The objective of this course is to provide a substantive guide to analyzing, purchasing, managing and repositioning distressed real estate (for the purposes of simplicity in this material I will utilize the singular term property or project in referring to the distressed real estate). The purchase of performing and no-performing debt is also covered. This study guide is not meant to be a textbook but rather an ancillary tool or outline to be used in conjunction with class lectures. As this is an advanced course, this text will assume the readers knowledge of fundamental real estate and finance terms. Although this study guide speaks to the individual as a Sponsor of the project, its aim is to be educational and useful to government officials, corporate real estate officers, brokers, land planners and other individuals interested in distressed real estate. This course and study guide is not meant to replace the use of professionals in any or all disciplines but to provide the frame work and understanding of issues necessary for the successful completion of the project.
The process is as much art as it is science and the Sponsor’s ability to balance roles, establish time allocation, expend capital and complete the project as intended is part of the art and can only be described but not necessarily taught. For instance, the decision to choose and utilize internal resources or engage outside expertise is one which can only be made by the individual and is often simply a determination made from years of experience.
The material herein is generic for most all commercial property types including apartment building, mixed-use developments, retail and office properties and hospitality deals. Appendix One focuses on buying homes and Appendix Two focuses on buying debt. No specific market area is targeted and the focus is limited to the continental United States. Asset values contemplated range from $1 million to $50 million as assets or portfolios in excess of $50 million have additional challenges not germane to this course. Although this course and study guide has been designed to cover most all substantive areas, it by no means reaches every situation that may be encountered in the highly unique and disparate field of distressed real estate. It is very possible to encounter an entirely unique challenge that necessitates a “never before” analysis and determination. Such is the excitement that can be found in repositioning distressed real estate. Let’s begin with this brief summary of distressed real estate: FACTORS RESULTING IN DISTRESS
The analysis of the distressed property or project begins with this simple question – Why is this project in distress? My good friend Jordan Paul, a distinguished expert in the field of distressed assets and debt, has identified the failure of a project as a result of a lack of one or more of the four C’s:
Capital – Failure to provide adequate capital to any project is a recipe for failure.
The inefficient capital can be in design deficiencies, construction failure or marketing shortfall.
Competence – All too often individuals or companies simply do not possess the adequate ability or experience to successfully complete the development of a property or project type.
Commitment – Sometimes an owner simply does not have the necessary commitment to the successful competition or operation of a property or project.
Credibility – If the use of the property or project is not feasible or is woefully miss-conceived, the result is often a complete failure or a significant distress.
The Diagram indicates each category / activity as a “Profit Center” because in each category/activity it is possible for the Sponsor to obtain fees from the property or project as opposed to hiring outside professionals. This includes the Capital section where the Sponsor should receive compensation for the equity capital provided as well as any loans made to the Project. Bankruptcy will be discussed in the Capital Section as Bankruptcy is in essence a statutory re-arrangement of Capital. This Study Guide assumes that for all categories the Sponsor will either engage a professional entity to perform the stated duties or closely monitor those duties.
Note: SEVEN CRUCIAL STRATEGIES IN NEGOTIATING THE DEAL: Know your desired outcome and set a ceiling.
Listen for emotional triggers and understand why they exist.
Obtain sufficient knowledge – no insider trading in real estate.
Always take a time out.
Beware of date deadlines – negotiate performance milestones.
Avoid positional bargaining.
Finalize the negotiation – avoid the Colombo.
SECTION ONE: REVIEW & ACQUISITION
1.1 Market Cycles: We all know that markets go up and markets go down. As such the four cycles inherent in this fluctuation are:
(a) Down Cycle
(b) Absorption Cycle
(c) New Construction Cycle
(d) Market Saturation Cycle
1.2 Non-Controllable Risk: Although world events are controlled by someone who is not us, we must nevertheless be aware of these risks and attempt to mitigate them: (a) Opportunity Risk
(b) Inflationary Risk
(c) Physical Destruction Risk
(d) Liquidity Risk
1.3 Controllable Risk: A brief list of potential risks that are more in our control are as follows:
(a) Poor assumptions in pro-forma (absence of adequate reserves) – See Capital Section
(b) Construction cost overruns (schedule failures, bankruptcy of contractors, weather conditions) – See Construction Section
(c) Extended lease-up, sell-out or construction schedules (excessive tenant relocations)
(d) Lower than anticipated rents or sales prices
(e) Higher vacancy and low absorption rate (inadequate marketing budget, vulture clauses, absence of market studies, pre-leasing and pre-sales) (f) Poor acceptance of the product by market (dated appearance, poorly functioning space, lack of expansion options) – see Marketing Section (g) Inaccurate or escalating operating costs (failure of systems, safety problems) (h) Staff problems (dissatisfaction, leadership failures) (i) Legal complications (excessive litigation)
1.4 Initial screen The purpose of an initial screen is to sort potential acquisition opportunities based on their potential for value creation and their match against your investment criteria.
(a) Is the property in a manageable market area?
(b) Is the property institutional grade and/or can it be upgraded to institutional grade.
(c) Is the recommended purchase price below replacement cost?
(d) Are there repositioning, re-leasing or re-development opportunities that would create value?
(e) Are there barriers to entry in market, limiting the potential for new competition to be built? These barriers may be a lack of developable land or legal limitations on growth (e.g. high impact fees, a lengthy and cumbersome approval process, requirements for pre-existing infrastructure, etc.).
(f) Is renovation or construction limited or restricted because of historic or new governmental restrictions?
1.5 Zoning: Compliance with local zoning must be addressed. Building and other code issues should also be identified, with particular focus on ADA, Seismic (if applicable) and Life Safety concerns. Additional areas of governmental concern: (a) Conformity to local and state and use plans
(b) Adequacy o water supplies and drainage
(c) Avoiding erosion, pollution, traffic congestion (d) Impact on schools and other government services (negative and positive) (e) Preservation of scenic, historic, natural resources 1.6 Rent Comparables: Any properties in the market that will directly or indirectly compete for tenants with the subject should be inspected. A summary of the current rents, asking rents, lease concessions, amenities, major tenants and relative strengths and weaknesses should be prepared for each property inspected.
1.7 Sale Comparables: Any properties that have recently sold (or are currently under contract for sale) and are similar to the proposed acquisition should also be inspected.
A summary of the sale prices, cap rates, rental rates, amenities, major tenants and relative strengths and weaknesses of each property should be documented. Note: Properties currently being marketed but that are not under contract should only be utilized in the event adequate comparable data for properties already sold or under contract is not available.
1.8 Visibility: Can potential customers easily find the property?
1.9 Access: Does the property enjoy convenient ingress and egress from nearby local and major thoroughfares?
1.10 Parking: Is there adequate parking for the tenants? Can parking be increased?
1.11 Population: Is the local market stable, recovering or declining (absorption rate)?
1.12 Design planning: Sponsor should obtain pertinent information concerning the following:
(a) List of contacts:
1. Building inspector
2. Zoning official
3. Fire inspector
4. Electrical inspector
5. Plumbing inspector
6. State highway engineer
7. Health or sanitary engineer
8. Electric company
9. Gas compan
10. Water company
11. Telephone company
12. Cable company
13. DEP agency
(b) Site conditions: Note any aspects of the improvements that differentiate the subject from competitors in the market, with particular attention to those aspects that are inferior and cannot be economically corrected. Examples of these include inadequate floor load capacity, floor plates that are too small; parking that is inadequate to serve the tenants.
(c) Building conditions: The size and efficiency of the building (gross square feet vs.)
net rentable square feet vs. net usable square feet). Any ability to increase the rentable area through re-measurement should be noted.
(d) Drainage conditions
(e) Retaining walls
(g) Curb and gutter
(i) Roofing condition
(j) Vehicular circulation
(k) Parking issues
(l) Service areas
(m) Storm drainage
(n) Sanitary sewer
(o) Electric lines
(q) Utility lines- high wire and under-ground
(r) Lighting issues
(s) Signage issues
(t) Public transportation authority
(u) Geo-technical data
(v) Environmental and Hazardous materials issues
(w) External team
(x) Energy Reduction and Green Solutions
(y) Safety concerns
(z) Due Diligence Items
2. Floor Plans
3. As-built site plans (include renovation and tenant plans) 4. Working drawings (architectural, structural, mechanical, plumbing, electrical, sprinkler, civil, lighting, landscape, signage, elevator) 5. Certificates of Occupancy (Base building and Tenant) 6. All licenses / permits
8. Zoning Certificates – with any variances
9. Local, County, State, Federal Use Agreements
10. Inventory of all personal property and equipment 11. List of municipal notices and violations
12. List of litigation and/or insurance claims
13. Marketing / Feasibility reports
14. Leasing Plans
15. Legal description
16. Current rent roll
17. Tenant leases – including leases in negotiation 18. Security deposit list
19. Service contracts
20. Management Agreement
21. List of all employees, wages and benefits including key man insurance 22. Employee contracts
23. Union agreements
25. Outside work bills
26. Insurance policies
27. ADA compliance reports or violation notices
28. Outstanding TI and leasing commission schedules 29. Last 3 years financial statements, audited balance sheets 30. Monthly operating statements – 3 years
31. Current year-to-date operating statement
32. Last 3 years real estate tax bill and any to be billed public assessments 33. Copy of Utility bills
34. Environmental and Hazardous materials permits, reports, violations 1.13 Confidentiality Agreement: A confidentiality agreement will be required by most sellers. Although it is rare for a breach of confidentiality case to be instituted, it is important not to unnecessarily expose yourself to liability. Significant issues include experts excluded, breadth of material, time limits and scope and types of damages from breach, etc.
1.14 Appraisal: Often an Appraisal received from the seller or otherwise is stale or unacceptable for other reasons, however, a close inspection of an existing appraisal can be very useful. Further, any new Appraisals and any other reports ordered should be initially received and marked “DRAFT” for review prior to delivery of the final report. This is important to insure accuracy and to avoid unnecessary legal issues.
1.15 Sources of Data: The following are good sources of research data: (a) CB / Torto-Wheaton Research: Maintains a database for new construction for 50+ MSA’s depending on the property type. www.cbcommercial.com/twr.
(b) F.W. Dodge: Maintains database on building stock and building starts www.mag.fwdodge.com.
(c) CosStar: Provides analyses of availability and vacancies for office and industrial properties for 15 MSA’s. www.rig.com.
(d) Construction Market Data Group: Provides mainly lead information on new policies
construction projects for contractors. www.cmdg.com.
(e) Salomon Smith Barney: Produces an index for apartments for 53 MSA’s using supply side statistics and demand side demographic data. www.smithbarney.com.
(f) Property and Portfolio Research: Produces forecasts of market return for office, retail, apartment and warehouse properties. www.ppr-research.com.
(g) Korpacz and Associates: Produces forecasts of market rental growth for office, retail, industrial, apartment and hotel properties based on surveys of investors.
(h) REIS Reports: Produces forecasts of market growth for apartment, retail and office properties. www.reisreports.com.
(i) William Lavitt & Company: Trend Index compares growth patterns of 150 U.S.
cities for retail, commercial office and single- and multi-family housing properties. www.williams-lavitt.com.
(j) Grubb & Ellis: National brokerage firm produces annual forecasts. www.grubbellis.com
(k) BOMA: Provides detailed operating income and expense information.
(l) National Real Estate Investors Association: Data for investors.
(m) TREPP: Focus on CMBS investments. www.trepp.com.
(n) County-Statistics: Income and employment statistics. www.stats.indiana.edu.
(o) US-Census: Population and housing data. www.quickfacts.census.gov/qfd.
(p) American Society of Appraisers: www.appraisers.org.
(q) Appraisal Institute: www.appraisalinstitute.org.
1.16 Title Insurance: Title Insurance provides protection against the cost of defending claims against the ownership of the property.
1.17 Title Review: A current title report should be ordered and reviewed. The review should focus on the following areas:
(a) Legal Description: The Legal Description should be reviewed to ensure that there has not been a change in the description since the most recent transfer of the property. The legal description should also be compared to the most recent property survey’s description if available.
(b) Ownership Entity: The name of the ownership entity should be reviewed to verify that it is the same as the Seller in the transaction.
(c) Judgment Liens: Any judgments should be reviewed to ensure that there is nothing that would have a material impact on the property and to assure that the liens are removed prior to closing.
(d) Mechanics Liens: A Mechanics Lien is a claim securing priority of payment for work performed and material furnished by a contractor or other person for the construction or repair of a property. In many states, unpaid architect and engineering fees can cause a Mechanics Lien to be filed. All Mechanics Liens will be reviewed and these should be noted for removal prior to closing.
(e) Taxes: It is important to check the title report to determine if there are delinquent taxes. The local tax assessment office must also be contacted to determine the total amount of annual taxes and to confirm that they are current. If the taxes are not current, this and any estimated accrued interest will be added to the capital cost estimated to complete the repositioning. Note: Transfers of ownership may trigger a reassessment of the property value and a corresponding increase in taxes.
(f) Easements: An easement is a right to the limited use or enjoyment of land held by another. An easement may be used to enable sewer or other utility lines to be laid, or to allow for access to or through a property. Easements referenced on the title report should be reviewed to ensure that there is nothing that would have a material negative impact on the property. Easements or reciprocal operating agreements that relate to parking or the use of common areas must be reviewed to determine the cost related to maintaining these agreements, potential revenues available as a result of the agreement and any other potential impact they might have on property value.
(g) Encroachments: An encroachment is a building, a part of a building, or an obstruction that physically intrudes upon, overlaps, or trespasses upon the property of another. Encroachments referenced on the title report or on the survey will be studied to be sure that there is nothing that would have a material negative impact on the property.
(h) Deed Restrictions and Other Title Exceptions: All restrictions and exceptions must be examined to determine if there is a material impact on the property value or utility. In addition, the reviewing party must verify: (i) There are no prior agreements affecting the property to which a new owner will remain subject;
(ii) There are no zoning restrictions that will prevent the intended use of the property;
(iii) All licenses, certificates of occupancy and other permits required for the intended use of the property are in place or obtainable; and (iv) There are no outstanding code violations relating to the subject property.
(i) Endorsements: Each state requires/allows different types of endorsements. An example of this would be a Code Change endorsement where, in the event of a casualty to the improvements, current building or zoning code would not permit rebuilding of comparable improvements. A local attorney should be consulted regarding all possible endorsements.
(j) Zoning: The title insurance policy should include a zoning endorsement which would ensure such things as height of a structure, distance of a building from the property line and category of land use.
1.18 Lease Plan: Every project should have a lease plan which determines the placement of tenants in a property, promotes property design or atmosphere and differentiates rental rates