So, you’re interested in redeveloping a commercial building? You want to buy a vacant property, rehab it, tenant it and then start collecting rent. That process is called “adding value” and it’s awesome. Congratulations! It’s one of the most fulfilling experiences in commercial real estate investing.
Or maybe you want to go all out and develop a project. You want to buy a piece of land and construct a new building for a prospective tenant. Again, congratulations. It’s going to be a challenging experience, but in the end, you’ll have done something only a few will ever accomplish.
Perhaps neither of those options is your path, and what you want to do is purchase a building with an existing tenant. That way you can start collecting rent immediately. Once more, hearty congratulations are due. Welcome to the club!
As you start your journey in commercial real estate and move through the process, you need to remember one thing. If you can understand this concept and accept it (you don’t have to like it), you’ll be one step closer to being a commercial real estate investor and/or developer: sometimes the only one who gets paid is the architect.
If you’ve ever bought a house, you understand the concept of a due diligence period.
Due diligence is that important period where you get to “kick the tires” to see if the property is something you actually want to buy.
In residential real estate, it’s typically a short period (two weeks) that the seller allows you to come in and check out the house. You may bring in your home inspector and they can tell you what deficiencies they’ve found that needs correcting. Those items can be used to further negotiate with the seller or you can accept the report and move forward to closing.
In commercial real estate (CRE), it’s different.
You still get a due diligence period but it is substantially longer. It can run as short as thirty days up to six months or longer. The inspection period all depends on the complexity of the project.
During this time, you can conduct various inspections (think home inspection, but on steroids).
If the building is existing, you can bring in a contractor to check the physical structure, an HVAC contractor to inspect the heating and ventilation system, an asphalt company to give a report on the condition of the parking lot. If the building has a system, you can get a contractor to check it out.
You may need to conduct environmental site assessments. These include: Phase I (historical analysis of the property); Phase II (soil samples); and Phase III (deeper sampling). You may also do asbestos testing throughout the property. These reports may even be done when the buildings are occupied. It’s important to know what you’re buying.
You may elect to survey the property to know its boundaries. For developing, you will need a topographic land survey to determine changes in elevation.
Any developing or redeveloping plans will require some architectural drawings and renderings. Some of these may include site plans, building plans, and the actual renderings. These will be needed by everyone from the city planners to approve the project, to the contractor to construct the building, to the tenant who is going to locate there.
The municipality may require a traffic impact study to see how your development is going to affect the public street system. This won’t be quick and it won’t be cheap.
You’ll need some legal work done. That may involve creating the entity which will own your new project or drafting the lease you will eventually use with your incoming tenant.
Also, you will want to talk with the existing tenants and find out if they’ve had any problems with the property and if they intend to stay. If there isn’t a tenant in place, you can use the due diligence period to actively contact prospective tenants and tell them what you’re working on. Time is precious and every minute counts.
Get it Under Contract
I’ve put many properties under contract and worked through the due diligence process. I’ve walked away from far more deals than I’ve ever closed. It’s part of the process of “kicking tires” and making sure the project is right for my partners and me.
As you can imagine, costs can add up and these do occur before you ever actually own the property.
My first experience with only a vendor getting paid was a restaurant project. A friend (Patrick) wanted to open a new concept in a building that would require substantial rehab. The building was larger than he wanted so we needed ways to convert it to a two-tenant building. I hired an architect and had multiple renderings drawn up. The proposed redevelopment was incredible. It would have been something Spokane had never seen.
The cost involved to do only the landlord’s side of the work (purchase the building, a complete facade upgrade, parking lot upgrade, interior prep for the restaurant) blew the doors off any budget that made sense. No matter what we did, we couldn’t make the project numbers fly. Eventually, I had to kill the deal and send the architect a check for $2,500.00 for his work to that point.
Unfortunately for us, only the architect got paid on this deal.
We did eventually find Patrick a great location for his restaurant that he leased instead of purchasing. You can see his website here: The Blackbird.
Earlier this year, I had a property under contract for a potential redevelopment.
The plan was to tear down the existing dilapidated structure and construct a new building. The property was in an industrial area so a Phase 1 report was needed. The findings stated that an auto repair shop was in the property’s lineage so the reporting agency recommended a Phase 2 test be conducted to make sure no soil contaminants existed.
After the Phase 2 report came back clean, I was good to proceed. However, the total cost for both reports was a little over $10,000. I wasn’t worried, though. I believed in the location and my ability to find a tenant.
During the due diligence period, I had hustled to find a tenant. I pitched it to everyone. It was near a very busy retail corridor, but most of the major players were already accounted for and they politely passed.
I talked with Jacobs Java, a partner of mine in another building and pitched an idea to them. I had renderings drawn up to show what could be done for them. The result was very cool. However, the concept wasn't in the cards and I scrapped the drawings. It cost me $500 to do the pitch, but I figured it was worth it.
I didn’t give up, though, and continued to call. Finally, when I found a prospective tenant, a national franchise, I was stoked. My vision was coming into line, but I needed more time to get a lease in place with the franchisee. The seller knew my position and agreed to extend if I made my earnest money non-refundable. I agreed and signed a document waiving the rights to my $10,000 earnest money to get another ninety-days.
Unfortunately, the franchisee had a family health problem arise and he put all future expansion plans on hold. My project was suddenly on life support. I scrambled to find a replacement tenant, knowing that $20,000 of my money was gone if I couldn’t make it happen.
Not Every Story Has a Happy Ending
When my due diligence period came to the end, I met with the seller and gave him the news.
I wasn’t going to move forward with the project. I didn’t have a tenant and couldn’t afford to float a vacant property by myself.
He said he would be willing to continue to work with me on the project since I’d spent so much time on it, but he wanted more earnest money. I couldn’t see putting more money on the table just to get more time. The money I had invested was gone and I didn’t need to chase it with more good money.
I thanked the seller for his time and left. I knew the cost for sitting at that table.
The only ones who got paid were the environmental reporting company, the artistic rendering company and the seller who kept my earnest money.
These stories aren’t to scare you away from investing in commercial real estate. Quite the opposite.
I worked in the due diligence period to get it right. I got to use the seller’s time to work out the kinks in my investment ideas. When the numbers didn’t work, I killed the deal. No further risk was taken by me. Yes, it cost me money, however, it would have cost me far more if I had moved forward with either deal when they weren’t sound.
For the deal I killed earlier this year, I had it under contract for six months. When it fell apart, I was very disappointed. So was the seller.
There were other projects that I’ve worked in the due diligence period where it didn’t cost me anything or hardly anything (a couple hundred dollars).
Please understand that many opportunities have worked out the way we planned. Money was spent appropriately and the deal was closed to our satisfaction.
Occasionally, when investing in any arena you’re going to hit a bump in the road. If you can remember to keep looking forward with a positive attitude, you’ll be a success.
However, if you continue to count lost money, you’ll never make it in this world.
Have you ever spent money during a
due diligence period only to walk-away from the deal?
I'd love to hear your story.