Due Diligence

I owe Point Source Solutions, LLC a shoutout for the great work they recently completed for a Rose City Commercial Real Estate client. Hats off to Andy Klopfenstein, Jeff Jackman and the crew for a job well done. First some background.

I thought this listing was going to be the best deal I had ever worked on. Dream client…great to work with. In demand food production building. We mounted an aggressive,  multichannel marketing campaign and were under contract in a week at full price with a list of buyers with backup offers. Great buyer with solid credit, great Buyer Broker, happy lender…nothing could possibly go wrong! To paraphrase Johnny Carson: “Not so, contamination breath!”

While performing the Phase I (written questionaire) Report it was disclosed the property had been a gas station decades ago. That disclosure led to Phase II testing…we brought in Point Source Solutions. While drilling they discovered small amounts of hydrocarbon contaminates. That led to drilling for Delineation Studies 1, 2, and 3. Each time Oregon DEQ asked for a new scope of work to assess the situation PSS responded quickly with a new scope of work, bids and completed testing on an expedited basis. Last week their efforts resulted in the Oregon-DEQ issuing an NFA (No-Further-Action) letter for the project. The whole process took about a year. Without the coordination and focused efforts of Point Source Solutions we would still be testing.

Rose City Commercial Real Estate maintains a list of valued resources for our customers. I’ve added Point Source Solutions for evironmental challenges…because using them really made a difference.

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This is “Rick’s Tips” with Rick Bean, Principle Broker at Rose City Commercial Real Estate, rosecitycre.com. This episode we’ll learn how different investors can put a value on commercial real estate when buying, selling, or leasing a property.

Why would an investor be thinking about valuing commercial real estate?

Investors will look at valuing properties primarily if they’re selling or buying properties, and the reason they want to look at the valuation is to see if they’re getting a good deal, a deal of a lifetime, or if the price is way too high. And one way to check that is to do a valuation method and check it with other valuations of similar properties in similar locations, similar qualities.

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Why would an investor be thinking about valuing commercial real estate?

Investors will look at valuing properties primarily if they’re selling or buying properties, and the reason they want to look at the valuation is to see if they’re getting a good deal, a deal of a lifetime, or if the price is way too high. And one way to check that is to do a valuation method and check it with other valuations of similar properties in similar locations, similar qualities.

What are the valuation methods that investors might use?

Well, there’s many, but the three that I see the most are the “gross rent multiplier” method, the “capilization of revenue into value” method, and then the “internal rate of return.”

What’s the “Gross Rent Multiplier” Method?

Say you have a house that’s giving you $1,500 a month of revenue, that’s $18,000 a year, and so you say “I want to get a twenty times multiplier” so you would multiply the annual $18,000 a year times twenty, the factor, and say this property is worth $360,000. That’s used for single family investors, small plex investors, and others that don’t need highly sophisticated return information.

What’s the “Capitalization Into Value” Method?

The capitalization model is a lot like putting a car motor on a dynamometer, you’re seeing what the horse power is. Now, you’re taking it away from the transmission because you just want to see what the raw output is. In the same way with a capitalization of revenue, we get rid of the debt piece. Debt is excluded from our calculation.

We want to see what kind of cash producing machine that is. So, we take the annualized revenues of operation, and subtract from that the annual expenses, and then we divide that by a capitalization rate. And that’s something a little more sophisticated investors work with. When someone sells an eight plex, often they will talk about gross rent multiplier. On an eighty-unit property, almost exclusively, they talk about the cap rate, which means capitalization of revenue into value.

What’s the “Internal Rate of Return” method?

Internal rate of return is one of the more sophisticated analysis tools and basically that says: “For however much money I invested on day one, and subsequently for additional capital calls or capital injections, what did I receive in terms of benefits?” So, some of the benefits I might get would be cash flow, some of the benefits I might get would be depreciation, which I can use to reduce taxes, and the of course there’s profit at time of sale.

When we combine all these things together that benefit an investor, and we compare that to the initial investment, that’s how we get the internal rate of return. It’s also based on the length of time it took us to do this. An investment that returns ten times the original amount in ten years, is not as good as something that returns ten times that amount in eight years. There’s not only a profitability component, there’s also a time component.

There you have it…in just about the time it takes to enjoy a cup of coffee you’ve expanded your knowledge of commercial real estate. To learn more about leasing, buying, selling or investing in commercial real estate, contact Rick Bean at 503.577.1034 or sales@rosecitycre.com.

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WHAT IS AN ESTOPPEL CERTIFICATE?

A real estate investor recently asked me what an Estoppel Certificate was and why he should know about them. The old Real Estate Adage is: “You earn when you buy…and get paid when you sell.” Due Diligence research is how you make sure you are getting what you are paying for, and an Estoppel Certificate is an important component of that research.

When investors purchase multifamily or other revenue producing real estate investments they are counting on a certain level of on-going rents. An Estoppel Certificate (EC) is a form signed by the building Seller and his tenant stating how much the rent payment is, when it is due, the beginning and ending of the occupancy and a few more details such as the amount of security deposit.

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PHASE III DUE DILIGENCE: PHYSICAL INSPECTION

I’ve used an image of a stereo microscope to represent this post…it’s important to have both eyes open when conducting Due Diligence.

I typically prefer to have the Books and Records Due Diligence research well underway before I set up a date for Physical Inspections.  Physical Inspection almost always involves out-of-pocket expenses that I prefer not to commit to until my B & R work shows its worth proceeding.

The Physical Inspection Process varies widely based on the age, current usage, previous usage, type of asset, size, type of investor, and more.  I’ve seen professional contractors that will waive the physical inspection on a small asset if they are convinced that the offering price is low enough.  On the other end of the spectrum, a church I helped an investor acquire had a stream of inspectors from roofing, oil tank location, radon, basketball floor evaluators, electrical, plumbing, boilers, and more.

The zenith of the professional inspection spectrum was clearly demonstrated by Marx Okubo recently.  Their on-site team included an Architect, an Engineer, and a Contractor. The inspection cost over $8,000, but the out-of-state buyer wanted an exceptionally thorough review of the physical plant.    In addition to the on-site inspection, they performed interviews and did a significant amount of online research. The client ended up with a 90+ page report with cost to cure estimates for deferred maintenance.  There was also a schedule of estimated repairs over the next 10 years of ownership.  I also gave the Buyer the option of using a service that bid only $1,500.  After the Buyer read the report she concluded that the additional expense was well worth it.

Two additional thoughts on Marx-Okubo:

1. I first ran into M-O on a lawsuit on a condo conversion project.  The thoroughness of M-O’s report proved that the developer had fully researched, documented, and disclosed information about the condition of the asset.  Yep.  That’s it.  That’s the kind of attention to detail my clients want.
2. One of the things Rose City Commercial Real Estate salutes is excellence in its many forms.  I have previously lauded restaurants, a property management company, a short sale advisor, and manufacturing entrepreneur, and more.  In no case do I solicit or accept compensation.  There is no quid quo pro.  The same applies to Marx Okubo.  I honor them because I just think they do a better job.

MY RULES: If I’m involved in Due Diligence:

1. Every room of every building gets checked.
2. Look underneath every sink for leaks and mold.
3. Inspect around every hot water heater.
4. Check the condition of the toilet floor area.
5. Check wood decks for rot.
6. Every roof gets checked, visually at a minimum.
7. Problems get photographed at a minimum, but I prefer video documentation.  Not at inspectors have that equipment…I bring my own.
8. If the buyer says that they are looking at the project as a condo conversion, I always recommend thermal imaging with an infrared camera. This is even more important in Oregon, where condo conversion developers are subject to being sued for defects for 10 years after the last unit is sold.

I know of an investor that bought a large multifamily asset a few years ago.  He was in a huge hurry because he was running out of time on the second leg of a 1031 Exchange, and needed to identify properties quickly.  Over 300 of the 350 units needed new hot water heaters.  The roofs were in bad shape.  A properly conducted inspection would have alerted him to the problem and saved him over $1,000,000.  In another case, a buyer discovered a hole in the floor of a second-story unit the size of a basketball.  The unit below had huge quantities of black mold in the carpet and several walls.

ENVIRONMENTAL RESEARCH typically starts out as a written survey attempting to catalog hazards that are suspected and known to have been present on or near the subject property in the past.  This is called a “Phase I Environmental Study”, or colloquially as a P1.  Should the buyer have concerns after reviewing the P1 they may ask for additional testing.  A note about Radon Gas Build-Up: Several people have asked me if this was just a way to give a few Radon Mitigation Contractors a way to make a living. One of the best friends I’ve had in my life, Bob McEwan never smoked a cigarette in his life, yet died of lung cancer. His beautiful Lake Oswego, OR home tested very high for Radon. Count me in as one of the believers in testing for Radon Gas, and mitigation when indicated by high levels. MOLD is greatly feared today, almost as if it were radioactive. The truth is that most mold spores, even ugly ones, are not fatal or even dangerous. The problem of course is that even one fatality is not acceptable.

Be aware that environmental issues tend to be expensive and time-consuming to resolve. I recently finished a deal that went under contract in 6 days from listing. It didn’t close for an additional 14 months due to working through environmental issues.

ALTA SURVEYS  (American Land Title Association) are often required by lenders of commercial properties. It protects the value of the loan’s security (the land and improvements) being reduced by lawsuits from encroachments on neighboring properties, etc. And yes, these more extensive surveys do uncover challenges. The owner of a 30 unit apartment I listed had built a fence but on the neighbor’s property. We negotiated a resolution, but that was a roadblock to closing before it was resolved.

CONTACT RICK BEAN:

Call  me at 503.577.1034 or e-mail me at rick@rosecitycre.com if you would like additional information about Due Diligence procedures or other investment real estate inquiries.

 

Other articles you may like:

Michael Kapnick: The way investment real estate ought to be done! | Rose City Commercial Real Estate

The Importance of Due Diligence in Multifamily Profits, Phase III: Physical Inspection | Rose City Commercial Real Estate

What You Need to Know about Capitalization Rate | Rose City Commercial Real Estate

 

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PHASE II DUE DILIGENCE: BOOKS AND RECORDS

Books and Records, the second phase of Due Diligence is vital.  Fail here and the cash cow you thought you had just might be a profit eating alligator.   Books and Records are the Seller provider documentation of the historic performance of the asset.  These will often include Profit/Loss Statements, Income/Expense Statements, Rent Roll for the most recent month, check registers, Service Contracts, Roofing Guarantees, Phase I and II Environmental Reports, Certificate of Occupancy (CO), copies of leases, Security Deposit Spreadsheet, Elevator Permits, Safety Inspection Reports, etc.

Books & Records evaluations tends to be low or no cost.  As such I always complete them to the point at which I know it makes sense to proceed further before I do the Physical Inspection.  Physical Inspections almost always cost more money.

REVENUES:  I recently underwrote a small shopping center for sale in one of Oregon’s most desirable areas.  I was shocked when I looked over the income and expense statement.  The best properties in the area were rented at yearly rates of $32 to $34/sf.  I felt the subject was a $25 to $27/sf per year property.  When I learned that it was averaging less than $19.50 I knew I had found a gem.  Walking the rents up on renewals is pretty close to a guaranteed way to create a huge increase in cash flow.  I also feel that the Cap Rate was at the high-end of the market and that in a few years this area should see Cap consolidation. Knowing 1.) The Market Cap Rate and 2.) Market Rents allowed me to be confident in suggesting my client make a full-price offer.  Note: You don’t often find “pride of ownership” flagship assets being sold below market.  When you do find them…write an offer!

PROPERTY MANAGEMENT: I just had a situation on an  Office Building owned by a group of professionals.  I was representing an out-of-state institutional buyer on the acquisition. I mentally calculated that amount reported for Professional Property Management was equivalent to 13% of total revenues.  A more typical cost for this size and type of asset is 4% of revenues.  That is a material difference…that allowed me to project an increase in cash flow of $2,500 per month on this item alone.  Digging further I discovered additional Administrative Fees and other charges that overstated costs even more.  Be aware that the 4% Property Management Fee I used in this example would be way too much for a large industrial site (2%) and far too little for an 18 unit multifamily. (8-10%).

PROPERTY TAXES are another important item.  The property taxes for the building cited in the above example were well below normal for an asset of its size.  Researching, I found that the largest tenant was a non-profit that had 50% of the area.  They also have a long-term lease with options through 2030.  My research showed that the exempt status would remain stable and I didn’t need to project a major increase in costs soon.

I also know that the Oregon Supreme  Court has said (paraphrasing broadly): “The MV Market Value of a property may reliably be represented by the recent sale amount of the said property.” My research showed that the price my investor was under contract for was 35% below Multnomah County’s stated Market Value.  This meant that while the taxes on the building were far less than I expected…a tax appeal after closing could lower them an additional 35%.

Property Tax Appeals can take from just a few weeks to well over a year.  This is an often overlooked area for additional profits.  I worked on an appeal of a larger apartment in Arizona where the resulting increase in cash flow was $13,500 PER MONTH.  It also reduced expenses to the tune of raising the sale value of the property by $3,200,000 at Market Cap Rates.

SECURITY DEPOSITS reported on the leases have to be matched with those reported as retained by the Seller.   I helped a 1031 Exchanger buy an apartment where  40% of the security deposits were incorrectly accounted for.  Footnote: Each one that was incorrect understated the amount that was to be transferred to the Buyers.  This is one of those duties that truly qualifies as a pain in the rear, but my client would have lost thousands of dollars if I hadn’t persisted.  The largest Due Diligence file I’ve ever seen was on an 896 unit multifamily acquisition I worked on in Las Vegas 5 years ago.  The file just for the leases was almost 10,000 pages.

SERVICE CONTRACTS include a host of vendors ranging from security patrol to, maintenance.  You need to understand what your obligations are and what you can expect from your vendors.

INSURANCE rates have plummeted in the last 7 years.  If you haven’t asked for a requote you are likely paying too much.  Always get a new bid at acquisition.

RUBS stands for Renter Utility Billing System.  One of the quickest ways to improve the profitability of a multifamily asset is to have the tenants pay for their utilities with their rent.  When utilities are included in rent the tenant will universally use more.  This seems to hold for all socio-economic situations.  A RUBS system reduces waste.  If a property is cash flowing, every dollar of expense reduction will generate an additional dollar of cash flow.  At a 7% Cap Rate: every long-term reduction of expense creates an increase in the sale price of $14.28.

WHY IS THIS SO IMPORTANT: Reducing annual expenses\raising rents by $70,000 will raise the value of your property an additional $1,400,000 at the time of sale.

Please contact Rick M. Bean at 503.577.1034 or rick@rosecitycre.com for more information!

Other articles you may like:

Michael Kapnick: The way investment real estate ought to be done! | Rose City Commercial Real Estate

The Importance of Due Diligence in Multifamily Profits, Phase III: Physical Inspection | Rose City Commercial Real Estate

What You Need to Know about Capitalization Rate | Rose City Commercial Real Estate

 

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To start off I thought we’d review the most important truisms of multifamily investing.  The best known is: “Buy low, Sell high.”  The second most important is: “The three most important considerations in real estate are 1. Location, 2.) Location, and, 3.) Location.”  OK, heavy duh factor on those two.  Today I want to focus on the third most important truism:

“You get paid most of your profits at the end, but you earn them at the beginning.”

It’s important to know your actual starting point.  Due Diligence research is how you establish that.  It’s how you know whether you’re looking at a cash cow or a profit-eating alligator.

Competent Due Diligence for investment real estate has three phases:

• Phase I:  Preliminary Title Report
• Phase II: Books and Records
• Phase III: Physical Plant Inspections

Contact Rick Bean at 503.577.1034 or rick@rosecitycre.com for a review of your Due Diligence information…or any of your other real estate investment needs.

PHASE I DUE DILIGENCE: PRELIMINARY TITLE REPORT 

This typically starts a few days after the opening of escrow.  The title company issues a Preliminary Title Report.  This will is a list of all items the title company shows that pertain to the Subject Property.  That includes liens, easements, and deed covenant, conditions, and restrictions, more typically referred to as CC&R’s.  This is a place where lazy agents do things that drive their E &O (error and omission) Insurance providers crazy.  If there are liens, they must be paid off before the title can be transferred.  And there may be items that are appurtenant with the land (run with the land) that any buyer needs to be aware of.

A Bridge to Nowhere:  I was representing a buyer for a property that had a Skybridge attached to it.  There was no easement agreement defining who had ownership of what parts, who was responsible for maintenance, and who was liable.  My Buyer saw it as a poorly maintained eyesore, the Seller saw it as an asset with great long-term potential, the owner of the building it connected to considered it a problem and locked their side to prevent entry.  This is a recipe for long-term litigation.

There were also 4 easements and 1 encroachment noted.  Proper Due Diligence meant verifying where these were so that the Buyer knew before buying whether or not any of these could potentially compromise the value of the asset.  The Preliminary Title Report in the example above also contained an erroneous finding.  When I matched the findings to the list of reported items I noted that an item recorded as an encroachment was actually a note.  In theory, if there was a problem the buyer might be able to sue the title company for satisfaction…but I put extra effort to avoid situations for my client where suing is the best option.

A Highway Through the Property: I represented a buyer in adding a 57 unit multifamily property to their existing billion-dollar portfolio of 7,000+ units. A thorough examination of the Preliminary Title Report showed that the entire property was subject to an easement for the State of Washington to build a freeway through it. This was placed on the property several decades before the property was built because the state knew a new highway would be needed in the future. Since the highway had already been constructed, we insisted that the seller work with us to remove that easement as a condition to closing to prevent problems in the future. We were shocked that the apartment builder had not been as diligent when they bought the property.

Bottom Line: In buying commercial real estate, an ounce of prevention is worth much more than a pound of cure.

 

Other articles you may be interested in:

Michael Kapnick: The way investment real estate ought to be done! | Rose City Commercial Real Estate

The Importance of Due Diligence in Multifamily Profits, Phase III: Physical Inspection | Rose City Commercial Real Estate

What You Need to Know about Capitalization Rate | Rose City Commercial Real Estate

 

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