Sounds boring, but this can save you a fortune.
“A well done is better than well said.” — Benjamin Franklin
In a recent article a “celebrity” buyers agency was patting their own backs over “arranging $40m worth of commercial property purchases in only 2 weeks”. My first thought was “why boast about the value of the deals”, that bottle of champagne is reserved for the selling agent. As a Buyer’s agent you should be more concerned about the number of deals and the rental yields achieved for your clients.
My second thought was “how on earth could they have managed so many deals so quickly?” Do they employ an army of property experts to perform due diligence, or were they skimping on this essential step and just fast forwarding to the part of influencing the client?
We understand commercial property to be a complex asset requiring proper assessment of diverse factors including the property itself, its location, whether it is fit for client purpose (now and in the future), its inherent value and fair market rental, and the changing needs of the economic environment which will impact future rents, vacancy and usefulness. Accordingly, we approach each property with a basic 18-task checklist, which expands depending on the specific nature of the property.
The purpose of this week’s blog is to share with you the basic due diligence tasks that should be undertaken prior to buying a commercial property. In studying the list, you can best decide if this is a task you want to undertake on your own, or if you need expert assistance. It should also provide you with a checklist to task your buyer’s agency and ensure you are engaging a quality one.
Our tasks are performed in 11 incremental stages with the property rejected should any stage prove unsatisfactory:
We commence the property journey by gaining a detailed understanding of our client’s commercial property needs, guiding them if requested on asset class, region, budget, target yield and target capital appreciation. We then scour agency portals and call our list of agents for up-coming or off-market opportunities. Typically for every 5 properties considered, only 1 is deemed suitable for client consideration.
Here are the 11 stages to help guide your next commercial property investment decision:
Step 1: Basic property information review – gaining an understanding of what the property offers, its location, size, purpose, build, rental yield, WALE, zoning etc. This information is sourced from digesting the information memorandum or building out our own if the property is ‘off market’, with the inevitable gaps filled in by asking the agent, council, town planner, tenant all the right questions.
Step 2: Pre-due diligence assessment – we then map the property to assess factors such as its location catchment, land scarcity, location to its target market, port or infrastructure, as well as features inherent to the property including age, build, building & land size, clearance, street access and exposure, parking and the positive and negative features of a specific site. It also includes mapping flood and other natural hazards and statutory limitations. Such information is obtained from public and subscription databases.
Step 3: Assessing current and future potential – looking deeper into zoning, permitted use, easements, statutory rights and planning approvals to understand what might impact the property currently and in the future. The property should provide good use and rental income in its current form and superior capital growth from potential value-add measures in the future. In some instances, we engage at our expense the services of a Town Planner to advise on future development potential and any issues an application may face. This is particularly true of medical sites.
Step 4: Vacancy and scarcity – a good candidate will be “infill” sites, i.e. well-established suburbs with land scarcity, surrounded by large and growing residential neighbourhoods ( the demand ). Land scarcity aids capital growth and often leads to longer-term value-add opportunities. Think of a large industrial site that in time is rezoned for retail or high density residential use like Alexandria in Sydney. Low vacancy validates our assessment of location, and together with building quality and functionality ensures that when tenants invariably leave it will be quick and easy to find replacements. Scarcity also enhances rental growth. We recommend our clients against paying a premium for a long-term lease to a brand-named tenant, and instead apply their budget towards the quality of the property. Tenants come and go for a variety of reasons, a quality property is yours forever.
Step 5: In-house assessments of fair market value and fair market rent. To recommend an asset, it must be a good property, fit for intended purpose and obtained at a fair price. Once we are comfortable with the property, we need to gain confidence in the price and rent. Price is often a function of rental yield, and we need to independently assess fair market rent to ensure the asking price isn’t inflated by an artificially high rent. The process to determine fair market value is undertaken by a team of qualified professionals within 1Group, and their findings are assessed and debated by experienced property professionals. Using proprietary coding we are able to calculate the cost to replicate the property as a check against the valuation, and provide a scale from great value to poor value comparing fair market rent to likely sale price. By the end of this process our clients are empowered knowing not only what they are buying, but also providing us with solid tools for negotiating for them the best possible price.
Step 6: Commercial evaluation of lease and contract of sale – every landlord wants quality tenants who honour the terms of their lease, and knowing they are mutually bound by its terms, our clients also want a fair lease that protects their interests. A commercial evaluation differs from a legal review, which largely focuses on key terms, whilst a commercial evaluation looks at the cost versus benefit to the owner, as well as the commercial risks involved in owning the property. For example, we rejected one otherwise first class property because the lease shifted all responsibility for contamination away from the tenant and onto the owner. The risk of ownership thus potentially outweighed the benefit. Similarly, a Contract of Sale was rejected because it provided for an “as is” basis whilst inserting a clause permitting the Vendor the right to withhold inconvenient information. These are often “small-print” details made in a large document, which needs to be read in detail by experienced eyes looking for subtleties aimed at unreasonably benefitting a seller at our client’s expense. Sometimes identifying such a point allows us to renegotiate a price, shifting the cost of rental incentives from the purchaser to the Vendor. In one instance it allowed us to take almost 10% off the agreed purchase price. In property contracts and leases the devil is very much in the details.
Step 7: Assessment of tenant – unless purchased with the intent to occupy, a decent tenant improves the investment experience and avoids a frustrating aftermath to the transaction. Whilst their occupancy may represent a relatively short period in your building’s life, and their rent a small proportion of the cost of the property, a tenant who is litigious, unreliable in paying of rent and otherwise troublesome is not a tenant worth having. Most tenants are small or medium size businesses, but even corporations have issues and the last thing you want is to fight an army of in-house lawyers. At other times clients have thought the tenant was the head-office only to find it was too a franchisee devoid of corporate guarantees, and regardless of agent puffery. We talk to the tenant, assess their reputation, obtain the rental ledger and obtain a background credit check on the business and its directors.
Step 8: Commercial inspection – supplementing all we know and like about the property as it presents on paper, we provide a first-hand, boots on the ground inspection by the 1Group team. We visit the property, using experienced eyes to assess a multitude of details of commercial importance which impact any tenant’s satisfactory use of the property and thus its long-term investment merits. Certainly, we will look at the building and note any defects, but in assessing its commercial merits and in discussion with the tenant we get to know things not readily discernible from maps, pictures and documents. The inspection is captured in video and numerous photographs so you are able to view everything we have seen. Examples of the commercial inspection may include the ability for forklift mobility or container drop-off of an industrial property, or accessibility for customers of a retail or medical property. The commercial inspection supplements a Pest & Building inspection, which focuses on building defects, rather than commercial defects.
Step 9: Assessment of investment merit– once we are comfortable with the physical characteristics of the property, we turn our attention to its investment merit from the perspective of our client’s personal financial situation. We run a cash flow analysis of the property and a full set of financial projections to determine if the investment will meet our client’s needs and goals. Some clients have a high tax burden and need the benefits of negative gearing, whilst others require free cashflow to supplement household income or improve their debt-service-ratio. Some prioritise capital gain, some income. Our due diligence models their personal circumstances to ensure the property meets their individual financial needs and quantifies the cost & risk vs financial benefit of the purchase.
Step 10: Negotiation – No property is ever perfect, but once we are confident we understand the core issues of the property, its fundamental value, the cost of any remediation and that it meets our client’s needs, then and then only, can our client make an informed decision on whether or not to purchase and how much to offer. Offers are typically subject to final due diligence unless going to auction. By this stage you can believe we will understand the property better than the agent (perhaps better than the Vendor) and are in a strong position to negotiate on behalf of our client. Throughout the process we have built up a rapport with the agent and they have come to respect our integrity and professionalism. For this reason, it is common for them to recommend our Offer in preference to even a higher offer from an unknown entity, who may or may not withdraw from the deal without reasonable cause.
Step 11: Management to Settlement – once an Offer has been accepted we are now best placed to commence the final due diligence which uses outside experts and incurs costs for our clients. Typically this includes Pest & Building inspection and legal review of documentation. We recommend cost-effective, highly competent 3rd-parties and project manage their work. Reports are reviewed, consultations conducted, and the information imparted to our clients in a full and balanced manner. As a result, by the time the Contract becomes unconditional as many of the unknowns and uncertainties as can be humanly known are unearthed, and importantly our clients are excited, rather than anxious, about taking on ownership of their new investment.
Due diligence is akin to peeling the layers off an onion; a methodical process, scrutinising facts, revealing hidden knowledge, and asking the right questions. It takes time, expertise and experience to conduct effectively. Sometimes uncovering facts facilitates a discount to the purchase price, or remediation by the Vendor prior to Settlement, or even rejection of a deal where the fault is egregious.
As previously noted, to be successful it must be a good property, fit for client needs and available at a fair price. If one in five properties pass initial due diligence, perhaps only 1 in 3 succeed final due diligence. If rejected this we recommence this process on an alternative property, and because we are very selective about our recommendations, when stock is low this can take several weeks to secure.
Purchasing a property is an exhilarating but exhausting journey, and that is why so many people turn to a Buyers Agency for assistance. But you need to pick the right one.
We can all claim great results and make bold promises. If you’re unsure who to trust, get your prospective Buyer’s Agency to provide you with their due diligence checklist and get a reference list of their most recent customers. When all is said and done, a lot more tends to be said than done.
Please reach out to us if you would like a copy of our proprietary Due Diligence Checklist and some recent case studies. Or help securing your next investment.
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