Every investor knows intuitively that it pays to learn everything possible about a potential property acquisition. The due diligence process enables a buyer to verify the seller's representation of the property and substantiate its market value.
But a buyer's investigation should not stop with conventional due diligence, which may overlook factors that can affect the cash flow or legal exposure of the new owner. A more comprehensive study of a potential acquisition can have significant impact on the new owner's net operating income (NOI). An effective way to reduce the risk in acquiring a property and gain negotiating leverage is to include a compliance audit in the due diligence process.
A compliance audit goes beyond the financial findings and anomalies that may be revealed in a conventional paper audit. The compliance auditor compares the property's physical and performance profile as described in the property prospectus to what is actually happening in day-to-day operations.
The process involves a thorough, on-site examination and cross check of the property's operating records. The auditor's report will highlight any gaps that are discovered and provide the buyer with information that can affect the transaction price and increase the new owner's NOI after the sale.
The auditor performs a comprehensive analysis of the data and provides the buyer with a report that assesses the property's financial and operational health. Armed with this information, the buyer can come to the transaction table with strong negotiating power, or at least the assurance that the property is fairly priced.
Perhaps more important, the compliance audit is an effective tool for owners and investors as they operate the property. A systematic and periodic examination of ongoing operations can yield significant and sustainable improvement in NOI as a function of ongoing operations.
The following example illustrates how compliance auditing works for a multifamily property. Its methods, however, are applicable to all commercial properties. Working on-site, the compliance auditor delves into several performance areas, each affording opportunity for improvement. Some areas examined in a typical compliance audit include:
Lease folder review — The auditor examines the lease folder contents to confirm the existence of a rental agreement and to verify that a credit report is on file and that it meets the established standards. The lease folder review also is used to verify that previous landlord, credit and employment references have been checked.
Resident retention audit — The auditor reviews monthly resident retention efforts at the rental community, compares established lease renewal rates to the rental rate actually obtained, and ensures that new leases have been signed.
Rent roll audit — Here the auditor selects a representative sample from the lease portfolio and compares lease information with the rent roll data. The examination might include a search for gaps between actual lease security deposits to rent roll records, a comparison of actual rent rates to rent roll rates and a comparison of lease-term duration to rent- roll-term duration.
Management report — The auditor analyzes the findings and publishes a management report including the auditor's recommendations. The report serves as the client's road map to improved profitability by highlighting areas of non-compliance.
Standards in these areas are normally well defined by the company, and every site manager is thoroughly instructed in the company's processes and expectations. However, even the best site managers are challenged to adhere to these standards. And busy site managers and property owners often overlook the opportunities for improvement.
In the case of dishonest site managers, non-compliance issues are certain to be hidden from the owner, and the compliance auditor must be knowledgeable about how discrepancies can be concealed.
Instituting a process of compliance auditing yields many short- and long-term benefits for current or potential owners. The process reduces delinquencies by assuring that the on-site staff is following established credit underwriting guidelines. This reduces unit turnover costs and increases cash flow. Compliance auditing also maximizes rental income potential and assures investors and clients of a commitment to management accountability.
The current economic environment requires out-of-the-box thinking to ensure the success of a potential investment and the ongoing profitability of that investment property. In good times and bad, compliance auditing is a management tool that makes good business sense.
Kenneth F. Schwendeman is a certified property manager (CPM) and the founder and president of Guardian Compliance Management Consulting. He has 25 years of experience as a property manager and compliance auditor.