Due Diligence

Matthew T. Pipkin Comments
Posted in Articles, Development
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Many parties interested in expanding their self-storage portfolios or venturing into the storage business have lately found good deals are becoming scarce, with capitalization rates pushing the envelope. Many investors share a common concern: "If we are going to underwrite and acquire existing facilities at these prices, we need to thoroughly investigate our acquisition, making sure there are no surprises after we become the operator."

Let's assume you have identified a self-storage facility for acquisition. You have negotiated and agreed on the purchase and sale agreement, including price and terms based on information provided by the seller and his representative or broker. At this point, there are several areas you should investigate to assess your potential purchase: financial, physical, legal and environmental.

Financial Audit

The financial audit should confirm computer-generated operating statements and reports produced by the facility with the actual performance of the property. Some owners feel they can achieve high valuations based on a single occupancy report or monthly summary. Later, it is generally discovered that the actual collected revenues are substantially less than the gross potential income reflected in the occupancy report--due, in part, to rental concessions, delinquencies, and unrentable or company units--or the owner had listed abnormally high prepaid-rent income. The financial audit helps you find a true and reasonably accurate portrayal of the facility's operating history, regardless what reports may demonstrate.

Initially, the financial audit is a tool used to derive the prorations to be awarded to the buyer or seller for various items. These items include prepaid rent, delinquent tenants, taxes, insurance, etc. For example, there is no substitution for rolling up your sleeves and methodically and meticulously auditing the rent roll for prepaid rent for which you, the buyer, should be credited at close of escrow. Here's a case in point: In the recent sale of an approximately $4 million, mixed-use storage/retail facility, the professional management company indicated prepaid rents were approximately $2,000 and would be credited to the buyer at close of escrow. After further audit of the rent roll on a tenant-by-tenant basis, the buyer found the management company had underestimated prepaid rents by nearly $15,000.

It is critical you tie the operating statements with the general ledger and bank deposits. Checking these three items against each other will probably generate many questions and give you a very clear idea how the property was previously owned and managed. Many investors hire an outside auditing company in addition to their own independent audit to catch any items they may have missed.

By looking at the bank deposits, you can obtain the most accurate portrayal of the property's cash flow over any given period, regardless of what any given computer-generated report may tell you. By looking at operating statements, you can see how new tenants were handled at the beginnning, middle and end of their contracts. For example, were they given free rent or discounts? How were late payments handled? Were any lien sales necessary? Finally, by looking at the general ledger, you can get a good idea of recurring expenses, such as advertising, management, utilities, taxes, insurance, repairs/maintenance, etc., as well as flag any abnormal expenses. This may also give you an idea whether the previous owner took steps toward preventative care of the facility in the event questions arise from the physical inspection.

Physical Inspection

The second aspect of the due-diligence process relates to the physical condition of the property. Typically, every buyer conducts his own investigation of the property, beginning with the exterior walk-through. This includes, but is not limited to, surveying the condition of the the buildings, signage, roofs, HVAC system, walls, stucco, paint, doors, asphalt/concrete, drainage, landscaping, gates and cameras.

The interior will be inspected, including the condition of the office, restrooms, managers unit (if applicable), floors, ceilings (looking for potential roof leaks), roll-up doors, partitions, sprinklers, lighting and security systems. From this investigation, you can create a punch list of items that may be capital improvements or deferred maintenance.

Most lenders and/or institutional investors require a third party to conduct a physical audit of the premises in addition to your independent investigation. This is not only very prudent, it lends legitimacy to your concerns if the seller has not provided the necessary care the facility deserves.

The audit ties the physical attributes of the facility with the operational side of the business, so it's important to make sure the personal-property items outlined in the purchase and sale agreement are on site and operational. You don't want to find, at close of escrow, that the previous owner has taken all the office equipment, for example. Also make sure inventory such as golf carts, security systems, computers, desks and other large items are on site and in working order.

One of the final steps to the physical audit is to walk the facility, rent roll in hand, and conduct a lock check to make sure unrented units are, in fact, ready to lease. A lock check also will demonstrate how the previous owner handled delinquent tenants, whether it be overlocking or some other form of notice. Many buyers will also take a sample of the rental contract to see how the owner conducts his lien-notification process. This is another way to see how the property was previously managed.

Legal/Title

Compliance of the facility to all zoning and city ordinances is critical. In most cases, you can obtain--and lenders often require--the equivalent of a zone-compliance letter. This letter is usually pretty innocuous and vague, but it provides you a reasonable idea what is permissible or not permissible in the zone on which the property resides. In some instances, depending on the local planning department, it may provide a more specific explanation of the property and its compliance or any violation as it relates to local zoning or code requirements.

A certificate of occupancy (CO) or its equivalent is invaluable and, in most cases, required by lenders. The CO indicates the facility, in its construction phase, has met the requirements of a city's building and safety department and is ready for occupancy and business.

In areas such as California, it may be necessary to provide a Natural Hazard Disclosure Report, which can be obtained from your escrow officer or broker for approximately $70 to $100 (actually, anyone can order this report). It includes information regarding the property as it relates to earthquake, flood or fire-hazard zones.

Most transactions are fairly straightforward with respect to title issues. One of the most important items required in due diligence is the ALTA survey. Title insurers issuing the supplemental ALTA title-insurance policy also require the survey. An ALTA survey should, with reasonable accuracy, lay out your building in relationship to any easements, dedications, points of note (i.e., ingress/egress, culverts, utility boxes, etc.), structures such as block perimeter walls and fences, monument signs and flag poles. If there is an encroachment by the seller's improvements on a neighbor's parcel or vice versa, or if an improvement encroaches on an easement, further legal advice should be sought immediately.

Environmental Audit

I cannot stress enough importance on this item. Every prudent lender and owner who has acquired a self-storage facility has required an environmental audit from a third party. Degrees of these audits vary, but the liability and expense involved with mitigating an environmentally tainted building or site far exceed the expense to perform an environmental assessment.

Environmental cleanliness is critical to lenders and institutions. Some local lenders may require a lesser audit, as they may be more familiar with the risk profiles on a local basis. National lenders unfamiliar with a specific market and its risk profiles may require a more extensive appraisal. Nonetheless, even if you purchase a facility on an "all cash" basis, an environmental audit should be part of your due-diligence process.

Conclusion

This article provides a broad-brush approach to due diligence, but each property and transaction is unique. Every buyer should conduct and rely on his own investigation to satisfy himself with any and all items relating to the property in question. There is a lot to consider when acquiring a storage facility. Many investors rely on third-party reports to double-check their findings, whether they be financial, physical, legal or environmental. But there is no substitute for taking the time, effort and care to perform due diligence in house. It will make the transition from buyer to operator much smoother.

Matthew T. Pipkin is a senior vice president with Lee & Associates, Newport Beach, Inc. He has been responsible for the recent sale of more than 500,000 buildable square feet of entitled self-storage land, and the sale or escrow of more than 2 million square feet of existing self-storage facilities. For more information, call 949.724.1000; visit www.lee-associates.com.

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