Why Due Diligence Is Even More Critical Than Ever

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The strengthening commercial real estate market shows confidence in the economy, which is a welcome change from the weak start to this decade. Buyers looking to acquire at this stage in the game, however, need to do so with an extra measure of due diligence, including a baseline business understanding of the market itself as well as the physical property.

There are two primary reasons for being more vigilant in the current market. The first is that many of the investors who purchased properties in 2010- 2014 did so with a speculative or value add strategy. They had a low basis and quite often, didn’t spend the customary time or money normally devoted to due diligence. Why? A majority of the deals were made with banks, receivers or directly from owners on a short-sale basis. As a result, there were no representations or warranties made – which put would-be acquirers squarely in the buyer-beware zone.

For those entering the market in 2016, that means you can’t just assume that the previous buyer conducted the appropriate amount of due diligence. Even if you or your clients are not steeped in the commercial real estate world, you can understand the situation from a residential perspective. Think about the glut of houses that were superficially executed fix-and-flips with new carpet and a fresh coat of paint, but didn’t touch the plumbing, roof, wiring or other critical structural items. The same hazards can lurk within commercial properties as well – two or three years into a purchase and buyers end up having issues with properties bought on the cheap.

Of course, the low prices of the past few years allowed buyers to book the risk into the transaction. Currently, there’s not enough gravy in the deals to insulate you or your clients from hidden problems. A more thorough, independent review of the physical structure is in order, including and not limited to its physical condition, traffic and the availability of vehicular access and parking, utilities, environmental concerns, and Americans with Disabilities Act compliance and accessibility, among many others.

Distinguishing Between Performers & Pro Formas

The second, equally important aspect comes on the financial feasibility side. We’re getting to the stage in the market when pro forma financials, in which a broker or seller pitches a best-case scenario, are being touted instead of actual financials. This is happening because, in many instances, we’re in the third or fourth trade on a given asset. Margins are getting slimmer and it’s getting more difficult for the property owner to demonstrate value, so the pro forma becomes a way to justify ever-higher prices.

For example, a seller might assume a 95 percent leased-up building at true market value rent versus what’s actually happening at the property. Don’t believe the hype! You absolutely must ask for and receive an accurate set of financials and then, drill down to true operating performance as opposed to assumed expenses or revenues.

If a property owner is at all sophisticated, they’ll have a set of financial books, including a rent roll and a profit and loss (P&L) statement. With the actual numbers in hand, then it’s time to verify them. Do you have the leases that support the revenues and the rent roll? Is there backup documentation on the expense side? Never assume that everything is correct.

Think Like a Contrarian

Now that the market has gotten pricier, buyers need to be more careful and discriminating. Just because an asset class is hot doesn’t mean it’s a class that every investor should be in. Take a hard look at why a given market is outperforming, what the history is and what the future could be. How much demand exists for the products or services provided by the intended purchase? What do the actual and potential revenues look like? Do they justify the acquisition? What happens if things don’t go according to plan?

Multifamily is the current favored asset class. Taking a contrarian view, that means office, industrial and some retail segments may merit additional consideration. While assessing the pros and cons of each investment class and individual properties, it is absolutely paramount to understand the dynamics in the marketplace and remain objective, as opposed to taking a broker or property owner at their word. If you are even the slightest bit uncertain about the numbers adding up, a commercial real estate broker or legal and financial adviser with specialized knowledge can ensure that you’re giving diligence its due.  Beth Jo Zeitzer

Davis Miles Referral
Lex Reception

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