Shrinking Returns Require Improved Acquisition Due Diligence
As cap rates continue to decline with a seemingly endless supply of investment capital, it is more important than ever that investors do a better job of underwriting and managing their real estate assets.
The acquisition underwriting process is a critical part of the asset life cycle. Mistakes or oversights made during this process can negatively impact returns over the entire hold period, which can be ill afforded with current returns so low.
Three key components to be focused on during the initial underwriting include your assumptions for income, operating expenses, and capital improvements.
Income
It goes without saying that the acquisition underwriting process should include a thorough review and analysis of market leasing assumptions, including rent and rental growth, lease-up period for vacancy, concessions, and tenant improvements. These numbers should be particularly scrutinized if the property being analyzed is not fully stabilized. Questions you should be asking are: Why hasn’t the current owner stabilized the asset? If the asking rent is too high, is there something wrong with the vacant space, or are there other challenges that need to be addressed? An important goal of your underwriting is to obtain confidence that you will be successful in implementing your proposed leasing plan.
Operating Expenses
Caveat emptor! Let the Buyer beware! The operating expenses presented in that colorful and attractive Seller’s Offering Memorandum don’t always equate to the correct level of operating expenses needed to properly manage the asset. Look at those proforma and prior year expenses carefully and make sure the expenses presented reflect the proper staffing levels and preventative maintenance needed to skillfully manage the asset. It is not uncommon for expenses to be understated in a Seller proforma.
Capital Improvements
Commercial assets are typically analyzed over a 10 year hold period. As such, make sure to evaluate all of the key building systems and add to your capital budget any repairs or replacement of major building systems (including elevators, HVAC systems, and roofs) that will likely be needed over the hold period. It is unlikely that an Offering Memorandum will address future capital needs, but that does not mean you should not include it in your ten year cash flow. Failing to include these items in your projections could be disastrous for your returns.
As a trusted due diligence consultant and investment advisor, RMC Realty Advisors provides the necessary resources to critically evaluate real estate investments. Our expertise does not only come from being able to find answers to critical questions—it is knowing which questions to ask in the first place that can be crucial for the success of real estate investments.
