The Latin phrase, "Caveat Emptor" (which translates to, “Buyer Beware!”), has a very important application specifically to commercial real estate investing. In this video, you'll discover what it means to commercial investors, how residential and commercial real estate differ in this area, and how to protect yourself from deception in 3 critical aspects of any commercial deal:
In commercial real estate the seller or commercial property owner has no legal obligation to disclose any adverse conditions of the property. It is the responsibility of the buyer to investigate the property and discover any defects. This means the seller does not have to disclose the roof that's caving in, the crumbling foundation, or the black mold hidden in the walls. Although Caveat Emptor does not protect the seller from fraud, he is not required to volunteer information, so you are essentially buying the property as is, with no warranty.
There are 3 areas in commercial real estate where the seller can deceive you:
- Physical aspects of the property.
- Financial aspects of the property, such as income or expenses information.
- Legal aspects, the seller could deceive you about the title or some pending lawsuit that you have no idea of.
Real World Example of Caveat Emptor
I have a real-life example of Caveat Emptor in action that happened to me. I was looking to purchase a 108-unit, two story apartment complex in a small town in Indiana. We noticed during our walkthrough inspections that the first-floor units had lots of vacancies and their rents were low. We wondered why, so we asked the seller. Why are the rents lower here? And why do you have continual vacancies on these first-floor units? He replied that he didn't know. So, we decided to do a full inspection and we found out the toilets wouldn't flush on the first-floor units. So that was a red flag for us. Again, we asked the seller, "Why have these units not been rented for a long time?" He didn't say, he kept it from us.
That led us to our next step which was to scope the sewer. We put a camera down the sewer lines and saw that the plumbing below the property leading to the toilets was crushed and you could not get the camera or anything else out from the toilet to the street or to the sewer. With that discovery we averted disaster! And the seller, he knew exactly what was going on, but he had no obligation to tell us because of Caveat Emptor.
Caveat Emptor: Commercial Real Estate vs Residential Real Estate
The main difference between commercial and residential real estate is that in commercial the buyer ALONE is responsible for checking the quality of the property before the purchase is made. When you do your due diligence and inspections you don't have the law on your side, whereas in residential you do. Here’s how this plays out:
1. Disclosure: In commercial real estate the seller does not have to disclose anything. They are not going to hand over you 10 pages of seller disclosures of plumbing problems, what the rents and expenses are, when was the roof last repaired, or anything else going on with the property that's important to know. In residential, not only will you get that, but it will be in writing and it will be signed. You see, in residential, you have consumer protection laws protecting you from seller deception.
2. Recourse for Deception: In commercial, if the seller commits fraud, there is legal recourse. But is there recourse for lying or deception? That answer is, it's unclear what the recourse is. In residential, if the seller lies, there's recourse. You can go to court and sue him or her for damages.
3. Due Diligence Period: In commercial this timeframe is much longer than residential. It's 30 days in commercial, whereas it’s seven days in residential. You get much longer here because you need to go through all the physical, financial, and legal aspects, and that takes a long time to do. For example, on a hundred-unit apartment complex, the inspections can take four to five days. For residential real estate, it can be two or three hours. That’s a considerable difference.
4. Consequences of Buyer Mistakes: When purchasing commercial real estate, it can be extremely costly if you make a mistake, and you don't catch something that the seller is hiding. In residential real estate, the stakes aren’t as high. Yes, you want to avoid mistakes, but they are more manageable and survivable.
How to Protect Yourself from Caveat Emptor in Commercial Investing
Since caveat emptor can have such a devastating effect in commercial real estate investing, you really need to know what you're doing in this business. The solution to protecting yourself is to partner or get advice from someone who understands all 3 areas where the seller can deceive you: the physical, financial and legal aspects of the property.
The truth is, an accountant can help you with finances, but has no knowledge of the physical aspects of the property. An attorney can help you with the legal aspects but is useless to help you with any financial details. A contractor can help with the structure and infrastructure of the property but doesn’t understand any of the legal problems.
So, what do you do? Who can handle all three of these areas in commercial real estate? Well, that's exactly what our company Commercial Property Advisors is here to do through our Protege Program. We partner with beginner investors, guiding them so they can successfully navigate Caveat Emptor in all three areas.