Due Diligence Mastery Lesson 6

Lesson Six: Due Diligence: Underwriting and Financial Analysis

One of the most crucial processes of purchasing investment property is the financial analysis and underwriting. This process will not only determine what the property value is currently, but also, how much debt you can put on it and give you an idea of what value you can achieve upon execution of your exit strategy. In addition, you will be able to determine where some savings can be gained in the operating expenses and any increases in the rental rate structure of the leases, both of which affects the bottom line and adds value to the property.

6.1 Key Questions to Consider

The following is a list of questions you need to answer as you’re creating and underwriting the financial analysis of the property:

  • What current in-place net operating income? What does the NOI trend look like? Look over the trailing 12 months and forward 12 months to see if it drops, and if so, ask why this is happening. Perhaps a major tenant is downsizing or vacating.
  • What is the expected sale price?
  • What is the current occupancy? What is the historical occupancy for the past three years? Is it dropping? If so, you need to determine if this is a market that is continuing to lose tenancies or what other problems you may uncover.
  • How does the average rental rate in the building compare with its competitive set? Are they above market or below market? What are the rental rates of the most recent leases done in the building? Are they above or below market?
  • What is the rollover (leases expiring) for the current rent roll? Is the rollover rent above or below market?
  • Are there any termination options in the current leases? (You need constantly update your financial analysis as you get feedback during your, initial investigation, due diligence and tenant interviews).
  • How are the expenses running compared to other buildings in the area? Are they higher? If so, what categories and why? Are the expenses lower? If so, are there deferred capital expenditures and maintenance? What are expense trends for the past three years? Make sure you come to a conclusion as to why a particular category is higher or lower for that matter.
  • Are the pass-throughs of operating expenses going to continue or drop if expenses are lowered? If so, an adjustment should be determined that will more accurately reflect the change in future income.
  • What is the condition of the tenant improvements in the rollover space coming up as well as the vacant suites? Are they typically built out and need only minor improvements and modifications or are they built out for a specific use and most likely will require a “gut and re-do” on the entire space? A realistic budget should be assigned to each suite, if necessary, in order to come up with a good number for tenant improvements required.
  • What is the market leasing commission being paid for new leases and renewals? What is the average tenant improvement allowance in the market for new and renewal leases?
  • What are the current lease comparables for the competitive buildings in the area?
  • What kinds of rental concessions, if any, are being offered?
  • Are there broker incentives being offered by the competition? What are they and for which buildings?
  • Are there common area upgrades that are needed? If so, you need to budget them and place them in your underwriting.
  • What kinds of conditions are the building systems in, i.e., roof; mechanical and electrical systems; elevators need modernizing? Do they need replacing, repairing or upgrading?
  • Does the building need to be brought up to current code compliance for: ADA; elevators; fire sprinklers; fire/life safety; OSHA compliant window cleaning roof supports, etc.? You need to contact the local municipal building and safety department authority to make sure there are no existing code violations or pending requirements that need to be made.
  • Are there any environmental issues affecting the property? If so, you need to determine the cost or if you even want to move forward with the acquisition.
  • Is the debt coverage ratio acceptable for your respective lender(s)? What is the highest loan to value that the lender will provide? Is the NOI at least 25-30% higher than the debt service?
  • Do the operating expenses in the offering memorandum reflect the same expenses found in the reports provided by the seller? If not, where are the discrepancies?
  • Are there any association fees or dues required to be paid by the building’s ownership?
  • Are there any services required by an existing tenant in the building such as security or parking attendants?
  • Are there any additional HVAC hours provided at the building owners expense to any of the existing tenants?
  • Will the lender require any holdbacks of funds or reserves for upcoming building improvements or re-leasing and/or lease renewals? If so, how much?
  • How will the parking income be affected upon expiration or termination of leases?
  • Is your exit strategy reflecting a realistic cap rate upon the sale of the property?
  • Are there adequate reserves plugged into your underwriting to cover any immediate repairs and future replacement of necessary items such as cooling towers; chillers; roof, etc.?
  • Are there any amenities that could be added to the building such as a common conference room; a work out facility; bike racks; smoking and/or seating areas, etc., which would enhance the lease ability of the building? If so, what would be the cost? Is it justifiable?

This list is not exhaustive; however, it gives you enough information gathering to cover a lot of ground in your underwriting process. Each property is unique in some way as well as each geographic location. There are some locales that have expenses to the property that are unique to that particular region, such as snow and ice removal, sinkhole problems, seismic concerns, and retrofits on equipment.

You need to continually be on guard as to what information is being given to you and its validity because once you own the property it is your problem to deal with. Make sure you are verifying information and are comfortable with your findings. Underwriting is an ongoing process during your due diligence and beyond, until closing. Even then, you will be looking back to see how accurate your analysis was during the time you own the property.

6.2 Building and Fire Code Violations

In this course, you have learned how to complete much of your physical due diligence and record review (however, this is continuously updated through the entire process) and are ready to work on the lender required documents, such as estoppel certificates, subordination and non-disturbance agreements, as well as the final appraisal for the loan.

The first final step is the estoppel certificates. Estoppel certificates are the statements executed by the tenants that are the verification of the key terms of the lease and that neither tenant nor landlord is in default. Tenants will note discrepancies or outstanding issues with the current landlord. Before sending estoppel certificates out to the tenants, be sure the form has been approved by the lender. Make sure that you review the prepared estoppels before they are sent out to the tenants, and then review them when they are sent back by the tenants for verification. Do not send any estoppels received by tenants with discrepancies or issues about the lease terms to the lender before receiving an explanation of the issue or discrepancy. The required estoppels should be delivered by the lender.

The second final step is the Subordination and Non-Disturbance Agreement form. The Subordination and Non-Disturbance Agreement is a form that is required by the lender and should be delivered to the required tenants at the same time as the estoppels. This form is sometimes dealt with post-closing.

The third final step is the appraisal. All lenders require a property appraisal on the property, which most likely the loan amount is subject to, and which is paid by the buyer. You cannot take for granted that everything is going to work out fine with it and not pay attention to what the appraiser is going to come up with as a final value for the property. You need to monitor and talk to the appraiser to make sure he has the proper information such as the most up to date rent roll; pending transactions, if any, and if helpful; the most resent lease and sale comparables that help justify the purchase price being paid; the expenses that you will be running the property at, i.e. showing cost cutting; any additional income that the property is generating should be provided; make sure they are accounting for any rental increases; pass through of operating expenses and anything else that will enhance the value of the property that you can provide them.

Although many of the appraisers do not wish to speak with the borrower, it is necessary to make that initial contact with them to make sure that you’re not going to get “short-changed” on the appraisal because they were not provided all they could have been in order to increase the value of the appraisal. It cannot be stressed enough; if you are not being proactive with the appraiser you run a high chance of getting a lower appraisal and therefore a less desirable loan amount and potentially higher holdback amounts. Get your mortgage broker involved as well in helping to work with the appraiser. It is always better to have someone other than yourself, who is not at the same firm, giving their input as well.

Finally, you need to be concerned with the closing statement. One of the most important items in due diligence is to properly review the closing statement prepared by escrow before finalizing the transaction. If you are not careful in scrutinizing it, it can cost you dearly. Remember always, the seller wants to get as much as possible upon the sale of the property, even if that means loading up additional items as a credit to them on the closing statement. This can take the form of many different items, such as: tenant improvements, leasing commissions; capital improvements; prorations of fees and licenses paid; inspections; service contracts; supplies; personal property; prorations of property taxes; annual membership or association fees, just to name a few.

In addition to the seller’s credits, you need to watch for lender and escrow fees. These can sometimes get added into the closing statement without noticing how they are being assessed to the buyer (i.e., inspection fees, legal fees, and additional documentation fees), which should be, at the very least, questioned, but try hard to eliminate. There are some buyer/sellers who are extremely proficient at loading additional expenses to pass on to the other party. If you are not paying close attention, it could cost you a tremendous sum of money. Make sure prorations of operating expenses are properly prorated under each line item and get back up information on each amount (i.e., copies or checks, paid invoices, lien releases) in the case of tenant improvement work or capital work completed.

In prorating fees on service contracts or annual inspections, be sure you’re only prorating the amounts allocated for the closing month. Do not credit the seller for annual inspections, as they are purchased as part of the asset.

Any credits or charges allocated to the seller must be verified. Make sure there are only those credits and/or charges that were agreed to in the purchase and sale agreement. This cannot be over emphasized. Once the transaction is completed, it is very difficult to get reimbursed. It is definitely worth the extra time and effort spent in carefully scrutinizing the closing statement expenses and allocations. Always be sure that you tell the escrow officer that no closing statement is released to seller or lender until it is cleared and they get approval by you. In addition, the buyer’s closing statement, when purchasing a property, shows only the buyer’s side of the transaction and not combined.

Have the escrow officer include any and all buyer costs, i.e. survey; third party reports; buyer expenses; insurance; commissions; etc. to be paid through escrow at the close. Any and all deposits and fees paid, i.e. loan application fees; rate lock fees; etc. are included as buyer’s credits. Also, make sure all lender fees, impound/reserve accounts are in line with the loan application terms. If you are assuming a loan be sure that you are getting proper credit for reserves and impounds. This applies equally when you are the seller. Make sure you’re getting credited properly for any reserves and impounds that were put aside by the lender. Have your mortgage broker read through and verify these as well. It is always a good idea to have another set of eyes to go over the closing statement. Someone who knows what they’re looking for. After looking at a number of versions, it’s quite easy to overlook an item.

6.3 Final Thoughts

Due diligence, if performed properly and thoroughly, will prevent you from experiencing major setbacks and expenses or keep you from making an investment that you should not. It should never be taken lightly or for granted. Every item should be scrutinized carefully and methodically. However, if you are to assume anything, assume there are a large amount of problems waiting to be discovered which could save you a ton of money and headaches, if you catch them; because the reality is there are always issues. You are virtually throwing money away by not performing a thorough due diligence on property you are looking to purchase. This course was written to give the novice a foundation to work from and to provide further enlightenment to the experienced investor on some important issues that they may not have thought about previously, as well as serve as a reminder/checklist.

Whoever may be conducting it, due diligence is an ongoing learning experience and you want to constantly hone your skills. Constantly strive to be the best at it. If you do, it will pay off greatly and save you countless problems and headaches to deal with later. Remember, a successful due diligence leads to greater buyer peace of mind and fewer (or hopefully no) post-closing surprises. Done properly, it will also save you a ton of money and ensure the proper investment decision is made, to buy or not to buy.

Assignment:

The final step in the buying process before the close is often the appraisal. For this assignment, discuss the differences between the inspection report and the appraisal. Also, discuss what actions can be taken if no good “comps” are found for your property.

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

Are you ready?

Congratulations, you have now finished the final lesson of this course. Now we recommend you review your assignments and notes before you take the exam. If you are ready, then click the button below and begin your final exam.