Let’s face it, not all commercial real estate investments go smoothly. The increased risk usually boils down to three factors which either cause or worsen a bad deal: lack of transparency, poor communication and weak financial and/or project controls.
Today, there are cloud-based software platforms that mitigate these risks, allowing developers, operators, and investors to track costs, monitor progress, audit processes and set benchmarks.
However, technology doesn’t replace foresight and planning. It’s critical that investors conduct their due diligence by asking the right questions beforehand, touching upon every aspect of the potential transaction. They will help confirm that the business is what it appears to be, identify any defects that could potentially derail a deal, garner information to use in deal-making, and verify that the project meets investment criteria.
EisnerAmper director Timothy Van Noy, who specializes in claims, forensic investigations, and fraud risk assessments in the construction industry, identifies eight things that real estate equity and debt investors should ask developers and operators before investing in a building or project.
Question 1: Do they have a structured enterprise-grade accounting system in place?
Whatever reporting you’re getting as an investor, make sure that it is timely and presents construction spending relative to schedule and actual project progress, Van Noy recommends. “I want to see how the contractor is meeting both time and cost budgets, and I’d also like to see variances explained,” he says. Cost tracking information should be provided on at least a monthly basis, along with payment and lien release information from the contractor and subs.
Related questions include:
- Do they have real-time access to actual spend vs. budget?
- Are payments being made to contractors in a timely manner?
- How do they track invoices that are submitted and accepted?
Question 2: Are they getting competitive bids for your projects?
Whether new construction, a renovation, or repair, competitive bidding should be used to procure construction services. One of the most important and time-consuming parts of a bid evaluation is the leveling process. However, this process can be streamlined through carefully written RFPs, a structured bid evaluation process, and software that facilitates the process.
As an investor, I want to see the bids coming in from contractors and subs and understand the selection process.
When investing with developers entering new markets, the investor should pay particular attention to the due diligence process for contractors and vendors, Van Noy says. When you look at contractors, get a list of their active jobs, current clients, and references—not historical. You need to understand how well they are doing on the other jobs and if there are any problems that might impact their performance on your own project. You also need to be aware of relationships that may exist between contractors and subs.
Question 3: Are they maximizing their purchasing power?
Developers and building owners should be evaluating their historical costs over multiple projects or buildings to identify metrics such as cost trends, vendor volume, and pricing, or market anomalies which can assist in procuring products and services at lower costs. This type of analysis requires minimal time once systems and procedures are established.
Question 4: Are they managing their project documentation effectively?
- Are there electronic copies of documents?
- Do you have centralized document storage?
- Is it secure? Are there adequate sharing and access controls?
- Is there an auditable system of record for documents that have been exchanged?
This is especially important for large projects where drawing changes, RFIs, change requests, meeting minutes, and identified issues need to documented, tracked, and resolved timely. This effective document control not only creates the project record, “but also makes sure issues are responded to within contractual time frames to avoid project delays that may turn into contractor claims,” Van Noy points out.
Remember that if you’re working in a shared or cloud environment, access should be controlled properly. “Only the party responsible for document control should have the ability to update logs or change documents—everyone else should be read-only,” he says.
Question 5: How much time and money are they spending on reporting?
It’s critical that the developer or operator should have a back-office capability, because structured reporting and tracking is so important to effectively controlling projects, Van Noy says. For instance, studies have shown that projects over budget at 20% completion generally finish with costs overruns.
Overall, a balance must be reached on project control and reporting so that the process is creating value instead of administering a project to death.
Question 6: What is the history of change orders over time, and who is accountable?
- How long does it take for a red flag or emergency to be recognized?
- Is it obvious to the team when projects are delayed or running behind?
Van Noy is a big believer in monthly reports on projects that: compare estimated to actual cost, cash flow, and schedule with variance explanations; present the status and age of RFIs, drawing changes, and pending change orders; and include a discussion of actual project status based on physical walk-throughs of the project. “It forces the contractor and developer to deal with these issues every month and keep a handle on the job.” He also recommends that investors participate in periodic walk-throughs with someone who can look at the reporting and recognize issues.
Question 7: Can you get a historical record of the capital projects and maintenance history in a building?
From the roof to the lobby to the boiler, how do they track capital projects, maintenance and inspections?
Almost every type of building should have a facilities plan that looks three to five years into the future and considers each major system or component. The plan should discuss the current age and status of each system or component and identify inspection, maintenance, and replacement dates in the projection time period. Notes Van Noy: “These plans can be an important component in developing both the operating and capital budgets each year as well as projecting annual cash flow needs.” These plans should be evaluated annually and updated on the selected three or five-year cycle.
Question 8: Is the building owner or manager tracking and controlling costs effectively?
Building owners and operators should demonstrate the ability to develop reasonably accurate annual budgets, track costs effectively, and assess performance to budget on a monthly basis with adequate assessment and explanation of budget variances. Major service and maintenance contracts should be evaluated for service quality and rebid annually. Consider having bidders evaluate prior-year repair and maintenance activities and offer ideas for reducing costs as part of their bids.