If commercial real estate needs to be sold or if a loan needs to be modified or refinanced on commercial property today, the owner faces some real challenges.
The volume of transactions, both sale and financing, have dropped significantly, as have market prices for most property types. Lenders and buyers are in short supply.
“Property owners have to make the most of every opportunity, so they need to be completely prepared,” says Erica English, a shareholder with the real estate group at Katz Barron Squitero Faust. “Ideally, an owner will do a self-audit of his or her property before approaching a potential buyer or lender.”
Smart Business spoke with Erica about what an owner should do to prepare.
Why is it so important for an owner to self-audit in advance?
A property owner needs to have realistic expectations about the prospects for sale or financing. To do this, the owner needs to use the same optics that a buyer or lender would be likely to use. If the owner’s expectations are aligned with the market, many missteps will be avoided, such as marketing at the wrong price or seeking loan terms that are unachievable for the asset.
The objective is to re-evaluate and critique the property with fresh eyes. Both strengths and weaknesses must be fully understood. If there are fixable problems, the owner has a chance to identify them and correct them before going to market.
How should an owner do a self-audit?
If the owner is considering a sale, it should conduct the same due diligence on its property and operations that a buyer would do. A good place to start is a title update and examination. This is quick and inexpensive and will often show unresolved notices of commencement, code enforcement liens, defective or missing satisfactions of mortgage, or other readily fixable title matters.
All of the leases and service contracts (including amendments, assignments and exhibits) should be organized, inventoried and re-read. A discreet set of copies should be made and set aside for actual due diligence. The rent roll should be checked and updated. The owner should consider whether a buyer would be likely to view a given lease as an asset or liability or of neutral value. Buyers are paying particular attention to go-dark rights and co-tenancy provisions, in addition to the usual issues of rental rates, length of the remaining term and unsatisfied free rent periods or other concessions.
The most recent environmental audit, asbestos survey and any mold contamination report should be re-read. If there are any monitoring programs or compliance orders in effect, the permits, records and reports from inception should be reviewed to confirm that they are complete and do not reflect a new condition or failure to comply.
City and county records should be searched for unrecorded liens, code enforcement citations and open permits. Permits for building operations, such as elevators and fire safety equipment, should be checked. Hospitality venues require more extensive permit reviews, such as liquor licenses, lodging and food service licenses and health department permits for swimming pools. Older structures in Miami-Dade County and certain other Florida counties must be evaluated for structural soundness and adequacy of key building systems every 40 years. If that anniversary is approaching, the owner should consider engaging an engineer to inspect and start the certification process with the county. If the property depends on grandfathering for its compliance with current zoning and building codes, the owner should evaluate whether the status would be lost if significant renovations are likely to be made by a buyer.
What if the owner is considering financing instead of sale?
A lender will conduct the same due diligence that a buyer would do, and more. In addition to studying the property and its collateral value, a lender will evaluate the adequacy of operating cash flow to service the debt and the ability of the guarantors to pay the debt if the property does not. Institutional lenders are not extending credit based on property value alone. Cash flow from bankable tenants and sponsor net worth and liquidity are now fundamental requirements.
The owner’s self-audit must include a critical look at the merits of the rent roll and an estimate of the loan amount that its net cash flow will support. The risk of future tenant defaults must be taken into account, even as to tenants who have no history of default or insolvency.
The owner should consult with its existing lender and other market sources to develop a sense of what a new lender would require in terms of minimum net worth and liquidity. The extent to which the owner or its sponsors are invested in leveraged real estate will also affect the credit analysis.
Cash flow problems and net worth deficiencies that may be shown by a self-test may not be immediately fixable, but the exercise will educate an owner on what is achievable in terms of refinancing and will help define the strategy. The self-test will also suggest critical priorities for re-positioning the property going forward.
Is the strategy different if it’s a renegotiation of an existing loan?
If new financing is not viable and the owner is approaching an existing lender for a workout (or if the lender initiates the conversation with a default letter), it’s just as critical for the owner to prepare. The viability of a workout effort largely depends on the lender’s sense that the exit strategy will improve within a reasonable period of time and the owner needs to be ready to educate the lender and shape its forecast of the property’s performance.
Erica English is a shareholder with the real estate group at Katz Barron Squitero Faust. Reach her at ELE@katzbarron.com or (305) 856-2444.