Due Diligence
Copyright 2014 by Virgo Publishing.
By: RK Kliebenstein
Posted on: 02/01/2002



 
The essence of any good real estate transaction is due diligence, a "cat and mouse"-like game played between buyers and sellers, lenders and borrowers that defines the risks in a transaction. Buyers and sellers alike can benefit from knowing more about the due-diligence process. Here are some key trade secrets.

The time to conduct due diligence is before you sign on the dotted line. Once you purchase the property, you own the mistakes and the genius. It amazes me that novices to this business would neglect to seek expert counsel when putting hundreds of thousands or even millions of dollars at risk.

Last year, I had two opportunities to work on due-diligence assignments that had potentially tragic results. The first situation was one in which the purchaser did not conduct a thorough due-diligence effort, purchased the property, paid cash and then sought financing. I was performing due diligence for the lender and found the purchaser had been duped by the seller. The property did not generate nearly the income the purchaser had relied on from the seller's data. In fact, the actual performance of the property was less than 75 percent of what had been reported.

Note to buyers: Before you purchase a property, you must ask yourself, why has the property not sold to one of the major buyers of self-storage properties?

There are numerous large self-storage buyers who are ready, willing and able to close on transactions. If a property is the correct size and price, and located in a good market, you will never get a chance to buy it except for very few reasons. If an institution doesn't purchase it, the property or transaction may "have hair on it." If you decide to purchase it anyway, keep these points in mind:

  • The same reasons the property did not sell to the institutions before will likely still exist to haunt you when it comes time for you to sell.
  • Lenders may have the same beef with the property as the major self-storage buyers. In order to get it financed, you may have to find a lender who does not know enough about the property or industry to make a good lending decision.

The second situation I faced was a little less traumatic. The purchaser engaged our firm to conduct due diligence after he closed. We found there was a moratorium on building or expanding his property, which was regrettable considering one of the compelling reasons for purchasing it was to expand. He also discovered a new 80,000-square-foot property had been approved in his market and permits were ready to be issued. So not only could he not build, but he had a first-generation, state-of-the-art product about to become his competitor. He wished he had done due diligence before he closed.

Note to buyers: Never close on a property unless you have made a thorough due-diligence effort. If due diligence is not your core business, hire a professional. Do not risk the purchase without help.

The Due-Diligence Team

Who should be on your due-diligence team? First, you want to have an attorney review the legal documents and investigate pertinent issues:

  • Purchase and sale agreement
  • Entity documents (Does the seller have the right to sell the property? Are there partnership issues?)
  • Title-insurance binder
  • Noncompete clauses
  • Zoning compliance
  • Ability to replace improvements as grandfathered (on noncompliant sites)
  • Environmental reports (particularly if there are issues)
  • Personal-property purchase agreement
  • Trade name and d.b.a documentation and rights
  • Issue and opinion letter on lease document
  • Reps and warrantees
  • How are prorations handled at close?
  • How are receivables handled at close?
  • When does the close technically take place? On the day of escrow? When funds are sent? When funds are received? When deeds are filed?

An accountant or self-storage consultant should check:

  • Bank statements compared to financial statements
  • Cash to accrual-basis conversion
  • Accounts-receivable and accounts payable reports
  • Reconciliation of site-management reports to the documents originally submitted for making the purchase decision
  • Physical inventory
  • Retail-sales inventory

A self-storage due-diligence professional should:

  • Audit lease documents
  • Conduct verbal estoppels
  • Conduct a market evaluation
  • Examine the propensity for rental-rate improvements
  • Interview and assess on-site personnel
  • Interview and retain or hire a third-party management company
  • Prepare three years of budgets
  • Examine manager- and employee-incentive program
  • Evaluate retail-sales program
  • Conduct a software evaluation
  • Archive integrity
  • Make operational suggestions to enhance the property
  • Inform you of ways to reduce operating expenses

The title-insurance agent will inform you of survey liabilities, such as:

  • Easements
  • Encroachments
  • Setback violations
  • Ownership issues
  • Pending litigation
  • General title flaws
  • Construction or contractor liens

An environmental consultant will provide:

  • A phase-I environmental site assessment
  • Further testing as needed
  • No-further-action letters
  • Indemnification agreements
  • "Bugs and bunnies, turtles and owls"
  • Wetland delineation

Engineers will issue:

  • Property-condition report
  • Structural evaluation
  • Permit compliance
  • Code-violation exam
  • Life-safety issues

Surveyors can provide:

  • Boundaries
  • "As-builts"

Insurance agents will discuss:

  • Current insurance coverage
  • Cost of new insurance

Property-tax consultants can predict:

  • Special tax considerations from the past that will expire
  • Future tax liabilities
  • The likelihood of appealing tax billings and winning

Appeasing Your Lender

Conducting a thorough due-diligence effort will serve two purposes. It will determine if the information on which your original offer was made is accurate, and what the lender will discover when it conducts its own due diligence. For whatever the purpose, you soon begin to realize the complex nature of the due-diligence process and the difficulty that ensues when judging a property's ability to generate and sustain income.

The lender will be much more critical of the property. It will want to know what the demographics are like and how they play a role in the marketing, the strength and diversity of the local economic and employment market. It will also want information regarding declines in occupancy, rental rates and the impact of existing and emerging competition.

Many borrowers are hesitant to disclose the weaknesses of their property for fear the deal will fall through. This is usually the result of an emotional attachment to the site. Your lender should be a sounding board for your investment choice. Clearly, it should not be the pivotal opinion on which you base your decision, but should be taken into consideration. If the lender does not see the upside in a transaction, it is likely one of three circumstances are in play:

1. You have not properly documented the potential of the property.

2. The lender does not understand self-storage lending and operation.

3. You are operating on your own instincts.

The bottom line is, if the upside is genuine, you should easily be able to document it. Lenders are not born to be deal-killers. They are likely to be as disappointed as you are if a deal falls out because of discovery during due diligence. Lenders do not make money by analyzing deals, they make money making loans. Their threshold for risk just may be less than yours. Here is a simple formula to follow in working with lenders:

  • Identify the risk.
  • Understand the causes.
  • Mitigate with solutions.

Many lenders are turning to professional due-diligence providers for expert assistance in identifying and analyzing the risks of a transaction. The due-diligence process gives lenders a clear picture not just of valuation, but also of cash flow and cash-flow preservation. It also creates a detailed analysis of each asset's ability to perform in expected and unexpected market and financial conditions. Most important, a complete due-diligence report provides solutions to mitigate potential concerns of a lender or rating agency.

There are several risk levels for a lender, which due-diligence should address:

  • What are the circumstances regarding the property that could cause a default?
  • What is the likelihood the borrower will default?
  • To whom and how will the bank sell the asset if it is required to foreclose?
  • How long will it take to sell the property?
  • How much can the bank expect to net out of the sale, and will it be enough to recover its principal, interest and costs?

For the lender, the process of due diligence may be to satisfy any one or many of several criteria:

  • Does the transaction meet the bank's lending parameters?
  • Is the underwriting in conformity with bank policy?
  • Does the loan meet FIRREA requirements?
  • Will the loan meet the requirements of the rating agencies?
  • Is the loan officer experienced enough in self-storage to recognize hidden risks?
  • What might a prospective purchaser find wrong with the property?
  • To whom can the bank sell the loan if it does not wish to hold it in its portfolio?

Due diligence means different things to different people. It is not an appraisal process. The result is not intended to establish a value, although that may be a byproduct of the process. The goal is more to disclose risks, not to offer an opinion as to whether the borrower can provide the solutions. If you have never owned and operated a self-storage property, what makes you think you are qualified to sustain profitable operations of a property, let alone turn around a distressed property?

So far, it sounds as if due diligence is a deal-killer. Is it ever a deal-maker? Here is a short list of how due diligence conducted by experts can enhance a transaction:

  • Discovery of hidden income to immediately make the deal better.
  • Discovery of potential income that will provide an upside to the transaction.
  • Disclosure of expense savings of which the current owner is not taking advantage.
  • Discovery of expenses that should have been capitalized.
  • Discovery of expenses that were one-time-only and do not affect normal operations.
  • Finding postings that were incorrect and added to net operating income.
  • Discovering facts that make the market more attractive than it has been in the past.

In sum, the due-diligence process may not be one you want to conduct on your own. You may be a good operator, but that does not necessarily mean you are a good buyer of real estate. There is a very big difference. While you can expect to pay up to $10,000 for a thorough due-diligence effort (excluding title insurance and legal fees), that may be a small price to pay relative to how much you are putting at risk.

RK Kliebenstein is president of Coast-To-Coast Storage, with offices in Boca Raton, Fla., San Diego and the Washington, D.C., area. Coast-To-Coast is a self-storage consultancy business that assists developers and owners in operating more efficiently and profitably. If you have questions about the due-diligence process, Mr. Kliebenstein can be reached by phone at 561.367.9241; e-mail duediligence@askrk.com; visit www.realestateinvestor.org.