Investment Analysis

The Big Fix

Is deferred maintenance the next obstacle to market recovery?

Deferred maintenance in commercial real estate properties poses a significant challenge for market participants over the next several years. While nonrecourse lenders may suffer the most in the short term, this issue will be a serious consideration for property owners, brokers, and buyers involved in prospective transactions. Neglected properties affect not only deal participants but the market as a whole as the industry tries to move itself forward in a stubborn economy.

Going Negative

Property owners with positive equity have an incentive to maintain the property — they want to protect their investment. However, when property values decline to the point where negative equity exists, the owner’s perspective and incentives change dramatically. First, the owner no longer has the option to sell or refinance without making an additional investment in the property. More importantly, on nonrecourse loans, if the borrower were to default, the amount of negative equity makes no difference with respect to the owner’s cash flow. Whether there is $1 million or $2 million of negative equity, the borrower gets and pays $0 when the lender forecloses on the property.

With no long-term incentive to maintain the condition of the property, the borrower instead is motivated to maximize its annual cash flow at the expense of property repairs and maintenance. In fact, once owners decide to default they are best served by increasing the amount of negative equity in their properties. The more equity they can extract by deferring maintenance, the greater their return on the original investment.

Lender Actions

However, from the lender’s perspective, the level of negative equity relates directly to the severity of losses associated with default. A default on a loan against a property with $2 million of negative equity will result in at least twice the losses associated with a similar loan that has only $1 million of negative equity.

Deferred maintenance is of greatest concern to lenders and servicers with exposure to loans originated between 2005 and 2007. Many of these property owners are underwater and believe default is inevitable. However, with robust monitoring and surveillance capabilities, lenders and servicers can identify these properties early on and enforce loan covenants intended to protect them from deferred maintenance.

Most commercial real estate loan covenants require borrowers to submit quarterly or annual operating statements. While a casual look at the properties’ net operating income or debt coverage ratios won’t necessarily expose the ticking time bomb associated with deferred maintenance, looking at this data in more detail can help to identify trends in expenses indicative of deferred maintenance. For example, aging properties that begin to show a decline in their per unit operating expenses, particularly those with rising vacancy rates, are worth a closer look. This type of analysis is critical for lenders to be able to identify properties with a higher likelihood of deferred maintenance.

After identifying the problem, lenders and servicers should review their loan documents and enforce existing covenants. Many covenants specify reporting requirements that can be used to declare a borrower in default before significant deferred maintenance occurs. For example, Freddie Mac’s uniform covenants for security instruments include specific covenants related to maintaining the collateral property. If a borrower fails to comply with these covenants, Freddie Mac can declare default. Similarly, some commercial loan documents include covenants related to the required expenditures on particular expense items, such as maintenance. Lenders could threaten, and if necessary declare, technical default in the event a borrower does not spend the specified amount on a given expense.

Extended Implications

Although deferred maintenance may be a way to extract equity from their properties before they eventually default, owners should consider how their actions may impact their future ability to secure debt funding in other transactions. This is particularly true in the apartment sector, where almost all 2009 lending was via loan products funded by Freddie Mac or Fannie Mae, or in the form of mortgages insured by the Federal Housing Administration. These lenders will remember how property owners handle the current market decline and the maintenance of their properties when evaluating future loan applications.

Deferred maintenance also will be an issue for participants in the purchase or refinance of existing properties over the next several years. Lenders and equity investors will undoubtedly require more historical evidence that properties have been maintained during the recent market downturn. Historical operating and capital expenditures will be reviewed carefully, physical inspections will be conducted more thoroughly, and needs assessments will be scrutinized in detail.

As such, brokers should prepare for a longer sale cycle due to the increased level of due diligence. Brokers also should prepare for lengthy negotiations in the sale of distressed properties. Prospective equity investors in properties that have significant or unknown deferred maintenance typically require a substantial discount to values derived using traditional stabilized income capitalization.

Tom Follain, CFA

Tom Follain, CFA, is a cofounder and principal in FI Consulting, a management consulting firm that assists commercial, government, and nonprofit sector financial institutions. Contact him at follain@ficonsulting.com.

Recommended

Adjusting the Rules of Refinancing

Summer 2020

The economic fallout of the COVID-19 pandemic will have long-lasting effects on refinancing in commercial real estate.

Read More

The Impact of Tenant Departures

Spring 2020

In this issue's Investment Analysis, while the office sector remains relatively steady after the Great Recession, single-tenant exposure in CMBS 2.0/3.0 can present challenges.

Read More

Gas Stations Fuel Investment

Winter 2020

The 1950s gas service station is long gone, but the sector’s outlook is bright thanks in part to diversified revenue streams.

Read More

Leverage Can Boost Equity Yield

Winter 2020

In this cash flow modeling example, learn how yields can be greatly improved by knowing when to incorporate leverage via a loan.

Read More