PHASE II DUE DILIGENCE: BOOKS AND RECORDS
Books and Records, the second phase of Due Diligence is vital. Fail here and the cash cow you thought you had just might be a profit eating alligator. Books and Records are the Seller provider documentation of the historic performance of the asset. These will often include Profit/Loss Statements, Income/Expense Statements, Rent Roll for the most recent month, check registers, Service Contracts, Roofing Guarantees, Phase I and II Environmental Reports, Certificate of Occupancy (CO), copies of leases, Security Deposit Spreadsheet, Elevator Permits, Safety Inspection Reports, etc.
Books & Records evaluations tends to be low or no cost. As such I always complete them to the point at which I know it makes sense to proceed further before I do the Physical Inspection. Physical Inspections almost always cost more money.
REVENUES: I recently underwrote a small shopping center for sale in one of Oregon’s most desirable areas. I was shocked when I looked over the income and expense statement. The best properties in the area were rented at yearly rates of $32 to $34/sf. I felt the subject was a $25 to $27/sf per year property. When I learned that it was averaging less than $19.50 I knew I had found a gem. Walking the rents up on renewals is pretty close to a guaranteed way to create a huge increase in cash flow. I also feel that the Cap Rate was at the high-end of the market and that in a few years this area should see Cap consolidation. Knowing 1.) The Market Cap Rate and 2.) Market Rents allowed me to be confident in suggesting my client make a full-price offer. Note: You don’t often find “pride of ownership” flagship assets being sold below market. When you do find them…write an offer!
PROPERTY MANAGEMENT: I just had a situation on an Office Building owned by a group of professionals. I was representing an out-of-state institutional buyer on the acquisition. I mentally calculated that amount reported for Professional Property Management was equivalent to 13% of total revenues. A more typical cost for this size and type of asset is 4% of revenues. That is a material difference…that allowed me to project an increase in cash flow of $2,500 per month on this item alone. Digging further I discovered additional Administrative Fees and other charges that overstated costs even more. Be aware that the 4% Property Management Fee I used in this example would be way too much for a large industrial site (2%) and far too little for an 18 unit multifamily. (8-10%).
PROPERTY TAXES are another important item. The property taxes for the building cited in the above example were well below normal for an asset of its size. Researching, I found that the largest tenant was a non-profit that had 50% of the area. They also have a long-term lease with options through 2030. My research showed that the exempt status would remain stable and I didn’t need to project a major increase in costs soon.
I also know that the Oregon Supreme Court has said (paraphrasing broadly): “The MV Market Value of a property may reliably be represented by the recent sale amount of the said property.” My research showed that the price my investor was under contract for was 35% below Multnomah County’s stated Market Value. This meant that while the taxes on the building were far less than I expected…a tax appeal after closing could lower them an additional 35%.
Property Tax Appeals can take from just a few weeks to well over a year. This is an often overlooked area for additional profits. I worked on an appeal of a larger apartment in Arizona where the resulting increase in cash flow was $13,500 PER MONTH. It also reduced expenses to the tune of raising the sale value of the property by $3,200,000 at Market Cap Rates.
SECURITY DEPOSITS reported on the leases have to be matched with those reported as retained by the Seller. I helped a 1031 Exchanger buy an apartment where 40% of the security deposits were incorrectly accounted for. Footnote: Each one that was incorrect understated the amount that was to be transferred to the Buyers. This is one of those duties that truly qualifies as a pain in the rear, but my client would have lost thousands of dollars if I hadn’t persisted. The largest Due Diligence file I’ve ever seen was on an 896 unit multifamily acquisition I worked on in Las Vegas 5 years ago. The file just for the leases was almost 10,000 pages.
SERVICE CONTRACTS include a host of vendors ranging from security patrol to, maintenance. You need to understand what your obligations are and what you can expect from your vendors.
INSURANCE rates have plummeted in the last 7 years. If you haven’t asked for a requote you are likely paying too much. Always get a new bid at acquisition.
RUBS stands for Renter Utility Billing System. One of the quickest ways to improve the profitability of a multifamily asset is to have the tenants pay for their utilities with their rent. When utilities are included in rent the tenant will universally use more. This seems to hold for all socio-economic situations. A RUBS system reduces waste. If a property is cash flowing, every dollar of expense reduction will generate an additional dollar of cash flow. At a 7% Cap Rate: every long-term reduction of expense creates an increase in the sale price of $14.28.
WHY IS THIS SO IMPORTANT: Reducing annual expenses\raising rents by $70,000 will raise the value of your property an additional $1,400,000 at the time of sale.
Please contact Rick M. Bean at 503.577.1034 or rick@rosecitycre.com for more information!
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Michael Kapnick: The way investment real estate ought to be done! | Rose City Commercial Real Estate
What You Need to Know about Capitalization Rate | Rose City Commercial Real Estate