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By

Kunal Moktan

The role of diligence in CRE

Commercial real estate (CRE) has been one of the best performing asset classes in the country in terms of yields and capital appreciation. CRE has taken prominence on the back of a steady influx of multi-billion dollar multinational companies entering the offshoring destinations of Bangalore, Hyderabad, National Capital Region (NCR), Pune and to a lesser extent Mumbai over the last two decades. These MNCs have been drawn to India due to a large and educated English-speaking labour force, cheap supply of office space (<$1 psf in most cities) and an accommodative regulatory regime.

 

This in turn has led to a significant amount of office stock to be built in these cities that have the potential to be monetized through sale to private equity funds and more recently through REITs. While both PE funds and REITs deal with large office portfolios, retail investors have also been participating in this opportunity by investing directly and more recently through tech-enabled CRE investment platforms like PropShare ( www.propertyshare.in).

 

The investment process in CRE typically involves the following steps:

 

  1. Property identification and price negotiation
  2. Due-diligence
  3. Execution / Registration
  4. Rent collection
  5. Exit through REIT or private sale

 

In this article, I will speak about due-diligence - one of the most important aspects of commercial real estate investing and the primary reason why retail investors get short-changed in CRE investments. While institutional funds appoint Tier 1 law firms to do the diligence, retail investors often go to Tier 3/4 law firms who are not equipped to recognize and eliminate the risks in property diligence. Below are some important factors to look for while conducting due-diligence before investing in a CRE opportunity:

 

Title

 

A clear title is the first and foremost thing to look for in the diligence. Title risk means the risk that the property does not belong to the Seller or that someone else also has a claim to the property. In order to eliminate this risk, the investor needs to appoint a law firm who specializes in title diligence. The law firm will go back in history and check the entire chain of ownership from the time the property was first sold or acquired either from the government or through inheritance till the time it was devolved to the current owner.

 

This involves doing multiple litigation searches, going through physical court records and analyzing the documents / sale deeds signed at each stage that the title was transferred. Good law firms also suggest that a Public Notice be issued in an English and a vernacular daily announcing the investment so that no person can claim title at a later stage.

 

Building permits, NOCs and Approvals

 

The law firm will also check whether all the government permits and clearances have been received for the building from various departments. This includes a certificate of commencement, building plan approval, municipal approvals, approval from the water and electricity boards, an Occupancy Certificate, Fire Department NOC, clearances form the Ministry of Aviation, Pollution Board, Ministry of Environment etc. This will ensure that the building is fully compliant with all the local and central government regulations and there are no violations in terms of height, built-up area, environment etc.

 

Encumbrance

 

Encumbrance means whether someone else has a parallel claim on the property other than the owner. This will most likely be a bank or other financial institution to who the property might have been mortgaged. An investor needs to ensure that there is no loan outstanding on the property, which would invalidate the transfer of ownership. Tenanted CRE is often mortgaged to banks for a Lease Rent Discounting (LRD) loan and such loans must be paid off before the property is sold. If the buyer does not wish to takeover the loan, he/she should insist on an NOC from the lender and a physical custody of the original documents. An easy way to check for encumbrances is to look at the Encumbrance Certificate (EC) that is publicly available. When any loan is sanctioned against an asset, the bank updates the property record in the sub-registrar's office. Good lawyers go back 30+ years to check that the encumbrances are clear.

 

Litigation

 

One of the key risks in any property transaction is litigation. Property is one of the most litigated asset classes in India and it is imperative for a buyer to ensure that there are no outstanding disputes with individuals, companies, lenders or the government. This could manifest itself in income tax cases, winding-up petitions, title litigations etc. In one of the recent properties in Mumbai, PropShare had to back-out from the investment as there was a winding-up petition filed against the Seller by a bank due to non-payment of an outstanding loan in a group company that had pledged the asset. The Seller did not initially inform us about this petition as it was with a group company.

 

Tenancy

 

If the property is tenanted, a diligence of the lease deed must be completed to confirm the lease terms like Rent, Common Area Maintenance (CAM) charges, property tax payments, rent escalations, lock-in period, notice period, indemnities, terms of arbitration, definition of force majeure, rent payment terms, car parking spaces and rent etc. The Buyer must ensure that the terms are in-line with what was agreed with the Seller.

 

Technical Diligence

 

This is one of the most important diligences, which is often ignored by even institutional investors. Technical diligence means sending a specialized project management firm to the property to check whether the building is technically sound and whether any capital expenditure is necessary in the near future. While doing the technical DD, the firm will check various equipments and services like the Diesel Generator, Lifts, HVAC air conditioning systems, plumbing, glazing of the facade, chillers, electrical circuits etc. The firm should report the make of the units, the age, expiry terms, functionality etc and should clearly point-out if any of the equipments require immediate upgrading. This can help the Buyer plan for capital expenditure and renegotiate the purchase price.

 

Another critical part of the technical DD is to check the Efficiency of the floors. Efficiency means Carpet Area / Leaseable Area. Carpet area is the usable area in any office building or floor - literally the area where a carpet can be laid (excludes pillars, lift lobbies, building lobbies, balconies etc). Leasable area is the area that the Buyer / tenant (if leased) is paying for. An efficiency ratio of 75% is acceptable in most markets with a few exceptions. This ensures that the developer has not sold excess area to the tenant or Buyer.

 

Others

 

Apart from these a Buyer should also ensure that the property tax payments are up to date, CAM charges have been paid (NOC from the manager is recommended), there are no transfer charges payable etc.

 

Commercial real estate is one of the best asset classes today because it provides a monthly income indexed to inflation and a capital appreciation kicker. However, the complexity of diligence and a fear of title and litigation risks often deter ordinary retail investors in participating in lucrative CRE opportunities. Due-diligence is simple if done correctly and through the right advisors. As an investor it is important to ensure that adequate time is taken to complete this process and the right advisors are appointed.

 

Kunal Moktan

 

The author is the co-founder and chief investment officer at PropShare Capital, India's first and largest commercial property investment platform.

 

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