DUE DILIGENCE ON BUYING A COMMERCIAL PROPERTY INVESTMENT BY PAUL NELSON
Commercial Property and real estate are an established asset class to the investment industry, with the market worth around $200 bn according to PCA/IPD Research (Sep 18). Individual investments can be worth more than $1 bn each as is evidenced by the recent sale of the MLC Centre in Sydney where the 50% stake sold for circa $800 m. Globally the commercial property investment market is worth more than US $7 trillion according to MSCI (Morgan Stanley Capital Index).
The due diligence (DD) process for a commercial property investment is the process by which the investor seeks to understand the many factors that can influence the decision to buy or not to buy. This process can be broken down into 4 main areas with a risk management overview bringing it all together.
Due diligence is therefore a really important part of the buying process with purchaser having a fiduciary duty to ensure investors’ money is invested with any understanding of the “risk” or acceptable levels of risk to the investor, depending on mandate or other factors.
Due Diligence Process
So where to start? Often all of these aspects of DD are dealt with concurrently but with check points if something significant doesn’t align with the vendors representations.
Classically it’s with the leases and the financial side of due diligence to check the revenue stream:
- Is the asset fully leased?
- What is the WALE? (Weighted average lease expiry)
- What is the quality of the tenant’s covenant?
- What is the rent review pattern (fixed or is there market upside?)
- If there are vacancies what is the market rent and incentives?
- Are the outgoing fully recoverable?
- What is the true net income?
Often this aspect of DD will be done by a Valuer who will value the property but in doing so look at these questions.
Legal due diligence would cover such aspects as: -
- Review the sales contract and appendices
- Checking the title
- Check the ID survey
- Checking for restrictive & other covenants
- Prepare summaries of the leases (Epitome’s)
- Check GST is recoverable on all leases
- Checking options and first rights of refusal
- Checking for inclusions exclusions and warranties
- Ensure the Building Energy Efficiency Certificate (BEEC) is current
Technical due diligence is one of the more difficult areas to execute as normally limited information is available and it’s difficult to do more than a visual inspection and make verbal enquiries.
Often a team of surveyors and engineers will swoop on the building for 24-48 hrs and try and extract as much information as possible including: -
- Condition of the structure and fabric
- Condition of the services inc.: -
- Air con
- Maintenance contracts review
- Capital works budget (capex) and past investment
- Currency and application of the annual fire safety certificate
- Checking the asbestos and other hazmat’s register
- Cooling tower & lifts registration
- Overview of potential environmental contamination issues
- Review of any fire engineered solutions
- Review of the outgoings budget (opex)
- Estimate of future Capex required
- Insurance replacement cost estimate
- Tax depreciation opportunities
A report will then be prepared to try to summarise the key issues with detail in the Appendices.
Planning & Environmental due diligence is sometimes a poor 4th cousin but there are key issues which must be checked including: -
- The current zoning, FSR and Height restrictions
- The original DA for the development and any subsequent changes
- Copy of the original Occupation Certificate (OC) and Fire Safety Statement
- Complying development certificates (CDC’s) for other changes including fit-outs
- Any fire safety issues from the local government
- Deciding what level of environmental DD is required:
- Stage 1
- Stage 2
- Stage 3
- Checking historic maps and contamination registers
Once the 4 areas have been looked at and results coordinated you need to draw together the priority issues highlighted and make decisions as to: -
- Do they affect value?
- What are the cost implications?
- Are the risks manageable?
- Should we proceed?
Often a vendor will prepare some due diligence documents which present an overview of the risks with the investment but remember it’s still caveat emptor (let the buyer beware) and you have to dig as deep as you can to protect investors funds.
Due Diligence has been defined as “required carefulness” or “reasonable care” so remember when buying a commercial property investment run through the different risk aspects and decide if the risks and rewards are in alignment. Disraeli once said, “Diligence is the mother of good fortune.”
Paul Nelson B.Sc. (Urb Est Man), EMBA, MRICS, LREA is a property professional with over 40 year’s experience in the UK, Hong Kong and Australia and a member of the PCA Academy Property Asset Management Committee.