Operational Due Diligence
Operational due diligence is perhaps the easiest category of investigation of an income property. The expense side of the operating statement provides a road map of sorts to “where the bodies lie”, as my good friend and colleague Ed Garcia puts it. What he’s humorously referring to is the common practice of an owner to understate expenses in order to make the income look better than it is.
Ed has spent thirty plus years financing real estate. To say he has seen it all doesn’t begin to describe the many ways property owners seek to enhance performance through omitting or misrepresenting operating expenses. This is the flip side of the issues we addressed in the previous article, Financial Due Diligence, which mentions the practice of padding a rent roll for the same purpose; both of which are akin to putting lipstick on a pig.
The astute investor knows that no matter how honest the seller is in supplying operational data there can and will be differences between the historical expense profile and the projected expenses under new ownership. For example, in some areas the sale itself can significantly change the property tax status, as well the insurance costs.
But the purpose of operational due diligence is to provide a baseline for the expense projection for the buyer’s first year of ownership. And in the process of verifying the major items it is often the case that hidden defects that did not show up during physical inspections will become apparent.
Utility Usage: The Key to Controlling Costs
Utility bills are typically among the highest line-item expenses in commercial properties, and have several characteristics not present in other expenses. I recommend getting copies of at least two years of the actual monthly bills, showing both the cost and the usage. If the property owner has not preserved the bills, they are readily available from the service providers.
Annual or monthly utility costs as reflected on an operating statement are not enough to determine if the cost and usage is in line. An annualized statement tends to smooth the seasonality of use, but may mask over-consumption.
Second, the operating statements reflect only the utility expense. The only way to accurately gauge utility consumption is by tracking the units of use (gallons, watts, etc.) on a per-occupied unit basis. This will isolate spikes in use indicating abnormal conditions, namely leaks and system malfunctions. Each utility category has a norm of usage that the utility can often supply. For example, a family of four, on average, uses about 5,000 gallons of water per month. Consumption over that amount may indicate a leak in that building or section of the property. Other utilities have similar norms, usually available from the providers.
Finally, many utilities are owned and operated by municipal providers. In recent years the fiscal stress on local governments has become acute. Some have turned utility operations into a profit center to generate revenue without raising taxes. Examine the rate trends, inquire about planned rate increases, and adjust your operating projection accordingly.
Sleeper Increases: Property Taxes
Property taxes are a significant expense item and should also be analyzed for the rate trend over time. The rate information is found on the source document or from the taxing authority. Most local governments rely on property taxes as their main source of revenue. It is very rare to hear of a tax rate being decreased, and an increase may have no relation to the inflation rate or price index.
It takes only a few minutes to verify the information straight from the source, and if you are in the tax office personally, there is an opportunity to strike up a conversation with a clerk who will grant some insight into the local politics regarding potential tax increases. I also use the opportunity to inquire as to whether the property taxes are current. Deferral of payment for property taxes is a common source of off-balance-sheet financing and another indication of financial stress for the present owner, another little tidbit that may be important during final negotiations before closing.
There will be an assessed property value on the tax ticket. This value is usually irrelevant to valuation, but it is wise to compare the assessed value of the subject property to others of the same type in the market. If it seems out of line, then a reduction may be possible. As mentioned above, be sure to inquire whether the sale transaction will change the tax assessed value, and when. Some states mandate the updated sale value be used. Others may have a phased increase, and some (though fewer and farther between) may take no notice of the disparity between assessed value and sale prices.
Insuring For Profit
Insurance policies are a wealth of information if used properly. Though policies are rarely transferred, the basic information from the current policy is needed in order to price coverage from your insurer. The amount of loss insured; the type of policy and standards of coverage (replacement cost, business interruption, plate glass, boiler, etc.); any riders attached for additional property or casualty (flood, disaster, etc.); and any exceptions to the coverage are essential in getting accurate and competitive bids.
Also compare the cost listed on the operating statement to the actual premium. Many owners may have one carrier or agent for a number of properties, and may also carry a separate liability or umbrella policy. If the amounts are pro-rated it can mean an expense reduction or, if the cost of a general liability policy is not included, a source of additional expense.
There may also be a risk assessment in the owner’s files. This is a report that the insurer prepares to notify the owner of any problems in the property that must be corrected to maintain coverage. This report is not always available, but can be a great shortcut to finding hidden problems. In sum the risk assessment is an objective third-party look at the property from the perspective of identifying possible liability for negligence, poor workmanship, deferred maintenance and latent defects. When you can get it an insurer’s risk assessment can be a wealth of information.
Do the Due: Check Every Expense
Remaining expense items should also be independently verified whenever possible. Be aware of how owners operate the property in order to normalize the operation under your ownership. For example, some sellers are hands-on owners, and the maintenance expense may reflect only the cost of materials, since they do not pay themselves labor costs. You won’t know unless you ask.