Real estate delivers better returns than the stock market does, but modeling returns requires critical thinking and a lot of due diligence. The better our due diligence, the better our models, the greater the access to capital. What makes commercial real estate such a unique asset class is that every investment is different and our due diligence needs to adjust accordingly.
When it comes to due diligence, information costs money and therefore must have a return on investment. In this article, I discuss the decisions that real estate investors face when it comes to physical due diligence—think environmental site assessments, property condition reports, BOMA surveys, ALTA surveys, seismic risk assessments, and the like—and how to wring the most return on investment out of the process.
Who should direct the due diligence?
A questions I often get asked is: should the seller do pre-disposition due diligence? For most transactions, the buyer performs due diligence assessments at their own expense. However, on large transactions where the broker expects the buyer pool to be large and competitive, I believe that the seller is well-served to provide a full due diligence package at listing. In this case it pays to proactively reveal any issues and hold the asset out for auction “naked to the world.” Because in a competitive bidding process, buyers will discount any imperfections and focus on key economics. With a large data room it is difficult for the buyers to fully integrate every issue or imperfection into their model. However, when the seller does not provide pre-disposition due diligence, a winning buyer who finds out about problems while under contract, and may be experiencing some buyer’s remorse, is far more likely to raise these issues and expect consideration.
The ROI of environmental due diligence
We do 25,000 environmental reports per year and I’m amazed at how many of the assets that we assess have issues. We find that about 10 percent of Phase I Environmental Site Assessments (ESA) across all asset types include a recommendation for further investigation (Phase II ESA), and another 10 percent advise the buyer of an environmental issue that may not require action, but is important in some circumstances. For example, some assets will have subsurface contamination from an on-site or off-site source that is low enough to be written off as a de minimis issue. However, if the buyer intends to develop the asset they will experience extra costs and delays due to soil or groundwater requiring special handling.
The real value in a receiving a clean Phase I Environmental Site Assessment is that you have an asset that is leasable, salable and financeable. Environmental issues—big or small—take time and money to remediate, which means that assets with open environmental issues are tough to lease, sell and finance.
The ROI of property condition reports
The data provided in the immediate repairs and capital replacement reserves reports is important new information for the buyer’s financial model. Buyers should understand the differences between an ASTM Property Condition Assessment (PCA) performed by a single assessor and the multi-disciplined team approach to the assessment. The standard scope of work for a PCA is defined by ASTM E2018-15 and requires the inspector to identify deficiencies that are readily accessible and easily visible during a walk-through survey of the property. It does not require the inspector to turn on or open up building systems. That means that if you want the inspector to, for example, turn on the air conditioning in the dead of winter, you need more than a standard assessment. Multi-disciplinary PCAs are generally custom scopes of work developed considering clients’ specific needs and concerns, and use specialty inspectors in addition to the generalist assessor. Commonly engaged specialists are structural engineers, mechanical engineers/HVAC experts, elevator inspectors, façade specialists, registered roof observers or ADA specialists. Of course, adding these specialists increases the price of the PCA, so it is critical that the client and consultant work together to make smart ROI-centric choices based on the age and size of the asset, the property type and information disclosed by the seller.
The ROI of adding an energy audit to the PCA
A PCA report provides recommendations to replace a mechanical system at the end of its useful life. But ROI can be improved if equipment is proactively fixed or replaced at the end of its efficient life. An average energy audit on an office building will yield a dozen recommendations with payback periods of less than three years. Common recommendations include lighting retrofits, building controls, building system tune-ups, water fixture replacements and building retro-commissioning.
Retro-commissioning is a cost-effective way to improve a building’s operating performance. As a building ages, its major building systems (including the central plant) steadily become less efficient due to things like tenant or use changes, schedule modifications, equipment failures, sensor failure or poor maintenance and management. When building systems stop operating per the design and use intent, it results in inefficiencies, higher operating costs and increased tenant complaints. Retro-commissioning addresses such issues by fine-tuning existing building systems to make them operate optimally through scheduling, sequencing, controls programming and optimizing set points. Importantly, it does not require replacement of large capital items. During the procedure, an energy engineer investigates and documents the proper and intended use of the building and recommends a list of corrections to be implemented that will meet current demand, improve the tenant experience and significantly lower energy bills. Retro-commission projects often have a less than a 24-month payback period, and really are a no-brainer. ROI is particularly great for larger, older assets, so buyers of office properties that are at least 100,000 sq. ft. and more than 10 years old should consider making retro-commissioning standard procedure.
The ROI of seismic risk assessments
Consider this: if the net operating income (NOI) associated with the asset doesn’t include the cost of insurance, then the NOI is overstated. A lot of commercial real estate assets do not carry seismic insurance. Therefore, the owner is essentially self-insured and the costs of insurance aren’t accounted for in the NOI. Investors are well-served to understand the seismic risk their portfolio is exposed to. Predicting loss in the event of an earthquake is difficult and investors should acknowledge that even the best models and assessments are imperfect. In Yogi Berra’s words: “It's tough to make predictions, especially about the future!” Nevertheless, engineers can distinguish vulnerable buildings during a seismic risk assessment (also known as a Probable Maximum Loss report). Owner/investors should consider purchasing earthquake insurance on all assets, and for vulnerable buildings and those with high Probable Maximum Loss ratings, they should consider the return on investing in an earthquake retrofit. Seismic vulnerabilities such as tuck-under-parking and weak cripple walls can be retrofitted for reasonable costs. Cities like Los Angeles, San Francisco and Santa Monica have implemented wide-reaching seismic retrofit ordinances in recent years that mandate the structural strengthening of vulnerable buildings. Over the next few years, these ordinances will require millions of dollars of retrofit work to prevent billions of dollars worth of potential loss during future seismic events.
The ROI of a BOMA survey
You would never buy a building without knowing how big it is. Well, you’d be wise to get a BOMA survey to confirm the exact space measurements because surprisingly, buildings are routinely 5 percent bigger or smaller than what the tax records or listing brochure shows. Even a seemingly small variation can have great consequences: if a building priced at $300 per sq. ft. is under- or over-stated by 2,000 sq. ft., then the value adjustment would be $600,000. That means that if a proportion price adjustment is realized, the ROI on your BOMA survey could be fifteen-fold.
Note that the BOMA measurement standard includes two acceptable methodologies for measuring single- or multi-tenant buildings: the simpler Methodology A (known as the Legacy Method) which results in different ‘load factors’ for each floor; and Methodology B (known as the Single Load Factor Method), which gives one averaged load factor for the whole building. There may be some nuances between these measurements, so it is important that your consultant is able to deliver a clear and highly defendable number.
The ROI of an ALTA survey
ALTA surveys provide an accurate, aerial view of a property and any potential areas of improvement or property development, giving investors the critical information they need to understand and realize the best possible future use of a site. By providing a bird’s eye view, it can, for example, be used to determine the optimal location for improvements, such as parking areas, green areas, building expansions etc. The survey will also show if there are any boundary issues or conflicts with neighbors, such as encroachments of improvements over property lines or possible improvement impacts on easements. Access to such information that impacts a site’s development potential or allowed future use—including utility easements, reciprocal easements, right of ways, etc.—will enable better investment decisions.
The ALTA survey also details restrictions that impact the future potential and profitability of an investment. It includes information about zoning and related setbacks, as well as exterior “footprint” dimensions of structures and ground heights, which helps investors verify compliance with current zoning regulations and determine what they can or can’t do with a site. It also gives investors critical information about the location of utilities, which must be considered in future development plans. The survey will show flood zones, and help inform decisions about whether flood insurance is prudent.
And, because an ALTA survey can be used to create base maps or backgrounds for development brochures, flyers and civil development plans, ROI is very easily achieved.
The ROI of credibility
Sellers respect a buyer who conducts thorough due diligence and when the buyer asks for consideration for an issue that is discovered during the due diligence, it will help if they have reliable, trustworthy reports from a highly credible engineering/due diligence firm. The seller is far more likely to accommodate a request for consideration of an issue that was discovered or assessed by licensed, credible professionals.
As I see it, commercial real estate provides the opportunity for superior returns to the stock or bond market for those investors who have the acumen to turn the due diligence process from a tedious task into a money maker.
Joseph P. Derhake serves as CEO of Partner Engineering and Science Inc., an engineering and environmental due diligence consulting firm. He can be reached at [email protected].