Eight risks that can turn investment properties into financial nightmares
Astute investors know that all properties have defects which if not identified during due diligence, can be money pits. There is a small window of opportunity during the brief due diligence period to identify these risks prior to purchase.
Identification of risks provides a bargaining opportunity to either negotiate a reduced price or request the risks be removed at the vendors cost. Risk avoidance can be achieved with meticulous due diligence, particularly in investigation of eight potential deal killers listed below.
1. Asbestos contamination risk?
Asbestos materials of various types were commonly used in Australian property construction between 1940 and 1990. Asbestos materials were embedded in wall cladding, roofs, gutters, drain pipes, vinyl flooring, electrical wiring thermal insulation, boilers, exhaust pipes, switchboards, thermal insulation and inside fire doors.
The new National Work Health and Safety Act of 2011 requires owners of buildings constructed before 2003 to conduct an asbestos survey. Where asbestos materials are identified, this triggers the mandatory requirement for an asbestos register and asbestos management plan (AMP). Some property owners appear to be unaware of this new obligation.
An asbestos register is necessary to track of asbestos materials remaining (or removed) in investment properties. Asbestos may also be located in inaccessible areas and unfortunately discovered during re-development with sometimes disastrous and costly results. Asbestos materials if disturbed can cross contaminate internal areas of the buildings, requiring evacuation, loss of rent and potential occupant litigation.
Asbestos removal is a legally notifiable project, which can result in extremely costly asbestos removal projects. Careful investigation during due diligence can forewarn investors, revealing the true cost of asbestos removal. Armed with detailed information and cost options, investors can then more accurately evaluate if they wish to proceed with the purchase or avoid the risk.
2. Electrical switchboard over-loading and fusion risk?
Building electrical cables and switchboards can become over-loaded with tenancy changes and added electrical equipment. The overloading of wiring inside electrical switchboards can remain undetected for many years. Electrical fusion is one of the primary causes of fires within buildings where overheating of electrical switchboards and wiring starts fires.
Further electrical risks can include lack of earth leakage protection (ELP) to reduce the risk of electrocution to occupants. Poor quality electrical installation and modifications over time, can overload electrical switchboards leading to potential fires or equipment failures.
A review of electrical maintenance should be included in due diligence investigations to identify weaknesses and potential costly failures. Where electrical maintenance is inadequate this may void insurance cover, with owners exposed to remediation costs.
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3. Fire and life safety non-compliance risk?
Fire and life safety systems for buildings require continuous testing and mandatory certification to confirm the fire detection and protection equipment will function to design when there is a fire.
Where buildings are refurbished this may trigger a mandatory requirement to upgrade the entire fire protection systems to the current Building Code of Australia (BCA) fire standards (This mandatory trigger activates when 50% of the building is refurbished within a three year period). Upgrading can require new fire sprinklers, fire stair pressurisation, new fire hydrants in fire stairs, smoke hazard management, and in extreme cases additional fire exit stairs.
Upgrading of fire protection systems can incur considerable cost and potential risk and cost of compliance should be calculated before settlement. Due diligence investigation should include a review of lease expiry dates and tenancy refurbishment timelines, to avoid trigging the 50% over three year rule.
4. Environmental site soil contamination?
Site contamination can occur from past site use, for example, contaminated industries such as petrol stations, industrial storage, chemical processing industries, dry cleaners, processing industries. Underground storage tanks (UST) even if removed, can leave toxic contaminants in sub-soils to contaminate the land and surrounding sub-terrain water courses. This may contaminate neighbouring properties, with the potential for future litigation.
Testing and soil removal can be a considerable expense particularly where the site is close to public waterways and the risk of cross contamination is high. The potential for sub-soil contamination is a risk often overlooked by property investors and an issue that should be investigated during the due diligence phase.
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5. Structure and façade water proofing risks?
Structural problems can include subsidence of foundations, cracking of walls, concrete cancer, leaking roofs, leaking windows or facades, flooding risk, or low earthquake resistance structures.
Where structural defects are identified, costs for repairs need to be estimated and negotiated with vendors prior to settlement. Unforseen property defects can result in major capital cost to correct structural weakness. Building changes and additions to original structure may overload design foundations with movement and consequential structural cracking. Façade deterioration can result in water entry and major internal damage.
In locations close to flood prone areas, underground basements and car parks may be flooded by back-flow of water through stormwater drains or sewers mains (i.e. Brisbane floods). Property constructed close to rivers beaches and harbours may also be impacted by salt migration and increased risk of rust and concrete cancer of steel reinforcing. Structural issues should form part of the due diligence investigation.
6. Disabled access non-compliance risk?
The 1992 Disability Discrimination Act (Commonwealth) has provided a standard that requires all buildings to provide dignified access with special facilities for people with disabilities (PWD). This has been codified in Australian Standards AS1428.1 as a requirement in new construction under the Building Code of Australia.
Where older buildings are refurbished, a mandatory requirement mat be triggered to upgrade the disabled access features to current Australian Standard AS1428.1. This can result where 50% of the building is refurbished within a three year period. Major capital expenditure could be necessary to provide new entry ramps, wide disabled parking bays, upgrading of lift controls, tactile ground surface indicators (TGSI) and large unisex disabled toilets, on each occupied floor in excess of 500 square metres.
Potential risk and cost to upgrade the investment property to fully comply with disabled access standards AS14281 may be overlooked during property acquisition. The requirement to provide disabled access and facilities can also be triggered with local government building approvals for tenancy fit-out where floors areas exceed 500 square metres.
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7. Air conditioning life cycle failure risk?
Air conditioning is not a luxury but an essential business component for tenants in modern buildings. Air conditioning systems are not like red wine and improve with vintage, but conversely deteriorate over time. Air conditioning plant and equipment have finite service lives with cooling and heating capacities slowly deteriorating over time. Original design cooling and heating capacities may be under-sized or mismatched to current occupancy loads. Additional air conditioning equipment may be required to meet comfort conditions specified in tenancy leases.
Due diligence should include condition and remaining service life of the air conditioning equipment. Replacement of air conditioning systems can require considerable capital expenditure that should always be estimated during due diligence. Replacement costs for air conditioning over a 10 year investment timeframe can result in large negative cash flow that needs to be included in calculation of internal rate of return (IRR) and return on investment (ROI).
8. Lack of mandatory certification to building codes?
In some cases where mandatory requirements for development approval, building approval or Occupancy Certification are incomplete this can lead to serious future consequences, including potential litigation from statutory bodies, potential restricted use by fire authorities and major difficulty in future when selling the property and non-compliance issues revealed.
Where non-compliance issues are unrevealed at settlement the obligation to remedy these issues becomes the responsibility of the purchaser. Non-compliance can include incomplete development approval conditions, incomplete Building Code of Australia BCA certification, Incomplete Occupancy Certification or lack of Annual Fire Safety Certification.
Where comprehensive technical due diligence is completed, these non-compliance risks can be revealed, and investors have the ability to either avoid the contract, or request a reduction in contract sum to compensate for rectification.
A further option is to request the vendor rectify the non-compliance risk and hold in escrow an agreed sum equivalent to the cost for the purchaser to rectify the risk. Where the vendor is unable to rectify the risk, the sum in escrow is able to be utilised by the investor to remedy the risks.
Comprehensive due diligence allows prospective investors to gather factual information about the condition, remaining service life, statutory non-compliance or other major property risks. The investor can then make a fully informed decision to either accept or avoid a contract on an investment property.
Clive Burrows is the founder of Risk Management Group, an Australian due diligence consultancy that has undertaken in excess of 200 due diligence investigations on $11.9 billion of commercial real estate transactions over the past 20 years.
You can contact Clive via email.