Real Estate Workouts: A Game Plan
The maelstrom of issues affecting the world of finance to date have not negatively impacted these major real estate sectors: apartment, office, warehouse and retail. Apartments actually may benefit from home ownership turmoil; office buildings remain in demand and warehouse properties are stable due to continued strong international trade. Retail, the most susceptible to consumer cutbacks, appears relatively unaffected thus far. Nevertheless, continuing disclosures of unhealthy practices increase the risk of financial problems for less-than prime properties. This means that lenders (and investors) should be alert for signs of distress and be prepared to take prompt action to “work out” problems with real estate loans.
Early Recognition
Often times, the most difficult first step is the recognition of a
potential problem and properly assessing its severity. Early recognition
often permits considering alternatives that later are no longer feasible if
the situation persists. For example, short-term loan relief in the form of
interest accruals by a lender or use of outside professionals to solve a
particular management problem may produce significant rewards.
Unfortunately, problems often have a way of surfacing all at once. From the
lender's point of view, it may well be worth concentrating efforts on a few
large loan exposures rather than attempting to solve all loan problems at
once. Working out a $500 million loan may be no more time consuming than
working out one a fraction of its size, whereas the benefits to the lender
obviously are much greater.
Loss Exposure
A critical early step in any workout is to determine if the value of
the property exceeds or is less than the outstanding loan balance. If it is
more (so that a cushion of value exists), one course of action may be to
sell the property at once before market conditions deteriorate further. If a
borrower has several loans with the same lender, excess value in some
properties can be used to collateralize the remaining ones and offset
possible future losses. In this way, the lender may be willing to carry the
distressed properties while recovery efforts are carried on while waiting
for market recovery.
Market Forecast
If a lender is considering restructuring a loan or if distressed
property is to be carried by the lender, an in-depth analysis of the current
market is crucial. A few of the questions to be asked are whether the
property will realistically support the revised loan terms and whether a
market upturn can be anticipated that will eliminate negative cash flow from
the property.
Property Evaluation
It is also crucial to determine whether a problem lies with the property
itself or with a weak market. Inherent weaknesses such as poor visibility
and access or ill-conceived design may prevent any significant improvement
in cash flow even when the market begins to recover. Of equal importance is
the physical condition of the property and the extent to which deferred
maintenance has occurred. Often, this requires the services of an outside
engineering firm.
Property Management
Both the lender and owners must decide whether a property is effectively
managed and the effect of a change in management. However, if the present
managers are considering market conditions, replacing them may be
ill-advised and it should not be automatically assumed that such a change is
desirable.
New Construction
When a distressed property is under construction, special concerns apply
for a lender, who must first determine the quality of construction to date
and the extent of any cost overruns. The possibility of a diversion of funds
to other projects must also be investigated. The lender should determine
whether contractors and subcontractors have been paid in a timely manner and
whether they are committed to the project if a change in ownership occurs.
The Borrower's Role
In addition to looking at the market and the property, a lender must take a
close look at the borrowers to determine the extent of their financial woes.
If they are more concerned with working out financial problems than
supervising construction or management of the property, the lender may be
well advised to insist that a condition of any workout be that new
ownership take over.
Inside Staff vs.
Consultants
A lender should be careful to assign staff members who have the
expertise and experience to deal with workout situations. Particularly
complex workouts may benefit from a team approach. Outside consultants
should be used to supplement the lender's own staff. Often, the decision of
how to deal with a problem loan requires a different orientation than that
of the lender itself. A consultant can offer this perspective as well as
expertise about the specific problem.
Real Estate Focus is provided by Somerset’s Real Estate Team for our clients and other interested persons upon request. Since technical information is presented in generalized fashion, no final conclusion on these topics should be made without further review. For additional information on the issues discussed, please contact Michael Fritton, CPA. Whether you are a building owner, building manager, real estate developer, real estate professional or an investor, we hope to provide you with timely information so you may be proactive in making your business decisions.
This article was written by and published herein with the permission from professionals of BDO Seidman, LLP. John Tax is a Director in the Real Estate and Hospitality Practice. BDO Seidman’s newsletter. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.
Somerset CPAs,
P.C.
3925 River Crossing Parkway, Third Floor
Indianapolis, Indiana 46240
317.472.2200 • 800.469.7206 • FAX 317.208.1200
www.somersetcpas.com
.jpg)