A Self-Storage Investment Journey – Chapter 4

A Self-Storage Investment Journey – Chapter 4

Due Diligence

CHAPTER 3 RECAP

In Chapter 3, I spent some time discussing several sections of the Purchase Agreement and some of the traps to avoid.  As a reminder, this journey is being recorded “real time” as I go through the acquisition of a Self-Storage facility.  Last week, we officially agreed to terms (signed documents) on Monday, 2/8 and the title company confirmed receipt of the earnest money.  That means the sellers have 10 days to deliver the requested information and I’ve got 30 days to review.  I can exit the deal at any-time during this window without penalty.  With that as the background, I decided to document the Due Diligence process. 

** DISCLAIMER**  This is neither legal nor financial advice.  It’s simply me sharing some knowledge.  I could be right, or I could be wrong…but it’s how I operate, and it works for me. 

WHAT IS THE PURPOSE OF DUE DILIGENCE?

This might be the most important phase of the acquisition process.  This is my chance to validate all the information (basically a trailing 12 month P/L) I’ve been provided, which is what I used to base my offer price.   I’m not suggesting that brokers will intentionally provide false information, but you better double check them every step of the way.  This is also a good time to talk about something brokers often do when determining the suggested asking price for their seller.  They use a term “pro-forma” or “projected” to support their price.  Basically, they are saying “yeah, we know that the facility only generates $5,000 today, but we project that it will generate $15,000 in a year so we want you to pay a priced based on the $15,000 I’m projecting”. 

 If you only hear one thing during this journey, hear this!  You don’t pay for someone else’s projection or pro-forma.  You pay for what the value of the property is TODAY.  The property that I have under contract right now was marketed with a pro-forma price.  I simply suggested that I would be happy to pay the asking price if they wanted to do the work necessary to meet the pro-forma but until then, here is what I’ll pay.    We are under contract for what the property produces today, not the broker’s pro-forma numbers!  Any work that I do to improve the NOI is upside for me, not for someone else. 

I got a little off track, but it’s a very important concept to embrace.  Do your own pro-forma(forecast) and start from a place of reality rather than with some fantasy numbers that a broker or owner puts on a marketing flyer. 

WHAT TO LOOK FOR DURING DUE DILIGENCE

When reviewing due diligence information, I start with the easy stuff and go from there.  The first thing I’m going to review is what’s known as a rent roll.  This shows every unit that is occupied and the amount of money the tenant is paying monthly.  It also shows how long they’ve been a customer.  I need these monthly rental numbers to match the P/L that has been provided.  If they are way off, I need to understand why.  Also, if half the customers are fairly new, I want to understand that as well.  Did they offer a few months free just to make occupancy look better for the sale? Don’t underestimate the shenanigans that people will perform to drive up the sales price.  Trust but verify.

I’m also going to review the previous 12 months bank statements.  Their deposits need to align with the P/L they provided, as well as the rent roll.  I’m looking for expenses that are getting paid out to make sure they are on the P/L as well.  On my current deal, I found a property insurance bill that is getting paid from the bank account but doesn’t reconcile anywhere on the P/L.  I’m sure there is a reasonable explanation, but I need to understand it because it is roughly a $5k per year expense, which equates to about $83k in value at a 6 CAP (which this property is).  Numbers matter.

I’m also looking at other payees coming from the bank statements that I’m not sure about.  I’ve asked for a description of each along with the GL code used to categorize the expense so I can make sure they are represented on the P/L I was provided.  Again, I’m sure it’s all above board but this is my chance to verify.  I’ve got no one to blame but myself if there is some unplanned item that shows up in the future and it’s hidden in these bank statements.  Do the work!

Commercial properties can often be built in industrial zones which create potential environmental issues so it’s critical to have environmental inspections to make sure there aren’t any issues with the property.  These inspections are generally referred to as Phase 1 and Phase 2 environmental inspections.  There are specialized companies that provide inspections for these issues and you’ll almost always do a Phase 1.  A Phase 1 is done without a site inspection by using data that various reporting companies use to determine the previous use of the property, along with other information that might point to a potential problem.  The Phase 1 is inexpensive but if it shows a potential problem, you’ll need to be prepared to pay a hefty fee for a Phase 2 (up to $20k in some cases) or be prepared to walk the deal.  In fact, if you are financing the property many lenders require a Phase 2.  The reason is pretty simple.  If there is a hidden environmental issue (like buried fuel tanks), the cleanup costs and liability can be astronomical. No lender wants to be stuck with a property like that, and they’ll spend as much of your money as it takes to protect themselves.   For the Phase 1 on this property, I actually subscribed to a service that had a “Free 7-day trial”.  I signed up, ran the Phase 1 for my property which found it to be clean, and cancelled the service.  Free is better. 

At this point, I’ve done what I can with the information I’ve been provided.  I’m waiting on additional information such as software / hosting agreements, employee agreements and a few contracts that they have with service providers.  I’ll also be reviewing each utility providers bill to make sure they are properly reflected in the financials.  Overall, these facilities are pretty simple, and the due diligence process isn’t complex compared to most of the contracts I was involved with in my prior life in the IT Services industry.   I’ll review those agreements as they come in, see if there are any potential transfer fees / limitations and put them into my proforma (budget).  

Since things look pretty clean at this point, I’ve decided to move forward with opening up a new bank account.  This will be for the holding company that is acquiring the facility and will be funded by the investors.  I wanted to get through the first part of diligence prior to creating this account in case there was something that didn’t look right.  I’m in for about $10k non-refundable at this point (legal fees, state fees, travel, etc).   The $25k earnest money is refundable, but it’s still a check that needed to be written.  You’ll need to account for these expenses as you start thinking about acquiring your own property. 

In parallel with the due diligence, I’m working on a transition plan to the new software platform that I’ll be using to remotely manage the facility.  We’ll need to stand up a new website, connect bank accounts, establish rates, load in existing customer data, assign new ids, communicate with customers, build an on-line facility map, train the call center representatives, etc.   I will also begin my search for a new PT person to provide 8-10 hours a week of “on-the-ground” support, performing tasks such as cleaning out units, making sure the facility is clean from trash, overlocking non-paying units, changing bulbs, etc.   It’s actually a pretty good part-time work for someone local because it can be done on an extremely flexible schedule.  All these items cost time and money that isn’t refundable if we don’t close.  With great reward comes great risks!  Commercial real estate investing isn’t for the timid. 

Lastly, I’m working on a plan to monetize the on-site apartment/office.  There is currently a 1,700 sq ft duplex on the property that is a 2-bedroom apartment on one side, and the facility office on the other.  We won’t have a live-in manager, nor will we need an office with our new operating model.  I’m trying to decide how to best use that space to create a revenue stream that doesn’t exist today. At the moment, I’m considering doing some remodel work and making it a light commercial office for an insurance agent or accounting firm.  The best part of this is that I have not included any additional revenue in my forecast, so anything I can come up with will just be icing on the cake!

WRAP UP

I’ll end this chapter here, but I’m still not sure where the journey will end.  I’m prepared to walk the deal should things come to light over the next 30 days that would prevent this from being a successful investment.  I like the property, but I’m not emotionally connected to it.  I’m emotionally connected to the profit forecast that I’ve projected, and that’s my focus during due diligence. 

Until next time – I hope this helps someone make the decision to take that step needed to create long term financial freedom.  Please don’t hesitate to call or email if I can help your journey in any way.  It doesn’t cost a penny to ask a question! 

Scott

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