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How do you audit a rent roll in property due diligence?

A vendor's rent roll shows what a building can earn; diligence has to establish what it does earn, and which of the differences will last.

Julian R. Sterling · from Real Estate Transaction Due Diligence

Reconcile every line of the vendor's rent roll to the signed lease, any side letter and twelve months of bank receipts, then split each difference into permanent and temporary. Capitalise the permanent ones at the yield and deduct the temporary ones once, at their present value. On an illustrative office quoted at 40,000,000 on a 2,400,000 rent roll, five findings cut the price by 1,340,870, 3.35 per cent, even though the rent receivable on day one is 330,000 lower than the roll.

Worked in full in Real Estate Transaction Due Diligence by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →

A rent roll is a summary prepared by the seller, usually by its property manager, and it is built to show the income the building can earn. Due diligence has to establish the income it does earn, and the income it will earn once temporary problems pass. The two lead to different numbers, and the price follows only one of them.

The assumptions

Illustrative multi-let office, as presented by the vendor

Input	Value
Rent roll total	2,400,000
Yield used to price it	6.0%
Quoted price	40,000,000
Discount rate for temporary items	7.0%
Letting fee on a new lease	15% of first year's rent

Step 1: tie each line to three sources

For every tenant, compare the rent roll with the lease and its variations, with any side letter or concession, and with what the bank actually received. Five tenants failed the test here.

Findings of the rent roll audit, per year

Finding	Nature	Rent roll	Verified
Rent review assumed settled, not yet agreed	permanent	180,000	160,000
Rent shown including service charge	permanent	25,000	0
Tenant in administration, re-let at a lower rent	permanent and temporary	150,000	140,000
Side letter: 15% off 300,000 for two years	temporary	300,000	255,000
Unit at heads of terms shown as let	temporary	90,000	0 for now

The bank statements are the check that the list is complete. With the side letter, the unlet unit, the two overstatements and a tenant that paid only 75,000 before entering administration, twelve months of rent receipts, with service charge collections separated out, should come to 2,145,000. If they show less, there is a finding still to find. On a large multi-let building it is tempting to sample; the safer rule is to test every tenant above a set share of income and every lease that expires, breaks or reviews within the first two years of the hold, because that is where the roll and the leases most often diverge.

Step 2: price the permanent differences

Three differences last for as long as the building is held: the unsettled review (20,000), the service charge counted as rent (25,000) and the lower rent on re-letting the administration unit (10,000). Together, 55,000 a year, taking the stabilised rent to 2,345,000.

Step 3: price the temporary differences once

Temporary shortfalls end, so they are deducted once, at their present value at 7.0 per cent, with the cost of re-letting where a new lease is needed.

Temporary shortfalls against the stabilised rent

Item	Undiscounted, fee included	Present value
Side letter: 45,000 for two years	90,000	84,176
Administration unit: 12 months void, 6 rent-free, 21,000 fee	231,000	219,321
Heads of terms unit: 9 months void, 6 rent-free, 13,500 fee	126,000	120,706
Total temporary		424,203

The result

Price adjustment from the rent roll audit

Component	Amount
Quoted price	40,000,000
Permanent, capitalised	−916,667
Temporary, present value	−424,203
Adjusted price	38,659,130

The rent receivable on day one is 2,070,000: the roll less the five findings in full. That is a yield of 5.17 per cent on the quoted price and 5.35 on the adjusted one, while the stabilised 2,345,000 yields 6.07 per cent on the adjusted price. Report both to the investment committee; price on the second. The same split between temporary and permanent shortfalls is worked for a single concession in adjusting a purchase price for a rent-free period.

What if: the yield

The permanent findings scale with the multiple; the temporary ones do not.

The same findings at different pricing yields

Yield	Quoted price	Permanent, capitalised	Total adjustment	Adjusted price
5.0%	48,000,000	1,100,000	1,524,203	46,475,797
6.0%	40,000,000	916,667	1,340,870	38,659,130
7.0%	34,285,714	785,714	1,209,918	33,075,797

At a 5.0 per cent yield, each 1,000 of overstated permanent rent is worth 20,000 of price. That is why in prime markets the unsettled rent review, which looks like a timing detail, is the finding worth the most negotiation.

The common mistakes

• Capitalising the day-one shortfall. 330,000 divided by 6 per cent is 5,500,000, a price of 34,500,000. That overstates the cut by 4,159,130, because most of the shortfall ends within two years.
• Treating heads of terms as a lease. Until it is signed the unit is vacant. Price the void and the incentive, not the rent.
• Reading only the leases. Side letters and concessions often sit in correspondence. Ask for them by name and confirm them against receipts.
• Accepting gross figures as rent. Service charge and insurance recoveries pass through; they do not support value.

All figures are illustrative. Where the vendor gives a warranty on the rent roll, its value depends on the limits and baskets in the purchase agreement, which is a separate calculation from the price.

Takeaway

• Reconcile roll, leases and receipts; the receipts prove the list is complete.
• Capitalise only permanent differences: 55,000 a year is 916,667 at 6 per cent.
• Deduct temporary ones once at present value: 424,203 here, for a total cut of 1,340,870.

Every finding of this kind, and how it was carried into the price, is tracked in the free workbook for this book.

Questions readers ask

What documents do you check a rent roll against?

The signed leases and their variations, any side letters or concession letters, rent review memoranda and at least twelve months of bank receipts. In the illustrative case rent receipts, net of service charge collections, should total 2,145,000 against a 2,400,000 roll; the gap must be fully explained by the findings, or the audit is not finished.

Should an unsettled rent review be included in the rent roll?

Not at the assumed figure. Until the review is agreed or determined, the contracted rent is the old rent. In the illustrative case a review assumed at 180,000 against a contracted 160,000 overstates rent by 20,000 a year, worth 333,333 of price at a 6 per cent yield.

How do you treat a tenant in administration in a rent roll?

As a likely vacancy: remove the rent, price the void, the rent-free period and the letting fee once, and capitalise any lasting drop in rent. In the illustrative case a 150,000 tenant re-let at 140,000 after a year's void and six months free costs 219,321 in present value plus 10,000 a year permanently.

Also on this site

• How do you adjust a purchase price for a rent-free period?Cost temporary shortfalls once, capitalise only permanent ones: £568,805 off a £24.43M price, not the £5.94M that pricing on today's income implies.
• How do you calculate net initial yield with purchaser's costs?Receivable rent less non-recoverables, over price plus purchaser's costs. A building quoted at 6.93 per cent verifies at 5.70, 123 basis points lower.
• Tipping vs deductible basket: what can a property buyer recover?Tipping recovers from the first pound once claims pass the basket; deductible only the excess. On 375,000 of claims and a 240,000 basket: 375,000 vs 135,000.
• How much does due diligence cost on a commercial property deal?Count the bids you lose. A 310,000 budget on a 30,000,000 deal is 1.03 per cent; at one win in four it costs 542,500 per completed deal, 1.81 per cent.
• How do you price building survey capex into the purchase price?Load, inflate and discount every item, including those after your exit: a £2.35M survey schedule takes £2.43M off the price, not £1.23M inside the hold.
• How do you size a retention on a property purchase?Works plus fees plus contingency, inflated to the works mid-point: a 400,000 roof estimate needs a 546,419 retention, 1.37 times the surveyor's figure.

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