Analyzing past operations in order to project future property performance is never a black or white endeavor – it’s very grey. Evaluating the true value of retail centers, office towers, industrial parks or multi-family buildings is a complex, multi-phase undertaking that often eludes complete clarity. From complex lease agreements and expiration dates to insurance costs and estate taxes, a wide array of variables serve to conceal the true value of a property.
In this post-recession economy, the only way to distinguish between a wise investment and a catastrophic mistake is thorough, in-depth financial due diligence. Investigating or auditing a property’s financials, in advance of an acquisition, can validate a property’s value and provide an accurate assessment of its current income stream as well as operating expenses. A cumbersome, paper-intensive, time-consuming process, financial due diligence can determine if an asset will be a positive, high-yield investment or a challenged, undesirable property.
Validating the Numbers in Every Acquisition
Financial due diligence is essential for basically any commercial real estate acquisition today. There is no such thing as a “small” acquisition that can afford to forgo a rigorous financial due diligence review. The current commercial real estate market involves assets typically ranging from $20 to $50 million, but can fluctuate from $5 million to $500 million. While multi-family investments are currently dominating market activity, retail’s Class-A shopping centers and distressed assets are also gaining momentum.
Property values are typically based on annual net operating income (NOI). For a property to be profitable, revenue must exceed expenses. This is a basic concept, yet many buyers bypass the financial due diligence phase only to discover later NOI gaps of $20,000, $50,000 and even $100,000 per month. Any unaccounted variation on the revenue or expense side directly impacts property management efficiencies from day one. In cases where financial due diligence was disregarded, the larger the property, the larger the disparity between expected and actual NOI. Ultimately, NOI gaps also impact the property’s cap rate and purchase price, for better or worse.
Moreover, most real estate property financial statements are highly complex. Inaccuracies rarely are egregious but rather are inherent to the process. For example, common area maintenance (CAM) charges consistently reflect discrepancies. Reimbursable expenses are often not passed through while non-reimbursable expenses are, resulting in miscalculations related to the portion of each tenant’s allocated expense.
Then there is the common practice of “massaging” the numbers, either by rounding them up or down or replacing actual numbers with fixed standard figures. In cases of fixed standard figures, collection rate and repairs/maintenance are two areas that require intense scrutiny. In the more malicious cases, a property’s financial statements can be purposefully misrepresented. In these instances, financial due diligence is able to reveal how figures are being manipulated.
The Financial Due Diligence Window of Opportunity
Financial due diligence is best performed by an impartial third-party provider, just after the sales contract is executed. The contract usually defines a period of time during which to search and synthesize financial data; conduct and complete a comprehensive review of past statements, income and expenses; and compare those findings with the data provided by the seller. Known as the ‘financial due diligence window,’ the buyer reserves the right during this period to abandon the deal without losing any escrow money. However, once the window closes, the buyer forfeits the right to walk away. Thus, once the contract is signed, the clock begins ticking and time is of the essence.
However, years of investment and property management experience do not qualify investors and their staff to conduct the kind of intensive, comprehensive financial analysis that is required for today’s market. Newcomers and seasoned investors alike will benefit from utilizing a reputable results-oriented third-party due diligence expert.
Utilizing proven methodologies, depth of expertise and industry resources, third-party financial due diligence offers investors both expediency and efficiency. From verifying, validating and auditing all income and financial statements, to analyzing and documenting 20 to 30+ expense-related line items, a cash-flow model is created. Based on a set of income stream assumptions, an investor then receives the data necessary to make a sound decision about a property.