Buyers Beware: Due Diligence When Buying Distressed Commercial Real Estate

Book: The Commercial Real Estate Tsunami: A Survival Guide for Lenders, Owners, Buyers, and Brokers
Author: Tony Wood (foreword by Matthew Anderson)
ISBN: 978-0-470-63637-4

Chapter 8 flips the camera. After two chapters aimed at owners and lenders, Wood turns to buyers. His headline warning: “buyer beware” has never meant more than it does right now. Distressed commercial real estate can look like a bargain until you find out what is buried under the foundation.

Buyers in the tsunami marketplace

Whether you are buying a million-dollar office building or a $30 million mixed-use project, the source of the deal matters. REO from a bank’s special assets department. A note purchase. A short sale from a distressed owner. The process changes, but the risk profile does not: you are buying problems someone else could not solve.

Wood makes a point that should be tattooed on every residential flipper trying to cross over: commercial real estate is a different planet. The due diligence, the leases, the tenant relationships, the environmental issues, the title quirks. All of it runs on different rules. Experience from the boom cycle can actually hurt you here, because you will assume things work the way they used to.

The information gap is the killer. When a borrower loses a property to the bank, the records often go with them. Deferred maintenance history, service contracts, tenant correspondence. The lender’s special assets team gets whatever the borrower felt like sharing, which is usually incomplete. Policies vary bank to bank, sometimes week to week. Many REO departments are already underwater and will get worse as maturities pile up.

Some lenders sell notes at steep discounts. All cash. Short due diligence windows. Wood is clear: not for the faint of heart.

Do your homework (seriously)

Wood says he watched buyers pay 2007 prices in 2009. Fifty percent above market. Why? No homework and no qualified representation.

You need a commercial broker or consultant who has actually closed distressed deals, not just listed buildings in good times. Pay for expertise through a consulting agreement, hourly fee, or brokerage representation. The cost of bad advice dwarfs the fee.

Wood also references the “Cycle of Market Emotions” chart from the introduction. Timing matters, but waiting forever for the perfect bottom means missing deals that work today. Greed and fear cut both ways. Know whether you are buying to occupy your own business or buying strictly as an investor, because the criteria are different.

Cash is king

If you have liquid capital, you are in the driver’s seat. Sellers and lenders do not want to wait 60 to 90 days to find out if your lender will actually fund. Cash buyers who can close fast get the discounts.

Wood spends a surprising amount of time debunking the courthouse steps fantasy. Yes, you have heard the seminar pitch: show up at the foreclosure auction with cashier’s checks and scoop up buildings at pennies on the dollar.

Wood’s response: mostly nonsense for commercial buyers.

The courthouse limits you to whatever happens to be on the block that day in that county. You lose access to the much larger pool of short sales, REOs, and distressed owner sales in the open market. Professional investor groups have been running courthouse auctions for decades. Wood references the old “40 thieves” nickname from the 1970s, groups that knew how to squeeze out novices.

Better opportunities, he argues, will be in the open market: troubled assets, commercial short sales, vacant buildings from owners in default, and bank REOs with a more navigable process.

Hair on the deal: due diligence that actually protects you

This is the heart of the chapter. Distressed properties almost always have “hair,” extra baggage beyond a normal transaction.

Sometimes the hair is obvious: vacant building, unfinished construction, no certificate of occupancy, lost anchor tenant. The dangerous hair is what you cannot see. And the lender who owned the property for six months may not know about it either.

Wood brings in Val Berlin Douglas, a title expert, to hammer home the title angle. Lenders and buyers care about different things. His example through Maura O’Connor: a retail center whose only access was an easement over a culvert expiring in 15 years. Fine for a 10-year lender loan. A disaster for a buyer planning to hold long term.

Other hair to hunt for:

• Deed restrictions and code violations
• Construction defects
• Ingress/egress and easement problems
• HOA books and meeting minutes (a pretty building in a lawsuit-happy association is not pretty for long)
• Tenant estoppels confirming lease terms
• Environmental and structural reports you may have to recreate from scratch

Properties end up in default for a reason. Your job is to find out why. Overleverage can be fixed by buying low. A bad location cannot. Wood’s rule: the discount has to match the problems. If you are not comfortable owning and solving every issue you uncover, do not close.

Complete due diligence, then negotiate price to reflect the risk you are accepting. Skip either step and you become the next distressed seller.

My take

Chapter 8 is shorter than Chapter 7, but it might save you more money. Wood is not anti-buying. He is anti-lazy-buying. The tsunami creates real opportunities for people with cash, patience, and the right advisors. It also creates a graveyard for people who treated commercial distress like a bigger version of buying a foreclosed condo.

The courthouse steps section made me laugh, because I have heard that exact pitch at every real estate meetup. Wood’s takedown is deserved. The open market will have inventory for years. Pick your property type and geography deliberately instead of showing up wherever the auction happens to be.

If you are sitting on cash and thinking about distressed commercial, read this chapter before you write your first offer. Then read it again before your due diligence period expires.

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