How to Be Prepared for Distressed Assets in 2024

Though there is recent optimism for an improving CRE market in 2024, there is still reason for concern about a potential wave of distressed assets coming due to several factors – reduced property values in several sectors, softening rent growth, a higher interest rate and tightened credit environment, and a wave of maturities coming due that will have trouble refinancing.

When a loan starts to exhibit signs of distress – whether the distress stems from the property itself, the market, or the borrower/owner – lenders start taking a closer look at what is going on with the property and preparing for what decisions they may need to make. Currently, banks are doing whatever they can to avoid taking the keys back, while special servicing groups and loan workout groups are bracing themselves for a potential influx of troubled loans. It has been a while since the industry has had to deal with a high volume of distress and the challenge with these loan workout groups is that they don’t stick around once markets correct themselves – I have heard them joke that they “work themselves out of a job” as they work through the stack of problem loans. This means that lenders and special servicing outfits are now rebuilding and retraining those teams on how to navigate this process and what due diligence should be done to aid in their decision making, avoid potential liabilities, and minimize loss.

Relearn the Due Diligence Basics and What Has Changed Since the Last Downturn

There are several due diligence tools to help the lender wrap their head around the asset and what the best course of action is. Pre-foreclosure due diligence is notably more involved than what is typically done during loan origination, and for good reason – they need to view it with more of an equity lens in case they go on title. There are also new factors to consider that didn’t exist during the last downturn, including new local ordinances, some with hefty fines, and new standards for environmental reports and cleanup levels. The scope of each report may need to be customized to help the lender understand specific issues at the property. Doing adequate due diligence up front will also help to avoid retrades from buyers negotiating aggressively because they know that lenders just want to get rid of the asset.

The distressed asset due diligence toolkit most likely includes the following reports and scope considerations:

• Valuation – Early in the process, it is important to get a handle on the value of the property and what the key drivers are. A good valuation advisor will help the lender address key questions such as:
  • Understanding the why: Why is this asset distressed? Is it a market issue (too much supply)? Is it a borrower issue where this asset was cross collateralized with others and this property is distressed due to challenges at other borrower owned properties? Has the property been poorly managed? Is it a recent issue or long-term problem, and why?
  • Market analysis: How is this property positioned within the market?
  • Is the current use of the property the highest and best use? If not, what is?
  • What types of buyer (REIT, insurance company, pension fund, individual, partnership) would purchase the property and why?

The valuation consultant would likely apply a combination of approaches to value including the cost approach, sales comparison approach, and income capitalization approach (direct capitalization and discounted cash flow analysis).

• Phase I Environmental Site Assessment – For lenders that have no intention of taking back a property but rather selling the note, they will likely skip doing any new environmental due diligence on the asset and leave that up to the note buyer. However, if there is a potential for a foreclosure outcome, a full Phase I ESA will help them understand and avoid taking on environmental liabilities with the property. A lot of environmental regulations have changed in recent years – the standard for Phase I ESAs was updated and cleanup levels have changed – so whatever was done at origination would need to be updated and a “clean” Phase I at origination may not mean a clean Phase I now. Depending on the property, the lender may need to go beyond the typical Phase I ESA scope to address building hazards like moisture and mold, asbestos, lead and radon. An Operations & Maintenance plan will ensure any known asbestos or lead containing materials are managed safely. If renovation is necessary during the hold period, an asbestos survey should be done beforehand. Additionally, for properties with hazardous chemicals or environmentally sensitive operations (think gas stations, auto shops, retail with dry cleaning tenant, manufacturing), a hazmat inventory and/or compliance audit would help the parties understand what materials and operations need to be dealt with during the hold period to avoid any future liabilities. Should an environmental concern be identified, the lender isn’t necessarily obligated to investigate or clean it up, but for valuation purposes they will likely want to get a handle on the costs to clean it up – a Phase II Investigation and/or Remedial Cost Estimate can help, but as I’ll discuss more – who engages these next steps can be a little tricky.

• Property Condition Assessment – In a non-performing loan situation, the likelihood that a property has been poorly maintained increases substantially, especially if the property is vacant. It’s important to gain a comprehensive understanding of the physical condition of the building, as it can directly affect the value and decision-making process including determining the feasibility of selling the property in its current state, estimating potential repair costs, and assessing the overall risk associated with the property. A Property Condition Assessment provides clarity on these items and will also mitigate risk by identification of any observed life safety issues and any big-ticket items that may need to be addressed during the hold period. If there are known or suspected problems with a high-cost item like the roof, façade, elevators, mechanical system or building structure, a specialist can be brought in for greater detail. With many newer local ordinances in effect these days such as California’s balcony inspection requirement for multifamily properties, Los Angeles’s WAIRE requirement for distribution facilities, New York’s LL97 ordinance for sustainable buildings, municipal seismic retrofit ordinances and more, it would be wise to ask your consultant to alert you if the property is subject to one of these requirements. If a post-foreclosure sale is the chosen course of action, the Property Condition Assessment allows for the establishment of realistic expectations for potential buyers. It provides insights into any necessary repairs or renovations, allowing the lender to communicate these aspects transparently and potentially increasing the marketability of the property. Armed with the findings of the Property Condition Assessment, lenders have greater negotiation leverage in discussions with potential buyers.

• Zoning Report – Understanding the zoning compliance of a property will alert the lender to non-conformances or violations that could pose a risk of loss in the event of a casualty, i.e. a fire. It will also alert them to publicly available information about new or proposed legislation, zoning laws, or moratoriums that would affect the property. If a material issue is uncovered in the Zoning Report, the zoning consultant can work with the municipality to assess the feasibility of restoring the site to conformance or bringing the site to code.

• ALTA Survey – An ALTA Survey is essential to satisfy the title insurer’s requirements for issuing ALTA Title Insurance to cover survey risks such as encroachments, boundary disputes, etc. It is also a useful tool to understand exactly what is being conveyed with a property. The survey can be thought of as an aerial snapshot of current existing conditions of the property, including boundaries, rights of way, buildings, other improvements, title-related elements, and survey-related exceptions to title that would not be covered by title insurance.

What to do for Troubled Construction Loans?

As any veteran construction lender knows, a proactive and preventative approach to monitoring construction loans is wise even in performing loans. When signals of distress arise, time is of the essence – problems can escalate quickly, especially if work stops on a site. For construction loans that start to exhibit problems, lenders typically need to address three key things in swift order:

• Get a handle on the status of the project – the existing lender (or a new lender stepping in with additional debt) needs to determine what percentage complete the work is complete, what the cost to complete is, and what needs to happen to get it across the finish line. An independent construction consultant can help answer these questions.
• Minimize loss – if construction stalls, the site needs to be stabilized and secured, for example by winterizing/weatherizing it and securing stored materials.
• Make sure it gets finished – regular progress monitoring by a 3^rd party consultant or potentially a more hands-on owner’s rep consultant working with the borrower and contractors can help ensure that work keeps progressing in a timely manner. If work has completely stalled and contractors have walked off the job, a consultant can help find a new GC and get the project restarted.

Relearn the Nuances – Navigating the Pre-Foreclosure Process

The steps and process of addressing a non-performing loan, and which parties should handle certain parts, can be tricky. Lenders should be mindful of certain “traps” that could present liabilities or tie their hands.

• At which point should the due diligence be engaged? The answer is “it depends.” Some due diligence may be engaged early on when a loan is identified as non-performing to help the lender assess the situation, but as the process can be long and windy and these reports have shelf lives, it may be wise to wait to order certain reports such as the Phase I ESA until further into the process, or do a high level desktop screen first and then order the Phase I ESA later to avoid having to update the report.
• Who should engage the due diligence? This also depends on the type of lender and what stage in the process they’re in. For a bank in the initial stages it is often the lender’s REO or workout group that would engage the due diligence. For agency or CMBS loans, this process will be handled by a special servicing group. However, the lender does not want to be directing certain activities because it could open them up to liability – for example if hazardous waste needs to be removed from the property, this should be done by the borrower, guarantor, tenant, or receiver. Sometimes an attorney is best placed to order reports in order to preserve confidentiality.
• Are there special instructions I should give my consultant? Absolutely yes. The consultant should be aware this is a pre-foreclosure situation and be directed as to what they should or shouldn’t say to the on-site personnel or borrower. They may need a good “cover story.” The consultant may need assistance with site access in situations where the borrower becomes uncooperative. Additionally, the lender may want to tell the consultant not to put recommendations into the reports but send in a separate communication so they are not obligated to proceed with those recommendations.

Webinar: Navigating Distressed Asset Due Diligence

There are many other nuances and challenges to consider in this process. While we are cautiously optimistic for an improved CRE market in 2024, it is wise to be prepared for some amount of distress to work its way through the system. To help lenders and special servicers do just that, Partner is hosting a webinar on January 24th at 2pm ET featuring valuation and due diligence experts, an environmental attorney, and a broker who specializes in distressed asset opportunities. Click here to learn more and register.