When acquiring real estate income properties due diligence is something that we know is important, but we dread doing it, often cut corners or rush through it, and then regret it later. We get excited about getting a deal done and lose sight of the mechanics of knowing what we’re buying.
There is only one thing we can take for granted about a commercial property: the seller always knows more about the property than we do. As a buyer, our job is to ferret out the information the seller may not want to volunteer, or perhaps isn’t aware of, in order to make an intelligent decision about the deal.
The information to be analyzed during the due diligence period falls into three general categories: financial; operational, and legal/physical conditions. This article addresses the first category; financial due diligence.
Discovering What We Don’t Know
John Maudlin, a noted hedge fund analyst and financial advisor, says in his book Absolute Returns, “It’s not what we know that will cause problems for our investments. It’s what we don’t know that always causes the disasters.”
I couldn’t agree more. Keeping track of the dozens of details involved in Even when we summon up the gumption to really dig into a deal we sometimes come away feeling we haven’t asked the right questions.
The Goal: Accurate
By definition, the valuation of an income property is highly dependent on the amount of income being produced, so to determine value we start with the financial data. The objective of due diligence is to collect the information needed to construct an accurate depiction of the property’s operation.
Therefore it is critical that we construct an accurate representation of the operations as they exist today. Different owners operate properties in different ways. We can only value the property based on how we will operate it, and how anyone else does it is irrelevant.
We verify every item of income and expense, adjusting the statement and then use that information to accurately project the property’s performance under our ownership, also known as a normalized income statement.
Get the Real Numbers
When we request information on a property listed for sale, we are usually given a pro forma statement of income and expenses. A pro forma income statement represents the income with certain assumptions that may or may not be the actual reality. We need the reality.
A dead giveaway to pro forma numbers is found on the top line of the income statement. “Gross Potential Income”, followed by a subtraction from potential income tell us that the numbers given are not actual performance. A typical pro forma statement will look something like this:
Gross Potential Income: $100,000
Vacancy loss (5%): $ (5,000)
Gross Rental Income $ 95,000
“Gross potential income” assumes that 100% of the units are rented and collected 100% of the time. The income is then reduced by an arbitrary vacancy factor that may or may not correspond to market or property performance. A pro forma income statement may mask the reality that the property has more vacant units than the numbers assume, or heavy collection losses and pending evictions. To use the potential income means we would be paying the seller for income that we must produce.
The use of the most recent actual operating performance is a cardinal rule in valuation. Historical data for the past three years of operations is the ideal to establish a performance trend for revenue and expenses. Three years is the magic number; a lesser period may hide problems that are not entirely cured; any longer period will include irrelevant information.
The property’s tax return may be used to verify the operations. When available, you can rest assured that expenses will never be understated on a return, though it may not always be an exact match due to differences in tax accounting from standard accounting practice. If there are major discrepancies in the reported taxable income, ask yourself this question: “If the owner will lie to the government, would he lie to me?”, then act accordingly.
Existing Loan Documents
The existing loan documents are obviously essential if any loans are being assumed. If not, then the existing loan information may not be relevant, and the owner may refuse to supply it anyway.
However, I like to know how much the owner owes and on what terms just as general background information to help me understand motivations. A search of courthouse records sometimes yields interesting information regarding notes that have been modified or extended. A note with such a history may be a tip that some financial stress has occurred, either with the property or elsewhere in the owner’s affairs. This can be valuable knowledge in final negotiations.
Now we move to the verification of the income, using the line items of the operating statement as our guide. It is important to not only verify the amount of the income, but also the quality. Inherent in every property analysis is measuring the risk that one or more tenants will vacate at the end of the lease, or worse, become a collection problem during the lease term.
Leases are the most important documents that attach to an income property. Read every word of every lease. The existing leases are what produce the income, so it is critical to review every lease. Make a note of any discrepancies, concessions, or required improvements. If the improvement or concession has not been met, you will inherit the obligation and must factor it into your operating projections. I have seen some of the strangest things you could ever imagine couched in lease addendums. Make notes of anything that needs clarification.
Rent Rolls are a convenient report that consolidates the information contained in the leases. A basic rent roll report should show the unit number or name, the tenant name, the rent amount, any past due balance, and the lease expiration date.
If past years’ rent rolls are available they can help analyze tenant turnover, identify collection problems and reveal any anomalies from the current performance. This is the basis for your first year income projection. If the owner does not have the report you will have to construct one from the leases.
However, especially in multi-family properties, the rent roll may also hide pertinent information. To determine tenant quality we have to go further.
Tenant files can reveal the most critical information regarding tenant quality. They should be examined for completeness and compliance with appropriate regulations prior to closing. Major concerns are tenant credit reports, complete applications, any personal guarantees, and for residential properties the required waivers for lead paint and mold.
In reviewing the tenant files, keep an eye out for recent additions to the rent roll. More than one seller has filled a property with sub-par tenants in order to boost the occupancy prior to offering the property for sale. The files may reveal poor or non-existent credit reports and a lack of landlord references. It will be your job to evict the tenants, refurbish the units, and incur the expense of re-leasing. If the problem is widespread the investment can become a turnaround project overnight.
This is an overview of the major income factors to investigate in an income property. There are innumerable variations, additions and permutations of relevant issues that arise as one inspects various property types. For a more detailed guide to investigations it is wise to seek a text which explores the subject in depth.
Once the income has been verified and the quality established, further due diligence will concentrate on the expense side of the operations. For a similar overview of the important issues to consider, see the companion article, Physical Due Diligence.