Let’s face it, there’s no good time for a storm or disaster event to occur. The devastating impact of recent Hurricanes Irma, Harvey and Maria showcase the full-scale capacity of destruction that Mother Nature can incur. But if a natural disaster occurs while you are still in escrow, and before the deal has been closed with the lender, it presents some unique challenges, especially if the property has been heavily damaged, beyond cursory drive-by visual assessments.
If your third party reports (Phase I Environmental Site Assessment, Property Condition Assessment, and Appraisal) have been done, you need to re-inspect. When the value of the property has been compromised, it essentially presents a reboot on escrow and the due diligence process. It is in every stake holder’s best interests to carefully reassess full damage, remediation cost and time scale for restoring the property relative to the investor or buyer’s needs.
Because of many potential vectors of contamination, a prompt Phase I ESA is an important starting point. If there has been a storm surge or flooding, inspecting for mold and asbestos is a high priority. Don’t forget that certain states mandate special licensing to be able to perform either of these assessments. Water-impacted properties have concerns ranging from mold (which can start forming colonies as fast as 24 hours after exposure), indoor air quality, and structural integrity. Careful moisture mapping can find all areas exposed to water and track the progress of material drying, which is essential in monitoring the possibility of mold and the need to remove materials. For older buildings, comprehensive evaluation will test for hazardous materials, including asbestos, but also lead paint, and all buildings may be contaminated with sewage waste, fuel and pollution overflow from neighboring properties. Generator tanks can be dislodged during heavy winds or storm surge, and either rupture or overflow.
A property condition assessment will determine damage impact to a property’s structure and foundation. Cosmetic damage involves dry wall, finishes, debris removal, landscaping, drainage, and roofing. More serious damage may involve corrosion of steel, wood frame instability (see moisture and mold above) and essential structural integrity. Mechanical issues may involve critical building systems such as electrical, plumbing, engineering and HVAC.
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Information ascertained from the Phase I ESA and PCA reports – issues and estimates to remediate – will factor into the ultimate decision of whether to move forward with the deal, as noted below.
A re-appraisal cannot occur until after third party due diligence has been reassessed. According to my colleague Bill Pierce, MAI, AI-GRS of Strategic Compliance Solutions, the biggest overarching goal of an appraisal is to fully understand the nature of the investment and its demand drivers proportionally to the balance of cost, restoration time and new value. If you are the borrower, you will not be directly involved in choosing an appraiser. Banks usually assign this process to their credit departments based on vetted qualifications, including rigorous state certifications and clean credentials on the ASC.gov federal registry.
First, the appraiser will ask some broad basic questions as a response to disaster event. What is the operational status of surrounding competition (particularly for retail and commercial sites) and is it advantageous to your property? Is the damaged space either occupied by retail, office, industrial or multi-family tenants? If so, what is their long-term occupancy status and continuous cash flow from rent payments? Finally, is the displacement of people around the damaged property temporary, long-term or permanent. This impacts supply and demand considerations of the site.
A more detailed appraisal follows, combining three key metrics:
1) Cost Approach (underlying land + building component analysis). This is the bedrock of the appraisal process, in which direct and indirect costs associated with the physical land and infrastructure are calculated. These values serve as an important underlying framework when weighing tolerable risk and external considerations. 2) Sales Comparison Approach (principle of substitution). Many property investors will ask, “Why can’t I just go buy another property with similar utility?” Answering this question requires a careful economic analysis of the time, effort and money required to restore or rebuild the asset. This comprehensive measurement is then juxtaposed to cost and cash flow potential of pre-existing property types. Is it more economical to walk away from the existing deposit and go buy another property on a value deal or to rebuild? 3) Income Approach (cash flow analysis – rent + reversionary interest evaluation). If you’re about to own an investment property which has been compromised structurally, does it still allow tenants to continue occupying the space, or will they be able to do so in a reasonable amount of time? Calculating this loss of cash flow is critical, particularly if the asset is long-term investment property. Is there an insurance policy in place to mitigate loss, and will recovering it involve lengthy litigation? Is it possible to buy a comparable (or cheaper) property with similar utility elsewhere to relocate tenants to recoup a return on and of investment?
The bottom line is that every commercial real estate deal is structured differently and with different investment motivations. Post-disaster considerations for those still in an escrow process should include weighing the down payment investment, the long-term cost of “making the property whole,” restoration of cash flow from secondary income stream (relocation + loss of occupancy/rent) and the availability of cheaper, more immediate options with similar utility.