When looking at a commercial Net Maddy property of any type you need to spend time on the financial aspects of the property before you form an opinion about the price that you think that you can achieve. The financial aspects of the property can have a major impact on the price and or the interest of purchasers. The financial aspects of a building or a property can impact the asset for many years and for this reason must be analysed and identified.
We have detailed some of the major aspects of financial concern in a property purchase or sale scenario. Whilst these are not the only categories of activity and concern, they are the major ones in most circumstances.
We recommend that you create a checklist from these items so that your property review and inspection process is suitably enhanced and professional.
The Asset Schedules: The property will contain many fixed and moveable assets. These will normally be detailed on the asset register. A well maintained commercial property will have an up to date asset register for your review. Obtaining the asset register at the early stage of sale consideration is productive as it will tell you in detail what you are selling and later become part of the due diligence process.
Bank and Personal Guarantees: An investment property comprises leases and other documents which support tenant occupancy. A normal leasing process would involve and create some form of guarantee to be provided by the tenant to the landlord for the duration of the lease. It is important that this guarantee has both strength and substance to reimburse the landlord in situations where the tenant defaults under the terms of the lease. At the time of property sale, these guarantee documents should have some form of ability to be transferred or re-issued to the incoming purchaser. This process is called an assignment of the guarantees. You should consult with the landlord’s solicitor to identify the types of guarantees involved and the ease in which this can be achieved at time of sale.
Capital Expenditure: Major items of plant and equipment which are replaced in a commercial property are usually regarded as capital expenditure and are separately itemised for the purposes of taxation and depreciation over a period of time. Taxation laws in your location will stipulate the depreciation terms as they apply to different types of capital expenditure. For example, a computer that is purchased for the building control system will depreciate far quicker than the air handling unit which was purchased for the air conditioning plant. Well maintained property records will include a detailed capital expenditure register and the date at which the capital item was purchased. Purchasers to the property will be interested in the depreciation that this register provides against the cash flow in coming years.
Taxation and GST: Every country and property location has its own unique taxation laws and requirements relating to property and particularly investment property. In the sale process, it is important to understand that these matters have been correctly handled and are up to date. It is sometimes necessary to view the net returns for the property for the last few years that were applied to the taxation statements and lodgement process. You can also seek written confirmation from the owner of the property that all taxation matters are up to date.
Income and Rent Analysis: The income for the property is a reflection of the leases and occupancy licences therein. It is essential to understand that the rent has been collected in accordance with the leases or licences and that all rental matters are up to date. Part of this process will also involve the checking of the rent review profile and the expiry profile of all leases. A property with a volatile leases or leases that are soon to expire is likely to impact the price or the buyer interest. When reviewing tenant occupancy against leases, you should review the original documents and cross reference this to the tenancy schedule and any discussions or information provided by the landlord.
Independent Valuation: Many property owners will obtain a valuation regularly in support of their property financing package. It is not unusual for such valuations to occur annually. Importantly they are done by a qualified and registered valuer. If you view this documentation and take it into account in the pricing process for the property, it is wise to consider the true independence of the valuation when it was done and its relevance to the current market. Some valuations for financing purposes may not be in parity with the existing market conditions. It pays to sometimes seek a true independent valuation at the time of sale or in preparation for sale.
Land tax issues: Property land tax has a direct impact on the investment aspects of commercial real estate. In different locations, the recovery and payment of land tax is impacted uniquely by local legislation. In some circumstances the land tax can or cannot be recovered from the tenants within the property. This will have immediate impact on the bottom line and net return from the property; this then impacts the price. Consulting with the financial adviser for the owner of the property, or the taxation office, will achieve clarity in this taxation impact. Given that most agents and brokers are not taxation experts, you should involve other professional taxation people as appropriate.
Lease disputes: Rarely is there a property that does not have an existing lease dispute or has been impacted by a previous lease dispute. For this reason it pays to question the matters of lease dispute and resolution. If in doubt, seek a copy of correspondence and any subsequent agreement between the appropriate parties. Unresolved lease disputes can jeopardise or slow the process of property sale.
Mortgaged interests: Most commercial real estate properties will have a mortgage of some type to a financier. When a mortgage exists, it is necessary to understand how it will be handled or discharged in the process of sale. The client should consult with the mortgagee to clarify these matters for you. In a situation of distressed properties, the sale of the property may need to realise a particular price before clear title can be achieved.
Operational expenditure: The running of a commercial property will involve the operational expenditure attributed to running costs. Most of properties of particular types in the same location will have similar operational expenditure. If however a property has excessive operational expenditure which is above the averages in the area, then the property is likely to be difficult to sell. Most purchasers of properties understand the averages of property expenditure deemed to be realistic for each property. This also says that real estate agents and brokers should be well aware of the expenditure averages and analysis process that should apply in this situation. Operational expenditure is analysed on the basis of $’s per m2 or $’s per ft2 (depending on your location, monetary base, and country)
Statutory charges: These are commonly referred to as rates and taxes. These will involve matters such as water rates, land tax, council rates, and any other form of charge which is raised by the statutory bodies. Importantly the charges so raised must be analysed for parity to similar properties in the same region. Part of the rating process involves a statutory valuation of the land on which the building and property is located. Whilst some property owners like to think that their valuation is high and justifiable (and therefore gives substance to the sale price of the property), it is this valuation that is the foundation for the charging and payment of statutory charges. The astute property investor will always question this statutory valuation undertaken by rating bodies in an endeavour to restrict or lessen the amount of statutory rates and charges paid each year.
Rent reviews: A significant concern in the sale of a property is the size and stability of future rent reviews. It is the rent reviews which will underpin the cash flow and hence the attractiveness of the property to purchasers. It is essential that the real estate broker or agent read all of the leases, before any assessment of price or method of sale is given. It is quite possible that the rent reviews projected and detailed in the leases can either hinder or attract purchasers to the property.
Rent arrears: Existing rent arrears should be identified with the owner of a property. Any matters of associated legal pursuit should also be identified. It is possible that the property has had a history of rent arrears and instability. Look for these matters and question the cash flow stability. A history of financial performance from the property over the last few years is the best way to achieve this.
Current building budget: This will involve a budget of income and expenditure as it applies to the building currently in the existing financial year. A good building budget will be written and supported by sound property strategy, projections, and controls. At the time of any potential property sale, it is important to understand that the current financial performance is in line with the expected building budget. If there are any shortcomings or overflows, it is necessary to clarify the reasons for such. If you do not do this, the purchaser of the property will.
The side agreements or deeds: Property occupancy and usage can involve supplementary side agreements and deeds. This can be with tenants or neighbouring properties. Documents of this nature will have impact in the sale even though they may not be registered on the title of the property that you are to sell. Documents of this nature will usually be supported by aspects of common law. If in any such arrangements exist, you must seek further detail and clarity as to how they will be handled at the time of sale. One of the common events here is the existence of rental incentives provided to tenants at the commencement of the lease. When these situations exist, the most common method of resolve is the discharging of the arrangement by the landlord prior to settlement. This can become a term of the contract.
Sinking funds: It is not uncommon for sinking funds to exist on larger properties. The fund is essentially established to set aside money to cover the cost of major items of repairs and maintenance. This would not normally include items of a capital nature. As an example, sinking funds may be used to cover the cost of painting the exterior of a large building such as a shopping centre every five years. If a sinking fund exists, it is important to understand how it will be handled at the time of sale. Consultation with the client’s solicitor and accountant is essential to the process.
Taxation depreciation schedules: The property will have a taxation depreciation schedule. When correctly maintained, these schedules have the ability to lessen the net property income in forthcoming years. This is an immediate taxation benefit to the purchaser of the property who will assume the depreciation schedule as part of the sale and settlement. As the broker or agent in the sale you should check the existence of such documentation and identify what benefits it brings to the sale process. A well constructed and detailed depreciation schedule will make the property sale more attractive.
Short term leases: Many properties have short term leases or casual occupancy active at any point in time. It is vital to know the mechanism under which this occupancy occurs and how it will be terminated. You do not want a short-term occupancy to jeopardise the stability and processes of the sale.
Un-documented lease occupancy: Some may call this a casual lease; however a casual lease can create concern and uncertainty in the process of sale. Some tenants may claim a long-term occupancy from the existence of a previous casual lease arrangement with the landlord. Claims of this type must naturally satisfy the requirements of law to be sustained or upheld by the courts; however you should be cautious in such circumstances given that it can slow down or even jeopardise the sale process.
Warranties and guarantees: When properties are constructed, the normal process of warranties and performance guarantees apply from the construction process. At the time of sale, you need to know if any such matters apply or exist. Copy of the documentation is essential. Further to this, in an existing building where recent fit out activity has created newly constructed premises, it is likely that warranties and guarantees exist for the tenancy construction. These will transfer to the new owner of the property in most circumstances however the documentation to allow this to occur must be suitably constructed. This is a matter for the solicitor acting for the client.
Utilities costs and supply: Every commercial property will be supported by the supply of water, gas, electricity, and communication systems. The process of supply needs to be understood together with the cost of the process. Obtaining copies of recent accounts for those services will help you here. It is possible that some utilities will be supplied direct to the tenants and some others will be supplied direct to the building owner. Any differences in supply should be identified and documented. The costs of supply should be compared to the averages of other properties in the area.
This brings to an end the matters relating to financial due diligence. These are the major issues that apply in the sale of commercial real estate; however you should look for any other items given that each property is unique in its performance and financial structure.
Your review of these items should include the gathering of all original documentation as part of the checking process. Your notes taken of any comments and findings should be well maintained to protect you in the event of any disagreement or dispute. Given that commercial real estate involves large cash flows and extensive legal documentation, the frequency of disputes is reasonably high. The only way to protect you here is in your quality notes, a questioning mind, and good documentation.
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John Highman is a prominent investment real estate speaker and coach that helps real estate agents and real estate brokers globally to improve their commercial real estate market share and close more sales and leasing deals. He himself is a successful real estate agent that has specialised in commercial, industrial, and retail real estate of all types for over 30+ years.
Whether you specialise in real estate sales, leasing, or investment, John has the tools that can help you and your office succeed in your market.
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