Physical due diligence adds value to the investment process when efforts:
- Focus upon the major issues that are relevant to the security of the investment.
- Utilize techniques that maximize effectiveness and minimize time commitments, resources, and costs.
The scope of physical due diligence should always provide results that are meaningful to loan underwriters in analyzing the soundness of an investment. To accomplish this, it should provide an understanding of the physical parameters of the investment and it should identify the major physical risks. The following are three examples that provide such results. They are a part of what I consider to be an appropriate scope of work for performing physical due diligence, which the remainder of this chapter presents.
First, property condition reports should verify the accuracy of the physical parameters that form the basis of the property's valuation (particularly the gross and net rentable floor areas by calculation from the plans). From this, the existence of lease load factors can be identified, understood and factored into the investment decision-making process, avoiding misunderstandings and misrepresentations. Load factors are percentage increases to the actual true net rentable floor area (NRA). These are sometimes added onto the floor area that a tenant occupies and are identified in his or her lease as their NRA. With load factors in place, a tenant's NRA is designated within the lease as larger than its measured area and the rent that is calculated based on the size of the lease space is larger than warranted. The existence of load factors is often accepted by tenants when space is in demand, but when markets experience a downturn, load factors disappear from leases and property values plummet.
Second, the reports should evaluate the appropriateness of the finished product for its intended use; for example, they should address the following important question, "Do the details of construction support the conclusion that the subject can be considered an appropriate investment grade property within its competitive market?" The answer to this provides the most meaningful contribution that physical due diligence can make to the investment decision-making process. There are many criteria that define investment grade real estate, and an understanding of these is most significant to the success of an investment. This book devotes a great deal of effort to cataloging the qualities that define investment grade and to explaining why they are important to the success of the property.
Third, property condition reports should identify all items expected to require capital expenditures during the loan term. This should include all physical deficiencies (items of deferred maintenance, violations of laws, codes or principles of life-safety) requiring immediate repair, replacement or alteration. This should also include identifying building components that are expected to exceed their expected useful life (EUL) during the loan term plus items of questionable durability and items of functional obsolescence. The property's income stream should be expected to support all such risks, which should be quantified along with estimated time frames for the anticipated expenditures. A spreadsheet projecting all of these anticipated capital expenditures over the term of the loan would provide an appropriate format to factor all identifiable physical risk into the proforma cash flow analysis.
