Proper due diligence is critical when deciding to purchase a commercial property, especially when tenants under existing leases are involved. Aside from the physical condition of the building and any financial or legal considerations, such as applicable leans, careful consideration of the various aspects of any associated leases is required in order to make informed business decisions, and to protect your interests going forward.
Validate the Stability and Expected Income from Tenant Leases
Is your expectation of property income validated by tenants’ lease terms? Minimizing investment risks of income-producing real estate, such as shopping centres and office towers, means that purchasers must verify the expected income from existing leases. To avoid discrepancies, buyers should review and confirm that the date and applicable rate of any rent increases corresponds to that detailed in the rent-roll, confidential information memorandum and other documents that the buyer depends on to establish property value.
Assessing the stability of long-term, anchor tenants is a critical aspect of your investment decision:
Building owners with commercial tenants are vulnerable to sudden economic downturns; a fully occupied building with a major tenant can become an under-occupied building if that tenant goes under. So the security of any income stream that depends on tenants must be carefully evaluated too. Payment histories and tenant credit files should be examined to determine how much risk is involved. Business Development Bank of Canada
Carefully Check for any Hidden Rent Reductions
Since the law sometime prevents a property buyer from enforcing contracted rent rates (lexology.com) after an owner orally agreed to, or historically accepted, a lower rent rate, buyers should corroborate that the rent stated in the lease is the actual rent paid by the tenant. For example, do any tenants have undocumented rent reductions?
To preclude unanticipated rent reductions where the tenant’s leased area is less than previously thought, buyers should compare the size and measurement stated in the lease with that outlined in the income documentation. Furthermore, purchasers should request area certificates from the vendor to substantiate that the certified area and measurement standard used agrees with the lease language.
Proportionate Cost Sharing Situations
In situations where tenants pay realty taxes, operating or other costs on a proportionate share basis, buyers should make sure that the denominator (rentable area of the entire property) of the proportionate share fraction does not include rentable areas with capped or limited taxes, maintenance and insurance (TMI) contributions preventing full recovery; otherwise, it puts the buyer at risk for covering any TMI shortfalls out-of-pocket, thus reducing the property’s net income. For office properties, in particular, recovery shortfalls can occur when the rentable area of certain premises are capped or reduced.
Avoid Shortfalls Due to Tax Recovery and Operating Costs
If major tenants or anchor tenants hold leases where realty tax recovery comes from separate assessment information, or customary tax valuation methodologies, the purchaser should make sure that he, or she, can exclude them from the proportionate share denominator used for other tenants. Diminished recovery can happen when the lease language specifies that a tenant does not contribute towards the realty taxes allocated to storage, parking and related facilities.
Purchasers should also exercise proper due diligence by closely reviewing operating costs, options to extend or renew leases and lease language to expose unaccounted for future credits, expenditures or payments that the purchaser may be responsible for.
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