Due Diligence: Purchase With Care
By John Tax
With real estate markets under pressure, buyers are looking for bargains and in some cases may be tempted to quickly close a deal before other buyers appear. As a result a buyer may curtail or even forego customary “due diligence” procedures, even to the extent of putting down a non-refundable deposit before a contract is signed. This could prove to be a costly mistake. Not-withstanding unethical behavior by a seller, a property’s physical condition and financial picture may turn out to be much different than expected upon close inspection after the title has passé.
What is Due Diligence?
Once a buyer has identified a particular property for purchase, the overall due diligence process generally consists of four steps:
- Making a physical inspection of the property and the adjacent area, with particular attention to possible environmental concerns.
- Making a detailed examination of all leases and contracts to confirm rents and terms and to identify any provisions that might affect future cash flow, such as rent concessions, periods of free rent, and below market renewal options.
- Preparing an investment analysis showing of the potential return under different assumptions with respect to interest rates, occupancy levels, rents and expenses.
- In some cases, entering into a letter of intent with the seller as a preliminary to detailed negotiations on the contract of sale.
Manipulating Cash Flows
Professional consultants such as accountants, attorneys and engineers usually are retained to carry out the steps just described. An experienced investor, however, will want to be sure that particular attention is given to actions of the seller that (intentionally or not) have the effect of manipulating present or future cash flows. The sales price of a commercial property such as an office or apartment building is a multiple of current and future operating income. Any miscalculation as to either the current income or the rate of expected growth could mean the contract price is significantly above the value of the property. Some of the buyer’s concerns about present and future cash flows are discussed below.
The owner of an office building intending to sell within a short time period can utilize several techniques to increase the rent roll. For example, in the case of a new building still in the lease-up period, the owner might negotiate above-market rentals in exchange for above-market cash and improvement allowances given to the tenants. The allowances in turn can be hidden on the balance sheet. Proper due diligence by a buyer could mean appropriate reductions to the effective rent figures.
Rollover Lease Assumptions
A critical consideration for a buyer, particularly in a period such as now when market rents are often below contract rent is the schedule of determination dates for existing leases. If a large number of leases are due to expire within the near future and before the market is likely to strengthen, the new owner will face a difficult decision as to whether to renew (or seek new tenants) at lower rates or permit the space to remain vacant until rents once again begin to rise. The present owner may have declined an opportunity to extend existing leases at lower rents in order to show a high level of effective rents until the property can be sold. While there is nothing unethical in doing so, a prospective buyer may obtain some negotiating leverage by pointing this out.
In addition, a buyer should challenge any renewal assumptions made by the seller about large space leases in the building. A major lease comprising 25 percent or more of a building that will expire within several years of the sale poses a substantial risk to the buyer since the existing tenant or will have negotiating leverage.
Options and Rights of First Refusal
In the tenant-favorable market of the past few years, tenants often were able to obtain such concessions as options to renew at a fixed percentage discount from “market rates at time of renewal.” This can be an invitation to a lawsuit at the time the renewal option is exercised and a buyer must consider how to exercise of such options will affect the income from the property.
Similarly, a tenant may have a right of first refusal ("RFR") on adjacent space in the event it becomes vacant during the lease term. Such RFRs can prove to be a serious obstacle to finding a new tenant, particular one seeking a large amount of contiguous space.
Retail Revenues in an Office Building
Retail space on the main floor of an office building often is an important revenue source. An effective due diligence team will determine whether the existing retail uses are appropriate and provide the maximum profit opportunity. An owner anticipating the sale of the building may have entered into a lease with a fast food operation or other type of retailer likely to generate high short term profits but that over the long run will detract from the reputation of the building. Alternatively, the owner may have installed a white tablecloth restaurant to serve upscale tenants of the building but which pays below market rent.
Other Types of Income
Lobby space can be a source of additional revenue for the building by means of kiosks, ATMs, newspaper stands, shoeshine facilities and similar operations. If such income sources already are present, the buyer should question whether they add or detract from the image of the building. On the other hand, if lobby space is unused, consideration should be given to developing such other income sources.
Property taxes are a sometimes the largest single expense for an office building. A due diligence team should carefully determine whether the leases require tenants to absorb the cost of property tax increases, including those due to a higher assessment caused by a change in ownership. The present owner may have incurred a large amount of tenant improvement costs shortly prior to the sale that are not yet reflected in an increased assessment.
The failure to carefully examine the insurance coverage for a building could result in sharply increased insurance premiums for the purchaser. For example, if the present owner has a portfolio of buildings covered by a blanket liability insurance policy, a buyer must determine how the premiums have been allocated among the various properties. Since the owner typically can allocate the premiums in any way desired, the premium allocated to the building in question may be much lower than if an individual policy is obtained. In addition, a proper due diligence investigation will determine whether the insurance provider has a satisfactory rating and the loss history of the building.
The foregoing discussion illustrates just some of the many issues to be resolved by appropriate due diligence when purchasing a commercial property.