The PCA or Property Condition Assessment is a consulting report offered by LOGAN in Latin America that is designed for the acquisition of properties by investors or real estate funds. The PCA product is offered by the consultants of LOGAN in Mexico, Colombia, Peru, Costa Rica, Guatemala, and other Latin American countries and is based on the ASTM International Standard. The purpose of this brief article is to touch on the uses of the report and related reasoning for ordering it.
Negotiation
A PCA is a tool used by professional investors to/ negotiate down the price of an asset during the due diligence period of an acquisition. The negotiation process starts with a Letter of Intent (binding or non-binding) and or a Purchase and Sale Agreement (PSA), where the two parties agree to the terms of the transaction – timing, deposits, prices etc. What is often overlooked, or sometimes not defined, is the status of the property. What condition is the asset being sold in?
According to a typical PSA, assets are usually presumed to be in ‘good’ condition – however this is not always the case. After signing the PSA, the buyer should order a PCA or Property Condition Assessment, produced by a third-party consultant to evaluate the status of each component of the property. With this report, the buyer can then thereby negotiate the price downward in order to compensate for repairs that need to be made or require the seller to improve the property to the expected standard before closing. Sometimes this is a binding condition in the Purchase and Sale agreement – meaning that the seller is required to improve the property or deliver it in the required condition.
Example Scenario
An investment fund or Fibra Ultra has just signed a Purchase and Sale agreement to acquire an industrial warehouse in Mexico City. The contract requires a deposit of 20% that is held as non-refundable, and the seller is required to deliver the property in ‘excellent’ condition. There is a due diligence period that starts from the signing of the PSA and the deposit that extends for 90 days. At the end of the 90 days, the remaining 80% payment is made, and the property is delivered. The investment fund decides to order the PCA or Property Condition Report from LOGAN to verify the condition of the property. LOGAN begins work and sends its team of property inspection experts to review the asset. Photos were taken and the property is visually reviewed – however, upon the review of the roof, LOGAN notices signs of water damage, and cracks in the impermeable surface. LOGAN investigates the age of the roof and finds that it is 40+ years old – which is beyond the useful life of this type of roof. After reading the PCA the Fibra Ultra contacts the seller and notifies them of the findings. Fibra Ultra then negotiates that the seller either replace the roof or reduce the purchase price by the cost to replace the roof. The seller decides to ask for a cost estimate from a contractor and reduce the transaction price by the cost to replace the roof. By ordering a PCA during the due diligence process, the buyer has saved over $100,000 dollars.
Refining the Acquisition Model – CAPEX Reserve
Refining the Financial Model – The financial model of an acquisition is a sensitive tool that real estate funds and professional investors use to decide which assets to purchase and at what price. Usually there is a minimum targeted return that real estate funds will accept for a particular asset in a particular location. Clearly, it is the interest of the acquisitions team of each fund to buy assets that have returns superior to the minimum acceptable return of the fund. This return is considered a discount rate or TIR (Latam) that is influenced by the free cash flows of a potential investment. The higher the free cash flow that returns a property (NOI) year by year, the higher the return the investment will yield. The estimation of the free cash flow is constructed by acquisition analysts by projecting rents and costs. One cost that is easily overlooked is the capital needed to replace components of the building referred to as capital improvements. This CAPEX percentage is usually linked to the income of the property and is used to replace items such as flooring, roofing, or mechanical equipment that wears out over time. A slight variation can have a big impact in the projection of the returns of an investment – and if this ratio is not estimated properly, buyers can make the mistake of buying properties that do not yield the minimum return threshold of the investment fund. Special attention must be paid to the CAPEX requirement for older properties, as their condition may vary greatly due to the level of maintenance and renovations completed prior to the transaction. In turn, the CAPEX reserve % for older properties may vary greatly as well.
Example Scenario
A buyer from Fibra X of Peru has just gone under contract on the purchase of a 30-year-old office building. They have signed a purchase agreement that gives them 60 days to review the property, before closing the transaction with the remaining 90% of the purchase price (a 10% deposit was made). Fibra X hires LOGAN to do the PCA, and LOGAN completes the detailed inspection the following week.
During the inspection of the property, it is noted that by LOGAN that the backup generator appears to be old, with rust appearing along some of the joints. Upon further inspection of the maintenance records provided by the seller, it is noted that the backup generator has not been serviced for 10 years, nor tested. The remaining life of the generator is estimated to be 2 years or less. In the PCA report delivered to the buyer, LOGAN notes this as a major concern, and within the replacement reserve table includes the replacement of the backup generator in year 2. This significant cost in year 2 skews the projected CAPEX percentage to 4% per year. When Fibra X uses 4% instead of the 2% for a CAPEX reserve in its acquisition model as originally projected, they realize that the investment is not feasible. The acquisition team decides to cancel the PSA based on the condition of the backup generator and peruse other acquisition opportunities. Fibra X can present the PCA of LOGAN to request the return of the deposit made, since the property is not in ‘excellent’ condition.