Avoid Financial and Legal Due Diligence Errors during Investor Underwriting
One of the most exciting roles in real estate investing is raising the desired capital for the deal. However, things will remain as exciting as it should be and the deal will be a successful one only when you pay careful attention to and during the due diligence process. If you are a novice and are wondering what on earth that means then due diligence process can be described in layman’s terms as all required and reasonable steps that you need to follow to satisfy the legality for buying and selling a property.
In commercial terms it entails:
- Third party representation and
- All detailed property issues.
Due diligence is an essential factor to make a deal successful that involve a considerable sum of money. Therefore, it goes without saying that financial and legal due diligence must be error free. Even a simple and a single mistake will not only prove costly to you, but the acquisition will pose its own unique set of challenges.
You must know that in this regard there is nothing called ‘one size fits all.’ Hence, it is paramount that you build a robust framework so that you can view clearly the entire due diligence process.
Investor underwriting standards
The entire process of due diligence emanates from the underwriting standards. Such underwriting should be traditional and disciplined. It is also required that the Due Diligence for investors also includes a heavy dosage of skepticism.
- In the broker perform at you must show the earnings increasing exponentially. However, in reality, it is a habit of going against this principle and in the opposite direction. Yet, you must know that nothing is forever and in this case, it will certainly not go up eternally.
- Therefore, it is best to prepare for the worst hoping for the best than the other way around. Make sure that you do not have an itchy finger when you anticipate completing a deal successfully.
Avoid situations in which the standards are compromised or relaxed or thrown by the side as in most of the cases. Forecasts should never be stretched so that you meet the numbers.
Use the income approach
A significant aspect of Due Diligence for the sale of the business as well as commercial real estate is to follow the income approach. According to this approach, it is the Net Operating Income or NOI that is divided by the Asset Capitalization Rate or ACR. This rate of capitalization may differ by sub-market.
That means in expressing the value in mathematical terms it will be:
Property Value = NOI / Asset Capitalization Rate
In this formula, the net operating income is expressed in annual dollar value while the asset capitalization rate is expressed as a percentage.
To arrive at the exact value of the property, you must use conservative growth rates for all expenses and revenues by default.
Since commercial real estate is essentially and characteristically a cash-intensive business, any improper accounting and wrong representation of facts and other major line items will naturally result in very costly mistakes.
Avoid the trap of overestimating
It is found through research and several studies that it is very easy and very alluring to overestimate revenue and underestimate the expenses. However, this is a trap that you should diligently and religiously avoid and never omit and costs, no matter how small and insignificant it is.
Proper market and competitor analysis must be made as well when you determine the property value. Skipping this step is yet another severe mistake that will affect the final deal. This is because both the revenues as well as the expenses have a different underlying driver that is characteristically its own considering different sub-markets.
It will pay you off well if you do proper and thorough research to understand what’s, how’s, and when of each driver that will have a significant role to play in the property valuation process.
The operating cost
Apart from that, the due diligence must also include operating cost to the last penny to prove an accurate picture. In most cases and especially in small apartment buildings it is a usual practice to self-manage the property. Therefore, the owners do not include the property management fees in their profit and loss account. This is another mistake to avoid.
Investors must include a pro-rata property management fees in the P/L account even if no one pays for the said fees.
The Method to Follow
When you are underwriting, it is wise to use trailing 12 to 24 months actual P/L. This will help you to understand the actual operating costs. The specific process must be followed to use this actual T12/T24 numbers.
- You must first normalize them for one-time expenses
- Next, you must account for all expense categories
- Understand the underlying financial performance of the property.
These steps will ensure that there are no errors in the underwriting by omissions or commission. It will help you to have an intellectually sound, consistent and conventional underwriting framework that will be easy to understand and implement.
Long term property value
It is also very important to increase the property value in long-term but not with forced appreciation. As an alternative, you should verify the results of all sales comparable though it is widely avoided. This is a very helpful process to provide a reasonable property estimate. Compare the transactions completed recently on a similar type of property and within the same sub-market.
You will get a lot of help from the commercial brokers who can provide you with guidance on property valuations and sales comps. This is because they have access to information and databases of the industry. Alternatively, you can take help of one of the reliable and top due diligence firms in India.
When you contact such professionals, you will also get commentary on the various effects that the primary drivers have and the role these play in determining the overall value of the property. In this case, it is necessarily required that the investor triangulates the valuation by adjusting their final estimate according to the market information.
Seema Mehra is a Chartered Accountant at Ashok Maheshwary & Associates, gst consulting firms in india that provides statutory audit in India in a convenient manner. She is a professional writer and loves to share financial related topics.