Every commercial real estate investing follows a similar lifecycle. This is known as the commercial real estate transaction process. It is also referred to as a commercial real estate deal process.
A Commercial real estate transaction is the process of transferring the rights of commercial property like office space, industrial multifamily rentals or retail, etc, between two parties mainly for business or income-generating purposes.
This process primarily moves in five phases. Let’s discuss the 5 steps of a commercial real estate transaction process.
The 5 main steps of a commercial real estate transaction process
1. Identifying Investment opportunities
Ibisworld reports that the global size of the commercial real estate market $3.2tr in 2021. It is a major asset class that offers investors the potential for an attractive return on investments.
Therefore, it is important to develop an investment thesis through deep research. The criterion for selecting a suitable property must include analysis of property type, location, purchase price, risk profile, etc.
Hence, investors can easily shortlist lucrative properties and rule out the depreciative ones.
The underwriting process must be properly executed with an extensive analysis of a property in terms of its financial aspects.
At this stage, the current data like rental income, cash flow, occupancy, property taxes, utilities, etc are combined with future performance estimations.
Therefore, underwriting is crucial for addressing sponsor questions relating to the reason for the property sale, rental limits, maintenance costs, location, occupancy status, and exit strategy.
The next step involves constructing a pro forma analysis that suits the price value expectations and underwriting returns.
However, creating a suitable underwriting process is a complex process. It involves making numerous financial models with different assumptions that explore potentially profitable as well as unrewarding scenarios.
Hence, it becomes impossible to manage large volumes of research data generated in the process.
3. Making an offer
If the underwriting process shortlists a suitable property for the investor, in terms of price and returns, the acquisition teams make an offer to the seller.
It consists of the following stages:
a. Preliminary due diligence
This involves acquiring maximum information about the shortlisted property without paying higher due-diligence costs.
Preliminary due diligence helps in gathering every little detail of the property and providing the best initial offer.
b. Communicating interest in the deal
In this stage of a commercial real estate transaction process, buyers communicate their interests to the seller’s representative or the owner. And, they confirm a possibility of deal execution.
So, the sellers become certain that the buyer is interested in closing the transaction at or near the contracted price.
Hence, often, at this stage, a seller selects a buyer based on their certainty of execution.
c. Walk-in tour of the property
Walk-in tours of the property serve as a win-win situation for both the buyer and the seller.
The buyers can ensure that there are no informational gaps and whether the property meets the seller’s description or not.
On the other hand, sellers get further confirmation of the buyer’s serious interest in the transaction.
d. Meeting with submarket lease brokers
Submarket leasing brokers provide an informed third-party opinion regarding the asset’s rental potential and its rates.
e. Compared with a competitive set
After acquiring the advice and opinions of experience lease brokers, buyers generally tour competitive properties.
When a buyer compares the properties, they can easily make an informed decision regarding their shortlisted property.
f. Submitting the first-round bid
When the buyer is satisfied with the property after the underwriting and due diligence process, the buyer makes an offer to the seller.
This initial bid is like the Letter of Intent (LOI).
Herein, the buyer addresses the major points of interest, and it is after this stage, that further negotiations take place.
4. Pre-closing stage of a commercial real estate transaction process
At the pre-closing stage, the seller eliminates most buyers. Generally, this is either because the bid price is too low or the buyer does not meet the seller’s terms.
Here, the seller wants to identify the ideal buyer who has the ability to close the transaction at the highest price.
The seller then shortlists the buyers among the remaining ones.
a. Best and final round bids
The best and final round bids are among the narrowed-down number of buyers. At this stage, sellers are confident that buyers will push higher on price to close the deal.
Strong buyers gain a sense of the competition and tend to bring down the price of the seller, while other bidders stretch to the desired number.
Hence, the seller conducts a buyer interview to get the best bidder.
b. Buyer Interview
The seller narrows down the pool of buyers even further and they conduct a buyer interview for the last two standing candidates.
Here, the seller wants to determine which buyer is most committed to sealing the transaction.
Further, the seller or their representative interviews the buyer. Here, they try to analyze the extent of their due diligence and the status of their capital stack (equity and debt).
On the other hand, the buyer tries to convince the seller of their intent in closing the transaction.
After the interview, the seller usually selects the best candidate based upon their representative’s recommendation.
c. Purchase and Sale Agreement (PSA)
The next step involves creating a Purchase and Sale Agreement. The PSA is the contract created between the buyer and the seller.
This documents every necessary information about the subject property exchanging hands.
Further, it also specifies both the parties’ rights, obligations, and liabilities. It also lays out the closing process.
Legal counsels of both parties then review and revise the PSA.
5. The closing stage of a commercial real estate transaction process
This is the final stage of the transaction process that brings the deal to a close. So, it focuses on completing the paperwork and the legal transfer of ownership to the buyer.
The buyer and seller hire a third-party escrow agent to manage the closing process with utmost transparency.
The escrow agent holds deposits and all other funds in a neutral account until all the preconditions set in the escrow agreement are met.
This process ensures that both parties comply with their agreed-upon obligations. After the preconditions are met, the escrow agent releases the fund.
b. Signing Closing documents, Authority Verification and Closing due diligence
The legal counsels for the buyer and seller provide each other with proof of the signing power for the legally enabled individuals. These individuals sign on behalf of each party and complete the transaction.
Finally, the buyer also ensures the accurate transference of property rights, and that there are no outstanding due diligence issues. This stage also involves completing a title report by title agents and purchasing title insurance on the property.
After the fulfillment of every clause in the PSA, the buyer receives the assignment documentation, which grants the ownership right to the buyer over the lease.
In closing, the legal counsels must offer memorandums to Asset Management, Property Management, Accounting, and all other relevant internal parties. In this transition memo, they must notify them of the closing of the transaction.
Read Lilypads’ article on the various property classes of commercial real estate here.