Having a well-thought-out and researched business plan (BP) for a held-for-sale, owned asset is important if holding costs are to be minimized and a recovery achieved. Additionally, a well written and researched plan will insure that the asset’s disposition plan is in conformance with internal and external regulatory hold and disposition requirements.

The purpose of this article is to outline the key elements that should be incorporated in the plan and the economic methodologies that an asset manager can use to test their economic assumptions. A poorly researched plan with faulty assumptions can create unreasonable client expectations (i.e. internal and external governance) and unplanned book value adjustments. Notwithstanding, this writing does not cover every potential issue associated with impaired asset management and disposition as the identification of every possible issue are beyond the scope of this paper.

I. Early Detection

The special servicer’s understanding of the loan’s collateral before the asset is acquired and designated as an asset held-for-sale is important. By the time a commercial real estate loan goes into default and the property reverts to the bank, significant damage can occur to the property’s operating performance and market value. Exercising the lender’s rights under the Assignment of Rents and the appointment of a receiver can be an excellent way to achieve this goal. One of the most importance objectives of a special servicer is to understand everything about the collateral and the market in which it operates.

II. Regulatory Considerations

Hold Period and Book Value

Before an effective BP can be completed, the asset manager (AM) must establish the property’s post-acquisition book value. Additionally, understanding the required hold period must be incorporated into the BP. This is especially true for a property subject to the Office of the Comptroller of the Currency (OCC) regulatory guidance. A bank’s marketing of an asset held-for-sale or an OREO whether “as-is” or “as-stabilized” is different from how a typical investor or developer would approach a repositioning strategy; a more typical capital improvement plan and a lengthy hold period necessary to stabilize a property's operating potential may not work within the regulatory constraints. A key difference here is that a bank asset manager can’t speculate; there has to be a high degree of certainty as to outcome, especially if a capital plan and repositioning strategy requires several years to achieve stabilization and significant capital advances.

In that regard, the following is a brief summary of the hold and book value requirements after acquisition pursuant to the Comptroller’s Handbook, A-OREO, Version 1.1, August 2018.

National Banks (NB)

A national bank’s holding period for OREO is governed by 12 USC 29 and 12 CFR 34.82. A national bank must dispose of OREO at the earliest time that prudent judgement dictates, but the holding period must be no longer than five years, unless the OCC grants the bank an extension.

Federal Savings Association (FSA)

The OCC generally expects that a time period of five years is sufficient to dispose of OREO unless the FSA provides a well-supported reason demonstrating the need for additional time and a reasonable plan for disposition.

Internal Regulatory Hold Period

Generally, it is best for a bank and special servicer (which may be the case under the special servicer’s pooling and servicing agreement) to have a shorter hold period (e.g. 2 years), unless there is empirical support for a need for additional time to stabilize a property’s operations which results in a significant and verifiable increase of the property’s market value. When I managed the Special Servicing for a major money-center bank our internal policy required that commercial OREO be sold and off the bank’s balance sheet within 24 months of acquisition (I managed assets subject to Pooling and Servicing (REMIC) and the OCC requirements). Our group’s asset managers’ performance review was partially based on asset manager’s ability to meet this internal policy; this was especially important when a property was to be sold as-is versus as-stabilized.

Accounting for OREO During the Holding Period

Pursuant to the Comptroller’s Handbook, subsequent to acquisition and transfer, OREO must be at the lower of cost or fair value, less estimated costs to sell.

Appraisals and Evaluations

12 CFR 34.85 and 12 CFR 160.172 require national banks and FSAs, respectively, to obtain an appraisal or evaluation, as appropriate, to substantiate the market value upon transfer to OREO.

Pursuant to the Interagency statement as of April 20, 2014, minimum appraisal standards conform to generally accepted appraisal standards as evidenced by the USPAP promulgated by the Appraisal Standards Board of the Appraisal Foundation.

Evaluation

The evaluation whether prepared by an individual or supported by an analytical method or a technological tool, provides a reliable estimate of the collateral’s market value as of a stated effective date prior to the decision to enter into a transaction.

Transactions that require Evaluation:

Has a transaction value equal to or less than the appraisal threshold of $500,000 (The Office of the Comptroller of the Currency adopted a final rule to increase the appraisal threshold for commercial real estate transactions from $250,000 to $500,000; this threshold increase means that transactions at or below this level do not require appraisals to conform to Title XI of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 and in the interagency appraisal rules.)

III. BP Executive Summary

The plan should begin with a request to market and manage the property as outlined in the BP. This section should begin with the following key bullets:

• Brief Property Description

• Property Type

• Book Value (include participation banks if applicable and the bank’s percentage)

• Estimated sales and disposition costs

• Appraisal and date (or valuation if appropriate)

• Management Company (if applicable)

The Executive Summary will conclude with a brief paragraph outlining what the BP is requesting; this should include:

• Recommended management company (each recommendation should contain a parenthetical reference)

• Capital Expenditures if applicable

• Recommended broker

• Sale Price (should include an “Ask” and “Take” sale price)

• Proposed marketing period

• Include whether a loan to facilitate is recommended or if the recommended sale price is based on all cash to seller

IV. Loan History/Background

This section would include a brief history and description as to the type of financing, sponsorship, participation, and brief overview as to cause(s) of the loan default. Should also include any loan workout and mitigation strategies that were employed; it should conclude with how the property was acquired (e.g. judicial or non-judicial foreclosure, deed-in-lieu of foreclosure) and whether there are any redemption rights and other claims that are being pursued by the lender.

V. Collateral

Improvement Description

Understanding the collateral and its unique build-out and construction will help the AM see any potential issues associated with its leaseability and its estimated market value. This should include improvements such as parking improvements, soft- and hardscape, building facade, floor plate size and height; fire & life safety, column width, floor-plate partitions (e.g. bearing vs. panel); water, sewer, power, and electrical systems and capacity, and chattel.

The differences and complexity in improvements can vary considerably depending on the type of real estate project; for example, what is included in a property’s description for a full-service hotel, with several restaurants, convention space, soft and case goods, with entertainment facilities or a special purpose, former company headquarters and manufacturing facilities will vary considerably.

VI. Risk Management

Environmental Condition

An environmental assessment of a property should be completed before acquisition; in cases where the property’s history and findings require a phase-two study, the appointment of a receiver could provide a way for the lender to determine if the property should be acquired.

Interpretation of phase-one findings and the approach to phase-two testing can vary considerably. For example, if there is potential hydrocarbons in the soil, should the test boring(s) be 100 feet or 50 feet on center? Or is some other metric more appropriate? Conversely the lender needs to make sure that when it authorizes a phase-two environmental study that the environmental scientist and consultant understands the scope of their review and methodology. For example, I was involved with a limited-service hotel, whereby the phase-two report included the consultant’s subjective, written discussion concerning the cost to remediate asbestos that had been used on the steel-frame infrastructure as fire insulation. However, in this case, the asbestos was incapsulated and was not friable; an “operations and maintenance” plan could have been employed rather than removal. However, because of the environmental report’s subjective discussion on remedial costs, the lender had to potentially discount the property’s value. Although the servicer wants to understand the property, it doesn’t want to create a disclosure problem based on a subjective opinion that is not within the legal or regulatory scope of impaired real estate ownership.

Environmental issues are best handled by consulting with a competent environmental engineering company (e.g. use a firm that provides environmental studies on behalf of major conduit and balance sheet lenders) and an environmental lawyer.

Geotechnical

Geotechnical issues generally affect residential or land held-for-development. Notwithstanding, it can also impact developed commercial real estate and multi-tenant projects. Geotechnical issues can include but not limited to soil type, compaction issues to catastrophic, hillside failure and slippage. Over my career in special assets, I have been involved with several major cases involving geotechnical issues in California. In many instances, there were no viable solutions available as the engineering and construction costs were not only prohibitive but were not a guaranteed, long-term solution. This, like many other risk management issues are best handled by a specialist.

Other Risk Management Issues

Other important risk management issues include but are not limited to: fire & life safety, Americans with Disabilities guidelines, FEMA flood studies, seismic analysis, as-built survey, title, regulatory, legal, and site infrastructure that are among the other required risk management due diligence issues that should be addressed in the BP if applicable.

VII. Appraisal

In this section a review of the appraiser’s finding should be outlined, including the appraiser’s income, sales, and cost approaches to value. Depending on where one is at in the market cycle, the appraised value could be overstated or understated. Generally the appraiser will look to actual sales in evaluating a property’s current market value; the problem however is that during a severe market downturn, there can be little to no recent sale comparables. As a consequence, current market trends can be missed. For this reason the asset manager should do a review of the market in which the property operates (see Section VIII, Market Analysis) to better understand yield and valuation trends.

VIII. Market Analysis

What is the current vacancy factor? Is the market in equilibrium? What is the total square footage of similar properties that make up the property’s competitive set? Is this a primary, infill, mature market with significant barriers to entry? What are the regional economic bases that generate market demand?

If the market is not in equilibrium with no barriers to entry with significant, double-digit vacancy, this is generally an indication to the special servicer to move quickly with positioning the property for sale “as-is” to cut a lender’s losses. My experience is that a lender’s second, third…write-downs are the most painful (especially if they could have been avoided).

Global/National Economic Factors

Given that national economic factors effect interest rates and liquidity, knowing where we are at in the economic cycle is important aspect of prognosticating value and having the appropriate exit strategy. In that regard, a well-researched marketing analysis begins with a brief discussion about the current national/global economic trends (property type and size is a factor in how extensive this issue is addressed).

Demographics

Understanding the market’s (or submarket) demographics can provide information as to a market’s viability and whether it is in equilibrium. These demographics should include: population, growth trends, age, household members, income, educational level, IT and transportation infrastructure, and economic bases.

Property’s Competitive Set

The analysis should provide a summary of the market’s performance metrics, including: vacancy factor, rental rates (need to understand how rental rates vary within a market or submarket), and leasing concessions; analysis should include average leasing square footage and the number of large square footage leasing transactions (i.e. > 25k-50k SF) that have been completed in the last 24 months. I recall how one of my AMs submitted a releasing and hold plan for an office building that had relatively large floor plates (e.g. 50k SF) that were not easily divisible. Minimum tenant size had to be 25k SF in order for the leasing/disposition strategy to work. Additionally, the plan required significant capital advances in order to devise the floor plates for a new tenant. I had the asset manager run an analysis on CoStar and found out, although there had been some recent leasing activity, that there had been no leases > 10k SF in the last 60 months. Suffice to say, I did not approve the plan.

Of course a property’s competitive set and its key data points will vary depending on the product type. If you have an impaired hospitality asset for example, then the rack rates and average daily rate (ADR), and other hotel specific variables will need to be reviewed.

Barriers to Entry

Another key market factor is barriers to entry. If it is relatively easy for a developer to construct a similar property, then stabilization in a down-market could take a significant period of time. Generally it would be better to price the property to sell and minimize any future losses or write-downs. Conversely, if the property is located in Union Square, San Francisco, where there are significant barriers-to-entry, relatively quick stabilization may be viable.

IX. Economic Analysis

Reconciliation of Cash Flow

Before a recommended disposition price is addressed, it is best to begin with outlining the property’s current and future economics, including gross revenue, expenses and net operating income. This should also include a review of the rent roll and leasing schedule. Again, what is included in this review will vary depending on the product type. What is important here is to correctly reflect how an investor would look at the viability of current and/or projected revenue. For example, if there are several non-credit tenants or above market rents that are scheduled to expire, then an appropriate adjustment must be made by the AM to reflect this fact. If an appropriate reconciliation is not made of the property’s cash flow by the AM, then it will be made by the investor when the property is offered for sale.

Tenant Credit

My experience, if not careful, is that both the commercial real estate broker and special servicer can focus on the “average rental rate” and not understand or overlook the rental-rate range that may exist in a given market. For example, I was in charge of a major corporate real estate portfolio for a technology company in San Jose, California. Rates in Silicon Valley during this period (i.e. 14 months) went from $1.65 MG to $3.65 MG. The reason for this rapid change in average rates was driven by demand from tech start-ups, whose only operating capital came from venture capital funding. The majority of these start-ups had never made a dollar in profit. Given this inherent risk, they were forced to sign leases at outrages rental rates. As these higher lease rates were included in the comps, it affected the market’s average lease rate. When my team began negotiating for R&D space, the landlord(s) wanted $3.65 MG, stating that this was the “market rate.” Obviously, higher the risk then higher the return and conversely, lower the risk then lower the return. Suffice it to say, given our company’s credit, we ended up doing the lease at a fraction of the "market rate."

Economic Bases

A review of the industries and the region’s economic bases assists the reviewer in understanding what is driving demand and a market’s degree of cyclicality. When we examine the market or submarket as a functioning economic unit, the focus is on the employment and income-generating activities that are the market’s economic base.

X. Asset Valuation

A discussion of the different approaches to value (e.g. income, comparable, and cost) should be included and which approach is most appropriate for the property type. Of course there is a significant number of variations in how value is determined depending on the type of income producing real estate that is being analyzed. For example, a gross rent multiplier for multifamily or feasibility analysis on entitled land held for development, etc. Notwithstanding, the primary focus here will be on commercial real estate income producing property, where using a discounted cash flow analysis would be appropriate.

Discounted Cash Flow (DCF) Method includes:

1. Forecast the expected future cash flow

2. Determine the required total return

3. Discount the cash flows (including reversion) at the required rate of return

All three approaches to value should be summarized, including the Sales Comparable Approach, Replacement Cost Approach, and Income Approach. The income approach should include a summary of the property’s operating and investment assumptions.

In addition to making sure that the operating assumptions are correct, the discount and terminal rates must match the risk and operating context in which this subject property exits. As discussed infra, whether the property is located in a market with significant barriers to entry, strong economic bases, fungibility, tenant credit rating, and regional/national returns all factor into how investors look at yield.

The following are some of the typical mistakes that are made when performing a DCF and IRR:*

1. Mismatched growth rates between rental income and expenses.

2. Failure to consider rental concessions and effective rents.

3. Absence of lease-by-lease analysis in properties encumbered by long-term leases.

4. Figures that project that expense recovery income will increase at the same growth rate as other expenses in a property encumbered by gross leases with expense stops.

5. Projections for vacancy and collection losses that are not synchronized with market conditions.

6. Use of operating expense categories that do not include all cost items.

7. Use of ending capitalization rates that are lower than starting capitalization rates with no justification.

8. Underestimation of sales and other reversion costs.

9. Use of an inappropriate internal rate of return.

Conclusion

There are few key takeaways here; first is that you can't successfully achieve a significant recovery upon sale if you don't understand the property that is held-for-disposition. Secondly, the AM must design a disposition plan that reasonably accounts for current and future market conditions juxtaposed with regulatory governance.

References:

Brueggeman, William B., and Fisher, Jeffrey D. Real Estate Finance and Investments. Tenth ed. 1997*

About the author Conrad Andersen

Conrad is the executive managing principal of The Syntax Group; the Syntax Group provides expert witness and litigation support for banks and special servicers. Conrad has approximately 30-years of experience in both master and special servicing, including corporate real estate held-for-sale management and disposition, CMBS underwriting, placement and commercial real estate capital markets

Disclaimer: The information discussed herein and in this website is merely for informational purpose only; it is not to be relied upon nor does it constitute legal advice. Legal counsel should be consulted concerning any of the information discussed in this article.