Just Due It
Today’s investment market requires a customized research approach.
The current economy and the lack of available credit have created a new paradigm for commercial real estate investors. Many lenders are indicating that, in the future, an appraisal won’t be enough to obtain financing: Market feasibility studies will be a necessary part of the loan request package. Buyers can help to protect their immediate and long-term returns by conducting extra due diligence processes.
Today’s tight market conditions make it essential for investors to customize the many assumptions that drive the financial results shown in a property’s investment analysis. Gone are the days when investment analysis or financial pro forma could be calculated on standard assumptions such as 2 percent annual market rent growth, 75 percent tenant renewal probability, and 5 percent vacancy rate. Carefully customized analysis for a specific property is required to ensure the investment’s actual operating results most accurately reflect the projected returns.
“Feet on the Street” Approach
Once a property is under contract, buyers should first complete standard due diligence functions including review of title, historical financials, and leases. However, prudent buyers should perform additional due diligence practices to ensure that their initial investment analysis on the property is correct. To customize these assumptions to the specific asset, buyers should tour the property and the market.
“Feet on the street” due diligence is essential to determine what other properties make up the subject’s competitive set, gain firsthand knowledge about market or neighborhood anomalies that may influence assumptions, and assess any physical challenges that may impact the property’s desirability.
For example, firsthand observation of an office tenant’s suite may reveal extreme underutilization of the space, which in turn would affect the renewal probability assigned to the tenant. Or, a specific vacant suite may have an undesirable configuration, making it difficult to lease. This would affect the market rent assumption assigned to the space, could result in a higher tenant improvement cost, or perhaps both.
In another example, suppose a visit to a small retail center with several restaurants reveals very light customer traffic over the lunch and dinner hours. This analysis could lead to higher vacancy rate or credit loss assumptions and influence the entire investment decision. Firsthand observation may uncover specific traffic patterns that are problematic to the ingress and egress of the property. Or, an observer may notice that competing properties had recent façade or common area updates, rendering them a superior classification than the subject property. These factors may influence many assumptions about the investment including market rent increases or the assumed timing or necessity of similar capital investments required to ensure the property is competitive.
Various market data reports and subscription-based services that detail market rents, inventory, vacancy and absorption rates, and other fundamentals are good sources of information about a given market and helpful in completing an initial property analysis. However, the information and insight required in today’s market should not be derived from just these types of resources.
Interviewing tenants — representatives at both the local operational level as well as those in a corporate decision-making capacity when applicable — is critical to supplement the observations made during the property and market tour. Interviews should follow a well-crafted, detailed list of consistent questions for each tenant, with further questions customized to address specific observations made at the property and in the market as they may be applicable to individual tenants or all tenants.
Interviewers should have the ability to process information quickly and ask appropriate follow-up questions to ensure an accurate understanding of information provided versus jumping to erroneous conclusions. Interviewers also should be able to dig deeper for relevant information with a professional demeanor. Circumstances or conditions revealed by tenants could affect many of the aforementioned tangible assumptions and provide invaluable insight on intangible matters affecting the investment decision. For instance, tenant interviews have disclosed general dissatisfaction with a property either caused by recent area development, difficulties with commuting patterns, or changes in corporate structure affecting a tenant’s long-term plans. Tenants also have revealed ongoing issues with physical components of buildings or dissatisfaction with management as well as many other critical issues. Ultimately, tenants can be the best sources of information about themselves, the property, and the market.
Further research and discussion with area real estate professionals paired with the processes described above allow buyers the necessary data to support and perfect the investment analysis assumptions.
Property Condition Assessments
The more complicated a property’s physical structure, the less adequate a property condition report becomes. A very detailed inspection of a property’s physical and structural components can be crucial in more-complex transactions and often warrants some duplication of the lender’s PCR to adequately project both operating and capital expenses. Equally important is contacting the vendors servicing the property for insight into issues from chronic maintenance problems to mechanical system failures. Selecting the appropriate personnel with extensive experience in construction and mechanical engineering in addition to a general understanding of commercial property operations is critical. Hiring a qualified professional can more than pay off when compared to the corrective costs that can be incurred on assets purchased solely relying on the PCR.
For instance, a PCR did not reveal a failing mechanical system in a 10-story office building. Uncovering the problem through a combination of inspection and research, which included gathering details from relevant vendors, resulted in a $1 million purchase price reduction to cover the cost of replacing the failing system. The PCR, which was conducted by a reputable national company, represented that the system was in good condition and reflected only typical annual maintenance costs and replacement after the expiration of the standard useful life.
In today’s market more than ever, specific due diligence processes are necessary to ensure investors make wise and profitable decisions. The time and expense required to go beyond the standard data found in appraisals, market reports, and PCRs are worth it, especially when compared to the costs incurred after purchasing an asset based on too-aggressive assumptions and too-low projected expenses.