Chasing the True Value of a Property: Third Party Due Diligence

Analyzing past operations to project future property performance is never a black and white endeavor, it’s very gray. Assessing the true value of shopping malls, office towers, industrial parks, or multi-family buildings is a complex, multi-phase 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 a property’s true value.

In this post-recession economy, the only way to distinguish between a wise investment and a catastrophic mistake is thorough and thorough financial due diligence. Investigating 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-return investment or a questionable unwanted property.

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 forego 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 shopping centers 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, yet 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 for variance on the revenue 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 the expected and actual NOI. Ultimately, NOI gaps also affect a property’s capitalization rate and purchase price, for better or worse.

In addition, 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 allocated share of expense.

Then there is the common practice of “massaging” numbers, either by rounding them up or down or by replacing the actual numbers with fixed standard figures. In the cases of fixed standard figures, the collection rate and repairs/maintenance are two areas that require intense scrutiny. In the most malicious cases, a property’s financial statements can be misrepresented on purpose. In these cases, financial due diligence can reveal how the figures are being manipulated.

The financial due diligence window of opportunity

Financial due diligence is best performed by an unbiased 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; perform and complete a comprehensive review of previous account statements, income and expenses; and compare those findings with the data provided by the seller. Known as the ‘financial due diligence window’, the buyer reserves the right during this period to withdraw from the deal without forfeiting the 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 intensive and comprehensive financial analysis required in today’s marketplace. Newcomers and seasoned 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 20-30 expense-related items, a cash flow model is created. Based on a set of income stream assumptions, an investor is then provided with the data necessary to make an informed decision on a property.