connects and services should be evaluated. It may be assumed a building is serviced by natural gas to find out later it is not. Also, it is good to figure out the capability of the existing utilities (e.g., electric, water, and sewer) should you get a manufacturing tenant who requires significant electric and water supply. Complementary to water supply is sewer which is based on an established use of the property. Increasing the water use will increase the demand on sewer and may require the purchase of additional sewer discharge units. Finally, the ability to upgrade utilities is a positive marketing aspect that can make the difference in attracting a tenant.

Due diligence is a critical phase in the analysis of a significant investment and establishing the confidence of the investors and lenders. How this period is planned, executed, and managed is critical to meeting the agreed upon period set forth in the purchase and sale agreement. While buyers can request the extension of a due diligence period, many sellers are reluctant because of the loss of valuable time while the property is off the market under agreement. If the deal is going to go sour, the seller wants to know quickly. Finally, it’s all about reputation in the marketplace. Establishing among sellers and market professionals your ability to perform and perform well yields continued exposure to future deals.