Investment Analysis

Hold or Sell?

Distressed condo developments may offer unseen challenges.

The real estate market collapse resulted in countless distressed condominium developments. Lenders are often asked to fund failed condo development completion costs and home owner associations’ operating deficits, with little promise of a positive performance.

How do they determine whether to sell or hold? The decision-making process illustrated below holds true for any investor considering purchasing a distressed condo project.

Two 40-unit buildings in a resort area, originally developed to appeal to second-home and investor purchasers, were completed in 2007. Building one has 15 sold units and 25 unsold units. Building two has sold eight fractional share ownership units and the remaining fractional shares are unsold.

The lender worked with the owner/developer from 2007 to 2011. The buildings are currently being leased by the night as vacation rental properties. The lender is not receiving interest or principal payments and is being asked to fund ongoing operating shortfalls. In addition, the wear and tear on the collateral is continuing and deferred maintenance is accruing.

The Lender Approach

Before any decisions, a lender needs to understand the true current value of the property: the cash price a buyer would be willing to pay in today’s economy. This may require the lender to actively pursue a third-party buyer to determine the market floor.

Next the lender needs to determine whether it can absorb the loss required to accept the third-party price. If the answer is no, then the lender should fund operations and employ management to ensure the property is maintained.

Even if the answer is yes, the lender should evaluate the outlook for market conditions and offset any potential gains against funding operating costs during the hold period. If the lender perceives a positive net gain over the hold period, it may elect to hold and fund operations.

Determining Value

Lenders are required by law to receive Financial Institutions Reform, Recovery, and Enforcement Act-compliant appraisals on real estate held as collateral. In the current market, many appraisals establish values with the caveat that the highest and best use of a particular property would be to hold the property until more-normal market conditions return.

The appraisal, therefore, establishes a value of an illiquid asset, while the lender is interested in the value at which the collateral can be converted to cash. As a result, lenders should consider other avenues for testing values. One approach is to request a broker opinion of value, engaging a broker with condo experience, comparable sales in the geographic market, and marketing successes. Another approach is for the lender to review its own loan portfolio for recent sales of the product type in the geographic market. A third approach is to hire an adviser to consider all the aspects mentioned above, plus provide an independent view of the local market conditions. This expands the review to include further analysis of operations and a comparison of hold time, projected value, and ongoing operating costs.

Operating Costs

Typically the original developer of a condo development hires a property management group to manage the property until it is transferred to the unit owners based on the condominium declarations. But often the property manager’s decisions are driven by the HOA’s board of directors, which often includes the developer as president.

This symbiotic relationship may mask a number of unseen operating costs. For instance, the level of deferred maintenance may not be openly shared with the lender. Other hidden costs may be delinquent payment of association dues, property taxes, and fees. This can result in reduced recovery to the lender as units sell, because unpaid association dues must be remitted to the HOA upon sale of a unit.

The HOA board of directors instructs the property manager and influences the operating rules of the association, which establish cost structures and maintenance plans. A developer may be keeping HOA dues artificially low to reduce the payments upon sale to the HOA. Thus, unfunded operating costs may be pushed to the lender.Alternatively, the HOA dues could be increased to bring in more cash from third-party owners immediately, while reducing future recoveries from unit sales.

Condominium laws are different in each state and often require a professional manager to ensure compliance. Legal counsel may need to review the current HOA status; however, the developer may skirt the issue to avoid legal fees, creating more future costs for the lender.

Graphing the Result

A graph comparing hold times to net values may best illustrate the lender’s choice. The accompanying chart depicts the property with a current market value of $7 million and a current debt balance of $9 million. It assumes that the market value will improve rapidly during years four through seven. It also assumes that debt and holding costs will increase by 10 percent per year.

This analysis illustrates the challenge posed by the difference between current appraised values and market clearing values, and the costs to carry real estate assets. In the example above, if a lender accepts the assumptions for market changes, the lender may opt to incur the holding costs for the next five years to have an opportunity to sell at break-even or at a gain starting in year six. The key risk lies in the assumptions used to determine market appreciation, compared to the hold costs.

Condo workouts are not easy but a third-party adviser often provides the clear-eyed vision needed to see the whole picture.

Jay Kelley and Juanita Schwartzkopf are managing directors at Focus Management Group headquartered in Tampa, Fla. Contact them at j.kelley@focusmg.com and j.schwartzkopf@focusmg.com.

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