Mind Your Gap

Due diligience
May 6, 2016

Due diligence uncovers facts that reshape the deal.

Private Real Estate Investments

Term sheet or letter of intent allows the buyer and seller to have a written agreement to terms of transaction. It details the purchase price, describes the provisions, and specifies the due diligence process, our topic of discussion.  

  

The due diligence checklist may look like this:  

  • Review the leases for the major tenants and review the history of rental payments and any defaults or late payments.
  • Get copies of bills for operating expenses, such as utility expenses.
  • Look at cash flow statements of the previous owner for operating expenses and revenues.
  • Have an environmental inspection to be sure there are no issues, such as a contaminant material on the site.
  • Have a physical/engineering inspection to be sure there are no structural issues with the property and to check the condition of the building systems, structures, foundation, and adequacy of utilities.
  • Have an attorney or appropriate party review the ownership history to be sure there are no issues related to the seller’s ability to transfer free and clear title that is not subject to any previously unidentified liens.
  • Review service and maintenance agreements to determine whether there are recurring problems.
  • Have a property survey to determine whether the physical improvements are in the boundary lines of the site and to find out if there are any easements that would affect the value.
  • Verify that the property is compliant with zoning, environmental regulations, parking ratios, and so on.
  • Verify that property taxes, insurance, special assessments, and so on, have been paid.

Due diligence uncovers important details. And these details discovered change the transaction.

A year ago, we evaluated a 75 percent occupied office building located in Redlands, CA. It was a class B building, built in 1975 with minor deferred maintenance. Using the sales approach, a market value of $85 PSF was reasonable. When we interviewed the various tenants, we learned that a major tenant was in a foreclosure process and would soon be forced to vacate the property. Our client was able to favorably negotiate the purchase price because of the embedded uncertainty.   

Tax payments, or rather lack of, dissolved a joint venture transaction. Our client, a real estate syndicate, was interested in purchasing a 60-unit apartment complex in Lancaster. The seller, who managed the property, offered to continue the manage the property for a miniscule management fee and keep 20 percent in the property in return. In the due diligence process we learned that the seller had not paid any taxes in past five years. “I pay enough property taxes on my other properties.”, he explained. Rest assure, the purchase never happened.  

Hidden title issues reduced the market value. Another client, a non-profit organization, was looking to purchase an industrial building in Chula Vista, CA. It was 115,000 SF building 65% occupied by the seller, a manufacturing company. Given our client’s status as non-profit, without a predictable income, they were not able to finance the purchase. The seller offered to change title without notifying the first lien holder. The seller forgot to mention that secondary liens were attached to title in sum greater than its value.

Environmental report revealed asbestos. “This assessment has revealed evidence of recognized environmental conditions and/or environmental issues in connection with the subject property. Based on the conclusions of this assessment, we recommend the following.”, concluded a phase 1 report. This transaction evolved the purchase of an empty mall with the intension to redevelop the are into a high-rise residential building. Here the purchase did take place, with seller taking all the environmental-related cost.      

The purchaser and lender perform the due diligence. The purchaser may review the transaction “in house” or hire outside consultants. Arguments arise which method is better. On one hand, in-house team ultimately takes control over the property, so logic dictates they show thoroughly understand the transaction. On the other, outside consultants may have a broad understanding of transactions in marketplace. a two-step approach works best.

The first step is for the purchase to completely understand the transaction. Equity and debt investors ultimately require answers from management, not their consultants. The second step is pay attention to lender’s due diligence. The lender may find issues unseen initially and are usually well experience in working with a range of property types.