When is a dollar not just a dollar?
Have you ever engaged a Property Condition Assessment (PCA) consultant to evaluate a core or core-plus property under contract, then shuddered when you received a comprehensive report which provided a lengthy list of capital, deferred maintenance and property defects seemingly above your pro forma assumptions? Or perhaps worse, placed a value-add property under contract, but then engaged a PCA consultant whose resulting report suggested they might have had blinders on during their evaluation of the property?
An equity PCA is a flexible document that is prepared by a knowledgeable due diligence professional for the sole purpose of providing the necessary insight to the client regarding the physical condition of the property, so that the appropriate risk-adjusted returns can be determined. In reality however, the property condition report is often used as a reference document for several other direct or indirect stakeholders that may be involved in a given transaction, and PCA providers are often requested to provide reliance to other entities after submission of their report to the client.
Investing in commercial real estate can be a dynamic, complex process, and a typical real estate acquisition can often involve a collaboration of different entities all working together to achieve their own individual financial objectives. Fiduciary advisors, capital partners, joint venture operating partners, and lenders are examples of the varying entities that can each have their own specific investment criteria to provide guidance whether a particular asset represents a viable investment. These complex dynamics can complicate the underwriting of any transaction, because what one entity might view as an investment opportunity may be perceived as a potential show-stopper for another entity involved in the same transaction, and all parties must be satisfied that their investment needs will be met for the transaction to successfully close.
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Below are examples of some potentially conflicting investment agendas from the various stakeholders in any given equity transaction:
- An acquisition officer may be compensated primarily for successfully sourcing deals, and therefore may be under pressure in a competitive market to downplay conditions or issues that could delay or prevent the closing of a transaction;
- Asset managers may be compensated for hitting NOI targets for the asset years after closing, and therefore may be overly conservative in their operating cost and capital reserve assumptions during due diligence;
- Investment analysts will underwrite initially a base case financial analysis, but then may be required to layer on discretionary value-add improvements into the financial model using input from any number of stakeholders;
- A joint venture operating partner with lease-up targets may be incentivized to front-load capital requirements if its aids their marketing efforts;
- A participating lender may be concerned only with substantial property defects that could cause the borrower to default on the loan, and therefore may disregard a collection of other issues below a certain dollar threshold as financial noise. Further, the timing of each substantial issue presented by the PCA consultant can become a critical factor as to whether the asset under consideration qualifies for a loan at preferred rates from the lender.
So how does the equity investor that places substantial capital at risk get the thoroughness they need from a PCA engagement, provide transparency to all stakeholders AND meet the varying underwriting needs of each entity involved in a transaction? Cost segregation can provide the answer. This effort involves a three-step process:
- Clearly communicate your investment strategy and due diligence objectives to your PCA provider immediately after initial engagement, so they can evaluate the property under consideration in context with the stated business need;
- Request a segregated cost approach to all cost issues presented in the property condition report – essentially enabling the cost segregation of conditions/issues into separate accounting buckets;
- Collaborate with your PCA provider to define the segregated accounting buckets needed in the cost tables, so the financial output meets the expectations of each stakeholder.
The current ASTM Standard E2018 for Property Condition Assessments requires only that costs be segregated between immediate costs and short-term costs. Consequently, many industry PCA cost tables provide only one fixed value for each of the immediate and replacement reserve tables. This is needlessly inflexible. Both the immediate and replacement reserve cost tables may contain dozens of individual line items.
The items listed in the immediate cost table are typically regarded by lenders as compulsory correction issues, and borrowers are typically required to hold funds in escrow to address these concerns. Consequently, property defects listed in the immediate table understandably receive greater scrutiny and attention by both borrowers and lenders. The Buyer may attempt to negotiate with the Seller to either correct or adjust the purchase price of the property due to immediate cost items discovered during due diligence, but may be in a weak bargaining position in a competitive market to expect any Seller participation.
How immediate cost issues are handled and allocated can sometimes make or break a transaction. In some cases however, it may be possible to defer what might initially be considered an immediate issue to the longer term reserve table. PCA providers can inherently be overly conservative in their opinion of what is considered an immediate repair or replacement condition. For example, provided there is management commitment to closely monitor an operational piece of equipment that may be admittedly long past its useful service life, there is no reason to demand that this building element be replaced in the immediate term.
With a more-defined segregated approach, the PCA provider may first provide a comprehensive list of property issues, conditions and the estimated costs to address that meets the overall need of the equity client. Then, in collaboration with the client input an appropriate allocation of all costs to meet the underwriting criteria of each entity (e.g., equity investor vs. lender) or by expense allocation (e.g., capitalized vs. amortized tenant expense item). The ways by which all-in, comprehensive cost table can be segregated can be totally customized to meet specific underwriting requirements defined by the client.
Segregated or filtered cost allocation is certainly a familiar concept in the commercial real estate world. Many investment analysts do this internally regardless of the input provided by their PCA consultant. The value of your engagement with a due diligence professional can be leveraged through stronger initial communication of your needs, then active collaboration thereafter. The due diligence professional can then effectively serve as a conduit for information between all stakeholders in order to facilitate a successful transaction by well-informed participants.