Due Diligence Protects Buyers
|Copyright 2014 by Virgo Publishing.|
|By: John H. Gilliland|
|Posted on: 02/01/2005|
Due diligence is the process of discovery and confirmation of the financial and physical attributes of an investment property. In all too many cases, this important process is rushed or, worse yet, skipped entirely in the excitement of buying a selfstorage facility. But think about it: You are about to invest hundreds of thousands or millions of dollars. Don’t you want to get what you pay for?
Take a moment and logically consider the process: As buyer, you 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.
Experts highly recommend including a list of necessary documents in the agreement (see sidebar). This will give the seller upfront notice that you are going to be thorough in your due diligence. It also gives him time to start gathering the information. If a knowledgeable self-storage broker represents the seller, this information should already be prepared and ready for delivery soon after an agreement is signed.
Time frames are important to establish at the beginning of the process. Most agreements allow for a due-diligence period of 30 to 60 days from the time all documents are delivered to the buyer. The countdown should begin after delivery. This gives the seller incentive to produce the documents in a timely fashion, and prevents the buyer from receiving the paperwork piecemeal.
Delivery of duediligence materials should be documented with a letter from the seller to the buyer, acknowledged by both parties, proclaiming the period has begun as well as its length and final date. During this time, a deposit is tendered to be placed in the broker or attorney’s escrow account. This deposit is typically fully refundable during the due-diligence period and 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’s the scenario with the facility being purchased, financial reports are fairly easy to generate. If the seller is using a manual accounting system, gathering the information may take longer.
The first report needed is a summary of unit types, the number of each, how many are rented, and what revenue is generated from those rentals on a monthly basis. Many popular software programs refer to this as the “Potential Revenue” or “Rental Activity Report.” A buyer also needs a complete rent roll, including tenant names (or a note that a unit is vacant), unit numbers, sizes, actual rent, account balance (to show rent owed or prepaid), 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 management-summary report, which can be helpful to validate the revenue stream. Profit-and-loss statements are needed for the past two years and the year-to-date for the current year’s operations; these can be provided by the seller’s accountant or internally generated. The revenue numbers should match those shown in the management-summary report.
Your lending institution will require certain documentation about the property. It’s a good idea to get the list upfront so you can include it 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 autorelated expenses. Although fully deductible as a business-related expense, it’s not typically deemed necessary for the operation of a facility and is 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. Typically, a buyer may 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 or seller.
The seller can provide several documents to assist the buyer in saving money and time in preparation for the closing. An example is the title-insurance policy issued when the property was last transferred. The old policy serves as a head start for the buyer’s attorney or title company in researching the chain of title, possibly reducing the new policy’s cost. The same can be said for the fire and liabilityinsurance policy. A buyer will need a new binder on the day of settlement; furnishing insurance agents with a past policy assists them in figuring a bid.
Two other areas of great potential savings are environmental studies and ALTA Surveys. A Phase I environmental study can cost $1,500 to $2,500 and take up to 60 days to complete. However, if the seller can provide a past report less than two years old, most lenders will accept it. In cases where the report is older, only an update letter may be required, which is far less expensive. In cases where there isn’t sufficient time to complete a Phase I, environmental insurance policies also are available.
ALTA (American Land Title Association) Surveys are typically required when obtaining institutional or conduit financing. These detailed surveys assure a lender and buyer the property description is correct with no boundary discrepancies. 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 inspect the physical property and review on-site books and records not provided with the copied materials. A buyer may hire an engineer or property-inspection service to assist in evaluating improvements and their ability to sustain cash flow over time. This assessment also will help determine what your reserve for capital improvements should be. Typical inspections will include roofs, gates, 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 other improvements.
On-site inspections include an examination of a sample number of leases. The seller does not customarily provide copies of every tenant lease. Instead, the buyer is afforded the opportunity to inspect the leases during the due-diligence period. Usually, he will randomly pull 3 percent to 5 percent of the leases and make sure they match the information on the rent roll.
If due diligence 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 the process. Second, your attorney can review documents, provide the title policy, and work with the other side’s counsel to bring the transaction to a close. Title-insurance companies provide good and marketable title, while escrow companies facilitate closing. Environmental engineers perform Phase I studies and other continuing services.
Surveyors and civil engineers conduct surveys. Accountants assist in the review of financial statements and verify cashflow projections. Finally, the insurance agent makes sure the property is insured to cover general risks as well as those specific to the self-storage 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.
Avoid Buyer’s Regret
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 will prove invaluable in the smooth transition and operation of the property. Due diligence is the key to ensuring you will be pleased with the acquisition once closing occurs.
John H. Gilliland is president of Investment Real Estate LLC, Investment Real Estate Construction LLC, and Investment Real Estate Management LLC, which provide brokerage, construction and management services to self-storage owners throughout the mid-Atlantic and northeast states. A member of the board of directors of the national Self Storage Association, Mr. Gilliland is also president of the Pennsylvania Self Storage Association. For more information, call 717.779.0804; email@example.com; visit www. investmentrealestatellc.com .
Due Diligence Document List