Due Diligence: Digging Deeper
Now more than ever, investors must be extra diligent to substantiate value.
Lenders have overhauled their lending criteria and underwriting guidelines, so why shouldn’t buyers do the same? During these challenging times, property investors must refocus on the fundamental aspects of investment analysis to properly substantiate value in the purchase price.
When a seller gives you the property’s tax returns and operating statements, it’s time to be diligent. The value of investment real estate primarily is a function of net operating income. Therefore, an investor should dissect each component of the NOI during the financial analysis of a property.
The first aspect to examine is the property’s income. It may sound basic, but it is imperative to ascertain an accurate picture of the actual income the property generates now and in the near future. The following major categories deserve intensive study to determine a property’s income.
This largest portion of the property’s income is often overlooked because it is such an obvious category. But collection loss is major issue, and investors need to have as much information as possible about tenant payment histories before placing an accurate value on a property.
The priority here is to make sure that the correct rents actually are being collected, for the right amount, and on time. Ask the seller for actual copies of rent checks received for the last three months from all of the tenants, or, at the very least, from the larger tenants. Compare the rents received with the rents listed on the operating statement and in the leases to make sure that all three are consistent.
CAM Charges, CPI Increases, and Reimbursements.
In my experience, some owners do not accurately bill tenants for common area maintenance, consumer price index increases, tax escalations, utility reimbursements, and the like. Additionally, in today’s difficult economy, some owners may not bill in a timely fashion for these items or even at all to avoid losing a tenant. I also have seen owners who do not have sophisticated enough management systems to accurately bill for these charges.
Owners who do bill these items may have arrangements with tenants to pay over time, thus potentially delaying the new owner’s ability to collect. This is more common with mom-and-pop-type tenants in smaller properties, but this is a large sector of the commercial leasing market, and one that has been hit hard by the economic downturn.
Buyers should insist on seeing billing statements for these items and, more importantly, corresponding checks from tenants proving these items are paid. If the owner represents uncollected charges as fully received on the operating statement, that amount must be discounted to reflect a lower effective gross income.
In today’s tough leasing market, rent increases are not immune from negotiation. Just because a lease calls for a scheduled increase does not mean that an owner actually is collecting the increase. For example, some tenants have negotiated temporary relief from monthly lease obligations, thereby making their current payments even lower than the base rate at lease commencement. Investors need to be wary of these situations and should address these issues prior to closing, either in the form of escrowed sales proceeds or a separate agreement with the tenants, so there are no surprises after closing.
In addition to income, investors should pay careful attention to the following items.
Expenses on operating statements and tax returns.
While analyzing tax returns, buyers should question whether capital expenditures should be re-categorized as operating expenses. Operating expenses reduce the NOI, while capital expenditures do not. It’s a fine line, and one that must be examined carefully. In the wrong category, $10,000 translates into $125,000 in value at an 8 percent capitalization rate.
If the property has had a recent insurance claim, or even if there has been a recent incident from which a claim could arise, insurance costs will go up. The property’s premium could increase by as much as 50 percent, even when the claim has not yet been paid. Investors should request a loss run from the property’s current insurer to safeguard against such potential increases in expenses.
When property ownership is transferred, the taxing authority often will begin calculating the taxes on the new sale price, which presumably is higher than the current assessment. Astute buyers will consider the difference between the current assessment and the new assessment in their financial analysis.
Negotiating the Sale Agreement.
Procure the right to interview the tenants to ensure that they are happy and do not have plans to move. Demand subordination nondisturbance agreements to confirm that all is in order with the tenants and their demised premises. Ask for a long period of representations and warranties so that the seller is liable for a longer time should any inaccuracies arise. Specify that all documents requested are part of the due diligence package. For instance, if you want to review all service contracts, specifically ask for that as a condition of the sale.
A few extra hours spent analyzing an asset before the closing could save investors many years of financial hardship.