I'm discovering a new asset class (with wild returns). Part III.

This post is a follow on from Part II where I talk about financing and lawyers. Here I talk about my due diligence and managing risk for a new project.

I don't know what I'm doing when it comes to retail plazas. I'm figuring it out as I go along. But by sharing my journey I'm hoping it'll shed some light on how I de-risk the opportunity.

I'm at the point where I've signed the purchase and sale agreement and put down the initial deposit. The money isn't "hard" yet. That means I can withdraw from the agreement and get my deposit back, no questions asked. But time is running out before the next phase kicks in and the money hardens.

A couple of weeks ago I jotted down all the risks I could think of when it comes to buying a retail plaza. Here is the list:

1. Are the current tenants paying above or below market rent rates?
2. Are there any problems with soil contamination that will need an expensive clean up?
3. Are there any issues with water or sewage?
4. Are there any problems with access or easement from neighboring tenants?
5. Are the tenants paying on time?
6. Is the building structurally sound?

I put away my "laziest" moniker for this one. Here's what I did for each:

1. Above or below market rates?

I set aside two hours to walk neighboring plazas (within about 0.5 miles) and collect as much information as possible. Almost every owner-operator (so not corporate stores like Verizon, Dominos etc.) shared their current rent which ranged from $14 per sq ft to $35 per sq ft. Obviously the price was dependent on the location, parking, natural traffic, building quality etc. But I soon had a pretty clear map of local rents. One owner even called me up after to ask if he could move into the plaza I'm buying! Another told me he could comfortably afford to pay 10% more and would do so because he'd sunk $100K into the business already.

I also had a windfall: right behind the plaza I'm buying 320 new condo were being built.

Overall I estimate that two of the retail tenants in my prospective plaza were at market rates, one was ~5% below and another ~15% below.

My risk estimate: 2/10 (low)

2. Soil contamination?

I've heard horror stories (like this and this) about contaminated soil clean up. Well guess what. While doing my rounds someone casually mentioned there used to be a dry cleaner in the plaza. Ugh. I searched on google and, yes, there was one for about three years. Was I also going to be on the hook for hundreds of thousands of dollars worth of clean up?

I tracked down the former owner through a little sleuthing. They were still in business, but in a different location in town. I asked the owner about their former location. It turns out is was just a pick up and drop off place, with no chemicals or cleaning on site.  

The seller also completed an environmental assessment just three years ago. It was completely clean. And having one so recent meant I got the bank to do a "light" version and save some money.

My risk estimate: 1/10 (low)

3. Water/sewage problems?

I called the local municipality water department and the water treatment plant. I've always found municipal employees extraordinarily helpful, if a little slow. They have no vested interest in whether you buy or not, and they've often worked for decades (literally).

Almost immediately the head of the treatment plant told me there were annual problems with the grease traps. Nothing major, but every so often the lines would block and need purging. He helpfully suggested I amend the contract with the quick service restaurant at the location to ensure regular cleaning at their expense.

My risk estimate: 4/10 (low-to-medium)

4. Access/easement problems?

I found a local attorney - one who was involved in the original zoning amendment - to represent me in this transaction. There's a large Home Depot next door and there is an agreement with this parcel of land around access. Not being a lawyer myself, I wanted to understand the risk. Here's what he wrote back:

"There is an easement agreement with Home Depot. It doesn't really affect you.  Look at page 11 in the title insurance policy.  It was done before your lot was created.  They just never did anything to modify it. Dealing with Home Depot is difficult. It has to do with the main road into Home Depot. Don't worry about it. It would take me a full day to find the document at the Registry of Deeds and read it. I just know it isn't a problem."

Perfect.

My risk estimate: 2/10 (low)

5. Are tenants paying on time?

I went through the previous 15 months' worth of the property management statements - right up until last month. (I want to know if there are any new problems also). I found three flags:

a. $11,552 in "unanticipated legal fees"

b. $2,742 in sewer cleaning

c. Two months of late payments by one tenant

The seller had good reasons for all, namely using the excess cash flow for a different property he's funding, a tampon blocking the toilet, and deferment from COVID.

My risk estimate: 4/10 (low-to-medium)

6. Structurally sound building?

Again, having a local attorney meant he knew the local players. In this case he knew the engineering team that did the construction for this plaza and others nearby.

I spoke with the engineer for about 15 minutes and we talked about barriers, drainage, and much more. No issues from him.

My risk estimate: 1/10 (low-to-medium)

With all this behind me I'm feeling confident to pull the trigger. I don't have the time or the stomach for a risky project. From everything I can see, the risks are manageable with this. The total time I've taken on these six steps has been about five hours. It seems well worth it.

I close in six weeks!

For random takes on real estate investing you can follow me on Twitter @laziestlandlord