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How to Avoid the Most Common Commercial RE Due Diligence Mistakes
Raising capital for deals is one of the most exciting roles in real estate investing. But deals are only successful if careful attention is paid during the due diligence process.
In layman terms, the due diligence process is described as “all reasonable steps taken to satisfy a legal requirement especially around buying and selling.” In commercial real estate this entails:
- Valuation
- Legal
- 3rd party representation
- Property-specific issues
Due diligence mistakes can be costly as each acquisition comes with its own set of challenges. There is no one size fits all. Hence, it is important to develop a framework through which to view the due diligence process.
In this post, we wanted to delve into the due diligence framework to help investors avoid common mistakes. This post is divided into 3 parts:
- Valuation and Legal
- Property Specific Issues
- Miscellaneous
Valuation and Legal
- Investor Underwriting Standards
Everything emanates from this step! Underwriting should always be conservative and disciplined mixed with a heavy dose of skepticism.
Broker proformas tend to show earnings increasing exponentially. Reality has a nasty habit of going in the opposite direction because nothing goes up forever. It is better to prepare for the worst and hope for the best, then vice-versa.
In anticipation of completing a deal, even the most experienced investors can get an “itchy” finger (it happens to the best of us). Standards are relaxed, and in some cases thrown by the side, as forecasts are stretched to meet the numbers. Care must be taken to avoid these situations.
Commercial real estate is valued on the income approach. Using this approach, the net operating income (NOI) is divided by the asset capitalization rate. The capitalization rate differs by sub-market.
In mathematical terms:
Property Value = NOI / Capitalization Rate
where NOI is expressed in annual $ and the capitalization rate is expressed as a percentage.
It becomes imperative that conservative growth rates for revenues and expenses should be used. Commercial real estate is a cash-intensive business. Improperly accounting for major line items can result in costly mistakes.
In our experience, it is very easy to fall into the trap of overestimating revenue, underestimating expenses and omitting certain costs. Revenues and expenses have different underlying drivers (see: “Market and Competitor Analysis”) for each sub-market. It pays to do research to understand what, how and when each driver will come into play.
A common example in smaller apartment buildings is the tendency to self-manage. Property management fees do not show up on the P&L as owners want to avoid paying for said fees. But investors should always include property management fees, even if they self-manage, to get an accurate picture of the operating costs.
When underwriting, it is prudent to use trailing 12-24 months (T12/T24) actual P&L. To understand true operating costs, it is imperative to use the actual T12/T24 numbers, normalize them for one-time expenses and account for all expense categories to understand the true, underlying financial performance of the property.
It is critical for underwriters to go through T12-T24 with a fine-toothed comb to avoid errors by commission or omissions. A consistent, conservative and intellectually sound underwriting framework should always be implemented.
You can refer to our earlier post: Forced Appreciation: The Secret Sauce for Creating Long-term Wealth Through Multifamily to understand how to increase long-term property value.
An alternative, not widely accepted but used as a means to provide reasonability around estimates, is to verify results against sales comparables, for recently completed transactions in similar property types, within the sub-market.
Commercial brokers can provide guidance on sales comps and property values as they have access to industry databases and information.
The guidance should also include commentary on the effect of the major drivers and what role they play in affecting the overall value. Essentially, the investor is “triangulating” the valuation and adjusting their estimates to market information.
- Lender Underwriting Standards
After the 2008 crisis, lenders have become conservative. The Dodd-Frank regulations, hastily assembled in the aftermath of the 2008 crisis, strictly regulate how much lenders can allocate to various lines of business. It also regulated how lenders measure the ongoing risk associated with each line of business. This has had the effect of severely tightening up lending in the overall economy.
Furthermore, lenders are not in the business of owning real estate. The last thing a lender wants to do is foreclose on a property, go through the headache of keeping a non-performing loan on its books while trying to quickly dispose of it, often at a discount.
Lenders analyze deals from a different perspective than investors. They are looking to manage their risk across the entire loan book. Hence, each investment in evaluated based on its ability to return the loan within the agreed upon period in line with the risk parameters of their loan book, subject to strict regulations. Each lender is different but some common items they assess include:
- Property vintage (year of construction);
- Physical condition of the property;
- Credit worthiness of the property and investor (the latter is not as important as in residential real estate);
- Environmental issues; and
- Sales and lease comps (including in-place lease assessment)
Loan officers are incentivized to fill out their loan books quickly as they have monthly, quarterly and annual targets. By developing a relationship, an investor can understand when lenders are more inclined towards certain assets and the terms associated with the lending. This can help the investor secure financing in advance to facilitate quick decision-making as enticing assets come to market.
It is prudent to involve the lender as early as possible in the investing process. An investor should have an ongoing discussion with their lender about their lending practices, guidelines and the state of their loan books.
In today’s competitive markets, deep lender relationships are critical. The investor with the fastest access to financing wins. Check with your lender before going too deep into the due diligence process to avoid surprises.
- Market and Competitor Analysis
Choosing the right market is critical. Over the past decade, investors in cyclical, coastal markets have enjoyed significant year-on-year increase in revenues. It would not be prudent to apply the same standards to linear markets.
You can refer to our earlier post: Choosing the Right US Market To Invest In: The 4-Step Guide to Successto get an in-depth framework on how to choose the right market to invest.
Applying the same growth projections to linear markets would result in valuations being grossly over-stated. This is the biggest reason why investors from more affluent markets – California, New York, Boston, Seattle, Miami, and Chicago – tend to overpay when investing in the Midwest or the South. They make the classic mistake of assuming that their home market conditions apply in all other markets.
After analyzing the macro – market analysis – we should now move to the micro -competitor analysis. Competitor analysis plays a significant role in understanding the drivers powering revenue, expenses, NOI and valuation.
A notable example can be found in Denver. Its high current absorption rate means that there is low vacancy. This results in multifamily operators having no incentive to attract tenants as the market is hot. Hence, incentives like rent concessions and free utilities are not offered.
Contrast this with declining markets (3rd or 4th tier MSAs) with high vacancy rates. In these markets, due to the high vacancy rates, operators are forced to offer incentives to lure tenants.
Furthermore, each market brings its own set of dynamics. In some markets, it is not customary for RUBS to be implemented. No matter how great the opportunity, if your competition is not implementing RUBS, an investor will have a tough time implementing it and gaining any upside. Tenants will leave and move to buildings that offer more value.
You can refer to our earlier post: The Essential Guide to Multifamily Syndication Terms
Property Specific Issues
- Not Walking Every Unit
Another critical step! Regardless of seller claims, it is imperative to walk every unit. It is important to have your team document each unit with pictures and videos for future reference.
Seller have been known to claim many reasons for an investor to not walk every unit:
- Don’t want to disturb tenants;
- All units are the same/What’s the point?;
- Investor is being bothersome; or
- Threaten to cancel the deal if this step is taken
It is the duty of the investor to stay firm on this point. An investor should follow the mentality of being cynical at best and paranoid at worst. Assume that whatever the seller does not want you to see is a major expense and adjust the valuation accordingly.
If after repeated attempts the seller refuses to allow you to walk every unit, you have two options:
- Walk away from the deal; or
- Assume the worst-case scenario (major rehab) and adjust your valuation accordingly.
If you go down the latter route, present the seller with your worst-case scenario estimate and explain why the valuation has changed.
The costs can be in the form of a reserve credited against the purchase price to ensure that the investor is adequately compensated for likely future inconvenience.
You don’t want a reputation as a re-trader but you also don’t want to be fooled by false promises.
- Lack of Lease Analysis / Assuming No Tenant Issues
As an investor is inheriting a large pool of tenant, it becomes critical to do a deep dive and analyze all leases. We highly recommend that your property management team be involved in this process. They can provide the investor with a heads-up on emerging issues.
Troublesome issues in lease can include fixed option rents, cancellation provisions and caps on pass-through expenses, among other things.
Like all other aspects of the due diligence process, an investor must keep themselves aware of the worst-case scenarios. An investor could be put in a tough position if a group of tenants decide to avail themselves of a troublesome contract provision. This will eat into the income and cause the property valuation to crash.
Leases (and bank statements) must be analyzed to ensure that:
- Lease expirations are not lumped together (e.g. all lease do not end in April);
- Economic vs. physical vacancy; and
- Loss to lease
It is important to involve your property management team as well as you real estate attorney to go through the leases to ensure that there are no surprises.
- Not Spending Time at the Property
It pays to visit the property during various times and days of the week. This is a key step in understanding neighborhood dynamics.
Put yourself in the tenant’s shoes. Surface-based impressions count for a lot. Potential tenants can form quick opinions that are hard to dispel.
Touring a property and neighborhood provides qualitative information to backup quantitative analysis.
- Non-Compliance with Municipal Building Codes
Many investors have had the horror realization that their new multifamily investment does not meet municipal or ADA codes. Usually, the infractions are discovered when a contractor goes to pull a permit from the city or when city inspectors check the property. Investors also need to be aware of sellers who’ve built without a permit.
It is a good idea to have a contractor or architect inspect the property to discuss improvements and compliance during the due diligence period. In some cases, these might not be deal breakers if the investor is aware and adequately compensated for the inconvenience.
- Building Approval Certificates
It is imperative to ask for a certified copy of the building layout plan from the seller. The proper authorities, with the seal and date of approval, must sanction the plan. It is prudent to carefully review claims by sellers/brokers and compare them against sanctioned plans. At the minimum, an investor must verify license copy and no objection certificates (NOCs) by the environmental and fire departments.
Miscellaneous
- Assuming Lenders Accept All 3rd Party Reports
Each lender has its own set of requirements (see: Lender Underwriting Standards) on acceptance of 3rdparty reports. Most lenders will only work with their preferred 3rd party vendors and will happily refer them. Lenders can require many specialized reports, including:
- Property inspection;
- Property condition assessment;
- Environmental reports; or
- Seismic or geological studies
It is best to get lender approval before hiring any 3rd party vendor. Otherwise, an investor can end up paying twice for the same report.
- Trusting the Seller’s Representative for Full Disclosure
“Caveat Emptor” – Buyer beware
The seller’s representative does not owe a fiduciary duty to the investor. They are not legally obligated to act in the investor’s best interests.
An investor must challenge all major details. Sellers cannot be expected to be forthcoming and provide full disclosure. It is considered best practice to ask for copies of receipts, lien releases and invoices.
In most cases, the seller’s interests are the exact opposite to that of an investor’s. It is important to get everything in writing (email is fine) and to meticulously record all correspondence. This information is needed for reference as well as for any future legal correspondence.
- Expecting the Closing Statement to be Without Issues
It’s the end of the due diligence period. You’re expecting a smooth sailing after months of demanding work. Beware! There is one critical roadblock awaiting you.
It is often the case that before the closing a seller will add items to be credited to them but overlook the items that should be credited to the investor. Some common “overlooked” items include:
- Leasing commissions owed to brokers on recent leases;
- Letters of credit or certificates of deposit used as a security from tenants that the landlord needs to assign to the new buyer;
- Tenant improvements and allowances owed; and
- Vendor billings that need to be prorated or paid in full prior to new ownership taking over.
It is imperative that the above items be verified before the final approval of the closing statement is signed and sent to the escrow officer.
Never underestimate the importance of proper due diligence. It is easy to get into a bad deal but a pain to get out of. A deal passed is much better than a completed deal that causes nightmares.
In conclusion, many new (and experienced) commercial real estate investors get caught up in the excitement to do a deal. They can often miss out on seemingly trivial details that can cause major headaches. Hopefully this post can help you avoid the most common due diligence pitfalls.
This article can also be found at: https://www.boardwalkwealth.com/2018/01/avoid-common-commercial-due-diligence-mistakes/
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