Do It Right: The ABCs of Due Diligence for Distressed Properties

Clients new to the world of commercial investment real estate may be salivating at the thought of a market filled with undervalued properties that can be had for a song. Do them a favor and inject a little reality into their dreams of market domination. Remind them that distressed properties are called distressed for a reason: Although the term may fit the seller’s frame of mind and circumstance, buyers should realize that such properties often have tenancy and deferred maintenance problems. Fully occupied, class A assets rarely come on the market -- even if the owner has financial problems. And if they do, well, take a number and join the other buyers who are probably willing to offer the asking price, if not more.

While today’s market offers plenty of opportunities in distressed properties, buyers must conduct in-depth due diligence to determine what a property is worth. Before clients agree to a purchase price they think reflects a property’s distressed condition, offer them this checklist of items to consider along with an appreciation of what can happen once the acquisition has closed.

Due Diligence Checklist

Tenants. Review and confirm the terms of all leases, paying particular attention to co-tenancy clauses, which are common in retail properties. These allow retailers to reduce the base rent, eliminate base rent and pay percentage rent based on sales, or terminate a lease when an anchor tenant or another identified tenant exits the property. Other items to take note of include “early outs,” which permit tenants to terminate leases in advance of normal termination dates, downsizing rights that allow tenants to reduce the size of the leased premises, tenant bankruptcies, and claims by a tenant against the landlord.

Require estoppel certificates from each tenant. This item usually is subject to negotiation between the seller and buyer as to the number of estoppel certificates required and, if less than all, from which tenants (anchors, occupants of more than a certain number of square feet). It also will indicate whether the seller is in default.

Existing Indebtedness.  Buyers may be able to assume an existing mortgage or other debt, but they should expect lenders to re-underwrite the terms, which may result in higher debt service, a shortened maturity, and increases in the real estate taxes, insurance, or tenant improvements impound or escrow accounts. In addition buyers must pay an assumption fee and the debt holder’s counsel fees and costs. As a condition to assumption, lenders may insist on a guarantee of all or a portion of the indebtedness.

At the same time, buyers can negotiate deferring interest payments, principal or both; reduction in the principal amount of the debt based upon the value of the property; a change in the interest rate; and reductions in the real estate tax, insurance and/or tenant improvement impound or escrow accounts.
Appraisal. A current property appraisal should be obtained. The appraiser will value the property using comparable recent sales, replacement costs, and capitalization of income methods. In the current economy, the first and last of the three methods may not be completely reliable as to value. With few recent sales of commercial properties other than foreclosures, relying on comparable sales is questionable, while the lack of activity has resulted in uncertainty as to the interest rate to be used in the capitalization of income method.  

Physical Condition. A licensed engineer’s inspection should confirm the property’s repair and maintenance needs, both long term and near term, as well as estimates of these costs. There may be a difference between what the seller thinks is necessary and the associated costs and what the engineer thinks is necessary.  

Violations of Laws. To obtain proper assurances that the property is fully compliant with applicable laws, codes, and regulations, including zoning and subdivision ordinances, contact the local governing bodies with jurisdiction over the property. If the property is not compliant, find out from local officials if the violation must be fixed in advance of closing and ask the engineer what it will cost.

Environmental. A current phase 1 environmental site assessment is a requisite to a commercial real estate acquisition. If the inspection reveals environmental problems, a phase 2 assessment may be required. Existing and prospective environmental remediation plans must be taken into account, in terms of time frame and costs. An environmental expert can assist on both of these items.  

Title and Survey. Does the seller have the financial ability to satisfy all of the liens and judgments that the buyer does not intend to assume? In addition, covenants and operating agreements with third parties regarding access and maintenance of common areas must be carefully reviewed and the terms confirmed, particularly regarding who bears the cost of maintenance and repairs. Also, obtain estoppel certificates from third parties indicating that there is no default on the seller’s part.

Litigation. Does the seller have the ability to settle existing litigation that could delay the closing or result in a new judgment lien filed prior to closing?

Service Contracts. Is the seller current in payment and is each contractor willing to continue providing the agreed to services on the same terms and conditions following closing?

Management. Will the buyer manage the property or hire a third-party management company? Consider engaging the management company currently handling the property to continue, even if the company is owned by the seller. Determine general management and lease-up fees, owner termination rights, and controls over rent receipts and the use thereof by the manager.  

Once the due diligence is completed, the buyer should re-examine the financial model used in deciding on the purchase price. Make sure clients have a due diligence or other out in the purchase agreement that allows them to re-negotiate the purchase price in light of the findings.  

John F. Dougherty Jr.

John F. Dougherty Jr. is senior counsel of Stradley Ronon Stevens & Young in Philadelphia, whose practice includes representing owners, operators, managers, and lenders in the commercial real estate industry. Contact him at (215) 564-8084 or You Own It…What Do You Do Next? The following suggestions may help determine the direction of a property’s future. Get rid of poor quality tenants. In difficult economic times, landlords often choose to ride it out with current tenants since some rent is better than none at all. Monitor tenants’ financial condition and keep their monthly rent as current as possible. If they go out of business or file for bankruptcy, it is very difficult to collect past-due rent from pre-bankruptcy lease periods.    Change the property’s focus. Purchasing a class C property and redeveloping it into a class A property is an expensive balancing act. A landlord may have to pay severance to terminate leases, relocate other tenants, face reduced rent from retail tenants if their revenue falls off, and finally, pay the redevelopment costs. New tenants will have to comply with exclusive-use rights held by current tenants.   Find novel ways to raise cash. Often a borrower has the ability to sell or pledge up to 49 percent of its equity interest in the owner of the property without the lender’s approval. This could be useful in providing security to mezzanine and similar type lenders or collateralizing unsecured debt that may need to be “worked out” later.