Thought Leader Presented by Partner Engineering & Science, Inc.
Property Condition Due Diligence Considerations for High-Risk Equity Transactions
Optimizing investment value requires more insight and detail from Equity Property Condition Assessments, which includes communication between stakeholders and risk management consultants.
Long-term real estate asset holds generally involve some level of change, improvement or repositioning to maximize returns on investment. The complex dynamics of acquisition and equity ownership involve more stakeholders and considerations than a typical transaction. A critical step in the underwriting process is performing an equity-level Property Condition Assessment report, in which a seasoned due diligence consultant can spend more time providing guidance and detailed insight into the condition of all building systems and components, as well as costs associated with immediate and future repairs and replacements.
The difference between passing on a high-risk property investment and a successful transaction can often come down to this very due diligence, the scope of which needs to appropriately reflect the term of ownership and business objectives of the transaction(s). Providing the customer segregated cost tables can help aggregate immediate and long-term reserve tables according to specific underwriting requirement or tenant improvement expense allocations, for example. The minute level of detail and planning needed means that the best assessment insights are often the least obvious and involve the most communication between the customer and the due diligence consultant.
If you are deploying equity capital in a real estate asset, it is strongly suggested you seek these details and expectations from your consultant and their Equity PCA report:
- Is the consultant willing and enabled with an appropriate budget to operate from the same level of detail as you when it comes to mitigating risk/? Are they listening and trying to understand a long-term repositioning strategy or offering assessments on short-term low-cost maintenance assumptions? And simply, do they distinguish their equity PCAs practice from the PCAs performed purely for financing purposes.
- Look for flexible scopes that are specific to the asset and appropriately consider or assist with potential capital improvement plans. Consider the asset type for scopes that need to be included (multifamily properties needing ADA/FHA evaluation based on the date of construction). Or, consider unique property scenarios such as a stalled development where the construction process may have been prone to cutting corners.
- Your consultant should be willing to identify and address concerns that are outside of the normal ASTM PCA scope.
- Take an initial site walk with your due diligence consultant and give them a list of all possible issues to dig into specific to the property type, location and deal – don’t be afraid to turn a molehill into a mountain!
- The consultant should be equipped to identify possible building code issues and do the research to find out if it’s a liability for the owner, as well as providing multiple cost scenarios and schedules for repair.
- Ask the consultant to present the absolute worst-case scenario for all potential problems as a starting point, and then work through them according to priority and cost.
- The consultant should understand what your eyes look for, and this includes property aesthetics. Does the property currently meet your portfolio objectives? If not, what is the scope of change that needs to be implemented? The consultant should know the landscaping, interior finishes, and other touches necessary to bring it to your caliber.
- Look for highly detailed unit cost rates in the final report that are consistent with your standards and quality levels. For example, the consultant should know and apply the higher carpeting cost per square foot for the preferred high quality, longer lasting, nicer looking carpet you install in your properties.
Below are two Equity PCA case studies from recent successful high-risk transactions:
Case Study 1: Retail Mall with Theater Complex, (Institutional)
During an initial site visit by an equity-level generalist PCA assessor, an aesthetic issue with the envelope was observed. With more detailed observation, the issue was linked to structural concern related to the foundation. In consultation with the client, a further forensic and civil engineering evaluation was conducted to reveal the source of the aesthetic issue and impacts to the foundation were tied to the surface water drainage in and around the foundation. The final PCA was structured with precise cost tables capturing the costs associated with the immediate structural and aesthetic repairs, as well as the necessary correction to the surface water drainage that served as the cause.
Case Study 2: Multifamily Property, (Equity)
We prepared an equity PCA with subspecialists for an institutional pension fund advisor looking to acquire a 200-unit, wood frame multifamily property built in the 1980s. Previous due diligence assessments made available by the client had failed to account for serious structural issues with the roof and inground hydraulic elevators, resulting in liability concerns for the stakeholder. The property roof coverings consist of Built-up Roofing (BUR) system with a spray applied foam coating. Prior due diligence consultants recommended additional spray applied foam to address multiple roof drainage issues to extend the life throughout the reserve term. Although a cheaper solution, it was not the appropriate solution for the position of our longer-term owner client and their equity investment. The reserve term was rewritten with a multi-step roof replacement and total structural overhaul of the elevators. Cost tables for this complex remediation were structured in phases, per the most critical work, and several recommendations were provided for each component of the overhaul.
PCA scopes and reports are never a one size fits all. And, investors and institutional owners require the consultant characteristics noted above to deliver accurate cost tables for extensive repairs, complex acquisitions, or maintenance considerations for their longer and higher-risk holds. Property condition risk is surmountable if the consultant can provide the necessary cost and mitigation plan detail and if the client engages the consultant with key strategic questions and information during the underwriting process.