Analyzing past operations to project the future performance of the property is never a black or white effort, it is very gray. Assessing the true value of shopping malls, office towers, industrial parks, or multi-family buildings is a complex, multi-stage task that often eludes full clarity. From complex lease agreements and expiration dates to insurance costs and estate taxes, a wide range of variables serve to hide 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 and in-depth financial due diligence. Researching or auditing a property’s financials, prior to 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 and time-consuming process, financial due diligence can determine whether an asset will be a positive, high-yielding investment or an undesirable property in question.
Validation of the numbers in each 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. Today’s commercial real estate market involves assets that typically range from $20 million to $50 million, but can range from $5 million to $500 million. While multi-family investments currently dominate market activity, Class A retail malls and distressed assets are also gaining momentum.
Property values are generally based on annual net operating income (NOI). For a property to be profitable, income must exceed expenses. This is a basic concept, however many buyers bypass the financial due diligence phase only to discover subsequent NOI gaps of $20,000, $50,000 and even $100,000 per month. Any unaccounted variation on the income or expense side directly impacts the efficiency of property management from day one. In cases where financial due diligence was not taken into account, the larger the property, the greater the disparity between expected and actual NOI. Ultimately, NOI gaps also affect the property’s capitalization rate and purchase price, for better or worse.
Also, most real estate financial statements are very complex. Inaccuracies are rarely noticeable, but are inherent in the process. For example, common area maintenance (CAM) charges consistently reflect discrepancies. Reimbursable expenses often do not carry over while non-reimbursable expenses do, leading to miscalculations related to each tenant’s portion of the allocated expense.
Then there is the common practice of “massaging” numbers, either by rounding them up or down or by 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 most malicious cases, the financial statements of a property can be misrepresented on purpose. In these cases, financial due diligence can reveal how figures are manipulated.
The Financial Due Diligence Window of Opportunity
Financial due diligence is best performed by an impartial third-party provider, right 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 prior statements, income and expenses; and compare those findings with the data provided by the vendor. Known as the ‘financial due diligence window’, the buyer reserves the right during this period to walk out of the deal without losing any escrow money. However, once the window closes, the buyer loses the right to withdraw. Therefore, once the contract is signed, the clock starts ticking and time is of the essence.
However, years of investment and property management experience do not qualify investors or their staff to perform the type of comprehensive and intensive financial analysis required in today’s market. Newcomers and experienced investors alike will benefit from utilizing a results-oriented third-party due diligence expert.
Using proven methodologies, depth of experience and industry resources, third-party financial due diligence offers investors both convenience and efficiency. From the verification, validation and audit of all income and financial statements, to the analysis and documentation of more than 20 to 30 expense-related items, a cash flow model is created. Based on a set of income stream assumptions, an investor is then given the data needed to make an informed property decision.