What is Due Diligence Anyway?

Commercial Real Estate is a completely different animal from Residential Property, particularly with respect to assessing value. This may seem like stating the obvious, however, it is easy to overlook the many details that come into play in arriving at a value.

Commercial properties are usually valued on their income stream. And, the value is determined in an inverse proportion to the degree of risk in the continuance and stability of the income stream provided by the property. The analysis and valuation of that income stream and the associated risk can be a very complex process. This is where due diligence comes into play.

Due diligence is simply verification, verification, verification! The sole function of due diligence is to verify that you are getting what you think you are getting; that you are getting what you have been told you are getting; that the condition of the property is as reported, etc.

Due diligence should start with the beginnings of contract negotiation. Unless you want trouble getting to the closing table, it is imperative to make the seller aware of what you are going to be asking for before the Contract of Sale is signed. I can almost guarantee that all but the most sophisticated seller will be overwhelmed when he sees my list of required due diligence items. As such, it is an absolute must to include the list of required items in the contract. You can expect that there will be some negotiation as to what will and will not make it to the final draft of the contract.

During due diligence leave no stone unturned. Beyond the physical condition of the building, there are literally an infinite number of intangibles that should be taken into account when evaluating a commercial property for purchase. Every document concerning the building and its operation must be examined. This includes leases with any and all extensions and modifications, notes and mortgages (whether or not your are assuming them), the title policy, certificates of occupancy, insurance policies, ADA compliance, elevator maintenance contracts, tax bills, tax receipts, tax history, parking lot contracts, etc., etc.

Using the list generated in the Contract of Sale, one should review each item and assign the task of handling the item to a member of the acquisition team whether that be the attorney, surveyor, building inspector, environmental firm or whomever. Make sure each is contacted, given the time table for the deal and then follow up on a regular basis. It is important to follow up with the members of the team. With the exception of financing, more deals are blown at the due diligence stage than any other. It only takes one missing document to completely stall the closing. Each day a closing is stalled increases geometrically the chances that some other element of the deal will unravel. Do not skimp on these details. If one is not going to undertake to do them oneself, then stay on top of the chosen delegate to ensure the job gets done on time.

Of the due diligence documents, the most important are the leases, insurance policies and the title policy. Of these, the leases are supremely important! There can be some really strange stuff couched in obscure lease language, so read every word of every lease. I usually do this myself because very few properties have just one standard lease. On the flip side, there may be forgotten sources of revenue such as tenant reimbursements for the first $200 of HVAC repair that might go back to the original owner but has been overlooked by subsequent owners.

The insurance policy can be a goldmine of information especially in the case of a building with some age. Insurance inspectors have seen every trick in the book, and if you can get a copy of the last risk assessment you can be miles ahead of the game – the insured has to request this but insist on getting a copy. Also get a claims history.

A copy of the existing title policy will give you the obvious information regarding easements, rights of way and the like. Be on the lookout for any special exceptions to title. Other useful information found in the title policy can be as seemingly innocuous as who the attorney happened to be that prepared it. It c an pay to know when a relative is involved.

Physical due diligence items can be handled in a number of ways and the execution will vary depending on the organization and resources of the buyer, the nature of the property and the type of financing used.

Having on both the buy side and the sell side of a transaction, I know that as a seller the best way to protect myself is by knowing what a buyer needs to know before he knows it and disclosing it up front. This essentially removes any landmines in the path to closing. On the buy side, I consider it unethical to sign a contract with any terms other than what I intend and agree to perform if the property is in fact in the condition represented by the seller.

One final item is to assess the degree of risk associated with the likelihood of the continuance of the income stream from a commercial property. Commercial properties are vulnerable to a sudden economic downturn. A building with 100% occupancy can become 50% vacant overnight with the bankruptcy of a large tenant whose business is dependent on market factors halfway around the world. In order assess the risks, one has to gauge the underlying quality of both the tenant base and the quality of the physical asset. This is the essence of due diligence. Examination of rent rolls, payment histories and credit reports of can be very enlightening in quantifying the risk factors of a particular tenant. But much can be gleaned in the course of a conversation regarding a tenant’s business. Ask open ended questions and seek out any resource available to help in the decision making process.

My experience suggests that even after some 20 years in this business I rarely if ever ask every question that needs asking. That is why it is important to have people around that can look at a deal with fresh eyes. And together manage to find answers to almost all of the right questions. Those that are missed get added to an updated due diligence checklist.

Preliminary checklist – the following is a fairly comprehensive listing of due diligence items. Depending on the specific situation some of these items may not apply and others may present themselves.

o Annual P&L – 3 years minimum
o Monthly P&L – at least one year
o Balance Sheet – 3 years
o Rent Roll – including term, deposit and payment history
o Tax Returns – 3 years
o Insurance: policy including all riders, risk assessment and disclosure affidavit for carrier
o All Existing Loan Documents: including notes, deeds of trust, closing statements, title policy, rate riders, etc. along with names and numbers of contacts
o Deed
o All Leases: entire copies plus andy addendum or riders
o All service or advertising contracts
o Copies of all recent appraisals, engineering reports, environmental reports
o Survey (as built), legal description, architectural and engineering plans and specifications
o Payroll register: List of building employees including name, position, wage rate and benefits
o Business license
o Physical inventory of furniture, fixtures and equipment and supplies
o Utility bills – at least two years of monthly statements or recap report showing usage and cost
o Bank statement showing deposits for last twelve months
o Phone system documents
o Computer system documents
o Fires system inspection reports
o Property tax bills and receipts – past three years
o Litigation History – details of any past or pending litigation or affidavit from owner stating there is none
o Engineering inspection and Survey
o Environmental inspection and Survey: key issues, asbestos, lead paint, underground tanks, wetlands
o Environmental Phase I: An environmental Phase I Assessment is an inquiry conducted to determine the environmental status of a property or facility in connection with a real property transaction
o Environmental Phase II: An assessment/subsurface investigation may include but is not limited to subsurface drilling and samplijng monitoring well installation and sampling, ground penetration radar and asbestos and lead sampling
o LUST survey – Leaking Underground Storage Tanks
o Financial Audit
o Title Search and Policy
o Property Tax verification
o Tenant Estoppel Letters
o Mortgage Estoppel Letters
o Legal verification: Licenses, permits, zoning

Land values are about to boom?

(Fall 2005 Volume 64 Number 4, Professional Report, By Herbert L. Krumsick)

Building values have gone up 25 - 50% during the last three to five years. Herbert Krumsick believes there are five significant reasons behind this run up in real estate investments. 1) Lost confidence in the Stock MArket. Many American businessmen and the public have basically said "I've had enough" and are looking elsewhere to invest their money. 2) A Flight to Tangibles. Investors want something they can feel, see and touch. 3)Real Estate Credibility. Real estate is gaining more respect as a recognized "asset class" for institutional investment and investment ingeneral. 4) Real Estate Commoditizaation. Real estate investment properties will become more of a commodity. 5) Cheoap Money and the Federal Reserve. The Federal Reserve has added tremendous liquidity to the financial system by lowering interest rates to their lowest level since the early 1960's.

Why Invest in Land Now and How? Currently very little, if any, institutional money is invested in land. Land investing requires a lot of real estate expertise and is not for the faint of heart. Because it is so much easier to value income properties than land, the skill sets required to become a good land investor are not as readily available or duplicatable as they are for income properties. Land investment takes intestinal fortitude, guts, judgement, and intuition which is much more closely associated with an entrepreneurial rather than an institutional mindset. Krumsick's formula for investing in land is as follows: 1) Buy bigger tracts of land; 2)Buy interstate frontage; 3)Invest in your area of compentence; 4) Corners are the best; 5)Buy transitional land; 6)Buy low sell high; 7) You must be patient; 8)Land investments are truly long term investments; 9) Go with the trend; 10)Land is a great disciplinarian; 11)No money to invest? Try a land joint-venture; 12) No money to invest? Try OPM (other people's money) by forming a joint venture.

Land values are about to boom?

(Fall 2005 Volume 64 Number 4, Professional Report, By Herbert L. Krumsick)

Building values have gone up 25 - 50% during the last three to five years. Herbert Krumsick believes there are five significant reasons behind this run up in real estate investments. 1) Lost confidence in the Stock MArket. Many American businessmen and the public have basically said "I've had enough" and are looking elsewhere to invest their money. 2) A Flight to Tangibles. Investors want something they can feel, see and touch. 3)Real Estate Credibility. Real estate is gaining more respect as a recognized "asset class" for institutional investment and investment ingeneral. 4) Real Estate Commoditizaation. Real estate investment properties will become more of a commodity. 5) Cheoap Money and the Federal Reserve. The Federal Reserve has added tremendous liquidity to the financial system by lowering interest rates to their lowest level since the early 1960's.

Why Invest in Land Now and How? Currently very little, if any, institutional money is invested in land. Land investing requires a lot of real estate expertise and is not for the faint of heart. Because it is so much easier to value income properties than land, the skill sets required to become a good land investor are not as readily available or duplicatable as they are for income properties. Land investment takes intestinal fortitude, guts, judgement, and intuition which is much more closely associated with an entrepreneurial rather than an institutional mindset. Krumsick's formula for investing in land is as follows: 1) Buy bigger tracts of land; 2)Buy interstate frontage; 3)Invest in your area of compentence; 4) Corners are the best; 5)Buy transitional land; 6)Buy low sell high; 7) You must be patient; 8)Land investments are truly long term investments; 9) Go with the trend; 10)Land is a great disciplinarian; 11)No money to invest? Try a land joint-venture; 12) No money to invest? Try OPM (other people's money) by forming a joint venture.

My Intent

We are just starting here. Over the next several weeks I will post a number of newspaper articles and the like that I have written on various topics pertaining to commercial real estate. I hope that you enjoy and find these topics useful - some will apply to our little market here on the Eastern Shore and others will deal with the larger issues facing the economy and commercial real estate.

Let me know what you want to see and I will try to oblige.

Retail is Hot!, Hot!, Hot!

We are beginning to see the effects of a national trend right here at home. Retail real estate is hot all across the nation. Larger retailers continue to be the drivers of development and the demand for product by investors continues to be very strong. And, here is the part that brings home to the Eastern Shore, as the competition for prime space in the major markets has heated up, national retailers are looking to secondary and tertiary markets for their expansion plans. We can see the results of this by the addition of Ruby Tuesday’s, Bob Evans, Applebee’s, the rumored Target, and the like.

Secondary markets are getting a lot of attention simply for the reason that the primary markets have seen so much competition for the prime locations. The major markets are becoming “picked over” from the perspective of the retailers. As such, they are looking further a field than would have been the case just a few short years ago.

The underpinning of this surge is driven by strong fundamentals. The retails sector has been able to avoid the woes that have plagued many other commercial real estate sectors. The fundamentals have remained solid with steady rent growth, stable vacancy rates and good prospects for new development. The industry’s average vacancy has hovered at about 10% over the past four years and little change is expected. Rents rose by 2.5% last year and similar performance is expected for this year. New construction of neighborhood and community centers is up only slightly from last year. And, although retail sales are expected to increase only 3.5% this year versus almost 7% last year, this does not appear to be dampening the expansion plans of most retailers. Solid fundamental coupled with ready access to inexpensive capital has heightened investor demand for retail properties in both primary and secondary markets.

With retailers looking to add stores across the country to meet demand, secondary and tertiary markets have definitely arrived on the radar screen. Smaller markets offer some real advantages: lower land costs, lower development costs and in many instances an easier process in dealing with municipalities. In addition, retailers that have saturated larger markets may move into secondary markets because they lay in the path of growth.

Retailers are also realizing that many secondary markets possess strong demographics of their own but on a smaller scale. This can be attractive to the larger players. Many are entering smaller markets with scaled-down versions of there prototype stores. There are also niche players that prefer the secondary and tertiary markets for the reason that there is less competition – these retailers prefer to be the big fish in a small pond.

Demand for retail investments does not appear to be lessening. Further, investor demand is not dampened by small market size. As the national retailers move into smaller markets it is generating strong investor interest – with excellent credit, the national chains are selling at very low capitalization rates in the mid-to-low-7 percent range. And these investment properties are selling as fast as they can be brought to market.

With retailers continuing to fight for market share, with continued strong demand by investors for retail investments and with a continued stable interest rates, it is likely that we will being seeing quite a few of these national retailers here on the shore over the next few years. Get ready to shop!

Christopher K. Sadler is a principal with the Commercial Real Estate firm of Oxford Commercial, LLC located in Easton. Oxford Commercial provides Brokerage, Consulting, Development and Management services to the commercial real estate industry on the Delmarva Peninsula. Chris can be contacted at (410) 770-9717 or at csadler@OxfordCommercial.net.

Are Real Estate Markets At Their Peak?

Well, once again there is worry that we may be in a bubble with respect to real estate values. There is some speculation that Alan Greenspan is taking aim at what he sees as the overvaluation in real estate prices just as he took aim earlier in this decade at what he saw as the excesses of Wall Street. This talk about a bubble has been intermittently front-and-center in the press for the last couple of years. The question: Is the market climbing that wall of worry as Wall Street says that all bull markets climb or is there real fundamental cause for concern?

While my chosen field is commercial real estate, I pay attention to the residential markets because movements in those markets have a definite impact on the commercial markets. A recent article in the Baltimore Sun illuminated a new worry from the homebuilding industry: speculation. The home builders are so concerned that they have commissioned a survey to determine how large a portion of home buyers are investors or speculators. Many of these investors/speculators are snapping up homes that they won’t live in and may not be able to rent.

The general concern is that the market has been so strong for so long that people are piling in. Prudent investors look for rents to cover expenses and look to markets where demand and rental supply are in balance. But many investor homebuyers today appear not to worry about tenants, cash flow or basic economics. They are betting that prices will keep rising without regard to supply, demand or the notion of assets producing income. Sometimes homes aren’t even built before they trade hands. Are these investors/speculators the day traders of the real estate market?

The National Association of Realtors has begun tracking investors and reports that they accounted for approximately 23% of transactions last year. If these are truly housing day-traders, they will be quick to unload if the market begins to go south. As such they could exacerbate any market correction that might occur due to increasing mortgage rates.

On the commercial front a good friend of mine who is an avid reader of the Wall Street Journal dropped off an article titled “Investors Slim down as Property Prices Bloat” by Sheila Muto. The gist of the article: Is the commercial real estate boom over? There is reason to believe that the markets may be nearing their tops as many in the “smart money” category are net sellers of real estate. Take one look at recent transactions in almost any market in the country and the prices are record setting. Couple this with rising interest rates, looming tax changes and it is no wonder that the big boys are cashing out. What is interesting is that many of those that are selling are not reinvesting. With values so high some investors would rather pay the taxes and sit on the sidelines for awhile.

The California Public Employees Retirement System (CalPERS) is probably the largest single real estate investor in the country. In the first quarter of this year they have closed over $6.5 billion in sales of office buildings and shopping centers. Many of these properties sold for record setting prices. This represents roughly one-half of its vast real estate holdings. However, they are not finished as they have an industrial portfolio on the market for $1.4 billion.

Hines Interests of Houston Texas is one partner that sold along with CalPERS. They sold 12 buildings at numbers that were substantially in excess of their optimistic expectations. They do not expect the current high prices being seen today to continue for another 12 to 18 months.

Similar to the residential real estate markets a combination of low interest rates, insatiable demand and a lackluster performance in the stock market has generated astounding appreciation. Many argue that commercial real estate continues to be a good investment given the alternatives especially with real estate investments generating returns that are as good as or better than stock and bond returns. However, some very astute and sophisticated real estate players are moving to the sidelines: Does this indicate a top to the market?

Housing markets are experiencing the influx of speculators. In commercial markets the “smart money” is moving to the sidelines. What is to become of the Eastern Shore? While we will be impacted by the larger markets, and while we are experiencing some speculation in the residential markets, I believe that we are in good shape with regard to both residential and commercial real estate. Firstly, in the residential markets demand exceed supply and while I think that many of the “growth controls” (if they can be called that) implemented by the Town and County are ill conceived, they have served to limit supply. If there is a downturn or the bubble bursts, the Shore will be less affected than the larger hotter markets. Secondly, with regard to commercial, we have not seen many of the excesses seen in other markets. Supply is in line with demand and even though values have increased significantly, in most instances the values are supported by the underlying fundamentals.

Finally, all that said, if you are even considering the possibility of selling commercial real estate, now would be a good time. I do not believe that the appreciation we have seen over the past few years will be repeated over the next few years. Values are high and demand for investment real estate is high. It is a sellers market. If you think you might be a seller, take advantage of it.