Applying this checklist can significantly increase a distressed project’s value and eventual sales price.
With the seismic rise of commercial real estate loan defaults, many lenders have become reluctant owners of real estate–owned assets (REOs). Taking ownership of nonperforming real estate holdings is often considered a last resort, mainly because financial institutions do not have the resources and experience to manage and operate them while maximizing their value. Lenders often want to get the properties off the books as soon as possible at fire-sale prices.
But there is a better option: developing a comprehensive strategy that protects and increases the value of the REOs and their eventual sales price. By gathering due-diligence information about the sources of a foreclosed property’s value, its future expenses, and its risks, the distressed asset has the potential to generate tremendous opportunity. And the sooner this opportunity can be realized the better, because the property’s market value likely will depreciate every day.
The following checklist is a tool to help lenders manage REOs and increase their value at the same time.
Take charge; do not let properties decay. Unfinished buildings can deteriorate rapidly. The longer they are left in the open, the more value they lose. Simple steps such as installing roofing materials, waterproofing, and addressing drainage and erosion can halt further losses and reduce the likelihood of additional incremental expenses. Open trenches, heavy equipment, and building materials are a hazard to everyone. Waiting to install fences, fill open trenches, and remove other dangers increases the risk.
Do not delay addressing resident and stakeholder concerns about deferred maintenance, late payments, and other frustrations. Delays make a bad situation worse and can end up consuming more time. They also increase the risk of liability, a damaged reputation, and potential lawsuits. When you take over a property, send a letter to residents and stakeholders stating that hazards and nuisances will be addressed as soon as possible. By doing so, you restore confidence with the community, build valuable goodwill, and even buy some time.
Make sure you know what you own. The REO lender cannot increase the value of something it cannot define. Approach this step as though you were a buyer conducting due diligence. Begin assembling information about exactly what you own as soon as you hire contractors. A review of the property’s most recent appraisal can provide detailed property descriptions, maps, photos, plans, and more. Other sources of information include property tax records and even the former owner, who might be able to provide plans, regulations, third-party agreements, and other important documents.
Protect your entitlements. Entitlements are a property’s zoning, land use, or other development rights and are critical to its value. Entitlement due diligence focuses on whether the property can be developed, used, or redeveloped for the purposes intended. It also examines whether the borrower complied with federal, state, and local requirements and if zoning or permitting changes occurred that may affect the asset’s real value. In addition, entitlement due diligence takes into account other issues of regulatory compliance that typically are not covered by appraisals or environmental consultant reports, yet may significantly affect the property and underlying loan.
If the existing entitlements do not fit today’s market, it is equally important to try to amend them for greater flexibility. For instance, an REO development that was zoned five years ago for several hundred single-family homes targeting affluent buyers might not work in today’s environment. However, it might be able to serve different customer segments. The new owner could change the zoning plan to include different types of housing and even retail spaces. If the original zoning plan allows some flexibility, it may be fairly easy to negotiate a new mix. If not, the lender should explore alternatives with local authorities. The government might be interested in revising the zoning in exchange for more open space.
You may determine that you can hold the same asset for six months, spend a modest amount of money to complete the entitlements, and sell the asset for significantly more than it would be worth without the entitlements completed. Your goal is to protect or obtain development rights that offer prospective buyers maximal flexibility and make the property more valuable.
Stay up to date with CERCLA’s safe harbor provisions. It is important when owning brownfields or other environmentally tainted properties to pay close attention to the limitations of the safe harbor provisions of the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA).
For example, consider a 2007 case in the U.S. District Court, Southern District of New York, involving HSBC Bank: the almost $1 million settlement should serve as a reminder that the provisions are not without boundaries.
The U.S. Environmental Protection Agency ruled that HSBC’s decision to cut off funds for waste management—and its knowledge that the owner intended to walk away after defaulting on its loan, leaving the hazards unremediated, if it did so—constituted participation in management, and that HSBC had effectively controlled the handling or disposal of the hazardous materials.
When it comes to CERCLA or state environmental cleanup liability, many of the devices routinely used as a part of the foreclosure or workout process to limit liability may not be effective. Lenders should work with appropriate counsel and stay up to date on CERCLA’s safe harbor provisions.
Watch out for hidden obligations. Sometimes the factors that affect a property’s potential value are invisible. For example, if a developer bought a large parcel of land and agreed to build schools on the property at specific future dates, the bank that now owns the project is responsible for building those schools. In addition, this obligation will transfer to whoever buys the development and will probably affect its sale price.
Thorough due diligence should reveal the existence of any such agreements, and it may be possible to renegotiate them. Regardless, the obligations should be disclosed to prospective buyers.
Think like an owner instead of a lender. To be successful with an REO deal, lenders must know what sets their properties apart. Ask the questions an owner would ask. What is most appealing about this property in today’s market? How much more could it be worth with different zoning? How can I build goodwill with residents, local officials, and other stakeholders? Have I examined all the revenue opportunities and probable costs? How do those affect the development’s appeal and value to a buyer?
Maybe you have the option of selling an REO property quickly. But if you want to minimize the negative impact of REO assets and maximize their returns, the alternative is the only smart choice.
