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Christine Ziomek
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June 1, 2011

When Time Is Of The Essence

Turning to Financial Due Diligence Experts in Time-Pressured CRE Purchases

By: David I. Tesler, Esq., CEO
Real Diligence, LLC

June 1, 2011 – When preparing for a sale, owners of commercial real estate usually compile a professional offering memorandum, complete with property descriptions, income and expense data, market comparables, and perhaps even an Argus run demonstrating future cash flow analysis. They bundle this information into an attractive brochure that has but one purpose: to sell the property at the highest price in the shortest amount of time. Their job is to sell the property. It is the potential buyers’ job to understand exactly what is being offered. With time always being in short supply in commercial real estate transactions, expert financial due diligence can make all the difference between a profitable investment and a catastrophic mistake. 

A Matter of Time vs. Money
The successful investor simply cannot rely upon the information found in the standard due diligence catalog of “dollars and dateReleases.”  While rigorous analysis has always been important, regardless of the economic climate, it is especially important in today’s marketplace.  The commercial real estate market is rife with distressed assets and uncertain projections. When done properly, financial due diligence produces a detailed, comprehensive and knowledgeable analysis of the property; one that allows the buyer to glean its true value and net operating income, and renegotiate the contract for sale from a position of strength. This process is document-intensive, detail-oriented and exceptionally time-consuming. Yet, it generally must be completed within a due diligence window of 30 to 45 days, adding significant time pressure to an already challenging process.

The quality of any financial due diligence review is based on its starting point:  the lease abstracts. Accurate analysis depends upon thorough abstracts for every lease related to the property, which can range from as few as 25 pages each to as much as hundreds of pages for anchor tenant leases.  Moreover, the most important data in a lease file are often found in the complex CAM provisions, addenda, memoranda, side letters and rent rolls, so these additional documents must be reviewed and abstracted as well. Unusual items, financial obligations, co-tenancy provisions, termination dateReleases, missing documents and other issues of import must be highlighted to give the potential buyer advance warning of any possible trouble spots or discrepancies in the seller’s projections.

On average, a trained abstractor will spend four to seven hours per lease to complete this type of in-depth reading. When the property for sale is a shopping mall with 150 tenants, for example, the time required for abstracting – 600 to 1,000 hours just on abstracts – clearly becomes burdensome. Even the largest REITS, with their sizable in-house property management departments, find their resources strained by such a commitment of time and personnel. And abstracting is merely the starting point for financial due diligence. Analysis, interpretation and summary of rent rolls, historical financials, etc. adds hundreds of additional hours to the process. Faced with this collision between the work required and the time available, commercial real estate investors increasingly are finding it necessary to turn to specialty firms that focus exclusively on financial due diligence.

Small Discrepancies Can Equal Big Savings
Financial due diligence specialists conduct comprehensive financial audits, compiling and interpreting many layers of documentation within sharply restricted time frames. This process includes:

  • validating and verifying all rents, as well as any income from additional sources, such as kiosks, parking, vending machines and the like;
  • validating and verifying all expenses; these are generally more numerous and variable than income items and can include outlays for anything from snow removal to elevator replacement;
  • establishing the historical record of income and expenses in order to verify the accuracy of the sellers’ projections for future budget and cash flow;
  • CAM (common area maintenance) reconciliation to compute each tenant’s accurate share of common charges; and
  • reviewing bank statements to confirm that income is reflected in statements.

The data is then compiled and presented in a comprehensive report, with a clear and concise executive summary.

A scrupulous audit of the seller's base-year figures, current expenses and tenant obligations often finds significant discrepancies in the building's stated value, which can substantially lower the projected reimbursement income. For example, a lease might contain a complicated amendment that subtly overrides the tenant's responsibility to contribute to real estate taxes or a tenant may be getting billed for more CAM charges than it is responsible for according to the lease. When these discrepancies are presented in a clear and timely summary, the buyer can either walk away from the deal or, what happens more typically, renegotiate a reduction in the property’s purchase price. Consider that a $50,000 discrepancy can turn into a $500,000 reduction in price, when the buyer’s cap rate projections are taken into account.

Purchasers can often find savings when they subject properties to a rigorous audit conducted by a firm comprised of dedicated due diligence experts. Such specialists are able to identify and evaluate the significance of any anomalies, highlighting those that the buyer should consider in determining its purchase price. Because they have reviewed thousands of leases from disparate types of properties, they have developed a depth of understanding that simply cannot be matched by an accounting firm, a law firm or even a large in-house acquisitions department that generally handles the purchase of a few properties each year. Indeed, specialty financial due diligence firms combine into one company the abstracting function often performed by attorneys and the analytic work done by accountants, allowing them to respond rapidly and flexibly to issues as they come up in the due diligence and lease abstracting processes. 

The challenges of working within a 30- to 60-day due diligence window remain considerable and always contribute to the pressure of investing in commercial real estate. However, purchasers can maximize both their time and their odds of investing profitably when they use meticulous, experienced and reliable financial due diligence specialists to beat the clock and close the deal.

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David I. Tesler, Esq., is the CEO of Real Diligence, LLC , a company that specializes in financial due diligence of real estate and notes. Real Diligence, is a part of the Madison Commercial Real Estate Services family of companies.

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