A reminder to "sharpen your pencil" when analyzing commercial real estate acquisitions

Here is a fairly common scenario: a new client calls and wants us to draft a new contract to purchase a commercial property right away. Through their broker, the client has already found this property which perfectly fits into their purchasing criteria—right location, size, asset class and, more importantly, the right price for the returns they projected via the broker’s sell sheet and seller-provided information.

The well-prepared offering memorandum from the listing broker reflects a financial summary which meets the client’s goals: a six cap using the seller’s projected net operating income, an eight percent cash-on-cash return and 13 percent internal rate of return at year five, and a 1.2 debt coverage ratio, which should satisfy a lender should my client choose to debt on this new acquisition.

Upon further discussion with this new client, I recommended that we assist in preparing some additional in-depth financial analysis on this new target property beyond that provided by the seller and what was reflected in the offering memorandum. Not surprisingly, the listing sheet, while accurate in the operating data included, omitted some expense items which should have been very realistically expected by my client. For example, the seller had largely managed the property himself so the actual janitorial and management fees reflected in the listing were considerably understated. The seller included actual repair and maintenance figures for the past year but it was obvious that there was a lot of maintenance that had been deferred and would necessitate some reasonable capital expenditures in the first year or two—again, these items were not included on the listing sheet. The vacancy rate assumed by the seller was only two percent when the prevailing rate for the area in question was typically closer to five percent. Finally, there were items we discussed with the seller which are almost never included in their listing sheets and, although usually relatively small, they can definitely eat into the projected net operating income over time items like legal and accounting expenses, advertising and supplies.

Long story short, we assisted the client with running their own numbers on the property which resulted in a financial picture markedly different than what the client was anticipating. Some of the above mentioned financial markers, once our client “sharpened their pencil”, looked more like this: a 5.2 cap rate, a three percent cash-on-cash return at year five, an eight percent five-year internal rate of return and a 1.02 debt coverage ratio.

The differences in these calculations were certainly not the result of incorrect figures provided by the seller nor were they inaccurately presented in the offering memorandum; however, it should not be surprising that a seller is always going to paint as “rosy a picture” as possible when marketing such a property.

In the end, my client was still satisfied with the financial projections we developed for them and they still decided to proceed; however, the debt coverage ratio ended up being an issue which was, alone, a key discovery when it came time to present this property to my client’s lender. The 1.02 debt coverage ratio presented some major hurdles for the client to overcome; however, they at least were prepared for it up front and long before they even entered into the contract. A quick “sharpening of the pencil” definitely helped avoid some unanticipated pitfalls for this client!

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

Client alert authored by: K. Shaylan Baldwin, Principal

This alert originally appeared in the Summer 2017 Real Estate Focus newsletter.