Due Diligence: Paving the Way for an Informed Decision
Real Estate Weekly
The real estate opportunity may seem enticing, just iffy, or lie anywhere along a wide spectrum in between. To help gauge whether to move forward, negotiate a point or two, or turn away from a potentially big mistake, due diligence is a prime resource. Led by your financial advisor — with an engineer, attorney, appraiser, and banker playing integral roles — the due diligence process gives you the information essential to making an informed decision. To see what is revealed in the process, let’s follow the path of a comprehensive due diligence.
Cash Flow Projections - Making the Numbers Speak
Reviewing leases and lease abstracts, the advisor looks to identify step-ups, free rent periods, lease expirations, renewal options, types of escalations, and other billings permitted under the leases. Comparing rent billings to cash receipts records, bank statements and the general ledger will help substantiate collections. This is used in establishing the framework for projecting revenue. This is mere prep work as the advisor then proceeds to ask to some incisive questions and verify the answers.
- How much of the building is currently occupied?
- What is the status of all new and potential lease negotiations and current renewals?
- How much space will be available, year-by-year, on expiring leases? A substantial amount may scare off lenders during a weak market.
- Could there be other income sources such as signage and profit sharing arrangements with internet companies?
- Are there any major tenants with above or below market rent? Below market rent tenants with expiring leases present upside opportunities. On the other hand you may need to establish a reserve for income projections from above market rent tenants.
- Are there quality credit tenants?
- Are there any current or pending disputes with tenants? A key concern would be disputes over billings for operating expense escalations?
- What is the timing of billing and collections for significant rent escalations, including those for real estate taxes and operating expenses?
- Do write-offs in the current and last several years point to a history of credit losses?
- Do aged receivables show signs of slow paying tenants or tenant disputes?
- Will you be able to pass on any increase in real estate taxes from a sale reassessment?
- Is there a summary of outstanding work letter and lease obligations for existing tenants and who will pay for the balances?
- In light of increasing demand and mounting costs for electricity, do leases with rent inclusion clauses allow for remeasurement?
Tracking the History of Expenses
The advisor will seek to get an accurate reading on the building's costs and expenses. Reviewing several years' of tax returns and financial statements, can establish a historical record of the operations of the property. Focusing on major accounts, the advisor analyzes selected invoices, contracts, and cancelled checks. Through this process, the advisor seeks to resolve questions on a number of crucial points.
- On a square foot basis, do the operating expenses compare favorably with similar properties?
- Can significant fluctuations, if any, from year to year be adequately explained?
- Are there related party transactions, including ones that were not at arm's length?
- Has the current owner lowered certain costs by pooling expenses with other related party properties?
- Are there unpaid tax obligations that could trigger a lien on the property?
- Is there a document summarizing all service contracts with details on the renewal and cancellation clauses?
- What type of legal costs have been incurred?
- Are there any outstanding insurance claims? Can a claims history be assembled and verified?
- What is the real estate tax status of the property? Are there ongoing certiorari proceedings? Are there any incentive or abatement programs available? Discuss these issues with the real estate tax attorney.
- Identify recurring and extraordinary repairs and capital expenditures. Are there budgets for future capital projects and deferred maintenance? Consider any work that could result from environmental considerations and building obsolescence. An engineer will be helpful in supplying this information.
- What union contracts and collective bargaining agreements cover the employees of the building? Are there multi-employer unfunded benefit plan obligations?
- How many and what types of employees are needed to operate the property?
- Have there been any communications or issues with any federal, state or local government departments?
It's not possible to foresee all circumstances that new owners may face, but it is important for the advisor to factor in the unique management philosophy of the incoming owners. Develop a cash flow model featuring a 5 to 10 year projection and including an exit strategy for years 6 through 11. The financial advisor can determine if the model's assumptions make sense by raising the following questions:
- Considering the current marketplace, the latest forecasts, and historic economic cycles, are estimates reasonable for rental growth, vacancy, tenant turnover, lease renewals, rent concessions, downtime, leasing, and tenant costs?
- Based on available data and input from the other professionals, do the expense projections reflect the operating expenses of the property?
- Are insurance costs from the new owner's advisors factored in?
- Have the new owner's management fee arrangements been included?
- Has a realistic inflation rate been factored into expenses?
Resources for an Informed Decision
Evaluating the cash flow model before and after the terms of the proposed financing, your advisor can assist in developing key benchmarks and ratios to help you make an informed decision:
- Fair Market Value: This is established by capitalizing net operating income or discounting future cash flows using prevailing rates, including the proceeds from a future sale.
- Debt Service Coverage: To ascertain whether the property's cash flow can support a certain level of debt, take the projected net income from the property before interest expense and depreciation and divide it by the annual debt service.
- Loan to Value: For a perspective on the borrowing ratio based on the property's fair market value, divide the debt by the appraised value. Traditional financing sources may lend based upon 60 to 70% of a property's fair market value. Other lenders may fill in the difference in the form of mezzanine financing.
- Debt Yield Ratio: To determine the maximum size of a loan a lender will make based on an acceptable ratio, take the stabilized net operating income divided by the debt amount and multiply by 100.
- Internal Rate of Return: This determines the interest rate that makes the present value of future cash flows equal to the initial net cash outlay and gives investors a reading on the potential yield.
- Sensitivity Analysis: To analyze the effect of a change to the cash flow model, the advisor modifies key assumptions and reviews the results.
Professionals performing a comprehensive due diligence must remain focused on the most precise and useful details to give you the tools for an informed decision. Due diligence is a process that combines painstaking attention to detail with inquisitive, inventive, and insightful analyses. In a real estate deal, the stakes, your stakes, are high and the rewards can be considerable. In such an environment, you owe it to yourself to look to due diligence to reveal the deal makers and potential deal breakers.
Berdon LLP audit partner Nicholas M. Loguercio works closely with real estate clients of all types and sizes advising on refinancings, certiorari filings, rent escalation lease clauses, and all aspects of the due diligence process. He can be reached at 212.331.7406 | firstname.lastname@example.org.
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