Don’t forget the details… some often overlooked aspects of due diligence.

When acquiring commercial real estate, the more significant due diligence items are easy to review and digest such as purchase price, rate of return, location, tenants, etc.   What about the smaller details, especially when it comes to reviewing the leases?   Here are some examples of often overlooked, yet critically important, aspects you should be looking for in a retail transaction:

NOI Growth:  We all want our commercial real estate assets to appreciate and there really are only two ways that can happen.   Either cap rates go down or net operating income (NOI) goes up.  For a number of years, commercial real estate cap rates have been at or near historical lows, primarily driven by low interest rates.   There isn’t much room for cap rates to fall further.  As an alternative, you can see asset appreciation through NOI growth, via regular rent increases.   It can be extremely beneficial to look for rent increases built into the existing rent structure, hopefully beating inflation.  We’ve seen some properties where the tenant has locked in no rent increases for 75 years!  Not only is your asset not appreciating but you are losing ground considering inflation.

Age of Building:   Newer construction often demands a higher price (lower cap rate), but there is a reason.  To put it simply, newer buildings have less things to fix.  Even with NNN leases, where all the operating expenses are the tenant’s responsibility, capital expenditures are often the responsibility of landlords.  The most expensive items are typically roofs, HVAC units and parking lots. All with finite lives.  These can be a significant out of pocket cost for landlords and greatly impact your return over an anticipated holding period.   On older buildings, do your due diligence and understand the remaining life on these property features.

Lease Durations:  After capital expenditures, nothing can have more of an impact on investor returns than tenant turnover.  It’s more than just the loss of rent, but also includes leasing commissions and the cost of new improvements that new tenants require.  While many national retailer leases can be twenty years or longer in duration, the smaller tenants typically sign five-year leases.  If these leases expire during your anticipated holding period then you should anticipate what those turnover costs might be.  Furthermore, you should examine the implications of foreseen vacancy occurring during loan renewals and if your ability to refinance may be put in jeopardy.

NNN Caps:  Most retail leases are triple net (NNN) in structure.  This means that in addition to rent, tenants are responsible for their share of common area expenses, insurance, and property taxes.  Thus, the Landlord is protected from increases in property operating costs.  There are exceptions, however, that investors should be on the lookout for in leases.  Occasionally, tenants will be granted caps on the amount their share of NNN’s can increase in any given year (i.e., no more than 5%).  Another example is that some tenants may have protections from large increases in property taxes when a property is re-assessed after a sale.  These are just two of many examples.  While a current owner may not have any current exposure to expenses, a new investor may take on added expense, and thus a decreased NOI, immediately upon sale.