How To Conduct Due Diligence on an Industrial Property, Part 2

In part one of this two-part series, Justin Smith — a partner with brokerage firm Lee & Associates — guided us through the first two phases of the industrial due diligence process.

As a reminder, Smith divided the industrial due diligence process into seven primary steps:

1. Collecting property information.
2. Financial analysis.
3. Market analysis.
4. Legal and regulatory investigation.
5. Property inspection.
6. Lease analysis.
7. Risk assessment and mitigation.

In the second (and final) part of this series, we’ll tackle phases three through seven of the process, with Smith once again serving as our guide.

According to Smith, the market analysis phase of the process essentially revolves around three key types of information: comparables (or comps, in CRE parlance), competitive properties and macro-economic data.

With regard to comps, you will want to review sales comps to understand how the price you expect to pay for the asset compares to recent transactions, while recent lease comps will help you ascertain whether any existing tenants at the property are paying a fair market rent. If there are no existing tenants at the property, that information will help you determine the rental rates you can expect to achieve at your asset.

In addition to analyzing the comp data, Smith encouraged investors to develop a list of competitive properties — both existing assets and those that are under construction. “If you find out that there's 10 neighboring properties just like yours that are under construction, that might change how you feel about your potential investment and how you model your leasing assumptions,” Smith said. That’s because the more competition that exists in the market, the more likely it is that your rental rates will trend lower.

It's also critical to look at larger economic trends that could affect your investment. Smith referenced the recent labor and supply chain challenges that have impacted industrial users as an example of the kind of economic trend that investors need to be mindful of. The key question is: how are larger economic trends potentially impacting demand for your prospective investment?

Once you’ve analyzed all of this information, Smith said that’s where you reach the “the art part” of your modeling assumptions (and he’s not the first due diligence guide to phrase it that way).

Because while the data will inform your perspective, each investor ultimately needs to make an educated guess about how much they can grow rents at the property.

Smith noted that for industrial investors, the two primary areas of concern with regard to legal and regulatory issues center around the property’s zoning and environmental reports.

Environmental reports. As Smith explained, a Phase I environmental assessment is a standard form prepared by an environmental consultant that will be required by most lenders and anyone purchasing the property as part of a limited partnership. Smith said it will comprise a “cursory in-person property inspection, and then a deep dive into all the regulatory agency records that keep track of any hazardous materials or any operations that might include hazardous materials.”

During that research process, the consultant will be “looking for ECs,” Smith said, “which are recognized environmental concerns.” Smith added that the consultant isn’t just seeking EC information pertaining to the subject property, but also any properties within a several-mile radius. If ECs are discovered, a Phase II is required.

Unlike the Phase I assessment, which is “very standard,” Smith said, a Phase II assessment “is specialized to whatever concern needs to be explored further.”

This exploratory process could take different forms, but Smith noted that three of the most common are soil borings, in which soil and groundwater samples are procured; looking under the slab of the building for vapor; and testing the air quality inside the property.

Zoning. Smith said that most industrial properties are zoned M1 or M2. Properties with an M1 designation are considered “light industrial” and commonly permitted uses include warehousing — distribution and storage — and light manufacturing.

M2 properties, which tend to be rarer, are generally intended for heavier manufacturing. Smith loosely defined heavier manufacturing as uses that have “chemical processes associated” with them or have “an outside component.” Smith observed that there are also specific zoning designations for life science and research and development properties.

According to Smith, it is key that an industrial investor analyze a property’s zoning situation beyond its current designation. “Not only do you want to look at what zoning is allowable in the property you're looking to acquire, but also what is the trend in zoning in general in the relevant city, county and state.”

That’s because, in the era of e-commerce, many communities are taking a “not in my backyard” approach to the zoning of distribution facilities. “Some cities and counties are coming up with zoning restrictions specific to e-commerce and specific to certain size segments of properties and restricting the allowable use to exclude e-commerce unless the tenant gets a conditional use permit,” Smith said.

Obtaining conditional use permits can be a complex (and costly) process, and if such requirements are applied to your property in the future, it could limit your potential pool of tenants. Moreover, Smith said that it’s still not entirely clear in many municipalities whether these conditional use permits are tied to the property and can be repurposed for a new tenant, or if they’re specific to the tenant that’s currently in place. In the latter scenario, a new conditional use permit would be required each time a new tenant takes over the property, or potentially even in a renewal scenario.

Of course, Smith acknowledged that sometimes these municipal restrictions can benefit existing property owners. If a given county or city “puts a moratorium on building new industrial construction for a few years, that will make existing properties potentially more valuable,” Smith said.

Other Regulatory Issues. In addition to zoning and environmental concerns, Smith cautioned that investors need to be aware of Americans with Disabilities Act requirements that their prospective property isn’t currently complying with. “Ramps are expensive,” Smith said with a laugh. “More so than people might think.”

Smith said that inspections “can be as simple as hiring a property inspector and it can be as complex as getting a full-blown property condition assessment.”

A basic property inspection will include “a visual inspection of all of the component pieces of the property and notes of any deficiencies,” according to Smith. On the other hand, a property condition assessment will provide you with “a schedule for the useful life of all component pieces of the property,” Smith said. This will include elements such as the HVAC system, sprinkler system, the roof, etc. More specific to industrial properties, Smith added that the assessment will also evaluate items such as the truck court, fencing, and detention and retention ponds for drainage.

The advantage of the property condition assessment, according to Smith, is that it helps you “understand what you will need to invest in the property in the next five years, and how that factors into your overall return.” That’s because the property condition assessment enables you to turn all of the component pieces of the property into “dollars in your model.”

With a property condition assessment in hand, your assumptions about capital expenses relating to building components become much more concrete, if you’ll excuse the pun, translating into clear expenses on the cost side of your financial analysis.

Of course, such clarity doesn’t come cheap. Smith estimated that for a typical industrial property, a thorough property condition assessment will cost about 10 times more than a standard property inspection.

“At least 80% of the time, the property [you’re acquiring] is subject to leases, and so you're going to have to go through all of them, whether it's one or a hundred,” Smith said.

Based on what Smith told LoopNet, the most salient elements of each lease that you’ll want to take note of are the current rental rate and any fixed escalations, such as a 2% annual rent increase These items will be integrated into your financial model.

In addition, you’ll want to be aware of the lease start date and expiration date, as well as any renewal, expansion, contraction or cancellation options. In terms of your financial model, it’s particularly important to be aware of any renewal options, as well as any fixed rental rates associated with those options. This could impact your ability to increase rental revenue at the property, as well as the potential for leasing it to a new user, redeveloping it or selling it vacant.

Essentially, a variety of your exit and value add strategies could be impacted by the terms associated with any existing leases.

Smith also recommended obtaining a payment history for any current tenants from the existing owner or property manager to ensure they are paying in full and on time each month. It’s similarly important to review the credit and financial standing of all tenants at the property. Obviously, if the property is leased to well-known public companies — Amazon or UPS, for instance — that’s a fairly easy task. If the company is less well-known, you’ll need to review any financial information that the existing property owner has on file — though Smith cautioned that such data is likely to date back to when the lease was signed and may not be current.

To further ensure the “veracity of your income stream,” as Smith put it, you can use reports pertaining to the specific tenant from credit agencies such as Moody’s, as well as look more broadly at reports about the tenant’s industry to understand the trends that could be impacting them.

One other recommendation that Smith made is to ensure that any tenant improvement reimbursements have been paid in full. In some instances, tenants will front the money for their build-out and then be reimbursed, in part or in full, by the property owner. If you purchase the property and those reimbursements haven’t been made, you’ve now inherited that cost.

“And that's a terrible surprise,” said Smith.

Smith summed up this phase of the process by saying it’s about “understanding what some of the risks are and then understanding what the insurance cost is of mitigating them.”

For the assessment component, Smith recommended obtaining a natural hazard report. This report from a third-party provider will highlight any natural risks associated with the property that you need to be aware of, such as being in a flood zone. It will also provide information regarding the topographical features of the property and its soil content. This can be particularly important in certain regions of the country. For instance, Smith noted that in Texas, the high clay content of the soil causes the ground to expand and contract, which can result in cracks in the slab or foundation of your property.

Like the Texas soil issue, Smith pointed out that many of the natural risks you’ll be looking for are based on where in the country (or world) the property resides. In California, understanding the seismic wherewithal of your property is critical, while flooding is potentially a greater threat in Florida.

Once you have a grasp on the risks associated with your property, you’ll want to speak with a property insurance broker to obtain an estimate and understand how much it will cost to ameliorate those concerns.

This phase of the process is also a good opportunity to revisit the zoning issues discussed in the legal and regulatory stage of the due diligence process, according to Smith. With an industrial property in particular, it’s important to develop contingency strategies in the event that the zoning of your asset is altered. Could you adapt the asset to a new use? Would it be feasible to sell the land to a developer?

As Smith noted, it’s always important to understand “if your plan doesn't go according to your base case, what other ways can you exit this investment?”