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Buying Basics 5477

February 1, 2002

9 Min Read
Buying Basics

If you are new to the self- storage industry, or if you've worked in self-storage but never purchased a facility, the decision to buy may seem overwhelming. There are myriad issues to consider: location, competition, occupancy, rental rates, lending environment, etc.--all of which will affect your return on investment. This article will touch on some important buying basics:

1. How to pay less for your purchase.

2. What to write into your purchase agreement.

3. What to do first after you go under contract.

4. How to verify a seller's income statement.

5. How to uncover undisclosed problems (including valuable information competitors want to give you).

How to Pay Less for Your Purchase

To begin, buy unlisted and unadvertised properties to minimize your competition and maximize time to negotiate a better deal. When you buy publicized properties, the volume of offers can drive prices distressingly upward in an auction atmosphere. But how do you find an unmarketed property?

You can search for sellers yourself or through a self-storage broker. Search technology is readily available but tricky to operate. As an example, a California buyer who purchased property in Memphis, Tenn., wished to find another facility nearby. I contacted more than 5,000 brokers by letter and flier, hoping one would know an owner willing to sell. In the end, one broker knew another who knew such an owner, and three brokers split a $75,000 fee on a $4.6 million sale.

The search technology used in this example included: 1) purchasing a computerized list of every local Yellow Pages listing; 2) sorting this list to extract brokers in selected area codes; 3) downloading the broker information to a contact-management program, such as Act; 4) combining letter and flier templates with fax numbers; and 5) electronically faxing letters and fliers from a computer. The returns were far greater than the cost.

Another way to buy properties for less money is to improve the terms of your offer. You send a strong signal by attaching a $50,000 check to your offer--even when you instruct the broker to hold it until your offer is accepted. Next, offer a short due-diligence period with extensions you can purchase. Due diligence is no more pleasant to sellers than sitting in a dentist's chair, and so a short duration is welcome. Finally, sellers may tell you what other features are important to them. For example, older sellers seeking replacement properties with less management intensity may value the ability to extend closing at their option.

What to Write Into Your Purchase Agreement

The key item missing from most standard purchase-agreement forms is a section on representations and warranties of the seller. Sellers should state they are aware of no undisclosed competition, threatened lawsuits, unrecorded liens, hidden hazardous wastes, undisclosed vendor or customer agreements, etc. They should also attest that financial documents are accurate and they have the legal capacity to execute sale documents. The exact wording should be copied from an actual agreement that has been torturously negotiated by attorneys for buyer and seller. Otherwise, an attorney for either client may draft the warranties so one-sidedly they are unacceptable to the opposing party.

Prepare your purchase agreement on letter-size (not legal-size) paper for two reasons. First, legal-size paper is intimidating and invites more scrutiny. Second, legal-size pages will not transmit clearly in fax machines with only letter-size trays. I lost one sale solely because a buyer's fax machine shrank legal-size paper to letter size. After all signatures were collected, the seller reneged on the sale and asserted the purchase agreement was too illegible to enforce. If your purchase agreement has a clause stating disputes will be settled by the American Arbitration Association (which it should), disputes like this can be resolved relatively quickly and cheaply without going to court.

What to Do First After You Go Under Contract

What you do next depends on what you have not done so far. If you have not seen the property because it is far away, don't buy your plane ticket yet. Instead, determine what conditions could kill this purchase, then eliminate ones that can be resolved quickly, inexpensively and before a site visit. For example, if the property is in distress or in rent-up, request a loan quotation. This way, you don't spend time and money before learning no standard loan is available for this property to any out-of-state buyer.

Keep in mind your primary task is to reliably estimate your future income from this investment. A seller's income may be different from yours for two reasons. First, there are timing differences because the seller owned his property in the past and you will own it in the future. For example, property taxes may double if a sale triggers a reassessment, or rents may plummet if a large competitor just opened. Second, there may be operational differences between you and the seller in matters of manager compensation, outside management fees, truck rental and late fees. Next, visit the site to verify past income and make necessary adjustments.

How to Verify a Seller's Income Statement

Your audit can be tricky depending on what measures a seller has taken to hide his problems. The main risk you run here, of course, is that his income statement overstates revenues or understates expenses--or both.

Walk the property first and inspect all units. As you see each one, check it off on a list or property diagram that describes what size each unit should be. At the same time, confirm that units on the rent roll are actually occupied. (If the rent roll is inaccurate, see the rent-roll test below and investigate further.) Finally, note when there are two locks on units signifying overdue payments. When you are finished, multiply the monthly list-price rental rate by the number of units of each size to determine the potential rent. Potential rent shows the total monthly rent you will receive if every unit you see is rented at full list price with no bad debts.

Compare collections to bank statements. You want to see that revenue on the seller's income statement is confirmed by deposits going into his bank. Start by obtaining all 12 monthly-income statements. Their total should agree with the annual income statement. Pick a month and ask the accountant to explain differences, if any, between revenues on one month's income statement and bank deposits for that month.

There are good reasons for differences. For example, some June collections may not have been deposited until July. Or a customer's annual prepayment, which appears as a single deposit on the bank statement, may be divided into 12 monthly payments on the income statement. Finally, customer deposits, which appear on bank statements because they represent cash received, may never appear on income statements if they are liabilities that will eventually be refunded.

Test the rent roll. Compare the list of occupied units you viewed to the rent roll and then to bank deposits or accounts-receivable for the current month. You want to confirm occupied units are creating income. Whereas the previous test proved the seller's income got to the bank, this test proves customers' payments got into the seller's income statement. The higher the disparity between physical occupancy (units physically occupied divided by total units) and economic occupancy (actual collections divided by potential collections), the more thorough this test will be.

The disparity between physical and economic occupancy results from discounts, free rent and bad-debt write-offs--all of which are areas susceptible to manipulation. If you continuously see locked units marked "vacant" or "bad-debt" on the accounting records, the manager may be collecting and pocketing customers' money. Or the owner may be simply locking empty units that will never have income (ones that leak, for example), or he may want it to appear to his customers that most units are successfully rented. Ask the accountant to walk you through some examples of how to do this test.

Verify expenses. Look at canceled checks. You will see recurring payments for utilities, phone, Yellow Pages ads, etc. Now check that they are consistent with expenses on the seller's income statement. Also compare canceled checks for large, one-time payments, such as property taxes and insurance, to the seller's income statement. Then ask the accountant to reconcile expenses on the seller's monthly-income statement to expenses on the bank statement. This will show whether a canceled check has been removed from a bank statement or an expense has been paid from another bank account, i.e., the owner's personal account.

Look for payments that do not appear on the seller's income statement. This will occur if the seller has personal expenses paid by the company's bank account, or if expenditures are for capital improvements. When you are finished testing, compare the seller's income statement to his tax return for expenses and income. Tax returns rarely overstate income unless the owner is contemplating a sale.

How to Uncover Undisclosed Problems (Information Competitors Want to Give You)

"You hear a lot just by listening," observed Yogi Berra. So discuss past and potential problems with the manager, repairmen, vendors and competitors. When you ask a competitor, "Why should I rent from you rather than [name of the place you are buying]?", he wants you to know every negative aspect of the property. He may reveal roof leaks, that the driveway drains into units, termites eat the furniture, a road is going to be built through the units, prostitutes operate out of units in the rear, the manager is on drugs, etc.

Check the storage section of the local Yellow Pages, which may disclose a new competitor who has begun advertising but not yet opened. Zoning and planning officials for the county may tell you about potential competitors. If you drive through the area, you may see signage advertising a facility about to be built.

What about fraud? Smart owners realize they raise their sales price by almost $10 for every $1 of additional rent they can create. There is nothing wrong with owners paying for units they use personally. However, suppose an owner convinces his friends to rent units by offering to reimburse 100 percent of their costs. Your safety net is the purchase agreement. If the seller claims there are no undisclosed customer agreements, you may have a quick course of action for the capitalized value of the fraudulent collections (or unrecorded expenses) through the American Arbitration Association.

The most important thing to remember is to be vigilant. Ask questions, get appropriate counsel and buy smart.

Burt Gay, a self-storage specialist at real estate brokerage firm Marcus & Millichap, has brokered 40 self-storage purchases and was formerly a CPA at Coopers & Lybrand. In addition to serving on the advisory board of the Georgia Storage Owners Society, Mr. Gay holds an MBA in finance from The Wharton School and recently received his Certified Commercial Investment Member designation in commercial real estate. For more information, call 770.393.1700; e-mail [email protected].

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