Commercial Real Estate Due Diligence: Financial Analysis

Introduction to the Article Series

When acquiring real estate income properties, due diligence is something that we know is important, but we dread doing it, often cut corners or rush through it, and then regret it later. We get excited about getting a deal done and lose sight of the mechanics of knowing what we’re buying.

There is only one thing we can take for granted about a commercial property: The seller always knows more about the property than you do. As a buyer, our job is to ferret out the information the seller may not want to volunteer, or perhaps isn’t aware of, in order to make an intelligent decision about the deal.

The first level of due diligence is market analysis. This is the process of collecting and analyzing demographic, socio-graphic, and geographic data to determine if the market meets your criteria for investment. A discussion of market analysis requires its own series of articles. This series on due diligence begins at the point that market viability has already been established and a specific property is under contract.

The information for property analysis during the due diligence period falls into three general categories: financial, operations, and physical/legal conditions. This article addresses the first category, financial due diligence. Part 2 addresses operations, and Part 3 discusses legal and physical conditions.

The Goal: Accuracy

By definition, the valuation of an income property is highly dependent on the amount of income being produced, so to determine value we start with the financial data. The objective of due diligence is to collect the information needed to construct an accurate depiction of the property’s Net Operating Income (NOI), the most critical number for accurate valuation.

To start, we must construct an accurate representation of the operations as they exist today. Different owners operate properties in different ways. We can only value the property based on how we will operate it, and how anyone else does it is irrelevant.

We verify every item of income and expense, adjusting the statement and then use that information to accurately project the property’s performance under our ownership, also known as a normalized income statement.

Get the Real Numbers

In initial sale offerings, we usually get a pro forma statement of income and expenses. A pro forma income statement represents the income with certain assumptions that may or may not reflect the actual conditions of rent roll and expenses required to determine the existing NOI.

A dead giveaway to pro forma numbers is found on the top line of the income statement.”Gross Potential Income,” followed by a subtraction from potential income tell us that the numbers given are not actual performance. A typical pro forma statement will look something like this:

Gross Potential Income:  $100,000
Vacancy loss (5%):         $ (5,000)
Gross Rental Income       $ 95,000

“Gross potential income” assumes that 100% of the units are rented and collected 100% of the time. The income is then reduced by an arbitrary vacancy factor that likely will not correspond to actual performance.

A pro forma statement may mask the reality that the property has more vacant units than the numbers assume or heavy collection losses and pending evictions. Using the “potential” income for valuation means we would be paying the seller for income that we produce.

Using the most recent actual operating performance is a cardinal rule in valuation. Historical data for the past three years of operations is the ideal for analysis. A lesser period may hide problems that are not entirely cured. A longer period will include irrelevant information. One year of data is the absolute minimum. Less than that is considered a distress sale and “buyer beware” applies.

If available from the seller, the property’s tax return can be used to verify operating data. You can be sure that expenses will never be understated on a tax return. However, if there are major discrepancies in the reported taxable income between the operating statements and the tax return, ask yourself this question: “If the owner will lie to the government, will he lie to me?”

Existing Loan Documents

Existing loan documents are needed if loans are being assumed. If not, then the existing loan information may not be relevant.

I do like to know how much the owner owes and on what terms, just as general knowledge to indicate motivating factors. A title report often contains information regarding modified or extended loans. That may be a tip that some financial stress has occurred, either with the property or elsewhere in the owner’s affairs, valuable knowledge in negotiations.

Verifying Income

It is important to not only verify the amount of the income, but also the quality. Inherent in every property analysis is measuring the risk that one or more tenants will vacate at the end of the lease, or worse, become a collection problem during the lease term.

are the most important documents that attach to an income property. The existing leases produce the income, so it is critical to review every lease, and read every word. Make a note of any discrepancies, concessions, or required improvements. If the improvement or concession has not been met, you will inherit the obligation and must factor it into your operating projections.

Rent Rolls are a convenient report that consolidates the terms in the leases. A basic rent roll report should show the unit number or name, the tenant name, the rent amount, any past due balance, and the lease expiration date. This is the basis for your first year income projection.

If past years’ rent rolls are available, analyze tenant turnover, identify collection problems, and note anomalies from current performance. However, especially in multi-family properties, the rent roll can hide pertinent information regarding the quality of the tenant base.

Tenant files
can reveal the most critical information. Examine each for completeness and compliance with appropriate regulations prior to closing. Major concerns are tenant credit reports, complete applications, any personal guarantees, and for residential properties the required waivers for lead paint and mold.

Keep an eye out for recent additions to the rent roll. More than one seller has filled a property with sub-par tenants in order to boost the occupancy prior to offering the property for sale.

Files with poor or non-existent credit reports and lack of landlord references are a red flag. If the problem is widespread the investment can become a turnaround project overnight.

This is an overview of the major income factors to investigate in an income property. There are innumerable variations, additions, and permutations of relevant issues that arise as one inspects various property types. For a more detailed guide to investigations, find a text that explores the subject in depth.

Once the income has been verified and the quality established, further due diligence will concentrate on operations and physical and legal matters, discussed in part 2 and part 3 of this series.

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