It's the top of the market and buyers are in a bidding frenzy. Desperate to grab any available retail property, they're scrambling to put together financing and close deals while the capital's still flowing. But a dark shadow — make that dark shadows — lurk on the horizon as buyers pressed for time fail to read the fine print and leave themselves exposed.

“There's a lot of dumb money out there,” says Jeff Pintar, first vice president of brokerage services for CB Richard Ellis Inc. in Anaheim, Calif. “Some property purchases won't make sense if just one thing goes wrong, let alone a number of things.”

What could go wrong? Real estate industry experts say buyers with floating-rate loans will be especially hard-hit as interest rates rise and cap rates fall. “I don't know what type of calculator they're using, but it isn't the same one we have,” says First Allied Corp. president Edward Glazer, who has put 37 of the firm's 55 properties up for sale as a single portfolio to see just how high the bids will go in this overheated market (see story on page 12).

A host of potential disasters await those who paid too much for properties and didn't do enough research in their haste to push through a fast sale and beat the competition. Perhaps the structures weren't solidly built, or the buyer didn't perform the required due diligence. Surprises also could include finding out the owner of the abutting property has the right to approve changes or the drainage isn't adequate or the co-tenancy agreements could get ugly.

As interest rates rise and problems are uncovered, many buyers may soon start to fear they brought “the mall from hell,” that will send shoppers, lenders and ultimately, profits, scurrying.

“So far, no one has had to admit to making a stupid purchase,” says Pintar. “But that's because interest rates are still cheap. Wait until they rise.” Then, says Pintar and others, there will be a spate of refinancing and portfolio sales.

“That's when you will see the morticians sweeping the bodies off the floor,” says David Lichtenstein, president and CEO of Lakewood, N.J.-based The Lightstone Group.

Surprisingly, it's often the buyers themselves that jeopardize the long-term health of their portfolios. Some overly optimistic real estate firms stretch the truth to get financing. One buyer included rent from a national retailer in its proforma operating budget presented to a lender even though the tenant had yet to sign on the dotted line, says Martin Bronstein, a principal at the Houston-based consultancy The Situs Cos. In another deal for a portfolio of properties in Virginia, the buyer neglected to mention that six of the tenants with whom he signed leases wouldn't be moved in by the closing date. “We were told the tenants were in place, but none of the spaces had been built out and leases hadn't started,” says Bronstein.

When implementing projects from the ground up, Gregg Dorman, a Chicago-based attorney with Seyfarth Shaw LLP who handles entitlement issues for Home Depot, warns that numerous unknowns can surface and drive costs up and delay development, such as the presence of toxic substances, old buried structures, soil instability and improper drainage. He also suggests that buyers understand local government signage regulations and request a list of requirements prior to closing a deal. Noting that no two municipalities have the same rules, Dorman says that a city that won't agree to a written list of requirements for the Certificate of Occupancy raises a red flag.

He cites a case in which the city of Overlook, Kan., refused to give Home Depot a list of requirements in advance. The home improvement chain went ahead and built its store, then could not get the certificate until it complied with the city's specifications for access easement and a storm-water detention basin, delaying the store's opening.

Ultimately, says Reza Etedali, president of Irvine, Calif.-based Reza Investment Group, success in such a competitive market comes down to speed. A case in point, he says, was a deal last year involving a Burbank, Calif., mall. There were multiple bids, but what clinched the deal for the buyer was the offer of a “certainty close,” including no contingencies up front and a waiver of due diligence. “The winning bidder,” he says, “had a due diligence SWAT team there reviewing the property while it was being marketed.”

But just how much can buyers speed up the process without compromising the outcome? “It works against buyers who want 30 days to close a deal, so many people hold their noses and agree to 14,” says John Sullivan, whose San Francisco-based consulting firm, Richards/Sullivan Capital Resources, specializes in fast-tracking due diligence.

DEFINING STYLE

Oak Brook, Ill.-based Inland Real Estate Group says it offers due diligence in 30 days or less and will hire consultants to help if there are too many deals for its own team to handle. “We won't sign off until the whole puzzle is together,” says Inland property management president Tom McGuinness. “Since we're doing our own projections, we have to live with it; first-year projections become my first-year budget.”

If the seller holds up the process by not supplying documents in the agreed time frame, the firm is willing to kill a deal rather than chance getting stuck holding the bag, says McGuinness. His firm was in contract to buy grocery-anchored shopping centers in Fort Lauderdale, Fla., but backed out because the seller had not provided all the required documents by the deadline, yet pushed to close the deal anyway.

He emphasizes, however, that his company uses due diligence to build a good rapport with sellers, staying in touch almost daily, checking on the status of the process and document details. Hopefully, says McGuinness, the “seller views us as honest and easy to work with and in the future will sell to Inland rather than to someone else.”

Michael Carroll, senior vice president and director of redevelopment for New Plan Excel Realty Trust Inc. in New York, agrees. The best way to get a deal and have time for adequate research is to buy properties that are never put up for auction. “We just brought seven properties in Michigan without having to compete with fund managers,” Carroll says.

Irvine, Calif.-based Passco Real Estate Enterprises Inc., which specializes in 1031 tenant-in-common real estate investments, manages its due diligence process without assistance from outside consultants, says Sterling MacGregor, vice president of acquisitions. He says his team covers territory where most consultants don't tread. This includes driving around the neighborhood to size up the competition and find out who shops where. Team members also conduct personal interviews with property management, maintenance vendors and tenants, as well as local disinterested third-party sources, such as brokers, appraisers, mortgage bankers, leasing agents and property owners.

Contact is also made with other agencies, such as the tax assessor's office and utility company to ensure no increases in taxes or utilities are pending. Checking with the police and fire departments may uncover other previously unknown issues. And local governments can reveal plans that could impact the property's future value, such as zoning or building code changes, public works projects or if there are competitors planning to enter the trade area.

CHECKS AND BALANCES

Tom Whitesell, senior vice president for real estate at the Santa Monica, Calif. office of Fremont Investment & Loan, recalls a buyer who came to Fremont for a construction loan to add value to a property he had already purchased with cash. During due diligence, Whitesell's team discovered that the abutting property owner had a reciprocal agreement with the former owner of his client's property giving him the right to sign off on any major changes to the site. “We delayed the closing until we could meet with the landowner to get an agreement,” he says, noting that it took several meetings, but if construction had started without the approval, the neighboring property owner could have stopped the project in midstream.

Steve Stratton, senior vice president and district manager for KeyBank Real Estate Capital in Las Vegas, points out that most lenders have difficulty underwriting deals involving co-tenancy agreements, which release tenants from leases if others involved in the agreement move out. He says his firm backed down on bidding financing for the Montecito Town Center mall because of co-tenancy issues. “We tried to do this deal but ran into co-tenancy issues, and had trouble underwriting it,” Stratton says, explaining that national retailers move in groups and have consortiums that cut tenancy deals with landlords that release others involved in the agreement from leases if one or more pulls out. “The borrower has to find a lender comfortable with that,” he adds, noting that Las Vegas-based Triple Five Group subsequently picked up the deal.

NO SUBSTITUTE FOR EXPERTISE

“Buyers don't always have the luxury of a lot of time, but leases must be scrubbed,” says attorney John Dougherty, a partner in the real estate department of Boston-based Nutter, McClennen & Fish LLD. He warns that lease provisions, clauses and other agreements with tenants giving them the right to leave under certain conditions, limit competition or restrict an owner's control over structural changes or the ability to fill empty space “generally are sleepy provisions hidden in the back of a lease.” He also points out that buyers should beware of agreements involving abutter rights and encroachments, parking easements and signage limitations, because these are issues that can burn down the road.

Getting Dougherty involved early recently paid off for one of his clients who planned to buy a property in Massachusetts that abutted a highway slated for improvements. The due diligence investigation turned up an eminent domain issue unknown to the current owner. The highway department planned to condemn the property because highway improvements would place any property improvements too close to the road, creating a visibility problem for motorists. Had the deal gone through and the state condemned the property, Dougherty's client would have recovered the cost of the land but not money spent on design and other predevelopment planning.

There are, however, early signs that buyers are becoming more cautious in the face of rising interest rates. The heart of any deal is getting the numbers to pencil out, says Dallas-based Jack Thompson, a principal and retail specialist at Ernest & Young's real estate advisory services division, suggesting due diligence increases with interest rate hikes.

Chris Angelone, vice president at CB Richard Ellis' Boston office, says that with the 100-basis-point spike in 10-year Treasury yields last month, “the magnifying glass is coming out.” Some buyers are using due diligence to get credit to compensate for interest rate movement. “We're in a flux stage, and those who went in before the rise are looking at ways to increase revenue,” Angelone adds. “People are going in with both eyes open now, but there is still a lot of competition for core properties.”