in the TIC/1031 Industry Presented at TICA Annual Conference Las Vegas, NV September 29, 2004 Presented by Thomas Amato, CRE Ira Slagter, MAI
Our Perspective 1031/TIC sponsors can learn from the evolution of due diligence efforts of institutional real estate investors. 1031/TIC industry should place greater emphasis on due diligence to improve the prospects of investment performance and mitigate loss exposure in the industry. Sponsors should take proper care in producing financial projections they embody a multitude of factors. Third-party due diligence and financial projections should be preferred, if not become the industry standard.
What is due diligence? Care that a reasonable person exercises under the circumstances to avoid harm to other persons or their property. Fair, proper, and due degree of care and activity. Verification of material facts.
What is real estate due diligence? Investigation, performed by investors, into the details of a potential investment, such as an examination of operations, management, and economic conditions. Facilitating process conducted by an objective, third party that identifies and quantifies the risks and other relevant issues associated with real estate acquisition. Ensures contractual obligations (requiring good faith efforts) have truly been acted upon.
Institutional investors have increased due diligence efforts: Institutional investors expect that fiduciaries actions are consistent with the prudent person standard. Such measures are directly related to whether investors may realize their expected outcomes. Those who put capital at risk are separated from those who make key decisions.
1980s vs. 1990s: across the board increased emphasis on due diligence among institutional investors. 45% 4% 8% 43% Less Time/Much Less Time More Time Equal Amount Much More Time
Primary reasons for increased emphasis on due diligence among institutional investors Greater concern and awareness of legal liability Industry places more emphasis on due diligence Organization is more sophisticated Difficult market conditions demand more due diligence 0% 20% 40% 60% 80%
Why increase due diligence this industry? Compensation arrangements that are transactionbased favor expedited decision time horizons. Strong competition for deals usually means less time available for due diligence chances are greater that important issues may be overlooked or not reflected in financial projections. Typically there are as many incentives to do deals as there are to do good deals.
What are benefits of proper due diligence? Results may suggest purchase price reduction or seller guarantees. Provides owners and lenders with a clear picture of cash flow and cash flow preservation. Provides solutions to mitigate potential lender concerns. Minimizes surprises after buyer assumes ownership.
What is proper due diligence? THREE AREAS OF FOCUS Property/Neighborhood Metro Market/Submarket Financial/Credit
What is proper due diligence? Property/Neighborhood Marketability to users Physical condition Local and regional accessibility Visibility and identity in marketplace Site layout, signage, parking, landscaping, points of ingress/egress Subject property zoning, and abutting property zoning and land use Compatibility of abutting land uses
What is proper due diligence? Property/Neighborhood (Cont.) Subject regional location and environs Neighborhood character and demographics Nearby property land use and zoning Subject neighborhood investment levels Direction and magnitude of metropolitan growth
What is proper due diligence? Metro Market/Submarket Metropolitan economic base Impact of U.S. business cycles on metro economy Metropolitan job growth outlook and risks Trade area/market area demographic/psychographic trends Metropolitan market demand/supply dynamics Submarket demand/supply dynamics Subject property/submarket demand outlook Subject property share/market penetration
What is proper due diligence? Financial/Credit Subject occupancy, lease-up history, and occupancy outlook Abstracts of all leases (or residential lease audit) to determine all key terms and occupancy/expense /revenue risk Tenant interviews and retail sales performance analysis (for retail) Analysis of receivables
What is proper due diligence? Financial/Credit (Cont.) Benchmarking rental rates assigned to space/unit Benchmarking operating expenses & real estate taxes Trend analysis of expense categories Establish pro forma expenses and income Establishment of cash flow assumptions Cash flow projections/dcf
Discounted Cash Flow Analysis Solid understanding of current market conditions. Realistic forecast of future market conditions. Well-researched estimates of pro forma income (derived from leases) and expenses. Proper understanding of real estate tax assessment process. Reasonable set of market rent and expense escalation assumptions. Selection of appropriate cap rates & discount rates.
Income and Expense Assumptions Market rent and rent escalation assumptions. Vacancy/credit allowance and down time between leases. Renew/lease assumptions impact on income forecasts and capital costs. Capital costs replacement reserve, tenant improvement allowance and leasing commissions.
Present Value of Reversion and Cash Flow Selection of appropriate going-in cap rate. Selection of appropriate residual cap rate. Selection of appropriate discount rate. Assumed year of sale. Deduction of costs of sale.
Appraisals and Three Approaches to Value Cost approach Market Approach Income Approach Value Reconciliation