Because more listing brokers include due-diligence material in their sales packages, initial property reviews tend to be more conclusive than in the past. Buyers are given a quick, accurate glimpse into the condition and performance of a property, past and present, making it easier to find the facility that best meets their objectives. The next steps are to negotiate the purchase price and terms of an offer. Once a property is under contract, facility inspection begins.
A well-drafted purchase agreement will identify time lines for all inspections. It will also state which documents the seller needs to provide and by what date. Both a financial and physical inspection should commence only when the seller has given the buyer everything required. Due to ever-tightening deadlines, these are usually performed simultaneously. However, a preliminary financial review is likely to occur first.
From start to finish, inspections usually run 30 to 60 days, but due-diligence periods have shortened over the past several years. Sellers are enjoying unprecedented demand for their properties due to available capital and low interest rates, so they’re demanding shorter due diligence to lessen the time their property is off the market. In addition, sales packages have become much more detailed in terms of representing a property’s true performance, so buyers can more accurately project expected returns. Finally, as a response to the highly competitive market, buyers are more willing to investigate a property before it’s put under contract. This means they’ve completed some of the due diligence before the clock starts ticking.
However, buyers are also at the mercy of third-party reports such as appraisals and Phase I environmental studies. In a market where demand for these services is high, the completion of reports could be hindered. For this reason, buyers should negotiate a full 60 days for their inspections.
In many ways, the financial inspection is the most crucial. The buyer of a commercial investment is, first and foremost, purchasing an income stream, but buyers have different goals when acquiring self-storage. Those seeking a total return (cash flow from operations and long-term appreciation) will focus on the internal rate of return over a projected holding period. Others are primarily concerned with immediate cash flow from operations. They concentrate on the return on investment, more commonly known as cash-on-cash return.
Regardless of his aim, a buyer first reviews a property’s financial situation to make sure the deal warrants further consideration. He’ll examine:
- Current rent roll
- Three months of delinquency reports
- Three years of occupancy and rental-rate history (if applicable)
- Three years of profit-and-loss statements (if applicable)
- Year-to-date profit-and-loss statement
- Three years of tax returns (if applicable)
- General ledger showing recurring expenses
- Six months of bank statements and deposit slips
- Current property-tax bill
- Insurance documents and the latest premium notice
- Twelve months of utility bills
The information furnished for the audit should corroborate the data presented in the sales package. If the buyer finds discrepancies, he should enlist the help of his broker/advisor to investigate the differences and determine how operations will be affected.
Only after the financial picture is approved will a buyer proceed with a physical inspection the property. This is more of a checks and balances to confirm improvements and identify items that could limit future revenue. Important items include:
- Site plans or existing surveys including full legal descriptions
- “As-built” drawings, if they exist
- List of personal property included in the sale
- All vendor contracts (landscaping, security, Yellow Pages, trash removal, etc.)
- Existing title policy or commitment
- Confirmation of existing zoning and land-use permits
- Three years of capital expenditures (if applicable)
- Aerial photograph (if available)
- Flood-zone certification
- Copies of all current tenant leases
- Phase I environmental study
In addition, a complete professional inspection performed by an engineer or firm of the buyer’s choosing will include examination of all building components, office space, apartments, paving and drive lanes, gates, cameras, electrical and HVAC equipment, plumbing, grading, drainage, etc. The assessment should give the buyer a complete and clear picture of a property’s condition and physical attributes and point out any red flags:
- Deferred maintenance that will require additional capital
- Functional obsolescence or competitive disadvantages
- Declining market demographics
- Environmental issues
- Site encroachments
Although the inspection process is time-consuming and often overwhelming, it’s absolutely necessary. For instance, sufficient reserves for future capital expenditures can be determined only one way: with an accurate assessment of the improvements and their remaining expected life. No one would buy a house without an inspection, and it’s even more imperative for commercial property where concerns include hazardous materials and environmental contamination, zoning and land use, liens and title issues, debt service, and lender requirements.
This article provides only a condensed outline of the inspection procedure. In a real sale, every item must be examined in great detail. Shortcuts can severely jeopardize your investment objectives. A thorough and accurate inspection is the only way for a buyer to ensure he is acquiring a facility that will meet his goals now and in the foreseeable future.
Rob Schick is senior vice president of Revel & Underwood Inc. Established in 1973, the firm specializes in the disposition and acquisition of self-storage facilities. Mr. Schick has more than 16 years of experience in investment real estate sales, representing self-storage buyers and sellers nationwide. For more information, call 800.875.5439, ext. 166; e-mail firstname.lastname@example.org.