Due Diligence Mastery Lesson 4

Lesson Four: Due Diligence: Other Critical Issues

In the previous two lessons, we have discussed the “traditional” due diligence that most investors will conduct. However, there are other critical concerns that must be addressed in order to make sure there are no hidden “land mines” that will cause you problems after you have closed escrow. This lesson will focus on these “hidden” critical issues and what you need to look for and ask for in order to perform your due diligence.

4.1 Document all Communication

In this business, there is nothing more important than having written documentation! It is very important to note and imperative that any and all questions regarding ownership and the building be put in writing and documented, (i.e., emailed, with an ongoing list being monitored and checked on regularly in order to make sure that no issue is overlooked or forgotten). Many owners, their representatives, property or asset managers will purposely put off answering or addressing issues that may impact the sale of the property in hopes that you will forget about it or come across another issue that may take its place so they do not have to deal with it, if it is put off long enough. The fact that you have a response from them in writing or have tried to address a particular issue gives written confirmation that could be used later to your advantage in negotiations or, if need be, in court. At the very least, it will help to keep track of the many items and issues that come up during the due diligence process. Develop a tracking list or process that allows you to follow up on issues and questions that you need addressed or answered. This will pay off later on when the transaction progresses and people “conveniently” forget to respond to certain questions. If you do not stay on top of the issues, they will fall through the cracks. Remember, this is your investment, so take the time to do this right!

4.2 Building and Fire Code Violations

Another important area to consider is the building and fire code violations. There may be outstanding violations on the building that have yet to be rectified that the current owners are not disclosing. It is necessary to go to the local municipal Building & Safety Department and check to see, if in fact, there are any violations currently on the property.

Make sure you also check to see if building permits and a certificate of occupancy (C of O) have been issued for the built out suites. It is a good idea to get a copy of all the building permits and C of Os on file so that you have a record of them. If there are some suites that cannot be accounted for, ask the seller if they have the building permit and C of O on file. If not, ask them to check with the contractor who did the build-out if they have them. On larger suites this could be a major problem with insurance companies if there were ever a claim and you could not produce the necessary paperwork. Ask the property or asset manager if there are any outstanding building violations that they have been notified of or have knowledge of that need to be addressed. Be fully aware of what existing non-compliance items might be triggered due to tenant or capital improvement work. This could potentially turn out to be a very expensive oversight, should you not thoroughly investigate.

4.3 Building Measurement Verification

Another area to focus your due diligence on is the actual building measurements. There are many times a building may not have current as-built architectural drawings or space plans, which helps to determine an accurate accounting of the actual square footage. Often a building’s measurement numbers will be over or under estimated, depending upon who has owned the property and for how long. It is possible that some additional square footage can be picked up if the building was never re-measured under BOMA ‘96 standards. Either way, it is cheap insurance to have the building measured professionally so that there are no mistaken calculations on anyone’s part. Later on, when you go to sell the property, you can send them along to the buyer as your part of the due diligence materials as to the actual square footage of the building, which most times, will put them at ease that you had it professionally measured. It is an inexpensive and prudent exercise to avoid any legal complications later on and possibly save you a bunch of money upfront in the event the numbers have been grossly overstated.

At the very least, verify the square footage on the existing building plans to the current rent roll to see what discrepancy may exist. Compare load factors to existing tenant leases and any provided building measurement calculations to see if there are any discrepancies. Also, confirm the actual load factor of the building to what it is quoted in the marketing of the building. It is common practice in many markets to artificially inflate or deflate the number according to what the competition quotes in order to stay competitive.

While considering the building measurements, you should also make sure during your due diligence process that you walk each and every suite listed on the rent roll for verification purposes. This will ensure that all the tenants and vacant suites listed are accounted for and let you know which ones are actually occupied and which ones are “dark”, i.e. vacated but still paying rent.

Also, you will earn a lot about the tenants while you are touring their space (i.e., How many employees they have? Are they filled or are there fewer employees in more space than they need? This may mean they are in trouble and/or downsizing or leaving in the near future).

You may also find out that the suite numbers on the rent roll do not match with the numbers on the doors which could indicate a problem with overstating suites and square footages. At the very least you will feel more comfortable knowing that all suites have been accounted for and there are no discrepancies, hopefully.

4.4 Insurance Quotes

One often overlooked, but potentially pricey area of the due diligence process is insurance! You must have insurance, so now is a great time to obtain a few quotes. If you do not already have a good insurance agent, see if you can get a good recommendation for one from someone you know and trust. You want an agent who has experience in insuring the type and size of property you’re looking to acquire. Ask them about their background and experience as well as some references. In the event you need them to help you with a claim, you want to feel secure in the fact that they know what they are talking about and can be an ally for you when you have to deal with your insurance carrier. Just like finding your attorney, your insurance agent will become another “member” of the team!

When it comes to insurance claims the trend seems to be for the insurance companies to find all the ways they can mitigate the payout to their insured. That is why you need a good agent to go to bat for you when the going gets tough and make sure you are getting treated fairly. After all, they are the ones writing the business for the insurance company so they do not necessarily want to alienate the agents who are writing business for them.

4.5 Cost-Saving Tips

Not all of your due diligence will be about the “now” of the property, but also about the future. There are several cost-savings tips that you should consider. The first would be the electricity. One of the more important issues that can have a major impact on your building expenses is its energy usage. Property taxes and utilities account for over a third of your expenses. It can be highly enlightening to find out why and where your utilities are running on the high side (if in fact there are indications that they are higher than normal by the cost and or usage). For instance, you may discover that a major tenant in the building is using an extraordinary amount of energy due to running after hours HVAC or 24/7 crews that were not initially agreed to in the beginning of their tenancies. Perhaps a tenant has added additional computer rooms that require more electrical and air conditioning that they didn’t have initially when they moved in.

The type of lighting (for example T-12 vs. T-8 fluorescent fixtures) will use more power as well as various types of HVAC systems, depending upon the different configurations as well as age of system. An energy audit will help to determine where savings can be found that can immediately impact the bottom line in a positive way. Sometimes it can be as simple as installing timers or adjusting the start and stop times on the HVAC units. As energy prices continue to go up this will become an even greater concern that can “make or break” the cash flow of an investment. At a minimum, it will keep you apprised of the building’s current electrical consumption status and allow you to plan how to better conserve utilities going forward. Energy conservation is an ongoing project in a building and one of the first areas that costs can get out of control quickly.

Some of the simpler but effective conservation methods that can be used in order to conserve electrical usage include the following:

  • Establishing guidelines for tenants and the janitorial service to turn off lights in the suites when they are not being used or after they have been cleaned. Educating the tenants as to how to conserve electricity and how they benefit by keeping expenses lower, will go far in keeping utility costs lower.
  • Switching to lower voltage or less lighting when possible in some of the common areas.
  • Placing light sensors in the restrooms and private offices and other rooms in suites so that the lights go off when no one is there.
  • Minimizing exterior lighting, if possible, without compromising security concerns. For instance, landscape lighting.

Some other areas that should be scrutinized for possible energy conservation are:

  • Parking Structure Lighting: Cutting out or down lighting in late evenings, and shut off during daylight hours. Be aware of security issues when resetting times. If there are tenants who stay late you don’t want to compromise their security.
  • Tenant “bill backs” for Usage: Many leases have provisions allowing certain kilowatt usage per square foot, thereby determining just how much electrical usage is considered acceptable. If tenant’s usage is suspect, then a meter can be installed, at their expense, and they can be billed back for any excess usage.
  • Evaluation of HVAC Efficiencies: An evaluation of the HVAC System in a building will help to determine what types of energy savings can be achieved. For example, in a chilled water system it is important to make sure that the water temperature is cold enough so that maximum tonnage is being delivered throughout the building, thereby satisfying the building’s needs more quickly and efficiently.
  • Eddy Current Test: This test helps to determine the integrity of the tubes within the HVAC chiller. Make sure that a recent test has been performed and obtain a copy for technical review.
  • Pneumatics: This is one of the largest potential problem issues in a building’s HVAC system. Think of it as the veins in a body. If the system is experiencing major leaks or the air compressor is not functioning properly, or the air dryer is not functioning, thus causing the system to be corrupted with water, the building’s HVAC system will run out of control. This could be an expensive problem in terms of energy savings and repairs.

These savings might seem small, but when you multiply them over several years, they make a huge difference on your bottom line! Taking the time now to find these areas of concern can benefit you down the road during your ownership and when you go to sell the property.

Assignment:

Not all of your due diligence will be about the “now” of the property, but also about the future. There are several cost-savings tips that you should consider. What are these “cost saving” considerations that you should evaluate and how can they help you to save money and increase your ROI?

This assignment is your study guide to ensure you have learned these materials before you take the required quiz.