When assessing commercial real estate, it is necessary to understand the financial factors that the property creates. This is before you price the property or consider it suitable for purchase. In doing this, it is the financial factors today that you need to look at and those that have formulated the history of the property over recent time.
In this case, the definition of ‘recent time’ is the last three or five years. Therefore, it is surprising how property owners try to manipulate the building income and expenditure at the time of sale; they cannot easily change the property history, which can uncover many property secrets.
Once the history and current performance of the property are fully understood, you can then relate to the accuracy of the current operating costs budget. All investment property should operate to a budget that is administered monthly and monitored quarterly.
The quarterly monitoring process allows for adjustments to the budget when unusual items of income and expenditure are evident. There is no point continuing with the property budget, which is increasingly out of balance with the actual property performance. Fund managers in complex properties would normally undertake budget adjustments every quarter. The same principle can and should apply to private investors.
So let’s now look at the main issues of financial analysis on which you can focus in your property evaluation:
A tenancy schedule should be sourced for the property and checked totally. What you are looking for here is an accurate summary of the current lease occupancy and rentals paid. It is interesting to note that tenancy schedules are notoriously incorrect and not up to date in many instances. This is a common industry problem stemming from the lack of diligence on the property owner or the property manager to maintain the tenancy schedule records. For this very reason, the accuracy of the tenancy schedule at the time of property sale needs to be carefully checked against the original documentation.
Property documentation reflecting on all types of occupancy should be sourced. This documentation is typically leases, occupancy licenses, and side agreements with the tenants. You should expect that some of this documentation will not be registered on the property title. Solicitors are quite familiar with chasing down all property documentation and will know the correct questions to ask the previous property owner. When in doubt, do an extensive due diligence process with your solicitor before any settlement being completed.
The rental guarantees and bonds of all lease documentation should be sourced and documented. These matters protect the landlord at the time of default on the part of the tenant. Therefore, they should pass through to the new property owner at the time of property settlement. How this is achieved will be subject to the type of rental guarantee or bond, and it may even mean that the guarantee needs to be reissued at the time of sale and settlement to a new property owner. Solicitors for the new property owner(s) will normally check this and offer solution methods at the time of sale. Importantly, rental guarantees and bonds must be legally collectible by the new property owner under the terms of any existing lease documentation.
Understanding the rental charged across the property is essential to property performance. In a single property with multiple tenants, it is common for various rentals to be charged across the different leases. This means that net and gross leases can be evident in the same property and have a different impact on the position of the outgoing landlord. The only way to fully appreciate and analyze the complete rental situation is to read all leases in detail.
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Looking for outstanding charges over the property should be the next part of your analysis. These charges would normally stem from the local council and their rating processes. However, it could be that special charges have been raised on the property as a Special Levy for the precinct.
Understanding the outgoings charges for the properties in the local area is critical to your own property analysis. What you should do here is compare the outgoings averages for similar properties locally to the subject property in which you are involved. There needs to be parity or similarity between the particular properties in the same category. If any property has significantly higher outgoings for any reason, then that reason must be identified before any sale process, or a property adjustment is considered. Property buyers do not want to purchase something that is a financial burden above the industry outgoings averages.
The depreciation schedule for the property should be maintained annually so that its advantage can be integrated into any property sales strategy when the time comes. In addition, the depreciation that is available for the property allows the income to be reduced and hence less tax paid by the landlord. It is normal for the accountant for the property owner to compile the depreciation schedule annually at tax time.
The rates and taxes paid on the property need to be identified and understood. They are closely geared to the property valuation undertaken by the local council. The timing of the council valuation is usually every two or three years and will have a significant impact on the rates and taxes paid in that valuation year. Property owners should expect reasonable rating escalations in the years where a property valuation is to be undertaken. Therefore, it pays to check when the next property valuation in the region is to be undertaken by the local council.
The survey assessment of the site and tenancy areas in the property should be checked or undertaken. It is common for discrepancies to be found in this process. It would help if you also were looking for surplus space in the building common area which can be reverted to tenancy space in any new tenancy initiative. This surplus space becomes a strategic advantage when you refurbish or expand the property.
In analyzing the historical cash flow, you should look for any impact from rental reduction incentives and vacancies. It is quite common for rental reduction to occur at the start of the tenancy lease as a rental incentive. When you find this, the documentation that supports the incentive should be sourced and reviewed for accuracy and ongoing impact on the cash flow. You do not want to purchase a property only to find your cash flow reduces annually due to an existing incentive agreement. If these incentive agreements exist, it is desirable to get the existing property owner to discharge or adjust the impact of the incentive at the time of property settlement. In other words, the existing property owner should compensate the new property owner for the discomfort that the incentive creates in the property’s future.
The current rentals in the property should be compared to the market rentals in the area. It can be that the property rent is out of balance with the market rentals in the region. If this is the case, it pays to understand what impact this will create in leasing any new vacant areas that arise and negotiating new leases with existing tenants.
The threat of market rental falling at the time of rent review can be a real problem in this slower market. If the property has upcoming market rent review provisions, then the leases need to be checked to identify if the rental can fall at that market review time. Sometimes the lease has special terms that can prevent the rent from going down even if the surrounding rent has done that. We call these clauses ‘ratchet clauses’, inferring that the ‘ratchet’ process stops lower market rents from happening. Be careful here, though, that some retail and other property legislation can prevent the use or implementation of the ‘ratchet clause.’ If in doubt, see a good property solicitor.