Commercial Real Estate: Operational Due Diligence

Operational due diligence is perhaps the easiest category of investigation of an income property. The expense side of the operating statement provides a road map of sorts to "where the bodies lie," as my good friend and colleague, Ed Garcia puts it. What he's humorously referring to is the common practice of an owner to camouflage problems in order to make the property look better than it is.

I've been in this business for almost thirty years. I can't begin to count the ways I've seen property owners misrepresent expenses. This is the flip side of the practice of padding a rent roll addressed in the previous article, Part 1: Financial Due Diligence.

The astute investor knows that no matter how honest the seller is in supplying operational data, there can be differences between the historical expense profile and the projected expenses under new ownership. For example, in some areas the sale itself can significantly change the property tax status, as well the insurance costs.

But the purpose of operational due diligence is to provide a baseline for the expense projection for the buyer's first year of ownership. A bonus is that in the process of verifying the major expense items defects that did not show up during physical inspections (see Part 3) may emerge. Numbers talk--if you know how to listen.

Utility Usage: The Key to Controlling Costs

Utility bills are typically the highest line-item expense in multi-family properties, and in the top 3 of other property types. I like to have at least two years of the actual monthly utility bills that show both the cost and the usage. If the property owner has not preserved the bills, they are readily available from the service providers.

Annual costs only are not enough to determine if the usage is in line. An annualized statement tends to smooth the seasonality of use, and evaluating by cost only can mask over-consumption (i.e. leaks).

The operating statements reflect only the utility cost. The only way to accurately gauge utility consumption is by tracking the units of use (gallons, watts, etc.) on a per-occupied unit (for multi-family) or per square foot (for office and retail) basis, using the actual bills to match cost and usage. This isolates spikes in use and abnormal conditions, i.e. leaks. Each utility has a norm of usage that the utility can often supply.

For example, a family of four, on average, uses about 5,000 gallons of water per month. Consumption over that amount may indicate a leak in that building or section of the property. Other utilities have similar norms, usually available from the providers.

An important note: Many utilities are owned and operated by municipal providers. In recent years, the fiscal stress on local governments has become acute. Some have turned utility operations into a profit center to generate revenue without raising taxes. Examine the rate trends, inquire about planned rate increases, and adjust your operating projection accordingly.

Sleeper Expense Increases: Property Taxes

Property taxes are a significant expense item and must be analyzed for the expense amount trend over time. The main source of revenue for local governments are property taxes, so the present tax is a reflection of the government’s spending level. In today's environment tax-assessed values are being decreased reflecting the recent housing bust, and rate increases are necessary to maintain revenues.

It takes only a few minutes to verify the information straight from the source, and if you are in the tax office personally, there is an opportunity to strike up a conversation with a clerk who will grant some insight into the local politics regarding coming tax increases. A title report will reflect if the taxes are delinquent--an indication of an owner's financial stress and level of motivation.

There will be an assessed property value on the tax ticket. This value is usually irrelevant to valuation, but it is wise to compare the assessed value of the subject property to others of the same type in the market. If it seems out of line, a reduction may be possible. Be sure to inquire whether the sale transaction will change the tax assessed value and when. This varies widely from one jurisdiction to another.

Insuring For Profit

Insurance policies are a wealth of information, if used properly. Though policies are rarely transferred, the basic information from the current policy is needed in order to price coverage from your insurer.

The amount of loss insured; the type of policy and standards of coverage (e.g. replacement cost, business interruption, plate glass, boiler, etc.); any riders attached for additional casualty (flood, disaster, etc.); and any exceptions to the coverage are essential in getting accurate and competitive bids. Always get a quote from your own insurance carrier.

Compare the cost listed on the operating statement to the actual premium. Many owners may have one carrier or agent for a number of properties, and may also carry a separate liability or umbrella policy. If the amounts are pro-rated it can mean an expense reduction or, if the cost of a general liability policy is not included, a source of additional expense.

There may be a risk assessment in the owner's files. This is a report that the insurer prepares to notify the owner of any problems in the property that must be corrected to maintain coverage.

This report can be a great shortcut. It is an objective third-party look at the property from the perspective of identifying liability for negligence, poor workmanship, deferred maintenance and latent defects, basically a preliminary due diligence report on physical conditions (see Part 3).

If the owner does not have a copy s/he can request it from the current insurer.

Do the Due: Check Every Expense

Remaining expense items should be independently verified whenever possible. Be aware of how owners operate the property in order to normalize the operation under your ownership. For example, some sellers are hands-on owners, and the maintenance expense may reflect only the cost of materials, since they do not pay themselves labor costs. You won’t know unless you ask.

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