Due diligence before the due diligence?
March 18, 2018
When we perform acquisition due diligence on behalf of a buyer, we find two types of issues. The first is where the seller has presented information that overstates the income or conditions. The seller may have presented that a tenant’s minimum rent is $10,000 per month, but the lease states $9,000. Or, perhaps the lease does state $10,000, but we find that the seller has been billing only $9,000 (with the seller having agreed to take less based upon some side agreement). The buyer can then go back to the seller and accurately claim that the income had been overstated. Or the seller did not present that a tenant has a right to terminate at the end of the fifth lease year in a ten year term if sales are less than $x, and we can see that sales are less than $x. These type of adjustments may require a purchase price adjustment because the seller had presented information that was not accurate, and was more positive that the situation actually is.
The second type of adjustment is one where the seller presented information that understates the cash flow, or may be more negative than the true scenario. Perhaps rent is presented as $10,000 per month with annual CPI increases, but the CPI increases have never been applied. Or, a tenant is being billed based upon the leasable area of the property, but the lease requires that the tenant be billed upon the leased area of the property. These, for us, are the more exciting issues because they represent the buyer’s upside.
With the first type of adjustment, where the seller presented overly optimistic information, the buyer goes back and, appropriately, asks for a purchase price adjustment. However, with the second type of adjustment, the buyer learns that they may be able to immediately increase the cash flow upon closing.
Occasionally, but not often enough, a seller will conduct its own “due diligence” on a property that they intend to sell. And, almost always, it pays off. This past week, we did a little pre-sale due diligence on a small center – 87,000 sf, grocery anchored, with 19 tenants. A number of issues came up provided a really nice pop to cash flow – a few tenants had gross up clauses that were not being administered; a few leases required expenses to be billed based upon leased not leasable; quite a number of tenants were allowed to be billed based upon “less separately assessed”; and, the best, was the grocery store had a cap reset at the beginning of each option period. Ultimately, a $49k increase to cash flow per year. Had we found those doing the acquisition due diligence on behalf of a buyer, we would play the music for a happy dance. In this case, doing this pre-sale due diligence on behalf of the seller, the seller is now able to increase the cash flow by that $49k per year. At a conservative cap rate of 8%, that more than $600k in additional value the seller will realize from the property. We also identified a “no increase in taxes due to a sale of the property more than one time in any five year period” clause that a buyer would be sure to pick up, but we were also able to pull that language that it was during the Initial Term. With that particular tenant now in a renewal period, the language no longer applies.
The moral – take some time before you put a property on the market so you, the seller, realize all of the value from your property. Otherwise, you’ll hear the buyer doing its “found equity” happy dance upon closing.