Rising interest rates, along with declining values in many markets and sectors, have created an environment ripe for defaults on loans with near-term maturities. Owners of office, retail, and even multifamily assets may struggle to refinance at current rates and be forced to sell.  Some may be unable to sell at a price that satisfies their current obligation and lack the cash to cover the difference, resulting in foreclosure. Before taking on distressed assets, opportunistic buyers and foreclosing lenders should be aware of—and prepared for—associated risk.

Jenny Redlin, Founder and Executive at Partner Engineering and Science, Inc.

Of course, real estate investors and lenders know that careful due diligence is required before taking title to any real estate asset. However, distressed assets and foreclosed properties require special consideration. Depending on the circumstances leading to distress or foreclosure, there may be deferred maintenance, deterioration, environmental liabilities, and a potentially drastic change in value involved. To manage their risk and properly plan for the disposition of these assets, buyers and lenders should investigate and address the following:

Disposition Plan

With the current state of the office market and uncertainty in many other sectors, it’s important to assess the value of each asset and its options for disposition. Is rehab/renovation in order? Is repurposing a viable path? What is the highest and best use for the asset, and how can it best be prepared for eventual sale?

To this end, several tools may help:

  • Current appraisal: if quick disposition is the objective, a current appraisal by a valuations expert who understands distressed assets will help you mark to market.
  • Market study: if the strategy for a specific asset is uncertain, a market study can help determine the best use for the asset based on an analysis of supply and demand in the subject area.
  • Feasibility Study: A feasibility study incorporates site information, infrastructure, permitting, construction costs, and zoning ordinances in the context of a proposed use.

Deferred Maintenance

Particularly in the case of vacant or under-leased assets, there is a good chance the property has not been properly maintained. Roofs, asphalt/paving systems, and façades may show signs of neglect. There may be significant capital expenditures associated with overdue replacement of aged-out systems like HVAC, elevator, or roofs. If the asset has been vacant for a long period, or closed without proper de-commissioning, there may be vandalism or mold/moisture issues to remediate.

To get an accurate, current picture of the condition of the property, order a property condition assessment (PCA) and be sure to discuss the scope with your due diligence consultant. A baseline, ASTM-level condition assessment may not suffice for distressed assets. Considering the circumstances surrounding the default, the disposition strategy for the asset, and the likely hold period as indicated by market conditions, a PCA can include specialty assessments for systems like roofing, MEP, or elevators that may be of particular concern. A properly scoped PCA performed by a team of specialists will ensure that buyers or lenders are aware of all issues present and can plan accordingly.

Environmental Liability

When you take title to real property, you assume responsibility for any environmental hazards present—regardless of when they occurred. As with property condition, deferred maintenance and neglect can result in higher instance of environmental contamination or non-compliance. Depending on the use of the property, there may be red flags: dry cleaners and gas stations at retail sites, hazardous waste and chemical storage at industrial sites, etc. Most often, however, environmental conditions are not obvious.

A Phase I Environmental Site Assessment (Phase I ESA) will determine if there are any Recognized Environmental Conditions (RECs) present and provide protection from environmental liability under CERCLA.  It is important to note that only a Phase I ESA will provide this protection; desktop and limited environmental assessments do not. Relying on a previously issued Phase I ESA is not recommended for the same reason; it will not protect subsequent owners from environmental liability. In addition, the environmental condition of the property may have changed since the previous report was written. Even if it hasn’t, ASTM 1527, the standard for ESAs, was updated in 2021. A property with a clean Phase I ESA written to the 2013 standard may no longer be “clean” under the updated standard.

Today’s CRE market is tricky—difficult in some markets and sectors, more stable in others—and will likely remain uncertain over the next year. This means that the number of distressed assets may increase, as may the risk associated with assuming them and the challenges related to selling them. Current, complete due diligence that incorporates disposition strategy is critical for lenders seeking to manage risk and preserving portfolio value.