Due Diligence and Risk Management

RK Kliebenstein Comments
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Risk management in self-storage acquisitions always begins with proper due diligence— research that informs a buyer of financial and market risks.

Buyers of self-storage properties should know that sellers or agents are looking to make the most money possible, which may mean certain liberties are taken in preparing pro formas. In fact, the fine print at the bottom of each listing basically gives brokers carte blanche to present the property in a “perfect world” scenario.

A good acquisition consultant recognizes this hype, and conducts checks and balances to analyze properties demonstrating real world data and securities. In later phases of due diligence, he will also retain the services of a tax consultant and insurance carrier to predict taxes and confirm premiums.

Taxing Example

Let’s consider the following example: The investment memorandum reports a normal, inflationary increase in insurance costs as it predicts a “next year” cap rate. Unfortunately, stabilized properties are often grossly underinsured. In our scenario, last year’s insurance costs were $3,500, up 10 percent over the previous year.

The broker’s package pro forma shows first-year ownership insurance at $3,850, reflecting the 10 percent increase based on previous years’ premium increases. The broker is informed by the seller that the insurance average is based on $5 million—75 percent of purchase price. This is possibly a little low but still within reason.

Recklessly, the broker failed to conduct even the most primary of due diligence efforts. Truth be told, when the owner was contacted about listing his property, he realized last year’s coverage was grossly inadequate. By acquiring the declarations page early on, a due diligence consultant was able to predict correct insurance costs and adjust the cap rate to reflect an accurate rate.

Wary and Wise

Confused about due diligence? That’s where an experienced consultant comes in handy. Seek counsel in the following areas to make sure you’re on the right track:

Legal. While most consultants are not attorneys and can’t advise you in this capacity, they can assist you in making business decisions reflected in legal documentation.

Survey. Time and money often are wasted because the survey ordered didn’t meet the requirements of all parties: lender, owner and title company.

Title. A consultant can examine surveys and advise on business issues, as well as inform clients of title exceptions that can reduce delayed closings if properly addressed.

Municipality Reviews. Interviewing various government agencies can uncover new competitors, potential assessments and use issues. When conducting these interviews, a good consultant may gain insight into possible changes in zoning that could affect a purchase.

Public Works. Street closings for maintenance or construction could be disastrous to store traffic—a compelling reason to pass on a deal. Can you imagine paying a low cap rate anticipating steady rent streams, only to discover after close of escrow that the street will be torn up in front of your property?

Police Reports. Review could uncover a highly negative reputation in a community that might not be disclosed by the seller.

Property Audit. This is the heart of due diligence. Conducting a thorough investigation and verification of reports can disclose property issues. On several occasions, an estoppel revealed that units counted as rented were actually abandoned, affecting the occupancy rate. Inexperienced auditors often fail to conduct a complete matching of computer records to actual physical status.

Management Review. Finding theft, shrinkage or mismanagement can increase a pro forma cap rate.

Financial Review. It’s necessary to review accounting reports used in financial statements. Most storage properties prepare simple income and expose statements on a cash basis. If a buying decision was made on a statement that understated expenses due to a large accounts payable balance, one might overpay for a property.

Conversely, if one-time, non-recurring expenses were charged to maintenance and repairs to limit tax liabilities, the net operating income would increase, creating value. Cap rate comparison is the most essential element of the financial review.

Market Study. Where are rental rates compared to competing properties? Where is room for improvement? Are there risks based on overstated rents? Sometimes brokers increase revenues and occupancy in the pro forma revenues, based on unfounded speculation. 

If a property is at 70 percent occupancy in a stable market after four years of operation, what is the genesis or logic of pro forma occupancy at 85 percent or 90 percent just because of an ownership change? Rarely do brokers take the time to investigate market conditions enough to make educated assumptions.

Choosing Consultants

Firms conducting due diligence often offer cafeteria-style pricing, which allows buyers to only choose services they need or are willing to pay for. Ask to see a sample diligence report prepared by the consultant in consideration. Does it seem complete? Detailed? Is the consultant experienced in self-storage?

To reduce risk in your next acquisition, find a firm with standardized pricing, error and omissions insurance, and multiple staff members who can respond quickly to meet the limitations of your inspection period. 

RK Kliebenstein is president of Coast-To-Coast Storage, providing feasibility studies and market analyses for self-storage projects, in addition to financing and consulting with self-storage owners. This article is an edited excerpt from his book How to Invest in Self- Storage, scheduled for a second release this year. The book is available at www.amazon.com and www.askrk.com.  For more information, call 877.622.5508; e-mail rk@askrk.com. 

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