Commercial Banks Likely Source of Distressed Assets

A forecast during a recent International Council of Shopping Centers (ICSC) webinar suggested that the next large source of “distressed real estate assets” will be from commercial banks. “Distressed real estate assets” is a phrase used in the financial markets to describe a real estate asset that is put up for sale, usually at a discounted price, because its owner is forced to sell.  An owner may be forced to sell an asset for various reasons including business bankruptcy, excessive debt, inability to refinance and/or regulatory constraints.  During the recent webinar, an ISCS presenter indicated that

Commercial banks hold about 50% of the maturing commercial real estate loans and are just starting to face reality by recognizing losses.  Another 150 to 200 banks are expected to fail in 2010.

As a result of these bank failures, the Federal Deposit Insurance Corporation (FDIC) will become one of the largest purchasers (and consequently sellers) of distressed assets.

According to real estate experts, more trouble is looming in these traditional commercial markets.  Another panelist at the same ICSC webinar said that

Over $1 trillion worth of commercial mortgages will be coming due with an estimated $170.1 billion in 8,084 commercial properties in distress (delinquencies, defaults, etc).

Predictably, a large percentage of these distressed loans will result in the real estate being sold at a reduced rate, sold at auction, or foreclosed upon by the lenders.

While distressed assets can be acquired for a discounted price, purchasers may also unknowingly acquire liabilities if proper due diligence is not conducted at the outset of the transaction.  Compounding this issue is the fact that distressed asset deals are often brokered by lenders or third parties, such as auction houses or court appointed receivers who may not be in possession of, or may not disclose, information on liabilities associated with the real estate asset. The purpose of this blog is to discuss circumstances under which a distressed asset can quickly become a liability in the absence of thorough due diligence programs.

Closed retail centers are often environmentally impaired as the result of past operations by dry cleaners, printers, photochemical processors, and other lessees.  Great corner properties that have a perfect “location, location, location” were often former gasoline stations with no information on the closure of their fuel tanks and distribution system.  The underground storage tanks may have never been removed, or worse, leaked product and impacted soil and groundwater at the property.  Those liabilities could result in a significantly lower than anticipated rate of return due to environmental cleanup and further legal liabilities. Additionally, potential sources of environmental impairment are often not identified in the chain of title or noted in legal documents.  Without completing appropriate due diligence consistent with ASTM E 1527-05, those potential liabilities may not be identified and a purchaser of a distressed asset may not qualify for Landowner Liability Protections (LLPs) provided under federal law.

In addition to conditions that result in environmental impairment, buildings that are part of a distressed portfolio often are subject to disrepair and inconsistent or improper maintenance.  As a result, those properties may have substandard utilities or roofing, or have structural problems that may require repair prior to leasing. The condition of building systems should also be evaluated prior to acquisition.

The FDIC has implemented a due diligence process to attempt to avoid those types of liabilities. CEC supported the FDIC when it was named Receiver for the closing of a Pittsburgh bank that occurred in August 2009.  The bank was closed by the Office of Thrift Supervision.  As part of the closing process, the FDIC contracted with CEC to use a process of environmental due diligence to gain initial information about a mix of residential and commercial properties of interest (to be foreclosed upon properties).  Environmental due diligence checklists (field screening) completed by CEC identified more than 15% of the properties with environmental “red flags” that suggested more traditional environmental due diligence was necessary.  Red flagged properties included commercial properties with a history of dry cleaning use or issues related to leaking underground storage tanks (LUSTs).  These  properties could have substantial environmental issues that will affect the FDIC’s decision on whether to foreclose or pursue other risk mitigation actions.

For more information on how public and private real estate companies, owners/developers, REITs, financial institutions, private equity funds, insurance companies, or governments can appropriately manage the risks in dealing with distressed assets, contact one of our due diligence professionals, Mary Guinee (mguinee@cecinc.com) at (800) 365-2324, or Ryan Dunning (rdunning@cecinc.com) at (800) 380-2324.