Due Diligence Series #3 – Financial Records and Operational Review

We are in the third episode in a series centered around the due diligence process for self storage in today’s world.

So far, we have discussed:

1. Timelines and what to get from the seller.
2. Physical inspections and third-party vendors.

Read Last week’s blog here.

Watch last week’s episode here.

Let’s discuss how we go about relating to the financial information we get from the Seller.

Financial Review

Remember what we asked for from the seller?

What in the world do we do with all of it?

Even if this is your first self storage facility, you will relate to the business and run your facility differently from the current owner. Yes, many of the expenses may be close to the same, but your job is to flush out what isn’t and adjust your proforma during this period.

Ultimately you are buying cash flows, not just real estate. In technical terms, you are making capital expenditures (buying the facility) to generate operational cash flows. The success of your venture will be how close the operational cash flows are to what you projected in your proforma.

That is what my relationship to the due diligence period is this:

I want to gather all the information possible so my proforma will be accurate. That will allow me to determine if the cash flows over my anticipated holding period, and the equity created, meet or exceed my overall investment goals.

Usually, the first thing I do is replace the easy numbers in my proforma with accurate ones.

• Insurance – I send the seller’s insurance policies to our agent and a couple of vendors from the SSA (Self Storage Association) to get bids. I want as apples to apples as possible.
  • We are usually changing what the seller has. Often, they don’t have the riders we use, such as “wrongful disposition” coverage and “environmental cleanup” of up to $25,000 per incident.
    • Coverage if we auction incorrectly (a self storage owner’s number one liability exposure) and clean up in the event someone leaves glowing 55-gallon containers in a unit.
• Taxes – I can, in most states, figure out what the property taxes will be based on the tax bill’s mil rate against the sales price (information on the tax bill we get from the Seller).
• Utilities – You will have their utility bills. Average them over a year. See how much the utilities appear to have gone up (or down in a few cases) over the past few years. Use that to project out—also, make adjustments upward for expansions based on what type of storage you may be offering.

Then, I will go through their profit and loss statements (P & L) with a fine-tooth comb, looking for what expenses I will be eliminating. Expenses such as personal automobile expenses, excess management fees owners often take to pay themselves, etc.

I think through how I will run the facility focusing on items like:

• Trash – Will I have a dumpster or use municipal trash pick-up?
• Employees – An entire episode could be written on this. Are we reducing or increasing employees? What will their compensation be with us? Am I keeping current employees or hiring new ones? Adjustments from how the current owner runs the facility to how we will are made on the proforma.

We go line by line down their P & L and think through our running, then make adjustments on our proforma. I relate to the proforma as what our future budgets are going to be.

I am also getting bids on any initial capital improvements I am making to the facility or construction bids for expansions (we will have a separate episode for conversions and expansions in this series).

We are also getting insurance bids, the cost of converting to a new storage operating system in most cases, and reviewing their current service contracts and seeing if we want to assume them or try to get out of them. Sometimes we have to keep them until their current term runs out. I am making sure we put in the calendar the date we have to give the notice to terminate if we can’t with a thirty-day notice upon closing.

I also make sure I forward the survey and any title information we get to our attorney for review.

Operational Review

This is where we begin to look at exactly what we will be doing differently from the current owners in terms of generating more income.

We usually start with what I call the management summary reports. I plot out the previous couple of years’ occupancy rates and this year’s occupancy rate month by month. I am looking for trends or patterns. Which way is physical occupancy moving?

Next, I plot out the economic occupancy. How much money, according to the reports should they have received, and what did they actually get? Is there a difference? How much?

For example, if gross potential income is $1.00 per square foot month, and based on 88% physical occupancy, they should have received 88 cents per month, but after adjustments and concessions, they are getting 75 cents per month, there is a 13 cent gap between economic and physical.

My job is to determine during this due diligence period why. The feasibility report may shed some light on it as the report will give supply-demand information on the trade area, but I will also dive into their operational procedures.

Do they make regular collection calls? Do they hold regular auctions? Do they let customers hang around owing money, or do they get them out fast?

What will we do differently, and how will that impact this economic occupancy in relation to physical occupancy?

In some cases, you will see economic higher than physical. In those, they are good at collections and keeping paying customers in, as well as getting additional fees.

At some point, I, or someone on our team, will go to the facility. We will take that day’s rent roll, then go through every file and compare:

1. 1. Match the unit number up on the lease with the unit on the rent roll.
   2. Match the name on the lease with the name on the rent roll.
   3. Match up the rent on the lease with the rent on the rent roll.
   4. Make sure the lease is fully executed by all parties, including the owner.
   5. Make sure there are no credit card numbers or info on or in the folder.

My experience is, no matter how well run the facility is, there will be a few things to correct from the above inspection. This step is critical because all of these must be correct in most states to have valid auctions. You need to have leases signed, or a customer can claim damages if you have an auction.

Next, I will take a random month’s bank statements and then take that month’s daily closes. I try to match up deposits with closes, then look at that month’s P & L and see how close all three are to each other.

This also lets me know how tight a ship the current owner runs. Are there daily closes? Can I match up the deposits exactly, or do the owners let the cash and checks pile up and then make periodic deposits? How close are the totals for the month on the bank statement, management reports, and the P & L?

Hint: I suggest you want all three to match. My relationship to it is that anyone in five years can take a random day at our facility to match the daily close management summary report to our deposit and then to a daily entry in Quickbooks. 

Next, we look at other income sources we will be putting in place. Examples may be:

• Tenant insurance.
• New retail displays.
• Truck rental.

We next look very closely at the current owner’s accounts receivable. Who is late and for how long? At some point, I want to go over each late customer with the owner or the manager, get the history and develop our strategy for what we will do with them the day we take over. Usually, for people who are over 30 days late, we will begin the auction process with them the day we close.

Sometimes, the current owners have “payment plans.” My coaching is never, never have payment plans. Let them go owing you money before you do a payment plan. You come out ahead, and they do too. If plans are in place, the managers are instructed the moment they are one day late in paying it, the plan is terminated, and the auction process begins. Accept no more money from them unless they pay in full or a negotiated amount by you to terminate their lease and let them go.

You absolutely do not want the cash flow to jammed up with customers who get further behind. I can take one look at a daily management summary report, and I can tell you if that owner has payment plans or not. It is a poor, weak way to run a business.

Conclusion

This, in general, is a summary of what we do during this portion of the due diligence process. We spend a lot of time here slowly piecing together the updated proforma.

The objective here is not to react each time we adjust it. Many changes will go in, and, if possible, I try not to react until we have all the information we are going to get. Then we look at the proforma and determine if this is a deal we can or should do.

In most cases, it will be a yes because of the work you did in the preliminary proforma.

When it is, it is up to you to pull the trigger. That, for me is often the hardest part of the entire transaction. But that’s just me.

We will layer on what we do during the due diligence period involving conversions and expansions in the next episode.