The client turned to Real Diligence to review and analyze the seller's offering memorandum for the purchase of a $12 Million shopping center in New York State.
The seller presented the building as a "net" property, with all expenses passed through to the tenants on a pro rata basis. This meant that in addition to their rent, each tenant was obligated to pay its pro rata share of the property's taxes, insurance and operating costs. As part of its financial audit, Real Diligence reviewed all expenses to ensure each was being accurately passed through to the tenants.
Combing through the voluminous documentation, Real Diligence discovered two significant discrepancies. One problem was that the owner was charging the center's anchor tenant a flat 4% management fee, rather than passing through its pro-rated share of the actual management costs. Although a clause in the anchor's 1980 lease did impose this flat fee, another clause tucked in a 1985 lease modification agreement very subtly overturned the original language and required management expenses to be pro-rated and passed through to the anchor, as they were for the other tenants. This modification had never been implemented, however, which meant that the anchor tenant was paying $20,000 more per year than its lease required.
A second discrepancy had to do with the property's utility bills. The owner was passing through to all the tenants the cost of utilities for one large retail space that was not in use. The owner's argument was that this expense was required to keep the building in good shape and so was subject to recapture. But Real Diligence made the case through a close reading of the lease documents that this expense should not have been passed through to the tenants. The tenants were being overcharged a total of $60,000 per year.
Based on the agreed upon 10% CAP rate and with the two discrepancies adding up to a shortfall in income of $80,000 per year, the client requested an $800,000 reduction in purchase price. The seller agreed to lower the purchase price by $600,000. Thanks to its meticulous and in-depth review of several passages buried in hundreds of pages of lease documents, Real Diligence identified two issues that resulted in a significant savings to the client.