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Six Points That An Investor Should Consider When
Buying ICI Real Estate

By David Eger,                 February 7, 2003 
Senior Appraiser
Altus Group Vancouver

It is often said that most of the money to be made in real estate investment is made the day you buy. There are plenty of risks when buying real estate. By avoiding the six common mistakes set out below, an investor will minimize risk and maximize potential profit.

1) Paying too much for a property. In other words, making an offer which is greater than market value.

Prudent purchasers of commercial properties should generally make their offer to purchase subject to an appraisal.

An appraisal is a supportable or defensible estimate or opinion of value. It is an impartial, expert and reasoned conclusion, formed by a trained professional based on an analysis of all relevant evidence. It represents the appraiser’s perception of the most likely and most probable dollar value of the appraised interest(s), subject to the qualifying conditions imposed. The opinion is the appraiser's opinion based on perceptions of the market as shown by the data in the report.

(Note that it is stressed that appraisers estimate value, they do not determine it. Courts determine value in case of a dispute.)

A professional real estate appraiser specializes in providing opinions of value of various types of property. They charge a fee based on the type of the property, complexity of the property, and purpose of the appraisal assignment. This fee is not based upon a predetermined value estimate and therefore an appraiser can provide an objective, independent estimate of value. All members of the Appraisal Institute of Canada are required to conform to the Canadian Uniform Standards of Professional Appraisal Practice.

2) Buying a property without obtaining advice from a qualified building inspector and/or an engineer.

Prudent purchasers of commercial properties should generally make their offer to purchase subject to a ‘Physical and Environmental Due Diligence’.

It is stressed that an appraisal and a building inspection should not be confused as serving the same function. An appraisal is an opinion of a property's market value. While the physical condition of the property is critical, the appraiser also has to consider subjective issues such as location, design/function, and supply and demand, all of which have a significant influence on marketability and value.

A physical and environmental due diligence is a thorough examination of the physical condition of the structure and its components. A building inspector or engineer should at the very least provide an opinion of:

  1. The structural soundness of the improvements and the services to the improvements.

  2. The condition of the roof and electrical and mechanical facilities, including air quality.

  3. The presence of any environmentally hazardous substances (such as asbestos).

  4. The presence of any insect and rodent infestation.

  5. The presence of any soils contamination (examples of this could include seepage from an adjacent gas station or an old dry cleaning operation).

  6. The overall type and condition of the soils, and their overall stability with regard to the existing improvements and any future development.

  7. Any potential of flooding.

The report provided should provide realistic costs and time lines for repair, replacement, and remediation of any of the above items.

3) Buying a property without conducting a detailed financial review.

The price paid for most income producing properties is directly related to their current and expected income flow. Verifying the current income flow and estimating the future income flow is a time consuming but important process. Typically, for larger properties, an estimate of cash flow over a 10 year period should be conducted.

Some of the important elements of a ‘Financial Due Diligence’ include:

  1. A review of all leases to identify not only their financial terms but also any important lease clauses, such as; options to terminate, options to expand or downsize, options to renew the lease at a fixed rent, options to ‘go dark’, future free rent periods, and any outstanding tenant improvement allowances payable by the landlord.

  2. An analysis of the tenant profile. Personal tenant interview are a good idea as well as some research into the overall strength of each tenant's covenant. The strength of the covenant of a tenant is determined by its financial stability and general reputation in the business world.

  3. An analysis of the historical operating statements (which should be audited), the year to date performance, and the current budget. Any budgets provided should be reviewed to determine if they are reasonable as well as to identify any possible mistakes.

  4. An analysis of accounts receivable and accountants payable as well as any contractual agreements (such as with cleaning, elevator maintenance, and security companies).

  5. An analysis of recovery revenue. The majority of leases which are typically struck for office and industrial buildings are on an a ‘net basis’, whereby the tenant pays basic minimum rent as stipulated in the lease, as well as its proportionate share of operating costs and taxes. The tenant therefore assumes the risk for potential increases in operating expenses and taxes. A gross lease is a lease in which the landlord receives a stipulated rent and the landlord is obligated to pay all or most of the operating expenses and real estate taxes. For most retail properties, some tenants pay less that the ‘full recovery rate’. It is therefore vital that the recovery or ‘additional rent’ section of the lease agreement for each tenant in a property be reviewed and fully understood in order to accurately estimate both the current and future income earning potential of a property.
  6. A review of property tax statements in order to determine if there are any arrears in unpaid taxes and utilities.

  7. A review of the property's tax assessment. Is it over or under assessed, properly classified, and will the assessment increase upon the purchase/sale of the property?

4) Buying a property without a full understanding of the market in which the property is located.

A typical market analysis will include the following:

  1. An Economic Overview. A brief review of the main economic indicators, both historical and projected, is required in order to determine if the future outlook of the local market and surrounding areas is positive or negative.

  2. A Competition and Leasing Market Overview. In order to estimate the future earnings potential of a property, an analysis of any competing properties and the rental rates which are being achieved in these properties is required. In addition, a review of new and any proposed developments in the area should be conducted.

  3. Investment Market Overview. An analysis of investment demand, investor preferences, and a survey of current valuation parameters will assist in determining not only the price to be paid but will also give an idea of the properties ‘liquidity rating’. In other words, ‘how difficult will it be to re-sell the property in the future if required to do so’.

5) Buying a property without a ‘legal due diligence’.

A typical legal due diligence will include the following

  1. A title search and a summary of all charges registered on title.

  2. An opinion of any impact on value with respect to the charges which are registered on title.

  3. A review of the heritage site registry. A ‘Protected Property’ or a property which is on the heritage list could affect the properties future development potential.

  4. A review of the property's specific zoning and official community plan designation, and any other municipal regulations, is required in order to determine if the property conforms to current municipal requirements as well as to assist in identifying the future development potential of the property.

  5. A review of the business licenses to determine if the building operations on the property are in good standing.

  6. A review of the most recent Fire Marshall and Health Department inspections to determine if there are any outstanding orders. 

A detailed and downloadable Legal Due Diligence Checklist is available in the BCRELinks Build a Deal section.

6) Buying a property without a review of the site survey and building survey.

Are the building areas and site areas stated correctly? The only way to determine this is through either reviewing or obtaining a site survey as well as a copy of the building plans and certified floor plans.

For investors about to embark on a due diligence program before acquiring a retail or office property, a detailed and downloadable Property Purchase Due Diligence Checklist and a Borrowers Checklist are available in the BCRELinks Build a Deal section.

 -- David Eger

Disclaimer: The views expressed in guest articles on BCRELinks.com reflect the views of the author and do not necessarily reflect the views of BCRELinks.com or Clark Wilson LLP.   

BCRELinks.com is a reference service developed by the Commercial Real Estate group at Clark Wilson LLP. The information and links posted to this website should not be treated by readers as legal advice and ought not be relied upon without further, detailed legal counsel being sought.

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