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Operational Due Diligence - Investigate Your Critical Factors

By Jo-Anne Oliveri, ireviloution intelligence, Brisbane, Australia

I’m sure you are beginning to understand the vital importance of an operational due diligence being conducted prior to your offer to purchase a rent roll becoming unconditional. Once that contract is unconditional you are bound to proceed with the purchase regardless of how inferior the business is that you are purchasing. Yes, I understand that in most purchases there is a retention period, usually three months (again, this is a time period I do not agree with) whereby you have the opportunity to not pay for any managements that you may lose in this period. But, under normal rent roll contracts it’s fairly standard that a percentage of the purchase amount is usually withheld in a solicitor’s trust account and is released when the retention period has expired. Some agents believe this period is their safe guard. Well, I’m here to tell you that you must not be lulled into a false sense of security and, with that said, I feel another article is worthy of this subject.

Due diligence being conducted prior to your offer to purchase a rent roll

This post focuses on what I refer to as the “critical factors” that need to be investigated when conducting an operational due diligence. These critical factors are:

  • Average management fee
  • Average distance to property ratio
  • Average weekly rent
  • Management splits (percentage of houses and apartments)
  • Number of owners against properties under management and how many are multi owners (including details of each owner’s actual number of properties)
  • Percentage of fixed term leases
  • Monthly disbursement methods and timing
  • Arrears management

In each of these factors we are seeking information that tells a story. It tells a story of risk factors and that’s exactly what operational due diligence is all about. What risks are you facing if proceeding with the purchase of this rent roll? How could it affect your current business operations?

I could write an article on each critical factor as each show a different set of possible risks or benefits to your current business operations. This post will focus on the average management fee.

The management fee is the determining factor that places the dollar value on your business. The value is normally multiplied by what I refer to as the “market multiplier” – the annual management fees multiplied by the current market value multiplier. Just by virtue of the fact your business is valued on your income generated through management fees, it is critical that management fee income is protected and never discounted.

When conducting operational due diligence it is not uncommon to find the management fee varies by as much as 4 to 5% in most rent rolls. Whilst this may be justified at the time to win business (new managements) the overall impact on your business value is disproportionate as it decreases the dollar asset value of your business, the business value in comparison to market average, and also the income generated from the management.

For example, if the current market value multiplier is around $3.00 per dollar income. Due to the fact that the operational due diligence uncovers significant management fee discounting and a high variation of management fees being charged, the value is much lower than market average based on risk factor and ongoing management. In turn, this affects the value of your current business. All of these factors MUST be considered.

As mentioned, whilst conducting operational due diligence I look for stories about the rent roll. These critical factors in question tell me a story about the current managing agency. Have they have built this rent roll fast, to then sell it off, or do they not back their business up with a high performance and knowledgeable team, or do they discount to get the business and therefore there have no client loyalty, or simply all of these? So, is this business worth what the current market value multiplier determines? The answer is no. In this case the advice is – offer a lesser amount than the current market value multiplier.

It is all too common for rent roll purchasers to pay far above the real value of the business because an operational due diligence has not been conducted. The amounts we are talking about can be hundreds of thousands of dollars. Would you buy any other business on face value? Would you invest hundreds of thousands of dollars without first investing a few thousand dollars to have an operational due diligence carried out? I would think not.

So, I hope you understand the vital importance of an operational due diligence being conducted prior to your offer to purchase a rent roll becoming unconditional. Don’t you agree it makes more sense to research the business you are considering investing in before making the decision to invest?

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