- In commercial real estate lending, physical risks arise:
- When the physical features of the property under consideration are inappropriate to its intended use when compared with other successful, competitive commercial properties located within the target market.
- In the form of unexpected maintenance or remedial expenditures that are required during the term of the investment.
- From a lack of commitment and/or means on the part of an owner to make the necessary expenditures to maintain the property.
A good indicator that a greater understanding of the physical risks of commercial real estate investments is warranted occurred during the last real estate market downturn. The downturn began in the mid 1980's in localized markets like Texas and Denver and extended into the early 1990's to include most of the United States. As borrowers throughout the United States defaulted on their loan payments, commercial mortgage lenders found themselves foreclosing on properties that required massive capital expenditures to repair and renovate. These same properties just a few years before had been "inspected" and found to be in acceptable condition for the purposes of a mortgage loan. The answer to the question, "What went wrong?" was generally accepted as a fait accompli. The consensus concluded that maintenance on the property had apparently been deferred as tenants vacated and the income from leases plummeted.
This condition continued, in some cases for years, until income no longer could cover the debt service and the lender was forced into an ownership position. The lenders then were not only faced with the massive losses in market value from the lack of tenants, but also with the expenditures to correct the physical deterioration that had progressed for years. The majority of problems related to the physical deterioration of the properties could have been mitigated had all of the major physical risks been identified at the origination of the loan. In addition, loan requirements could have reflected solutions to such conditions as they surfaced.
Typically, lenders track the financial well-being of loans over the entire loan term. In contrast to this, the physical well-being of the property is expected to be provided by the one time inspection at origination. As a result, an accurate assessment of the physical well-being of the property, as the loan matures, is generally missing. As history repeats itself, disappointments and surprises in physical condition should be expected during future market downturns unless the dynamics of the "bricks and mortar" are better understood as they later influence the investment-yield analysis. As you will see in the discussion below, the physical realities can have a profound affect upon an investment’s yield and its ultimate fate.
The identification of five major issues underlying the last downturn will give some perspective. For each, I will clarify some terminology as we examine current market conditions to see if we can draw upon similarities. The issues include:
An owner maintaining little or no dollars-at-risk.
The property lacking the physical features that generate success.
Deteriorating physical condition.
The need to upgrade obsolete features.
Environmental problems.
DOLLARS-AT-RISK
"Dollars-at-risk" is the total amount that an owner has paid for a property (development cost or purchase price plus all improvements that he has made) less the amount of his mortgage. Dollars-at-risk is also known as basis. For obvious reasons, prudent lenders require an owner to maintain sufficient dollars-at-risk to assure his continuing commitment to the investment. Usually, owners are reluctant to reveal the price they paid for the property, and thus, their dollars-at-risk. When it is shared, it is likely inflated to give the impression that more dollars-at-risk are maintained.
For this reason, many loan underwriters substitute equity as a measure of an owner’s continuing commitment to the investment. Equity is determined by subtracting an owner’s mortgage amount from the market value (estimated sale price based upon an income-approach analysis and/or comparable sales). Equity represents the amount of cash that an owner would keep if the property were to be sold. Traditionally, lenders require owners to maintain an equity position by limiting loan amounts to not more than 75 to 80 percent of market value. An owner can have equity in a property and still maintain no dollars-at-risk if the loan amount is greater than the price he paid for the property. Equity is a poor measure to guarantee that an owner will stay committed to their property during a downturn. Like market value, equity is a theoretical value based upon current market conditions. As markets deteriorate, market value and equity diminish.
During the last real estate market peak of the mid-1980’s, many owners found themselves in the enviable position of having obtained mortgages that exceeded their costs. This was made possible by the then high occupancy levels within most major markets, generating net operating incomes at all-time highs. That resulted in properties qualifying for levels of debt that far exceeded the total original development cost of the property. Loan amounts at 75% of market value commonly exceeded development costs.
During the downturn that followed, those owners with little or no dollars-at-risk abandoned their properties to lenders when vacancies rose and the rents became insufficient to cover mortgage payments. The lenders had taken on all of the market risk. They took the losses as the owners walked away whole.
Current low interest rates and high rental incomes are again resulting in loans that exceed owner’s costs and extinguish their dollars-at-risk. This is made possible because property values were written down on the books of the many lenders who had foreclosed. They then sold these properties at historic low prices. In today’s booming market, the new owners of these properties are getting loans that exceed their costs. Might history repeat itself? During the next downturn, will owners once again abandon their non-performing properties to the lenders? If witness to the last market downturn was not enough, common sense should dictate that the best means to assure that an owner has a strong commitment is to require that he maintains sufficient dollars-at-risk.
During the last downturn, borrowers with a history of being strong market players whose properties could no longer support debt service exhibited some conscience with lenders. They hoped to maintain the cordial relationships that they had nurtured with their lenders during the good years, so that they could again become players when the market finally improved. Fearing the wrath of a long memory, many handed over the keys without a prolonged legal tussle.
Others, panicked by their potential losses, fought through the courts to cling to their properties. Lenders found themselves in a veritable war zone of bankruptcy court proceedings. In court, lenders learned how too little basis can trigger bankruptcy filing and "squeeze down" of lenders interests during foreclosure (for an explanation, see how dollars-at-risk can affect an owner's commitment to the property in Chapter 2). As a result, many foreclosures took years and cost hundreds of thousands of dollars in legal fees.
In today’s market, there is no need for a borrower to maintain a conscience in their relationship with the lender. All reasonable requests for loans are generally accommodated by loan originators seeking the lucrative fees generated by underwriting high volumes of loans which are packaged into CMBS pools. Review of the borrower’s default history and assurances that he maintain sufficient dollars-at-risk is not included as part of due diligence because it is not considered in the ratings provided by rating agencies. The next downturn could see property owners devoid of any conscience. Long after they stop paying debt service, they might struggle using any legal means to maintain the benefit of a property’s cash flow.
Loan underwriters that recognize the significance of dollars-at-risk use basis as a gauge to compare proposed loan amounts to their organization’s risk tolerance levels. They raise a "giant red flag" whenever proposed loan amounts allow an owner to cash out of the deal. They recognize that physical due diligence should always include the verification of an owner’s project development and construction costs or the purchase and sale documentation.
Until now, a methodology to verify the accuracy of the total development cost provided by an owner or to estimate this value when none is provided has not been available. This book provides the tools to assist underwriters in the determination of this value as accurately as possible. It provides a comprehensive guide to the estimation or verification of an owner’s project development and construction costs. These allow underwriters to verify an owner’s dollars-at-risk.
PHYSICAL FEATURES THAT GENERATE SUCCESS
There are properties that continue to perform, year after year, as economic successes. To do this they must remain leased. This requires balancing tenant satisfaction with economic return. Physical features play a large role in sustaining this balance. When the features are appropriate to maintain success, the property is said to be "investment grade real estate".
It was clear to lenders who foreclosed upon many properties that a large percentage had physical features that were deficient. Lenders found that those properties could not be re-leased to new tenants for the originally intended purpose without major alterations. It became obvious to lenders that, for future investments, deficiencies in desirable features needed to be identified and understood to avoid commitments based upon misrepresentations and misunderstandings.
As a result, many lenders have identified the features that generate success for each commercial property type within the geographic regions where loans are made. When new loan opportunities are investigated, lenders compare the features of potential new investments against those of the successful, performing properties. The theory is that those that provide desirable features and that generate success will likely stand the test of time and continue to perform to expectations. The concept of investment grade real estate represents the most basic real estate fundamental that underlies the success of every performing property. The combinations of features that generate success for each commercial property type need to be understood for entire geographic regions and within competitive marketplaces. Lenders that do not address investment grade issues run the risk that in the next downturn their loans will again be found to have physical features that are deficient and thus require expensive alterations.
The definition of "investment grade" is a moving target. Driven by market pressures to accelerate the development process, reduce construction costs and provide more (desirable) features than the competition, commercial real estate products are constantly evolving in terms of sizing, amenities, materials and construction methods. This makes it increasingly difficult to assess a property's physical features. This book provides current state-of-the-art details of the desirable physical features that provide the balance between user satisfaction and economic return. It addresses all major issues for each commercial property type within the context of diverse geographic concerns.
PHYSICAL CONDITION
At loan maturity, the owner of an investment grade property is expected to be capable of refinancing. The new loan should be of a sufficient amount to pay off the remaining principal of the current loan. This is known as take-out financing. Deteriorating property conditions endanger an owner’s ability to obtain take-out financing on the property. Physical due diligence efforts are successful when the physical condition of the property at the time of loan maturity is equal to or better than at the time of its initial funding. This requires that all major repairs and replacements expected to be needed during the loan term be identified. This further requires that the necessary funds to complete the work need to be allocated and accumulated to perform the work. This essentially guarantees that all repairs will be made, and the property will be in good repair should a borrower need take-out financing.
In structuring loans during periods of prosperity, long-term planning and budgeting for repairs appears a remote concern. Many lenders do not require borrowers to reserve an escrow for major repairs and replacements. For such capital expenditures, fiduciary reserves are merely projected and included in the cash-flow analysis. Many borrowers object to such a reserve. Some will go as far as to threaten that the issue is a deal-killer. Rather than retain an appropriate portion of the income stream for future repairs or improvements, many owners will demand that cash flow be distributed to them in its entirety. For lenders that succumb and fund loans without controlling maintenance reserves, the physical condition of their loans at maturity remains "anyone’s guess." For these properties, physical health at the end of the loan term will likely mimic market strength. If market performance is poor, the physical condition will follow, leaving a lender fully at-risk to this issue.
When all of the excess cash flow from past good years has been distributed to the owners and market performance then drops below expectations, there is no cushion of cash to perform repairs. Consequently, a drop in occupancy creates a drop in income, which leads to an accumulation of unattended physical deterioration. Tenants start to vacate as the property becomes less desirable. Eventually mortgage payments are missed and the loan goes into default. By the time the foreclosure is culminated, deterioration can be significant. As experienced by most lenders during the last downturn, the cost to repair many properties was so huge as to be prohibitive. All too often, the resultant losses equaled the total value of the loan.
This book provides a comprehensive guide to the understanding and identification of all of the major physical risks for each commercial property type. Many insights regarding the elimination of these risks are presented, including methods of structuring adequate reserves to not be perceived as onerous or at cross purposes to a borrower’s interests.
OBSOLETE FEATURES
Older properties often contain obsolete features that need to be upgraded when buildings are renovated. This is frequently encountered in situations where renovation, reconfiguration, or redevelopment of a building’s interior triggers existing laws and code requirements. Most common are life-safety upgrades such as the addition of smoke detection, annunciation, fire sprinklers, and elevator-recall provisions as well as modifications in accordance with the Americans with Disabilities Act (ADA). The need to remove friable asbestos-containing material (ACM) surfaced as a unique public health issue facing properties constructed prior to 1978. For the numerous properties that had to remove ACM, this removal likely represented the most costly item within this category. Other commonly encountered items include unavoidable operation upgrades such as retrofit of chillers to non-CFC refrigerants and lighting upgrades to utilize replacement bulbs for non-energy efficient, phased out products.
Older properties raise the specter of potentially high costs to retrofit interiors for the correction of functional obsolescence, the term used to describe these items. This is particularly significant if future renovations are likely to trigger the event. During the last downturn, the need to upgrade obsolete features was frequently encountered by lenders after they had foreclosed or held or maintained an indicia of ownership. Lenders seeking to renovate the older foreclosed properties found themselves required by laws and codes to include expensive life safety upgrades, ACM removal, and ADA modifications. Later when they went to sell the renovated properties, further losses accumulated. They found that market values and sale prices were reduced by the remaining operation upgrades (i.e. chiller retrofits, lighting upgrades, etc.) that had not been performed.
Items of functional obsolescence represent an ultimate liability to the property. As demonstrated, an ultimate liability reduces the present market value. One must always assume that a prudent purchaser would identify items of functional obsolescence. Costs to correct items of functional obsolescence should be reflected in the savvy purchaser's offer. Lenders that recognize this require that loans to older properties include provisions to correct some or all items of functional obsolescence during the loan term. They recognize that obsolete features ultimately will have a negative impact upon market value, particularly following a major downturn.
Most property condition reports used in the evaluation of the physical risks associated with new lending opportunities do not identify items of functional obsolescence. They are usually never addressed in reports for Commercial Mortgaged Backed Security (CMBS) pools. The ramification of obsolete features is not included as part of CMBS due diligence, because it is not specified in the property condition assessment criteria of the rating agencies.
All owners of buildings where asbestos assessments were performed prior to October 1, 1995 face a dilemma. They must determine if the sampling and testing conformed to the Asbestos Hazard Emergency Response Act (AHERA). If it did not, they have a choice in complying with the requirements of the current U.S. Occupational Safety and Health Administration 1994 amendments to 29 CFR 1910 regarding occupational exposure to asbestos (known as the OSHA Asbestos Disclosure Regulations). They must either:
Perform a new assessment (conforming to the higher AHERA standards) to confirm the presence or absence of asbestos containing materials (ACM); or Develop a new Presumed Asbestos Containing Material Operation and Maintenance (PACM O&M) program.
Lenders who loan on properties where compliance with current OSHA amendments has not been confirmed expose themselves (as "potential responsible parties," as defined in the OSHA Asbestos Disclosure Regulations) to the risk of unknown costs to comply in the future. In addition, lenders are exposed to the risk of toxic tort liability for any ACM that had not been identified using lesser standards in the past.
Many owners who removed asbestos in the past take the position that further sampling and analyses constitute an unnecessary cost, and chose to operate under a PACM O&M plan. They recognize that future removal of the PACM will require sampling prior to the demolition preceding renovations. From a lender’s standpoint, without further sampling prior to closing the loan, it is unknown whether or not a significant volume of ACM exists as defined under the more severe AHERA standards. If it does, eventual removal and disposal costs could be high, and the remaining ACM represents an ultimate liability to the property. If the cost of further assessment work were the only issue, the decision to postpone testing to the more severe AHERA standards could be viewed as a "pay me now, or pay me later" issue. With confidence that no ACM exists, the cost of periodic sampling and testing would not constitute a significant risk. Concerns arise in not knowing whether or not the ultimate liability of remaining ACM, as defined under the more rigid standards, may be significant. This book shows how a lender can often develop comfort regarding this issue by using a little common sense.
ENVIRONMENTAL PROBLEMS
During the last downturn, the biggest surprise was environmental problems. For loans made prior to 1986, incurring liability for on-site hazardous substances or fuel oil contamination was not part of the collective consciousness of the lending community. Under the federal Superfund Amendments and Reauthorization Act (SARA) of that same year, the concept of "potentially responsible parties" was introduced. For the first time, persons who had no involvement in creating a hazardous substance problem could be jointly and severally liable for the cleanup simply because they were current "owners" or "operators" of the property.
Every lender can expound upon the numerous environmental problems that surfaced as they began to conduct "routine site assessments" to make "appropriate inquiry" into old loans that defaulted on their mortgage payments. Lenders were surprised by the liabilities that they faced. Certain property types and traditional categories of tenants that had been considered as reliable sources of revenue were transformed into pariahs. Dry cleaning operations, auto service stations, quick-stops selling gasoline, manufacturing operations handling chemicals, any property with a subsurface sewage disposal system, floor drains or underground storage tanks, filled land, properties with past histories of nearly any type of manufacturing — these were some the images of recurring nightmares. Lenders expanded their vocabularies to include "first and third party environmental risk." When lenders needed to take title to many of the under-performing properties within their portfolios, they were faced with first remediating soils and groundwater. Many had loans on properties that were too contaminated to take title. In these cases, rather than foreclose, lenders were walking away from loans. As a result, environmental issues joined the list of problems which caused lenders to write-down the entire book value of some loans.
Nowadays, lenders have grown confident in screening new lending opportunities for environmental risks. They almost universally utilize third party consultants to conduct Phase I Environmental Site Assessments in accordance with the nationally recognized ASTM guidelines. After having survived the environmental surprises of the past, they could not imagine ever exposing themselves to such risks again. Now, most believe they understand site cleanup procedures and the protocols involved in traversing the regulatory maze: ranging from identifying on-site contaminants to obtaining regulatory clearance with state’s letters of "no further action required." Most have also developed confidence in extending loans to formerly contaminated sites that have been cleaned up.
I find that few lenders are aware of the potentially significant environmental risks that may be looming over many of their loans. To begin with, a new national debate centers upon the fear that many sites, judged to be already cleaned up under a state voluntary cleanup program (and possess the state’s assurance of "no further action required"), will be subject to the stigma of "reopening" in the future. Reopening refers to the specter of additional remediation of on-site contaminants after the initial cleanup has been completed and approved by environmental regulators. It results from the awareness of the likely future consequences to a developer who successfully, and in good faith, remediated a site to the satisfaction of an "under-performing state’s" voluntary cleanup program.
Should a lender be required to foreclose on a property that is subject to "reopening", as new owner, the lender would inherit any residual environmental risk. An owner could be judged to be a potentially responsible party. If reopening became an issue during foreclosure proceedings, a lender could avoid the environmental liability by choosing to follow EPA’s "guidelines" - the lender must avoid managing the property and sell the property as soon as possible. Buyers of impaired properties tend to be the bottom fishers. Such a sale will likely result in a big loss.
The current status of environmental regulations has state regulatory programs at odds with the federal EPA. Relations are cordial, but no less at odds. The current political climate that encourages "states’ rights" has empowered states to develop their own versions of Voluntary Cleanup Programs (VCP’s), whereby an owner of a contaminated site approaches the state voluntarily to work out a cooperative process to ready the site for redevelopment. All the releases of liability typically offered to date under the auspices of state voluntary cleanup programs do not offer any guaranteed liability protection to lenders of contaminated property. All have provisions for "reservations of rights", in which the state reserves the right to make further requirements should some future problem result from the contaminated condition. As such, owners of "state approved" sites that have been cleaned up to the standards adopted by the state are not immune to further action or litigation.
Besides the liability issues, the residual contamination levels that remain on site raise concerns. The state voluntary cleanup programs are all based upon the philosophy of risk-based corrective actions. With this approach, contamination is permitted to remain in soils and groundwater at concentrations that far exceed traditional prescribed numeric standards, as defined in current federal regulations. Based upon this approach, contaminants that remain are most often "remediated" merely by implementing institutional controls (i.e. deed restrictions, operating agreements, etc.) and containment strategies (horizontal and vertical barriers). These run the risk of not being 100% effective. By their nature, they are vulnerable to the simplest of on-site maintenance activities performed by uninformed individuals. This can result in contaminants migrating off-site and causing unforeseen problems.
There are other issues of concern. At present, EPA is trying to organize the process by setting standards for state programs to follow. This attempt has not been well received by the states that refuse to voluntarily resubmit to any central control by EPA. The state programs have the present support of Congress. On the local level, they have been, and continue to be, very popular with their constituents. The programs are viewed as a most valuable contributor to economic revitalization. Where once many contaminated sites lay dormant for years, they are now being recycled and are viewed as fine candidates for capital investment.
These issues and more are fueling the national debate popularized by the phrase, "How clean is clean enough?" The prospect of a new round of environmental problems is certainly not anything that lenders want to face again, particularly during a downturn. Few lenders would likely consider the risk of re-opening as acceptable, had they been aware of this prospect. These, and all other related environmental issues, are addressed in detail within this book for all those who need to know more. I’m sure that you will appreciate how this book clarifies all of the contemporary environmental issues, including the manner in which the answer to "How clean IS clean enough?" is emphatically provided.
THE NEED TO IDENTIFY ALL PHYSICAL RISKS
There is a need for lenders and investors in commercial real estate products to understand the importance of the identification of all physical risks that can result in major capital expenditure requirements. Their negative effect upon cash flow is frequently overlooked in determining market value. Many real estate lending professionals have learned from the last real estate market downturn that more attention needs to be focused upon the fundamental analysis and valuation of the collateral. They recognize and are concerned that their colleagues do sometimes not understand that an appraiser’s obligation in estimating market value is to reflect market behavior. In doing so, a professional appraiser will mirror the actions and investment criteria of active buyers and sellers of the type of real estate involved. As was the case in the late 1980’s, active market participants’ behavior does not always reflect what the market value should be with respect to sound underwriting principals, but rather what is evidenced in the market at the time of the appraisal. Thus market data, rather than professional judgement of the appraiser, forms the basis of selecting a yield capitalization rate (discount rate) and, thus, the property’s market value (Willison, 1995).
It is common for an appraisal of a given property to not reflect projected capital expenditure (replacement) reserves if the net operating incomes (NOI’s) of comparable properties from which the overall capitalization rate was derived did not include reserves. Though this practice may be acceptable for determining market value in a real estate transaction where the buyer is a user, it should be unconscionably obvious to a loan underwriter that it is not acceptable from an investment-yield perspective. Well informed underwriting recognizes that income property finance is a risk management activity of the most sophisticated variety, and that loan underwriting involves considerably more than property valuation. From a lending risk prospective, this requires that cash flow analysis and risk tolerance levels always be based upon all identifiable property-specific criteria. If the industry is to reduce portfolio losses in the next market downturn, lenders cannot abandon fundamentals to worries about competitive advantage. They must consistently direct and apply sound underwriting procedures that reflect the physical risks.
