A sound investment requires an understanding of all the risks involved in the transaction. The main objective of real estate financial due diligence is to thoroughly inspect the fundamentals of the property, financing, seller and compliance obligations to be able to reduce and mitigate financial uncertainties.
Whereas the pricing of transactions is mostly driven by the capitalized NOI approach, further price adjustments have been common in the market in cases where the acquisition target is a special purpose vehicle or other company owning the properties.
Such adjustments are specific to each and every transaction and are typically triggered by the key findings of financial due diligence processes carried out by third-party advisors on behalf of the purchaser. Financial due diligence contributes to a deeper understanding of the transaction perimeter and helps identify potential issues which may not be in line with market standards. As a result, in addition to price adjustment implications, these analyses often highlight matters which need to be addressed in the reps & warranties section of SPAs or regulated in indemnification clauses.
Verifying NOI figures and reconciliation with actual rent roll data are amongst the top priorities of the due diligence process. Collecting and summarizing historic datasets for a 3-5 year period is beneficial for recognizing potential trends, assessing the time required to find new tenants in case expiring leases are not renewed and to get a general overview of the development of NOI over the past years. In-depth analysis also contributes to the elimination of one-off effects and the calculation of a long-term stabilized NOI.
Financial due diligence also targets the quantification of potential service charge leakages or, in some cases, the verification of profit margins applied on service charges. It also assists in calculating the effect of specific contractual terms which may be effective for certain tenants, such as rent-free or discount periods, in quantifying profits or losses on fit-outs or in assessing structural vacancy rates.
Analysing the financing structure of the target is of utmost importance as it contributes to the assessment of related risks and may help identify topics that need to be addressed. Key conditions, such as the currency of related loan facilities and bearing interest at a floating or fixed rate, may all be critical from the purchaser’s perspective when considering a potential transaction.
Overall, there are numerous aspects of real estate transactions which require detailed financial due diligence in order to be able to properly address the specific attributes of the asset or entity subject to the envisaged transaction.
By Aron Kovaloczy, Managing Director, DLA Piper