Variations on the due-diligence process theme

New wrinkles in dealing with the ‘numbers’ and approaching inspections

A couple of recent investment sale transactions reminded me that my commercial real estate brokerage business is a “practice,” in which every deal has a wrinkle making it somewhat different than any other similar one.

The variations were present in the way we went about dealing with the “numbers” as well as the inspections, both part of the “due-diligence” process that comes into play in these transactions.

Typically, the numbers come into play at two stages of an investment deal. I usually collect as much info about the numbers as I can before listing a property so that I can analyze them and make a recommendation to the owner of the property as to what listing price to put on the property.

The information I collect includes, but is not always limited to, income and expense data for three years, a rent roll, income tax returns and insurance policies.

After analyzing the data, I incorporate it into my marketing package, but generally hold off on providing the actual documents to a prospective buyer until after an offer has been made and there is general agreement on the selling price, subject to review of the data.

The “numbers” are also reviewed by the buyer’s lender prior to the lender making a commitment to finance the acquisition of the property. In most cases, both the buyer and the lender want to make sure the cash flow from the property will service the debt and provide a reasonable return on the buyer’s investment.

With regard to inspections, I generally take a walk through the property before listing it, and ask a number of questions about the condition of the building, roof, mechanical systems, power, utilities, vendors, etc.

Prospective buyers will also walk through a property before making an offer to purchase, and their offers are also subject to further inspections by vendors or contractors of their choice, and at their expense.

Again, lenders also require various inspections by vendors of their choice, not wanting any surprises that will interfere with cash flow or require substantial unanticipated capital expenditures.

A different approach

One of the deals I recently concluded proceeded in the typical fashion outlined above. We provided basic financial and property info to the prospective buyer, he visited the property and reviewed what was provided, and a deal was struck on the purchase price.

But as the due-diligence activities intensified, concerns were raised about the cash flow and expenses, and inspections by various contractors revealed that there were items that would require significant expense to repair.

As a result, the buyer came back and asked for, and got, a reduction in the purchase price. Although the seller was motivated to sell, he also knew that he would probably have to offer a reduction in price to any buyer who fully investigated the property, and therefore agreed to the reduction in order to move on.

In the other deal I recently concluded, my seller client decided to flip the process on its head. In other words, he required any interested buyer to conduct all of his due diligence before making an offer so that there would be no reason to come back later on and ask for a reduction. Not only that, but prospective buyers were told that they would also have to make a non-refundable deposit if their offer was accepted, so they had a significant amount of money at risk if they decided not to go through with the transaction.

The main reason this seller decided to take this route was because he had an asset that was in high demand and knew that there would be several prospective buyers.

These buyers were given every financial document in the possession of the seller, and were also given the opportunity to comb through the building with as many contractors as they wanted prior to making an offer. The idea was to eliminate any surprises up front, and get a buyer locked in.

This technique will probably only work with a highly sought after asset, but it was very interesting to see how things unfolded, and it worked. The other deal also worked, but in a far more conventional way.

I wanted to add one more note to this column, about Section 1031 exchanges. These have been part of the U.S. tax code for decades, and offer a tremendous wealth-building opportunity for real estate investors, as capital gains taxes generally due on the sale of investment real estate can be deferred well into the future, and in some cases actually avoided upon the death of the taxpayer.

Congress is in the hunt for additional tax revenue, and there are proposals floating around from the president and both houses of Congress to either eliminate or sharply limit the benefits of Section 1031. All real estate investors should be following this closely.

Dan Scanlon, a senior associate with Colliers International in Manchester, focuses on business tenant representation and investment sales. He can be reached at 603-206-9605 or dan.scanlon@colliers.com.