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Rethinking Real Estate’s Part in M&A Due Diligence

Rethinking Real Estate’s Part in M&A Due Diligence

By Cece Conway

During the past 10 years, the amount of money raised and deployed by private equity firms for mergers and acquisitions (M&A) has consistently increased. According to McKinsey’s annual review of private investing, private equity’s net asset value has grown more than sevenfold since 2002, twice as fast as global public equities. Today, there is more capital chasing fewer deals, causing compression in the returns. In this environment, where private firms are fiercely competing to deploy capital, the prices being paid for these companies are at an all-time high.

Given this competitive environment every dollar counts to increase a company’s earnings before interest, tax, depreciation and amortization (EBITDA) and drive the monetary returns demanded by the market. An often-overlooked area of a private equity acquisition is the real estate portfolio of the acquired company and the value or cost these assets potentially bring to the deal.

A thorough evaluation of the portfolio during due diligence by a commercial real estate consultant can help uncover hidden costs or opportunities to monetize the assets by asking the following questions.

Do the target’s leases contain any “gotcha” clauses?

A critical review of the leases of the acquisition target should highlight potential liabilities. An example could include evergreen renewal clauses, which allow for a lease to continue for an undefined term if the agreement is not renegotiated or cancelled within a specific time period.

Did the target defer maintenance to its real estate portfolio?

If maintenance was deferred, your real estate partner can help establish a capital budget for repairs and timeline required to make the necessary improvements. According to Buildings.com, on average, if targets defer maintenance, buyers can expect future expenses to be equal to or greater than the cost of the part squared or 15 times the total repair cost. Examples of frequently deferred maintenance areas include HVAC, plumbing systems, roofs, parking garages, and masonry/tuckpointing.

If the target’s properties are leased, what notification is required to the landlord?

Some leases require prior notification to the landlord of an acquisition/transfer, and failure to do so will put the tenant in potential immediate default.

Are the leases overpriced relative to market?

During due diligence, the portfolio should be benchmarked against market leases providing insight as to whether the leases are at, above, or below market.  This knowledge will provide a blueprint for active management and renegotiation of the leases in the future to bring costs in line. Similarly, if an owned asset is remaining with the seller, this process will help establish fair rental rates for a lease.

Are the real estate assets well located for the business needs?

As part of due diligence, the demographic attributes of the portfolio can be evaluated to determine if the various locations optimally support the business.  These studies can identify commuting patterns for employees as well as customers.  They can show population statistics and growth as well as access and transportation information.  These attributes can be compared against the performance of specific locations to help determine whether a specific site should be closed, relocated or perhaps, negotiated out of the purchase.

Can the real estate be monetized and help offset the cash required for the acquisition?

If owned assets are to be transferred in the sale, a real estate consultant can value these properties and negotiate a simultaneous sale-leaseback, which will allow the private equity firm to bring additional capital to the closing table to offset the equity investment.

There are many things to learn from a thorough investigation of the target’s real estate, including opportunities to create future value and help avoid unexpected costs. In this competitive environment, the impact of the real estate can no longer be ignored.

Cece is an executive vice president of Transwestern’s occupier solutions group in Chicago. Cece plays a key role in Transwestern Chicago’s business strategy and transaction services for national account clients and local Chicago firms. Cece has an extensive background working with clients on multi-market portfolios to develop and implement real estate strategy.

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