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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   July 2009

Get the Facts Straight

Help clients dig deeper with their due diligence before they purchase income-producing property

Property-buyers can fall into many due-diligence pitfalls when purchasing income-producing commercial real estate. Perhaps the most-significant is not customizing the underwriting assumptions to the specific property they wish to purchase.

Buyers often rely solely on underwriting assumptions when considering an investment-property purchase. Initially, underwriting assumptions are somewhat standard for most buyers. 

In a stable market, these often include a 2-percent to 3-percent annual rent-growth rate, a 5-percent vacancy allowance, a 75-percent probability that existing tenants will renew and allowance of a 15-cents- to 50-cents-per-square foot capital expense.

Due diligence that customizes and substantiates underwriting assumptions is critical. In a tight credit environment, buyers seeking financing must be able to substantiate and support their assumptions more than ever. 

It isn't enough to rely only on appraisals and property-condition assessments (PCAs) to ensure feasible underwriting.

Beyond simply being a financing source, mortgage brokers can help their clients by knowing how to ensure that property underwriting is customized to the property in question. They also should know how proper due diligence can help. 

Knowledge of these issues can help ensure that a property's actual financial performance won't be drastically different than the initial or preliminary underwriting.

Ultimately, buyers must do their due diligence to back up their assumptions. Here's why.

Capital expenditures

Because projected capital expenditures can have the most influence on underwriting results, buyers should investigate the asset's current condition thoroughly. Lenders often require a PCA, which will provide some basis for projecting ongoing maintenance and repair costs, as well as capital expenditures.

One mistake many buyers make, however, is stopping there with their efforts to assess the property's condition and future capital costs. PCA reports commonly overproject the remaining useful life of equipment or building components or fail to project costs to correct existing conditions adequately. This is because a visual inspection rarely reveals deficiencies in the existing conditions. Additional investigation is needed that PCA consultants typically do not perform.

Further, more-complex properties may expose buyers to greater risk in projecting capital costs accurately. 

For example, consider a midrise office building that has more-complex heating, ventilation and air-conditioning equipment like chillers, boilers and variable-air-volume boxes for air distribution with computerized controls compared to a small neighborhood retail center, with split heating and cooling systems or rooftop-packaged units for the tenants' heating and cooling needs. 

The office building's greater exposure would warrant investigating the equipment's repair and service history beyond the PCA, interviewing the applicable vendors whenever possible. These vendors often can reveal major, yet-to-be-corrected problems.

Talking to the property's tenants also can reveal any inadequacies in the system's ability to heat and cool the building properly.

Many common deficiencies -- with large and small costs associated -- may exist on a property. PCA consultants, however, often miss existing major issues or issues that have the potential to become major expenses. As a result, buyers shouldn't rely solely upon this source for their capital-expenditure assumptions. 

Additionally, most PCA consultants lack property-operating and property-management experience. Therefore, they may not recognize operating concerns that may not always have a large capital expenditure associated with the condition but rather less-tangible problems that may affect a property's financial performance over time.

Tenant renewals

When conducting due diligence on a property to back up underwriting assumptions, a buyer representative should conduct interviews with existing tenants. This representative should have a comprehensive set of questions developed for this purpose. 

Many questions are global to any property, and others are specific to certain asset classes but not to others. Some questions may be specific to the individual property and will develop from questions or concerns that arise after site visits, tenant-suite evaluations or the start of other due-diligence activities.

In all cases, however, property-buyers should seek information that helps to perfect and substantiate the assumptions that drive the underwriting.

For example, many property-buyers will assign all tenants a 75-percent probability of renewal at the lease-term expiration. They may not conduct any upfront research, however, for a major tenant that has public information available. They also might not give cause for adjustments or information of concern about certain industries' financial strength.

For most tenants and for most properties, buyers must observe tenants' use of space and customer activity and ask tenants specific questions to customize the tenant-renewal assumption to each tenant and for each property being considered.

This assumption is important to get right because it determines the projected capital costs for tenant improvements and leasing commissions during the year a tenant's lease expires. Landlord costs to renew a tenant typically are much less than costs to fill a space with a new tenant. A 75-percent renewal assumption calculates 75 percent of renewal costs and 25 percent of new-tenant costs.

In addition to substantiating tenant-renewal assumptions, good tenant interviews will help buyers assess tenants' overall satisfaction with the asset, reveal the tenants' known future plans relative to their occupancy and reveal any existing problems with the asset or with the current management. The latter can be important if your clients are considering a postpurchase engagement with the same property-management company or personnel.

Leasing assumptions

Leasing assumptions are another important underwriting component. Market rents, growth rate, vacancy rate, absorption, tenant improvement and leasing costs should be customized and substantiated. Although appraisals and other market-statistic reports will give a good initial basis for these assumptions, they do not alone provide the necessary information to customize to the asset.

Buyers should have an experienced commercial real estate professional tour the property, including each suite. Some observations may raise concerns. 

For instance, this activity will help assess whether office tenants need their entire suite or something smaller if there is a lot of unused space. Or a restaurant tenant may have few to no patrons during typical meal times. 

These observations could provide reasons for modifying the leasing and renewal assumptions that may be more appropriate for the market and property.

They will also allow the buyer to adjust assumptions on rent and the time needed to lease the space if unusual circumstances come up. Talking to people at the property could reveal that a space has been vacant for many years. Or touring each suite may show that a space has an unusual or undesirable configuration.

Either circumstance may lead to a reduced market-rent assumption to entice tenants to lease the space, longer absorption assumptions or increased tenant-improvement costs to reconfigure the space when feasible.

•  •  •

These examples illustrate what cannot be garnered from PCAs, appraisals and market reports. In addition to a PCA, buyers should interview a property's tenants and tour the property. 

These additional steps can give some insight into how buyers should complete their underwriting before making any final purchase decisions. 

Brokers who help their clients understand why they might need to do additional due diligence on top of the standard reports can help their clients have a successful deal.


 


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