Buying It Right

Reprint from Waren Gorham & Lamonts' "Real Estate Workouts & Asset Management"

Buying It Right or - You Want How Much?

by David J. Stoller

David J. Stoller is a principal in the firm of Stoller & Associates, Inc. a Miami, Florida based firm specializing in real estate due diligence, acquisition underwriting, portfolio analysis, feasibility studies, loan workout and asset management advisory services. Mr. Stoller has been president and CEO of a NASDAQ listed company which owned and operated 35 shopping centers in 10 states, a national commercial real estate portfolio manager with Bank of America and a senior real estate analyst with The Goodkin Group.

The process of conducting a due diligence review of a typical commercial real estate project and related mortgage as part of a pool offering must consider the strategic as well as the tactical issues relating to the investment’s life cycle. One way to approach this is to break the process of underwriting down into five stages.

Analysis

Acquisition

Asset Management

Disposition or Exit Strategy

Bid Pricing

In each of these stages, we consider the impact on the borrower’s continued creditworthiness and debt support, the property’s continued performance (or lack thereof) and the loan itself. In effect, it is a residual analysis. Value is determined through analysis while all costs, as well as the timing of those costs associated with achieving that value, are estimated and deducted from value (on a present value basis) resulting in a bid recommendation. The resulting bid amount is sometimes referred to as the derived investment value or DIV. The DIV is also sometimes referred to as net realizable value or NRV.

There are three primary players in the process of due diligence. These include:

The Seller: This is usually a financial institution such as a bank, savings and loan, thrift or insurance company. Generally, the motivation is to improve the balance sheet and increase earnings by reducing non-performing assets and loan losses. The portfolio can consist of a combination of performing and non-performing assets including loans that are paid current, loans that are delinquent and possibly in foreclosure or even bankruptcy, and foreclosed real estate referred to as other real estate owned or "OREO". Other assets in the pool can include unsecured debt and personal guaranties.

The Buyer: This is usually a joint venture between an investment bank or money partner and asset management firm. The motivation is to create a profit over and above the acquired DIV and, to a lesser extent, generate asset management fees. The money partner is typically a Wall Street house with investment banking and corporate finance resources to securitize the acquisition. Their experience is extensive and they are patient. The asset management firm is well versed on the myriad issues related to problem credit resolution. The asset managers have the lending, legal and real estate experiences necessary to develop, evaluate, understand and implement the exit strategy.

The Underwriter: The underwriter is the person(s) or firm actually conducting the due diligence. Frequently, the buyer engages the team approach including two people, a site reviewer and a file reviewer. The site review covers the real estate while the file review covers the mortgage, borrower and related documentation. Strategy and recommendations are developed jointly, but the site reviewer is generally responsible for the final disposition strategy and bid recommendations.

Listed below is a checklist of the items reviewed during the due diligence process. In a perfect world, the seller will have complete and accurate information pertaining to the property, the borrower and even the loan itself. However, in the real world, rarely is the information complete or accurate. In fact, there are times that, for various reasons, the loan documentation, payment history and even interest calculations are not entirely reliable. Consequently, when conducting due diligence, it is important to remember to check and re-check data as well as ask a lot of questions.

Due to the frequent absence of good information, the underwriter must make certain assumptions to arrive at a bid and exit strategy. Similarly, the buyer’s discount rate and resulting bid may reflect the quality of the information available. Therefore, in order for the seller to realize the highest price possible and for the buyer to mitigate as much risk as possible, the parties in the process must utilize tremendous effort to provide and obtain the most complete, accurate and timely information possible.

This checklist is meant for information purposes only and is not intended to be all inclusive for all types of due diligence.

Real Estate

Description of the Collateral: A detailed description of the real estate can be found in the appraisal. However, an appraisal is not always available. In that event, the site reviewer conducts a site assessment. This assessment includes the property type, age, size, configuration, land area, parking, amenities, location, etc. Loan collateral can also include personal property such as a hotel’s FF&E, credit enhancements, personal guaranties, security agreements, UCC’s, etc.

Market Analysis: Supply and demand analysis addresses current and "pipeline" inventory, historical absorption, cap rates, vacancy rates, historical and projected absorption, competitive audit, lease rates, concessions/abatements, tenant improvement allowances, leasing commissions, and landlord/tenant workouts, and tenant bankruptcies.

Property Taxes: Delinquency, if any; Penalties and Interest, if any; Tax Appeals, as appropriate; Assessment Districts; Improvement bond allocations, etc.

Environmental Considerations: Phase 1 Environmental Site Assessment and recommended mitigation or remediation as required.

Appraisal: When reviewing the appraisal, one must consider the effective date vs. the report date; FIRREA/OCC compliance, if applicable; Assumptions and Limiting Conditions; and if the value is "As-Is", "Stabilized", "Liquidation", etc.

OREO Property Management: Myriad reports must be analyzed including deferred maintenance, health and safety issues, daily traffic reports, advertising and marketing, capital and operating budgets, etc. The underwriter must identify areas of neglect and abuse in case the property was "milked" during the foreclosure process. These areas should also be addressed during the receivership process. Other issues to be addressed at this time include architectural and engineering, structural, HVAC, roof, electric and plumbing.

OREO Marketing: The underwriter must consider, evaluate and budget all outside contractors and vendors currently or prospectively providing services pertaining to the asset under review. Outside resources include, but may not be limited to brokers, sales and escrow activity, lawyers and title officers.

Location Analysis: Fundamental real estate issues must also be addressed such as accessibility including ingress and egress, visibility, topography, vehicle and pedestrian circulation, neighborhood characteristics including economic and demographic trends, new job formation, new construction, business and lending activity, rent trends, taxing and assessment issues.

Physical Analysis: A review of the physical plant must be addressed such as functional, economic or physical obsolescence, ADA compliance, amenities and competitiveness, deferred maintenance, health and safety issues.

Feasibility Analysis: Here again the underwriter must address fundamental real estate issues such as political, economic, social and financial feasibility, zoning and ordinance compliance, permits, licenses, etc.

Cash Flow Analysis: Comprehensive budgets and forecasts must be created to project possible yields to the investor. As stated earlier, in a perfect world, current leases supported by current estoppel letters, along with historical operating data are available to the underwriter. However, since this is not the case, the underwriter will need to make certain assumptions to conduct the analysis. These assumptions should be market based and data sourced. Different buyers use different methods for evaluating yield. The important thing to remember is that while different yields mean different things, quantity, quality and durability of cash flow is the key! Quantity refers to how much cash flow is being generated by these third party tenants; quality refers to the tenants’ creditworthiness and ability to meet its lease payments and durability refers to the remaining term of the lease (i.e. 3, 5 or 10 years with options). Some of the more widely used methods include NOI, NPV, IRR, ROE, ROI, LTV, DSCR and land residual. Typically, a five year analysis with a sixth year reversion is assumed. Generally, the exit strategy should be completed within the first year of closing the acquisition. Where a foreclosure, bankruptcy, or other litigation are involved, one to three years is not uncommon.

Mortgage

Description of the Loan: A loan summary is usually supplied by the seller. This summary contains the loan’s salient points including the current outstanding loan balance, interest rate, maturity, amortization, additional funding, participation, seniority, etc.

Current Status: This includes a review of the loan’s book balance, if the loan is on accrual or on non-accrual (i.e. 90 days delinquent even if a foreclosure action has not commenced) and status as either performing, non-performing, subperforming, substandard, doubtful or in-substance foreclosure, etc.

Loan Documentation: This is one of the most critical phases of the due diligence process. A complete review of the documents can include, but may not be limited to the promissory note, deed of trust, mortgage, security agreement, personal guaranties, multiple borrower agreements, cross-collateral and cross-default agreements, UCC filings, etc. If the documentation appears incomplete or in error, and the deficiencies can not be resolved or the seller’s representations and warranties do not adequately mitigate this risk, the underwriter should consider rejecting the loan purchase.

Loan History: A review of the loan history includes the paid through date, NOD, late payments, late fees, default interest, secured advances such as property taxes, legal fees, foreclosure costs (Trustee Sale Guarantee), receiver/trustee fees, deferred maintenance (health and safety issues), tenant improvement allowances, leasing commissions and any other costs or advances capitalized to the loan balance.

Title Review: A thorough review of the liens and encumbrances (monetary or non-monetary) must be conducted. The site reviewer is usually assisted by the buyer’s legal counsel in this part of the due diligence process. Some of the issues to address include mechanics liens, easements, seniority of primary debt, subordinated interests such as leases and other lienholders, other lawsuits, federal tax liens, current and delinquent property taxes, assessments, bankruptcy exceptions and any other clouds on title that cannot be resolved or mitigated. Here again, if this questions cannot be fully addressed, the buyer should consider not purchasing the loan(s).

Litigation Review: This is a contingent liability that the underwriter must attempt to quantify and include in the DIV/NRV calculations. Examples of relevant litigation issues include judicial foreclosure, bankruptcy and related adversarial proceedings, cash collateral and sequestration orders, receiverships, DIP reports, affirmative defenses, counter-claims, lender liability claims and/or exposure.

Borrower

Borrower Credit Analysis: This part of the due diligence is typically the most difficult as there is usually a severe lack of good information to conduct a proper analysis. In a perfect world, current tax returns and financial statements are analyzed for liquidity and equity. A current credit check (TRW,etc.) may be obtained as well as a D&B. Other borrower related documentation that should be reviewed include (where applicable) 10-K, 10-Q, annual reports, articles and by-laws to assure the borrower is in good standing and corporate resolutions to assure that the Borrower is authorized to have taken the loan. Since the loan has already been funded, the relevance of the analysis pertains to the Borrower’s ability to contribute to the exit strategy. When considering the making of the loan in the first place, the loan officer will consider the borrower’s ability and willingness to pay back the loan. These factors are equally important after funding, but more important in a default or workout environment. Therefore, the underwriter will look once again at the borrower’s ability to pay the debt.

Historical Borrower Performance: In this case, we look at the borrower’s willingness to pay the debt. For example, if the borrower is working with the lender to payoff the loan at par, or at least negotiate a discounted payoff (DPO); or has the borrower become contentious and adversarial asserting various lender liability claims. An important consideration in this matter relates to whether or not a legitimate lender liability issue exists. Another consideration is a potential or existing bankruptcy. Myriad issues surround the issue of bankruptcy such as liquidation or cramdown. In any event, a bankruptcy filing is usually a good indication that the borrower may no longer posses, the willingness, desire or even ability to pay the debt in its entirety.

Once these elements have been considered, the underwriters are ready to develop an exit strategy and bid recommendations to the client.

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1717 North Bayshore Drive, Suite 321
Miami, Florida 33132-1180
Tel: (305) 530-0046 Fax: (305) 350-6826
E-mail: exec@stollerassociates.com