Due Diligence Mistakes To Avoid
Looking to buy a self-storage store? You don’t have to search the wide landscape. There are more than 50,000 self-storage facilities in the country, and a healthy portion of that number changes hands every year. The problem isn’t finding a facility to buy, it’s making sure that when you buy a self-storage property you are getting everything you wanted and not the things you don’t want.
The self-storage REITs buy and sell hundreds of facilities every year, so one would imagine these big companies have the process down pat. Everyone else has to push up their sleeves and get deep into the due diligence process, scrutinizing all facets of the property you want to buy or sell, from the structure to the land, from the financials to the permits, from the competition to the city’s plans for your street.
Still, there are always things that get overlooked. And the biggest mistake people make is “falling in love with a deal and not doing the homework,” says Jim Chiswell, principal of the consulting firm Chiswell & Associates LLC in Purcellville, Va. “Trust but verify everything you are told, especially by a realtor, even it is your own realtor. Do your homework; there is no substitute for it.”
Before you buy any project, you should have a face-to-face conversation with the person who owns it. “Right now, self-storage is one of the best investments in America,” says Chiswell, “so why is this person walking away from it? Does that person know something I don’t know, such as the state is going to expand the facility’s access road from two lanes to four and it will take a year and a half, which means a loss of traffic, or that the roof needs to be replaced and it will cost $250,000 and the current owner doesn’t want to pay it?”
Due diligence can be broken down into three subsets: scrutiny of the physical plant or buildings and grounds; verification of financial, title, and all other records; and investigating outside considerations such as competition, new developments, or a changes to your access road.
By far, the number one thing most people overlook in regard to the structure of the building is the roof.
As a contractor, Caesar Wright, president of Mako Steel, sometimes advises people in a transaction. From his point of view, the most important thing you can do is evaluate the existing roof.
“Most facilities have metal, standing-seem roofs, which means they should be water-tight, but the last thing you want to do is get into an acquisition and then realize you have a leaky roof,” he says. “I really encourage people to get a roof inspection. It’s money well spent.”
Beyond the roof, Wright suggests making sure all the “moving parts,” such as unit doors, work as they should. Perhaps the most commonly overlooked issue is that the facility is up to code in regard to ADA (Americans with Disabilities Act) compliance. “If you are looking at a facility built back in the early 1990s, the responsibility of the purchaser is to bring the facility up to current code, specifically the office and restrooms which could cost $25,000,” says Wright.
The other overlooked part of the physical property is the land itself. Most banks will require some type of environmental study, which should be done in all transactions. There is more to the land than that. For example, how well does the property drain in a big storm?
“Flooding can be a major problem that is not immediately identifiable,” says Shawn Hill, a principal of The BSC Group. “You buy a property and the next time there is a significant rain storm one of the buildings or some units flood. Before you bought it, did you visit the property when it was raining? Did you check the buildings for signs of water damage?”
Here’s a hint for prospective buyers, says Hill, “Read the online reviews to see if anyone is giving the property negative reviews and saying, ‘I moved out because every time it rains my stuff gets wet’.”
On the seller side, Charles Plunkett, founder and CEO of CAPCO Steel Inc., always recommends the current owner disclose every known or even suspected deficiency. “If there are groundwater issues or if the property flooded 12 years ago, it’s important the seller disclose and for the buyer to ask so there are no surprises down the road. If the buyer is unhappy because of something that happened years before and seller didn’t disclose then there is cause for legal proceedings.”
Another overlooked problem is critters—big but mostly very small. “I was talking to a guy last week who for over a year has been dealing with a cockroach problem in two of his buildings,” says Chiswell. “He was using a professional exterminator, but when your building is full you have to fight the problem above, below, and in the hallways. I always ask in a purchase, ‘Who are you using for pest control?’ If the owner says, the manager and not a professional or not doing it all, that is a red flag.”
On the other hand, if the owner is using a professional exterminating company, get the name. Chiswell says, “I’m going to call that company and say, ‘we are in the process of buying ABC Storage and we understand you do pest control. What changes would you recommend’?”
Sometimes the physical overlaps with the financial. This is particularly the case with due diligence on each individual rental unit. Let’s start from the seller’s perspective.
“A common mistake sellers make is not proactively cleaning up their books and putting some history behind the numbers in advance of the sale,” says Hill. “Sellers should proactively unwind any commingled expenses and make the books as clean as possible, not only so that potential buyers believe they are accurate, but also to assist the buyer’s lender and other parties that will be working on the transaction.”
Plunkett adds, “The seller’s records need to be accurate. Most buyers, when they look to buy a facility, are going to audit the leases; they are going to make sure the owner hasn’t leased 100 units to cousins, so as soon as the facility gets sold, the cousins all move out.”
Doug McCarron, a principal with Premier Storage Investors LCC in Thousand Oaks, Calif., strongly recommends conducting a “lock check,” which essentially means matching the activity of each unit with its financial record.
“Some owners/managers do not keep up with auctions and their occupancy reports do not reflect what is actually happening from a revenue standpoint,” says McCarron. “Without conducting a lock check, there can be phantom income within the P&L, which could be anywhere from $5,000 to $50,000; and you could be applying a cap rate to income that is not actually achieved.”
Chiswell stresses the importance of conducting physical lock checks. “You want to know the status of every single unit,” he says. “If the computer shows that unit 300 is delinquent and is overlocked, then I go out to see; and if there is no overlock, that’s a problem. If I go to a unit that is supposed to be rented and there is no lock on it, that’s a problem. In those cases, I’ll lift the door to see what’s going on. I’ll also lift and look inside every vacant unit. That type of unit by unit due diligence has to be done.”
Those pesky numbers, just what do they mean? “You have to know what you are getting is what the seller is claiming to sell you,” says Chiswell. “For example, the seller says he is 90 percent occupied with 600 rental units. So you take that 90 percent and multiply it by the rental rates the units should be generating and you find out that the 10-by-10 units that are supposed to rent for $150 are 80 percent of the time being rented for less than $100, then that’s a problem.”
One of the financial items that sometimes gets overlooked is late fees. “We have seen a number of properties where late fees have been accruing for 12 to 24 months and the current owner is not keeping up with auctions at the facility,” says McCarron. “You can have someone who is 12 to 24 months late on their payment and they will never pay, but from an accounting basis the owner is accruing all this as late-fee income. The day you take over, you have to wipe out the income that is never coming in from tenants who haven’t paid their fees.”
In addition, as a new owner, you have to take those tenants off the book, spend money to auction the units, and then you have to backfill. Getting what you think you are getting involves a whole realm of off-book investigations from title searches to zoning reports to simple surveillance.
“If you have a building that is literally on someone else’s land, you are in trouble,” notes McCarron. “Hiring the proper surveyor and title company can help you navigate those waters.”
Or as Hill says, “It’s not fully understanding if there are existing conditions with respect to zoning or entitlements. You buy a property and believe the outside vehicle parking is OK, but a month after the purchase someone knocks on your door and says, ‘Hey, we saw you bought this property and have identified some issues you may not be aware of’.”
Of course, your response would be that the former owner did all this before and it was never an issue. Bottom line, however, is that the sale may have raised the profile of the deal with the local authorities, which can have unintended consequences.
Friends in local places that are not your friends can trip you up. “I can’t tell you how often I work on deals where the owner had financed a deal years ago with his local bank and now wants to refinance with a commercial mortgage-backed securities (CMBS) lender,” Hill reports. “The CMBS market does a lot more due diligence and it says, ‘We have some issues with title policy or zoning.’ Well, the local bank had a more relaxed position or simply missed it altogether.”
So, it’s important to do your homework and not shortcut the due diligence process. “Spend the money to make sure you have the right entitlements, have the right zoning, and can rely on the income that is reported,” says Hill.
David Rochefort is the vice president at Noah’s Ark Development, part of Bulverde, Texas-based Parham Group. Typically, Noah’s Ark likes to buy sites and then do the development itself. Rochefort fields dozens and dozens of calls from people trying to sell land or claiming they have a great site for a new self-storage facility.
When Mini-Storage Messenger reached Rochefort, he just got off a phone call with a prospect who had 26 acres on what the man called a great location right off a highway. “A quick search showed there was already a big self-storage across the street in a very rural part of the state, where the population in a one-mile radius was 80 people,” says Rochefort. “Guess what? There was not enough demand.”
“So many people who want to build self-storage don’t do the right due diligence,” Rochefort adds. “They don’t do market research, trade area research, or radius studies where you can look at the population, the competition in the area, just to see if the site makes sense for self-storage.
People don’t even do a basic title search or realize entitlement issues, Rochefort points out. “They don’t think about useable space. If they only have one acre and will be losing a bunch of it for retention or storm water management, that’s not enough land,” he says. “Someone came to us who had bought a property but didn’t realize the Texas Department of Transportation wouldn’t let them put a curb cut in. He was landlocked unless he shared a driveway with a neighbor.”
A major mistake most people make is not giving themselves enough time for due diligence. If you want to buy a site that has to be rezoned for self-storage, to find that out or go through the process can take months.
Rochefort likes to tell this story: Mike Parham, who founded the Parham Group, wanted to build self-storage on a site near Austin, which, as it turned out, was near a cavern that was supposedly home to an endangered species, the Texas blind salamander. To get approvals, Parham had to invest in a study just to prove there were no blind salamanders on the property and his project wouldn’t upset the environment.
However, the most overlooked factor in site selection is, according to Rochefort, homeowner associations. Forget state or municipality restrictions, HOAs not only can give or not give approvals to build but can dictate buildings materials and even the amount of landscaping.
By far, according to many industry consultants, the most serious issue that is overlooked is real estate taxes, mostly because it is a future not a past event. If you purchase a self-storage facility for a price that is far greater than the price at the last sale, that could mean a re-assessment of real estate taxes.
“The biggest thing that is overlooked in doing a pro forma is taxes,” asserts Chiswell. “If I’m buying a facility that is currently assessed at $3.2 million and I’m paying $6 million, I better know what is going to happen to that tax assessment. Some jurisdictions chase the increase in value. If, for example, my taxes are going to go up by $15,000 that is going to mean an additional $15,000 in expenses, so at a seven percent cap rate that is $200,000 lost from an investment standpoint.”
Echoing Chiswell, Hill reports, “the number one thing that can have a major impact immediately” that is overlooked is real estate taxes. The key to real estate tax issues is understanding how the community or municipality works its re-assessment policies (i.e., how often it is done, does it happen automatically on a sale or is it done periodically).
It’s a little more than knowing policy. “If you look at Cook County in Chicago as an example, it is broke, so whatever your taxes might have been historically that all might change because the county needs money,” says Hill. “Call the assessor; call a tax attorney in the market and ask what is the review methodology and how does it work. Also, what is going on in that local municipality that could impact what you will be paying?”
At some point the buyer has to understand what is going to be the correct real estate tax number because it is a fixed expense. “There are things you can do to ameliorate the tax situation so work with a consultant who understands how the municipality does things,” says Hill.
In fact, instead of dealing with all these issues on your own, it might be best to hire the right consultant who can take care of everything so these commonly overlooked issues are not overlooked. It would be money well spent.
Steve Bergsman is an author, journalist, and columnist. His stories have appeared in more than 100 newspapers, magazines, newsletters, and wire services around the globe; his most recent book is “The Death of Johnny Ace.”