Due Diligence of Property: Keep a check

Author: Prachi Gupta

‘Some people really trip on success or popularity. My friends would talk to me about that, about tripping on all this stuff, but you know what I tripped on? I started buying property.’ – ROY AYERS

“Due diligence” is a term used for a number of concepts involving either an investigation of a business or person prior to signing a contract, or an act with a certain standard of care. It can be a legal obligation, but the term will more commonly apply to voluntary investigations. A common example of due diligence in various industries is the process through which a potential acquirer evaluates a target company or its assets for acquisition.

Due Diligence is a form of research conducted by the investors to ensure that they are exactly what they agreed to acquire and emphasises understanding and quantifying the risk of the proposed deal. Black’s Law Dictionary defines Due Diligence as the diligence as ‘the diligence reasonably expected from, and ordinarily exercised by, a person who seeks to satisfy a legal requirement or to discharge an obligation’. If thus, describes a general duty to exercise care in any transactions and conducts investigations into all the relevant aspects of the past, present and predictable future of the status, reliability and valuation of the property.

One of the main reasons for a due diligence is that it is essential for a purchaser to determine the genuineness and legitimacy of the property’s ownership of its assets, and whether the transfer of their title needs a third party approval, and if it is subjected to any statutory, regulatory or contractual approval. Moreover, the purchaser should also be aware and acquaint himself with all the existing and potential liabilities that it would get into, all of which would require a comprehensive 360 degree approach of due diligence conducted by a purchaser is to minimise the risks involved and to anticipate and protect itself from future financial, commercial and legal problems.

Hence, it is very essential to have a sound understanding of the financial, commercial and legal problems of the target company in order to:

(1) Provide an important input to valuation by forecasting potential growth, key success factors and ways to increase profits margins.
(2) Secure the best possible negotiating position for a purchaser by enhancing his negotiation power.
(3) Aid post-deal integration by exposing stewardship and other issues ahead of a deal allowing for efficient integration planning.
(4) Minimize the risk by providing a thorough understanding of the property and its valuation.
(5) Expose potential deal-breakers at the inception to avoid unnecessary investment.

Commercial due diligence (CDD) is normally undertaken in context of a change of shareholding in a business including acquisitions, joint ventures and managed or leverage buyouts. Commercial Due Diligence is a service for potential acquirers of businesses (e.g. large corporate firms, private equity funds) providing a thorough assessment of a target’s positioning within its commercial environment. Since, CDD is more dependent on sources external to the target, it also involves more complexity in terms of data gathering and analysis.

Legal due diligence (LDD) on the other hand is performed by lawyers and is significant in assisting the purchaser/client who are unfamiliar with the local jurisdiction, to draw out factual information which assists them in assessing the viability of their objectives.
Purchase of the immovable property like ownership flats, apartments and row
houses entail pecuniary involvement which generally run into lakhs of rupees and therefore requires any person who ventures into such an acquisition to take utmost caution in such a purchase whereby his/her hard earned monies are suitably protected and the roof over his/her head involves no legal complications. Nowadays people are becoming more aware of the legalities involved while purchasing a property

The legal documentation of a property underpins both the ownership entitlement and the contracted cashflow covenant for the investment property. It is vital to understand every contractual aspect of the property and ensure the contractual arrangements are verified with the current financial and operational details of the property investment. The legal documentation should be reviewed by qualified and experienced legal professionals.

General rules to be followed while purchasing property

When buying commercial or residential property you would need to check for the following documents:

• Market Trends about prevalent rates of property in the vicinity and last known transactions.
• Identify the property one wish to buy and formulate commercial terms.
• Distinguish between terms and conditions of the contract which are negotiable and those which are fixed e.g. price, payment schedule, time of completion etc.
• Ask for photocopies of the all deeds of title related to the property to be purchased. Examine the deeds to establish the ownership of the property by seller, preferably through an advocate. Ascertain the survey number, village and registration district of the property as these details are required for registration of the sale. Previous encumbrances and loans, if any, on the property must be cleared before completion of purchase of the property. The title of the Vendor to the property must be clear and marketable.
• Finalize commercial terms of purchase of the property. Ascertain transfer fees, stamp duty and registration charges to be paid on purchase of the property.
• Ascertain outgoings to be paid for the property i.e. property tax, water and electricity charges, society charges, maintenance charges.
• Request Vendor to obtain, if applicable, consent, permission, sanction, no objection certificate of various authorities such as the (a) society (b) the income tax authority (c) Municipal Corporation (d) the competent authority under the Urban Land Ceiling and Regulation Act (e) any other authority.
• Permanent Account Number of Vendor and Purchaser under Income Tax laws, Payment of stamp duty on the formal agreement or document for transfer of the property, signing by both the Vendor and Purchaser and registration.
• After payment of the entire sale price, take over legal possession of the property along with documents of title in original from the Vendor of the property.
• Change name of the holder of the property to the purchaser in the records of the society, Electricity, Company, municipal corporation, Index II etc.

Detailed research of the Certificate of Title should be undertaken to determine if any encumbrance detrimentally affects the title such as easements, covenants, caveats, mortgages or any other charges or interests. As mentioned under the financial due diligence section, leases and licenses underpin substantial value of an investment property.

Detailed due diligence can be vital to uncovering “hidden expenditure” associated with owning a commercial property investment. Capital expenditure items need to be risk weighted after thorough analysis by mechanical and structural engineers and services consultants. An estimated timeframe of expenditure requirements classified by low, medium and high risk should be completed which results in quantifiable capital expenditure items to be structured into the investment cashflow. Some of the major capital expenditure items will be dealt with later in this paper.

For instance A syndicator purchases a high yielding investment property and can therefore offer a good initial return to investors. However generally a high yielding investment means that the market has priced future risk into the property be it capital expenditure, lease expiry, above market rental or some form of obsolescence. If the syndicator hasn’t completed the full due diligence and provisioned for the future risk they could face major cashflow shortages in the future. This could not only lead to a shortfall in forecast cashflows to the investors but in more extreme cases may also lead to an inability to service debts as they fall due, breaches of banking covenants and potentially insolvency.

When purchasing an investment property a syndicator should closely analyse major lease expiries. Expiry risk can be quantified and managed through appropriate communication and proactive tenant management.
Example
An office building was recently purchased in a capital city where a major expiry was looming in the first 12 months of the syndicate cashflow. The tenancy expired and the tenant moved to a competing building. It was later discovered that the manager had not approached the tenant to discuss a further term. A classic case where the most obvious and basic step was overlooked.

It is critical to carry out a detailed review of all leases, agreements to lease, subleases, deeds of variation, deeds of renewal, car park licences, and signage and rooftop licenses. Where there are mismatches between documentation and operating cashflows, questions must be asked of any side agreements, either formal or informal. While the tenant may be happily occupying the premises today, if the landlord has not legally bound them to the premises the tenant could walk tomorrow creating a major cashflow shortfall.

A review of each of the maintenance contracts and analysis of the benchmarking results will enable a prospective purchaser to determine if a maintenance contract should be renewed, renegotiated or cancelled. Typical maintenance contracts include facilities management, cleaning, cooling tower maintenance and testing, lift maintenance, rubbish removal, electricity and property management. Planning restrictions and overlays can present serious threats to the commerciality of a potential upgrade or development of real estate assets. Due diligence should include investigation into planning permits, planning ordinances and any Section 173 agreements.

For instance In Melbourne during the late 1980s and early 1990s, the Melbourne City Council enforced casual car parking restrictions on many of the new commercial office buildings in order to encourage shoppers into the CBD. This restricted the amount of permanent reserved car bays which could be contracted and in some cases could restrict revenues or the availability of space for a large tenant in the building.

Review of the Vendor’s Statement will allow the purchaser to establish the following:

• Council rates, water rates and land tax notices;
• Any claims or requirements by council;
• Any road widening request on or adjacent to the site; and
• Environmental or other critical reports.

Example

An industrial property recently sold where there had previously been an order by council to seal the gravel hardstand area with concrete or asphalt to prevent dust blowing onto neighbouring properties on a windy day. The purchaser had not picked this up in their investigations of the Vendor’s Statement or with council enquiries. The purchaser had to bear the cost of $150,000 to seal the hardstand as the order passed with the property.

The contract of sale may provide evidence of issues that may be of significance to the purchaser, these could be as follows:

• Special conditions in the contract, e.g. environmental indemnities;
• Schedule of chattels included in the sale; and
• Key terms and conditions of the commercial agreement as negotiated must be crosschecked in detail with the contract.

In determining the depreciation allowances for a property investment it is important to review all buildings and plant and equipment and produce asset registers and a depreciation schedule.

In preparing these schedules, there are a number of items that should be considered such as the building’s age or the installation date of the plant and machinery, its original cost, building or plant life and any written down values by the existing owner. Depreciation is critical for understanding the after-tax return on investment. For detailed advice on depreciation schedules we recommend consulting an appropriately qualified and experienced quantity surveyor, plant and equipment valuer or tax consultant.

Physical due diligence of a property should consider building structure, façade, foundations, common area interiors, tenant areas, and building and net lettable area surveys. Physical due diligence should always be undertaken with the assistance of chartered building surveyors or structural engineers who specialise in identifying risk areas and quantifying cost implications of each risk item. The engineer will comprehensively analyse all facets of the building structure and the condition of the finishes.

If a structural engineer had have been employed to undertake a comprehensive façade analysis, the purchaser at least would have been aware of the problem and may have been able to identify an earlier and cheaper remedy or quantify the risk much earlier. The structural engineer will cover all structural aspects of the building including BCA compliance, building structure and fabric, common area interiors, tenant areas and amenities.

Capital expenditure is often over looked or under budgeted when purchasing property. Capital expenditure items should be considered not only to avoid major operational hazards but also to maintain the investment’s positioning in the market.

Building services due diligence should be undertaken with the assistance of a mechanical or services engineer and cover the condition and lifecycle of lifts, air-conditioning, electrical services, hydraulics, building maintenance unit, fire services, and security. A full examination of service records and compliance to building regulations should be undertaken. Building services can be another one of the “hidden costs” that are overlooked or not thoroughly investigated during the due diligence period. Appointing qualified professionals to conduct inspections of the services within the building can prevent unexpected expenses in later years that, if identified during the due diligence period, could have changed the investor’s decision about purchasing the property.

Environmental problems have become increasingly prominent throughout the industry and have had a significant profile in the media. Whether its the effects of asbestosis, a legionella outbreak or contaminated ground water, investors and property professionals are certainly aware of the hidden risk of environmental contaminants. A comprehensive investigation by a qualified environmental consultant is essential in any due diligence program. All aspects should be considered including asbestos, underground storage tanks, CFC’s and other air conditioning chemicals, hazardous storage and a thorough investigation of all air conditioning equipment.

Upon completion of investment cashflow, the purchaser is now able to determine what they are prepared to pay for the asset. The table below sets out the capitalisation method of valuation. The capitalisation rate used will be in line with the current market conditions and the purchasers’ investment criteria and objectives.

Each asset class requires different types of issues to be addressed during a due diligence period and while there are a number of common items in the process, it is important to note the differences.

Financial due diligence in this case would often include:

• Review of historic trading performance in light of broader hospitality and economic conditions;
• Review of the property’s financial reporting system;
• Review of the property’s accounting policies;
• Review of key leases, contractual obligations and material contracts to determine the significance and potential implications of both recorded and unrecorded liabilities and other risks;
• Review of liabilities in regard to superannuation fund arrangements and employee leave liabilities; and
• Review audited financial statements and management letters.

Operational due diligence in this case would usually include:

• Review of operational structure for areas of risks such as cash handling or management;
• Review of recent trading performance;
• Operational performance against industry benchmarks;
• FF&E allowances; and
• Capex requirements.

Market due diligence would usually include thorough competitive set analysis such as:

• Segmentation analysis;
• Rate analysis per market segmentation;
• Occupancy analysis;
• RevPar analysis;
• Additions to supply and likely impact on competitive set;
• Penetration analysis; and
• Future market projections.

Due Diligence is a critical part of the acquisition process. The thorough investigation of each of the key areas in this paper enables a purchaser to identify the risks associated with purchasing a particular property and quantify the mitigation of those risks. Once risks have been identified and quantified a purchaser is able to make an informed commercial decision on the viability of the asset as an investment.

Conversely due diligence is useful in identifying potential upside in the running cost and better negotiation of more favourable leases to “add value” to the asset. If a potential purchaser believes that they are able to provide better management and reduce outgoings in the building then this will result in additional income on an ongoing basis.

*Prachi Gupta is a practicing Advocate at the H’ble High Court of Delhi. She is a Post-Graduate (LL.M) in Intellectual Property Laws from Mewar University.  She specialises in Property disputes, Arbitration, Conciliation and Mediation, Negotiable Instrument Act,  Company Disputes and Civil Disputes including Intellectual Property Disputes, Matrimonial disputes etc.

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