Do your homework

Due diligence: Why it pays to do your homework

Total Property - Issue 7 2017

A significant shift in credit lending approval criteria by the major banks has put new focus on due diligence. Lending, in many cases, now hinges on comprehensive due diligence.

But a reduction in the supply of funding by the Australian-owned banks, which dominate the New Zealand mortgage market, coupled with an increase in the cost of funding, has put pressure on the market and on yields and prices. This is evident in the development land sales market, where the rising construction costs are another consideration in costing a project.

The major banks have long been careful when deciding who they lend money to, although this has become more pronounced in current market conditions.

Whilst the banks may have previously made assumptions based on the rental yield generated from a property and borrower's asset backing, they now require that more detailed investigations are carried out.

Primarily, they are focussed on matters that could affect their return and the value and enforceability of their security. There is much more emphasis on minimising risk, and the thresholds that need to be met to obtain funding have lifted. In a market where lenders are being more selective about the projects they finance, it is essential for borrowers to demonstrate to lenders that they are mindful of the banks’ changing appetite to risk.

Due diligence is one area where prospective buyers can make a difference in securing funding.

The acquisition of commercial property requires intensive due diligence to uncover key information that may not be readily apparent or available in evaluating the value of a property or portfolio.

Such hidden details can undermine the financial merits of an otherwise profitable deal.

For veteran commercial property investors, stricter requirements around due diligence are unlikely to be an issue, as they are more likely to carry out comprehensive investigations to limit the possibility of post-transaction surprises as a matter of course.

Buyers should view “deep due diligence” as an opportunity, given the breadth of risks at play.

The main aim of commercial property due diligence is the thorough inspection of the fundamentals of the property, seller, financing and compliance obligations to reduce and mitigate financial uncertainties.

Prospective buyers must scrupulously examine zoning restrictions, potential liens, and possible encroachments on the property. Existing structures must be fully inspected to discern needed repairs and their costs. They must determine whether or not they will absorb legacy liabilities from prior owners’ legal and regulatory violations.

Given the vast array of documents in a commercial real estate transaction, it is important to prepare a due diligence checklist, marking off each item of concern once it has been addressed.

Due diligence on a commercial real estate opportunity begins with understanding the transaction’s objectives – is the property being bought as an investment or for development, or is the property to be the site of your business? The goals in pursuing a commercial real estate transaction serve as the foundation for the due diligence that follows.

A personal visit to and inspection of the prospective property will also help frame the due diligence process. During a walk-through, buyers will be able to analyse the property in terms of its intended use, and concerns that arise will affect negotiations. For example, a property that a buyer plans to turn into an office complex with ample parking may be hilly and expensive to grade to accommodate the anticipated volume of vehicles.

One major area of due diligence is on tenant arrangements. Buyers need to carefully scrutinise the contracts in place with tenants, paying close attention to the length of leases, terms and conditions and renewal deals. Lease agreements can be lengthy and complex, so getting expert assistance is essential.

Engaging a commercial property lawyer to carry out a quality due diligence review will identify the key legal risks for the property. Reviews are usually confined to reviewing the title, lease documentation and council land information memorandum, although this is dependent on the nature of the commercial property and additional investigations may be required.

A legal due diligence report will identify risks such as incomplete lease documentation, tenant early termination rights, onerous lease clauses and outstanding statutory or regulatory requirements.

An effective legal due diligence should be accompanied by valuation advice from a registered valuer and a technical review of the property by a suitably qualified inspector or engineer.

A valuation report will help vendors gauge whether they are receiving a market value for a property. Conversely for purchasers, it is also a required resource when negotiating with banks on borrowing terms.

Checklist

A thorough investigation arising from the due diligence process will cover, among other things:

• The structural soundness and quality of the building

• Town planning and other zoning or permitted use aspects of the property as they relate to the purchaser's use or intended use of the property

• The current deeds of lease and statement of lessee's position regarding rights of renewal

• Site access, including disabled access

• Condition of utility services (water, sewerage, power)

• Access to public transport

• Distance to amenities, such as meals, banking services, postal services

• Environmental issues, such as site pollution or contamination due to previous uses of the site

• Susceptibility to earthquake damage

• Pest control history


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