Due Diligence in Self-Storage
|Copyright 2014 by Virgo Publishing.|
|By: John Gilliland|
|Posted on: 02/01/2004|
Due diligence is the process of discovery and confirmation of the financial and physical attributes of an investment property. This important process is, in all too many cases, rushed or, worse yet, skipped entirely, in the sheer excitement that accompanies the probable purchase of a self-storage facility.
But think about it. You are about to invest hundreds of thousands or millions of dollars, and you must make sure you are getting what you pay for. Take a moment to logically consider the process. A buyer must carefully draft a sales agreement, review the documentation, conduct a site visit, consult the lending institution, and enlist the help of professionals to properly perform due diligence.
It all starts with the sales agreement, in which the buyer must outline the documentation needed to properly determine the value and suitability of the purchase. The sales agreement should also outline the time frames in which this process will take place. It is highly recommended that a list of necessary documents be included in the agreement (see accompanying sidebar).
This will give the seller notice upfront that you are going to be thorough in your due diligence. It also gives them time to start gathering the information. If a knowledgeable self-storage broker represents the seller, this information should be prepared and ready for delivery soon after an agreement is signed.
It is important to establish time frames at the beginning of the due-diligence process. Most agreements allow for a period of 30 to 60 days from the time all documents are given to the buyer. It is important to have the time start after all documents have been delivered. This gives the seller incentive to produce the documents in a timely fashion and prevents the buyer from receiving all of the paperwork in a piecemeal manner.
The delivery of the due-diligence materials should be documented with a letter from the seller to the buyer. It should be acknowledged by both parties, defining the exact time frame, from the beginning to the final date. During this time, a deposit will be tendered and placed in the broker’s or attorney’s escrow account. This deposit is typically fully refundable during the due diligence period. It only becomes nonrefundable once the process is complete and the buyer is satisfied with the information.
Let’s start with the revenue side of the financial documents. Most self-storage facilities are run with the assistance of a software program designed specifically for the industry. If that is the case with the facility being purchased, financial reports are fairly easy to generate. If the seller is using a manual accounting system, the information may take a bit longer to accumulate.
The first report needed is a summary of all the unit types, how many there are of each, how many are rented, and what revenue is generated from those rentals on a monthly basis. This report is called the “potential revenue” or “rental-activity” report on the more popular software programs.
A buyer also needs a complete rent roll, including tenant names (or a note that the unit is vacant), with unit numbers, sizes, actual rent, account balance (to show rent owed or prepaid rent), deposit amount, and date of last rent increase. An explanation of any rent specials is necessary to determine actual rent collected. A list of delinquent tenants with an accounts-aging report should accompany the rent roll. Many software programs will produce a monthly managementsummary report, which can be helpful to validate the revenue stream.
Profit-and-loss statements from the seller’s accountant or internally generated from the management computer are needed for the past two years and the year-to-date for current operations. The revenue numbers should match those shown in the management-summary report.
Your lending institution will require certain documentation about the property. It is a good idea to get a list of documents it requires upfront so you can include them in your due-diligence request in the sales agreement. First and foremost are the past three years of tax returns on the property. If a sole proprietor owns the property, the Schedule C portion of the return is all you need. If the ownership entity is a partnership, corporation or limited-liability company (LLC), the returns for that entity is sufficient.
A note about tax returns: Small businesses are afforded a myriad of deductions relating to their business operations, but not all of these deductions are considered when valuing a self-storage facility. For example, take auto-related expenses. Although fully deductible as business-related expenses, they are not typically deemed necessary for the operation of a facility and not taken into consideration in the determination of net operating income.
To confirm the expense numbers provided by the tax returns and profit-and-loss statements, a buyer can look at the invoices for operating expenses, tax bills, insurance binders, service contracts and employment contracts. It is typical for a buyer to request backup documentation on a few expenses if any discrepancies are uncovered. From the profit-and-loss statements and tax returns, a buyer should be able to validate the net operating income represented in the offering memorandum provided by the broker and/or seller.
There are several documents that can be provided by the seller that may assist the buyer in saving some money and time in preparation for the closing. One of these would be the title-insurance policy issued when the property was last transferred. This policy will give the buyer’s attorney or title company a head start in researching the chain of title and should reduce the cost of the new policy. The same can be said for the fire- and liability-insurance policies. A buyer will need a new binder on the day of settlement; providing the insurance agent a past policy aids him in providing a bid.
Two other areas of great potential savings are environmental studies and ALTA (American Land Title Association) surveys. A phase-one environmental study can cost $1,500 to $2,500 and takes up to 60 days to complete. If the seller can provide a past report, most lenders will use it if it is less than two years old, or they will only require an update letter (which is much less expensive) if it is more than two years old. There are also environmental insurance policies available if lack of time to get a phase-one study is an issue.
ALTA surveys are typically required when obtaining institutional or conduit financing. These surveys are very detailed and provide a lender and buyer with assurances that the property description is correct and there are no discrepancies in the boundaries. ALTA surveys range in cost from $2,500 to $6,000, depending on the size and complexity of the property. Most local banks will not require an ALTA survey, and most buyers are satisfied with a legal description or standard survey.
During the due-diligence process, a day is scheduled for the buyer to conduct an on-site inspection of the physical property and any on-site books and records not provided with the copied materials. A buyer may hire an engineer or property-inspection service to assist in the process of looking at all the improvements and their ability to sustain the cash-flow stream over time.
This assessment will also help determine what your reserve for capital improvements should be. Typical inspections will include the roofs, gates, all vacant unit doors, office space, apartment, blacktop, fencing, structure of the buildings, company units, utility rooms, HVAC systems, plumbing, electrical systems, storm-water-management systems, and any other improvements on the property. On-site inspections will also include inspection of a sample number of leases. The seller does not customarily provide copies of all the tenant leases. Instead, the buyer is afforded the opportunity to inspect the leases during the due-diligence period. Typically, the buyer will randomly pull 3 percent to 5 percent of the leases and make sure they match the information on the rent roll.
If this due-diligence process seems a little overwhelming, you can and should enlist the help of professionals. First and foremost is your self-storage broker. Part of his job is to guide you through this process. Second, your attorney can review any documents, provide the title policy, and work with the other side’s counsel to bring the transaction to a close. The title-insurance company can provide a good and marketable title. The escrow company can facilitate the closing. Environmental engineers can perform a phase-one study and other continuing services if any issues arise. Surveyors and civil engineers can do the required surveys. Accountants can assist in the review of the financial statements and verify the cash-flow projections. Finally, the insurance agent can make sure the property is insured to cover any general risk and those risks specific to the selfstorage industry. Professional help can save you considerable time to get the process done right the first time. You will find it is money well spent.
Taking the time and effort to perform a thorough due-diligence study on a self-storage acquisition is critical to a successful term of ownership. Any issues that may hinder a sale should be discovered early in the process, giving the parties time to work out an agreeable solution. The information you acquire and discover will prove invaluable in the smooth transition and operation of the property. Due diligence is the key to ensuring you are going to be pleased with the acquisition once closing occurs.
John H. Gilliland is president of Investment Real Estate LLC and Investment Real Estate Management LLC, which provide brokerage and management services to self-storage owners throughout the mid-Atlantic and Northeast states. Gilliland is also a member of the board of directors of the national Self Storage Association and president of the Pennsylvania Self Storage Association. For more information, visit www.investmentrealestatellc.com.