Due Diligence Mastery Lesson 5

Lesson Five: Due Diligence: Property Inspection & Inspection of the Property’s Books and Records

During your due diligence process, one of the most important areas that you want to focus on is the property inspections. There are often “hidden” issues that cannot be seen by just viewing the property on your own. You need to hire experts in the field of property inspections in order to find these issues before the sale is finalized. Depending on how the purchase agreement is written, you might be able to renegotiate the price. At the very least, you will know what you are about to get into before you purchase!

5.1 Property Inspections

At this stage of the buying process, you are ready for the property inspector experts to come in and evaluate the building. Let’s review a few of the basic areas that the inspection will cover. Even though your inspector is the expert, it never hurts to know what you should be looking for as well! You are the one person who this matters to the most!

The first is domestic water pumps. These provide water throughout the building. Make sure they are running smoothly and quietly and be aware of any rust on the equipment, platform, or piping leading in or out of the units. Rust will indicate deterioration of piping which will cause leaks or destroy the pipes.

The second area is an emergency generator. The area surrounding the generator, as well as the generator itself, should be clean and well maintained. Look at the maintenance logs to make sure that they are up to date and that it’s being started on a regular basis (i.e., twice monthly). An indication of not being run on a regular basis would be excessive black carbon around the exhaust. Have a discussion with the building engineer/maintenance personnel to find out more about the upkeep. Check the log on the Automatic Transfer Switch (ATS) to determine that it is functional and being tested regularly.

The third area is the elevators. Check to see if the elevator’s mechanicals have been modernized (i.e., solid state vs. relay switches). Look at the elevator maintenance logs to see if they are checked regularly (i.e., once per week), and look for any repairs performed and/or repeat problems. If cabling is stretched or frayed or digging into the drum, this will indicate a need for drum replacement. Also, if there is excessive carbon in and around the elevator mechanical equipment, this will indicate a lack of maintenance.

In addition, make note of the ride and leveling (i.e., stopping at each floor even with the threshold) to determine whether maintenance and repairs are required. Make sure that the One Year and Five Year tests have been performed and ask to see a copy of the reports. This is required by the local building codes.

The fourth area is the roof. Depending upon the age of the building and its locale, the roof can be a major expense if it needs replacing. Visually inspect the roof to look for soft spots; stains and areas where the membrane material has pulled away from the roof surface. Also, look at the flashing (metal caps) affixed to the perimeter of the roof to see if it is pulled away, excessively dented or destroyed. Be sure to look at ceiling tiles and/or hard lid ceilings on the floor directly below the roof for stains and/or wet spots. Ask the top floor tenant(s) if they have experienced any leaks.

The fifth area is the curtain wall. Inquire about the curtain walls and ask if they have been resealed, if so, when and where, and if there have been any leaks. This can be found out through tenant interviews and interviewing building engineers and property management. Also, walk the perimeter of the building looking for corrosion of window sills.

The sixth area is the window system. An important area to look for during the inspection is to see if there have been any window leaks. Check for new tiles next to the window system. This may be a mask for a water migration problem; especially on the top floor of the property. It may be a roof leak issue or a drain connection from the roof drainage system. In cold climates the roof drains are insulated to prevent water condensing on the drain pipe due to warmer air surrounding the drain as it passes through the ceiling. Make note of the gasket system surrounding the window. Are the corners in each window tight or is there a void due to system shrinkage? Look for telltale water stains on the wall below the window system. This would indicate water migration above or below the sill plate. From the outside, look to see if the entire color of the window system is the same. If not, the color disparity could be due to failure of the window coating. If the seller has had a window wet-seal completed recently, ask why. If only part of the property was sealed ask if it was part of a multi-year project. Inquire if the warranty is still in effect and is it transferable to the new owner. Also, ask if the sheet glass is still in production and can it be purchased and delivered within a reasonable time frame.

The seventh area is the water heater. Inquire about the age and condition as well as physically inspect. Make note of any rust, corrosion or any leakage. The eighth area is the fire life/safety panel. Inquire about its age; are parts readily available? Is it up to code and when was its last inspection? (Get a copy of the report). Fire Life/Safety Panels reaching the end of their useful life can be one of the most expensive single items a new owner may be obligated to change due to the sale. Have the seller state, if possible, that the existing fire life/safety system is currently code compliant, and there is no agreement with any code enforcement entities that on sale there will be an upgrade required within a specified period of time.

The ninth area is the fiber optics. If the building has fiber optics; are they owned by the building or by an outside company? The reason being, it is a potential income source for the building. The final area is fire sprinkler area. If the building is sprinklered, find out if they are on recall and if so, are they scheduled to be replaced. If the building is not sprinklered, are there any ordinances requiring the installation of fire sprinklers by the local fire code. It is a good idea to find out if there are any pending code changes coming up in the near future that would impact you in the requiring of sprinklers in the building.

5.2 Review of Property’s Books and Records

In addition to inspecting the building itself, it is important to review the books and records for the property. You need to find out as much information as possible about the past and current status of the property. Let’s begin with the property’s books.

The value of having the building “as-built” building plans cannot be underestimated to the prospective buyer. Not having these on-site to reference will cause loss of valuable time needed to operate the new property. Mechanical, electrical, plumbing and all design data are contained within the as-builts. If the seller indicates that they are unaware of their location, have the seller inquire with the city building department if the set of permit drawings are on file, and have them get a copy.

The property’s project manual is as valuable as the as-builts. This book contains all of the sections required to construct the building and it will give you insight to the level of detail that the design team used to create the site. Within the manual will be specific levels of information such as: elevator speeds, chiller tonnage; live and dead load floor loading, etc. Not all properties have a project manual, but the larger ones generally will.

In addition, operating and maintenance manuals would include the submittals that were provided by the vendors during construction. Most of the equipment will not be in the warranty period, but will provide valuable information to you as a new owner of the building: specifications, recommended maintenance, etc.

5.3 Review the Property’s Financial Statements

You want to get at least the last two to three years’ operating expenses history/reports on the building, as well as year to date. This will not only show you what and how the expenses are, but also any trends that may be occurring such as an electrical usage, elevator and/or HVAC repairs, continuous maintenance issues (i.e., roof repairs; plumbing issues, etc.). It will also indicate where you can implement cost cutting measures which go straight to the “bottom line.”

What you are looking for are the “red flags” that point to recurring problems and expenses so you can pay special attention in investigating those issues. Always ask for copies of all the utility bills for the past two years. Be sure to question ant large amounts and ask for detailed back up information to determine where the money is being spent. It could be a buried association fee or maintenance expense; an energy conservation agreement which includes the financing of the equipment; roof maintenance contract required by the installer, etc.

Make sure you compare the operating expenses provided by ownership to the Offering Memorandum and financials provided by the brokerage firm, if available, to see if there are any discrepancies and/or missing information. This can impact your underwriting significantly, if you are not careful.

Make sure you compare the operating expenses provided by ownership to the Offering Memorandum and financials provided by the brokerage firm, if available, to see if there are any discrepancies and/or missing information. This can impact your underwriting significantly, if you are not careful.

Another key financial report to review is the Common Area Maintenance (CAM) Reconciliations report. The CAM reconciliations are an important component of the property’s financials. These are expense recoveries paid by the tenant based upon their base year expense stop or other terms in their lease, such as after-hours HVAC costs and extraordinary electrical usage over and above normal usage.

If you are running your financial analysis and basing the property’s income on CAM pass-throughs, you need to understand how they are passed through and exactly how to each tenant, as per their lease document. For example, if a large tenant in the building is at the end of their ten-year lease, their pass-through amount most likely will disappear, assuming they remain in the building and renew, due to the fact they will get a new base year.

Make sure you can get a copy of the previous two year’s CAM reconciliation reports to verify CAM income and to insure that you can do CAM reconciliations going forward. In addition, request history for all the Operating Expense Base Year information. After the escrow is closed, your tenants might ask you for information on how their Base Year was calculated. Also, upon the close of escrow, you want to make sure that you’re receiving the proper credit for any CAMs that have been prepaid or credited to a tenant, although there is usually a time frame negotiated in the purchase and sale agreement for the reconciliation of CAM differential between buyer and seller. However, you want to get as much as possible in order to minimize having to chase them down to collect your money after escrow closes, which is always more difficult.

Finally, you should obtain the Aging Report. Ask for a copy of the most recent aging report, which shows the tenants who are current with their payments and which ones are behind (including how much is owed); what categories do they owe on, such as rent, pass-throughs of operating expenses, special expenses incurred, etc., and how long they’ve been behind (i.e., 30, 60, 90 days, etc.).

The Aging Report will tell you a lot about who is a chronic late payer or who you can expect to have a problem with. Ask the property manager if there are any tenants who are habitually late in rent payments. They will not always tell you the truth, but you can get a good idea from the Aging Report. Also, when reviewing the tenant files for correspondence, you will see late notices which will “red flag” those tenants who are late payers.

Question all delinquent rents. Many insights on charges can come from the review of the delinquent rent. Delinquent rent many times is caused by tenant dispute of the charges. If the charges were not collectable, they would ultimately affect the proforma of the building. When interviewing a tenant who has a history of late paying or disputes, dig deeper by asking them why.

Get a detailed report for each tenant to determine what the delinquency consists of specifically and if any amounts are being disputed. Also, prepaid rent or any credits owed to the tenants should be reflected in the report and buyer should receive a credit.

5.4 Other Considerations

There are also several other considerations that you should review. The first is warranties. Make sure you get copies of all the existing warranties on the property (e.g., equipment, roof, etc.) and make sure they are transferable. This could easily “fall through the cracks” if not addressed. The second consideration is parking. Be certain the property meets the local city requirements in terms of adequate parking ratios and handicap parking spaces needed. Also, when reviewing leases verify there are enough parking spaces to accommodate the unleased square footage currently available in the building. For example, the landlord may have oversold the parking to lease space to a tenant with excessive parking needs, thereby leaving less for the remaining space to be leased. This is generally fine if it does not exceed 1.25 times the allocated parking ratio. Interview the current parking lot operator if it is operated by a third party vendor. Make sure that the contract is cancelable. During tenant interviews, ask tenants if they find the availability to be adequate and if there are any suggestions or issues they would like to address.

The third consideration is ground leases. In the event there is a ground lease involved in the purchase of a building, it is imperative you understand all aspects, costs and requirements as the ground lessee and how it impacts your financial analysis. Make certain that you allow enough time to get an estoppel certificate signed by the ground lessor. Dealing with ground leases always requires more time than projected. Be sure to allow ample time to deal with a ground lease scenario. It is similar to conducting a whole other transaction in itself, only you are dealing with a somewhat disinterested third party when the ground lessor has nothing to derive.

The fourth consideration is the operating budget. Most property management firms will have prepared an operating budget for the current year, and later in the calendar year, next year’s operating budget. This budget will factor in any upcoming maintenance and needed repairs to the property. Always ask for the current year’s operating budget and, if they have it, next year’s budget as well. This will alert you to any expenditures planned for repairs, replacement, maintenance issues, code compliance issues, upgrades, refurbishment plans, and tenant improvement projects coming up. Some property managers are reluctant to hand it over and may give some excuse for not being able to. Do not just passively accept it. Insist you need to see it. If they say they can’t, ask if there is anything that the ownership is trying to hide from you. Tell then it is important for you to review it. There is much to be learned from it and tells you a lot about what’s happening with the building.

The final consideration is the property tax appeals. In most states the property taxation process allows for an appeal if the property owner believes the tax assessment to be excessive or unfair. Since property taxes are such a large part of the operating expenses, it makes perfect sense to challenge the tax assessor’s property tax bill so that you know you are getting the lowest possible assessment allowed. This can be done primarily through third party tax consultants who specialize in doing just that, property tax appeals. They have the local expertise in property values and processes in getting your tax bill reduced. This is generally done on a percentage of the savings or negotiated fee basis. All in all, it’s a worthwhile fee paid to save a good chunk of money. It is too important to overlook, although some property owners do.

Assignment:

After the buying process has begun, you are ready for the property inspector experts to come in and evaluate the building. If possible, obtain a copy of a property inspection. What are the key items that you would look for in the inspection? What actions can you take if notable items are found in the inspection report?

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