Due diligence. We’ve all heard the term, but what does it mean, and what happens behind the scenes during the due diligence period? How do we know if a property is worth buying? Does self-storage due diligence differ from other real estate due diligence?
We answer those questions and more below. As a passive investor, you’re about to get a behind-the-scenes look at what it takes to close a self-storage deal.
What is Due Diligence?
The due diligence period officially begins once the contract is signed by both parties. During due diligence, the buyer can inspect the property and decide if they want to move forward. In today’s market, due diligence periods for self-storage facilities are typically 30 days. A buyer must act quickly to complete all inspections and make a go/no-go decision before the 30 days is up, or they could lose their earnest money deposit.
When our team conducts due diligence on self-storage properties, we examine four critical aspects of the property to mitigate as many risks as possible before moving forward with the deal: financial, physical, ownership, and market.
As soon as our due diligence period begins, we ask for several financial documents including three years of profit and loss statements, three years of Schedule E tax returns, a bank statement for the last 12 months, a current rent roll, and a few other less crucial documents. Once we review these, we feel we have a good idea of where the property has been and where it’s going.
If we are buying a facility in lease-up (i.e., the facility just opened so occupancy is naturally low), three years of records will not be available. In this case, we’ll already have the financials from the time the facility opened, but we will request copies of signed leases and other management documents to provide more details on current tenants.
The financial review is tedious and takes the longest amount of time. Understanding these reports is the biggest differentiator between self-storage and other types of real estate. Customers aren’t locked into long-term leases, and there is usually a seasonality to occupancy. This is typically reflected in the financials, which are critical for us to understand.
Most of the questions we present to the seller revolve around delinquent payments, lease agreements, or capital expenditures. Most sellers understand this part of the process and work with us to answer our questions.
We recently toured a property that was a conversion from a grocery store to self-storage. Prior to our site visit, we were informed the roof had a leak and the seller was gathering bids for the repair. Our conversation led us to believe this was a minor issue.
However, during our visit, we discovered 80 units that were unrentable and more issues with standing water on the floor of the facility. We did not move forward on that deal.
Besides a site visit, how do we discover physical defects prior to closing? We order a Property Condition Assessment, or PCA, which is a thorough physical inspection of the self-storage facility.
A PCA provides us with specific intel on the condition of the roofs, doors, mechanical and electrical systems, fencing, electronic gates, retaining walls (if any), and more, and will provide an estimated budget for repairs. Self-storage has specific components that differ from other property types. As a result, we always hire an inspector with self-storage experience.
What about ground contamination, or illegal dumping from past customers or property owners? A Phase 1 Environmental Site Assessment (ESA) will let us know the answers. A Phase 1 ESA removes liability to the buyer for any present contaminants or contaminants discovered after closing, so we always order a Phase 1 ESA.
Beyond the Phase 1 ESA and PCA, we order a survey to discover any easements and encroachments and to understand the layout of the buildings and boundaries of the property. We request all site plans and certificates of occupancy to ensure the buildings are built to code.
What happens if we find a physical defect that wasn’t disclosed by the seller prior to the contract? Sellers understand that if we have discovered something, it becomes a material fact that must be disclosed to the next buyer. One bird in the hand is worth two birds in the bush, as the saying goes. In other words, it’s easier to work through surprises with us rather than find another buyer. If there are no surprises, then we’re comfortable with moving forward.
If you have ever shopped at Costco, you know to hold on to your receipt because you won’t get out the door without it. That receipt is proof you own the items in your cart. A real estate deed is like that Costco receipt. It shows proof that the seller owns the property they are selling.
Like the faithful Costco employee checking receipts, we check to make sure the seller is the rightful owner of the property and has the legal capacity to convey, or sell, that property to us. This is accomplished through a title search by our attorney or title company.
We also purchase an owner’s title policy to protect us from claims to the property by third parties. On the surface, this may seem like overkill, but one would be surprised at how many title issues pop up in real estate transactions.
Finally, we reexamine the market to make sure we didn’t miss a new self-storage facility planned for development nearby. We use data sources and the city’s Planning and Zoning Department to provide us with the information we need. We also ask the city for a zoning confirmation letter to verify the facility we’re buying complies with zoning and there are no outstanding violations with the city.
Once we complete our due diligence and feel confident about moving forward with the purchase, we have 30 days to get the deal closed. A flurry of activity begins between our lender, our attorney, and our management company. Documents are signed, the loan is funded, and the customer information is transitioned to our management software. We also visit the site as needed to meet with the management company and prepare for the transition. The goal is to make sure everything is in place to rent units as soon as we close.
As a passive investor, I hope this article has given you a behind-the-scenes look at those aspects. Stay tuned for next month’s article on the state of the self-storage market