Occasionally, a Lender has a borrower whose property, whether a new purchase or a refinance, has certain pre-existing environmental concerns. Perhaps the improvements were constructed prior to 1978, and there may be Asbestos Containing Materials (ACMs) or Lead based paint (LBP) concerns, or perhaps there are soil impacts resulting from periodic historical releases associated with normal agricultural uses of a property. In circumstances where pre-loan removal or remediation of the concern is not feasible, Lenders may address these concerns via an environmental indemnity, requiring borrowers to mitigate or properly manage any existing concerns to ensure that such concerns are not problematic during the term of the loan, either for human health and safety reasons, or for servicing the loan.
Often times, a policy of “management in place” is sufficient to address the Lender’s concerns and help the borrower maintain best business practices. This frequently means that an Operations and Maintenance Plan (O&M Plan) would be put in place at the commencement of the loan, to run at least during the term of the loan, if not longer. The O&M Plan would require the borrower to properly manage the issues of concern, and not exacerbate the impacts or create any pathways of exposure which could negatively affect normal business operations or ability to service the loan. For ACM and LBP issues, this could mean only de minimus and non-intrusive maintenance and refurbishment of affected areas during the term of the loan, to reduce the likelihood of exposure to such concerns. Site (re)development that might mean material disturbance of affected areas could require consultation with and pre-approval of mitigation plans by the Lender, to ensure that the terms and conditions of the environmental indemnity were being met. Changes to the Approved Use of the property should also be subject to Lender consultation and pre-approval; since such a change could alter the identified pathways of exposure which the O&M Plan was supposed to address, and thereby increase the risk of environmental liability.
As a matter of compliance and monitoring, Lenders should consider requiring the borrower to provide, at least annually, a summary of borrower’s efforts and activities to “manage in place” any identified pre-existing environmental conditions, if periodic site visits are not feasible. By requiring borrower to provide the Lender with even a brief statement stating that the O&M Plan is being properly managed and that there has been no material change or exacerbation of the identified impacts, the Lender is compelling the borrower to pay at least periodic attention to the obligations that the borrower agreed to at the time of the closing of the loan. At the same time, the Lender can demonstrate that it was diligent in following up on its obligations to maintain a situational awareness concerning its collateral, by reviewing and notating where necessary such periodic borrower summaries.
This periodic follow up by borrowers and Lenders is cost effective and does not require much time or resources to implement, but serves to ensure that both borrower and Lender have a plan in place which provides periodic follow up on such pre-existing environmental conditions. If there is no change in circumstances, then no additional resources are required; if the review identifies a change, then both parties have the opportunity to correct the situation sooner, when the situation is more manageable, rather than later, when the fix may be more costly and time consuming. As the old adage says, “an ounce of prevention is with a pound of cure.”
Wednesday, September 17, 2014
Tuesday, September 16, 2014
Leased fee, fee simple. Who cares? Your regulator.
"Fee simple" and "leased fee"? What's that about and why does it matter?
Don't get distracted by the term "fee simple". It sounds strange because it's a vestige of middle-age, English common law. For purposes of illustrating the point, let's (over)simplify. Assume, for the sake of this conversation only, that fee simple is a rough translation for "ownership".
Example
Here's an example. Your borrower owns an office building. So, in other words, your borrower is the "landlord" to several office tenants under standard office leases. The tenants occupy the building. The landlord, in general, does not.
It might be common in real estate circles to say that your borrower owns the "fee", and that the handful of tenants that occupy the building own a "leasehold" interest -- a fancy way of saying they rent space.
Now assume that your bank is considering making a loan to this borrower. The loan will be secured by the borrower's interest in the office building. You are ordering the appraisal. What interest should you ask the appraiser to value?
What does it mean to appraise the "Fee Simple"?
It's a natural reaction to say "fee simple" -- after all, your borrower is not renting the property from someone else. They own it.
But here's what will happen if you do that. In valuing the property under the income approach, the appraiser will perform market research and use accepted methods and techniques to determine the appraiser's opinion of market rent. In other words, the appraiser will come up with an opinion as to the rent that your borrower could get if they leased space in the building today -- or, more precisely, as of the effective date of the appraiser's opinion of value. Then, the appraiser will use that opinion of market rent to value the building, more or less ignoring the current leases.
Below-market rents highlight the distinction
But what if some or all of the tenants in the building signed long-term leases 10 years ago, and still have 10 years left on their leases? What if those tenants are "credit" tenants (e.g., big, successful public companies with low risk of default) and as a result have sweetheart deals, even in light of today's real estate environment? Well, in that case, the appraiser's opinions about the "market rent" don't bear a resemblance to the cash flow that's actually coming in the door based on the specific terms of those leases. If you want the appraiser to dig through the terms of those leases, the rent roll, and other information and use the actual numbers in the income approach, then you need to order "leased fee".
What if I order it the "wrong" way?
In most cases, if this gets mixed up, it's just a misunderstanding. But getting this wrong can cost time and money. If you order a fee simple appraisal, the appraiser may not think to ask you about leases and rent rolls. He may assume there isn't a lease in place. Then, if you suddenly ask him why he didn't consider the lease, or if the appraiser runs into a tenant on his site visit, you could have an issue. The appraiser may have to go back and review leases and rework his income analysis. It pays to get this right up front.
(Aside from the regulatory issues discussed below, it's not "wrong" to order a fee simple appraisal for a building with tenants. There may be very legitimate reasons for wanting to know the market value of the building using the prevailing market rents and ignoring the specific leases in place. For example, it may be that the leases in place have above-market rent. In that case, a fee-simple appraisal may serve as a means of stress-testing value in the event those tenants were to default and the landlord was forced to re-rent the space. But you should understand what you're ordering. And the appraiser should take care to clearly explain in the report which interest he or she is valuing.)
Does my regulator care?
When you're dealing with a property with below-market rents, it might be tempting to view this distinction as an opportunity to influence value. You may be confident that your borrower's "good for it" and looking for a way to get the property to "appraise out". If you order a "fee simple" appraisal, you could take advantage of the market rents, even though your borrower's locked into below-market rents. But don't do it. Your regulator is paying attention.
Each of the prudential regulators requires that appraisers report appropriate deductions and discounts, and that includes, specifically, for properties with below-market rents. Refer to Appendix C in the December 2010 Interagency Appraisal and Evaluation Guidelines. There you'll read:
"For properties subject to leases with terms that do not reflect current market conditions, the appraisal must clearly state the ownership interest being appraised and provide a discussion of the leases that are in place. If the leased fee interest is being appraised and contract rent is less than market rent on one or more long term lease(s) to a highly rated tenant, the market value of the leased fee interest would be less than the market value of the unencumbered fee simple interest in the property. In these situations, the market value of the leased fee interest should be used."
Don't get distracted by the term "fee simple". It sounds strange because it's a vestige of middle-age, English common law. For purposes of illustrating the point, let's (over)simplify. Assume, for the sake of this conversation only, that fee simple is a rough translation for "ownership".
Example
Here's an example. Your borrower owns an office building. So, in other words, your borrower is the "landlord" to several office tenants under standard office leases. The tenants occupy the building. The landlord, in general, does not.
It might be common in real estate circles to say that your borrower owns the "fee", and that the handful of tenants that occupy the building own a "leasehold" interest -- a fancy way of saying they rent space.
Now assume that your bank is considering making a loan to this borrower. The loan will be secured by the borrower's interest in the office building. You are ordering the appraisal. What interest should you ask the appraiser to value?
What does it mean to appraise the "Fee Simple"?
It's a natural reaction to say "fee simple" -- after all, your borrower is not renting the property from someone else. They own it.
But here's what will happen if you do that. In valuing the property under the income approach, the appraiser will perform market research and use accepted methods and techniques to determine the appraiser's opinion of market rent. In other words, the appraiser will come up with an opinion as to the rent that your borrower could get if they leased space in the building today -- or, more precisely, as of the effective date of the appraiser's opinion of value. Then, the appraiser will use that opinion of market rent to value the building, more or less ignoring the current leases.
Below-market rents highlight the distinction
But what if some or all of the tenants in the building signed long-term leases 10 years ago, and still have 10 years left on their leases? What if those tenants are "credit" tenants (e.g., big, successful public companies with low risk of default) and as a result have sweetheart deals, even in light of today's real estate environment? Well, in that case, the appraiser's opinions about the "market rent" don't bear a resemblance to the cash flow that's actually coming in the door based on the specific terms of those leases. If you want the appraiser to dig through the terms of those leases, the rent roll, and other information and use the actual numbers in the income approach, then you need to order "leased fee".
What if I order it the "wrong" way?
In most cases, if this gets mixed up, it's just a misunderstanding. But getting this wrong can cost time and money. If you order a fee simple appraisal, the appraiser may not think to ask you about leases and rent rolls. He may assume there isn't a lease in place. Then, if you suddenly ask him why he didn't consider the lease, or if the appraiser runs into a tenant on his site visit, you could have an issue. The appraiser may have to go back and review leases and rework his income analysis. It pays to get this right up front.
(Aside from the regulatory issues discussed below, it's not "wrong" to order a fee simple appraisal for a building with tenants. There may be very legitimate reasons for wanting to know the market value of the building using the prevailing market rents and ignoring the specific leases in place. For example, it may be that the leases in place have above-market rent. In that case, a fee-simple appraisal may serve as a means of stress-testing value in the event those tenants were to default and the landlord was forced to re-rent the space. But you should understand what you're ordering. And the appraiser should take care to clearly explain in the report which interest he or she is valuing.)
Does my regulator care?
When you're dealing with a property with below-market rents, it might be tempting to view this distinction as an opportunity to influence value. You may be confident that your borrower's "good for it" and looking for a way to get the property to "appraise out". If you order a "fee simple" appraisal, you could take advantage of the market rents, even though your borrower's locked into below-market rents. But don't do it. Your regulator is paying attention.
Each of the prudential regulators requires that appraisers report appropriate deductions and discounts, and that includes, specifically, for properties with below-market rents. Refer to Appendix C in the December 2010 Interagency Appraisal and Evaluation Guidelines. There you'll read:
"For properties subject to leases with terms that do not reflect current market conditions, the appraisal must clearly state the ownership interest being appraised and provide a discussion of the leases that are in place. If the leased fee interest is being appraised and contract rent is less than market rent on one or more long term lease(s) to a highly rated tenant, the market value of the leased fee interest would be less than the market value of the unencumbered fee simple interest in the property. In these situations, the market value of the leased fee interest should be used."
Kroll Bond Rating Agency Releases Report Examining CMBS Equity Cashouts
Kroll Bond Rating Agency (“KBRA”) has released a research report delving into borrower equity cashouts in the commercial mortgage backed securities market. Given increased competition amongst lenders, we sought to quantify the impact that equity cashouts have had in driving our main stressed metrics into riskier territory.
Although slightly less than half of the loans in KBRA’s Top 20 rated universe have returned equity to the borrower, we also individually reviewed characteristics of the loans to gauge the story behind the numbers. After further review, it is evident that a majority of the cashouts have occurred in loans where the borrowers have had long operating histories of at least five years and where equity has built-up in the property either through equity investments and/or asset appreciation.
That said, the credit metrics of these loans weakened faster than the broader universe. As one would expect, stressed leverage for cashout loans deteriorated faster than the broader Top 20 universe, ending Q2 2014 at 104.3% compared to 101.4% for Top 20 loans.
Although slightly less than half of the loans in KBRA’s Top 20 rated universe have returned equity to the borrower, we also individually reviewed characteristics of the loans to gauge the story behind the numbers. After further review, it is evident that a majority of the cashouts have occurred in loans where the borrowers have had long operating histories of at least five years and where equity has built-up in the property either through equity investments and/or asset appreciation.
That said, the credit metrics of these loans weakened faster than the broader universe. As one would expect, stressed leverage for cashout loans deteriorated faster than the broader Top 20 universe, ending Q2 2014 at 104.3% compared to 101.4% for Top 20 loans.
Chicago: It's the hottest commercial property market since 2007
Sales of Chicago-area commercial properties are on pace for their best year since the crash amid an improving economy and low interest rates.Investors acquired more than $9.15 billion in local apartments, hotels, retail, office and industrial properties through August, up 28 percent from the $7.14 billion spent through the first eight months of last year, according to New York-based Real Capital Analytics Inc.
Sales volume is on track for its highest annual level since its peak in 2007, when $22.5 billion in commercial property sold.
Investor demand for real estate continues to rise amid the slowly growing economy, which is pushing up occupancies and rents, and low interest rates, which has kept borrowing costs low and made it harder to find good returns on other investment types. At the same time, many landlords are capitalizing on soaring prices by putting their properties up for sale. And even higher prices in hot coastal markets are drawing more investors to Chicago.
“Nationally there's more being invested in commercial real estate, but I imagine Chicago is benefiting from the compression in yields and increase in prices in places like New York, San Francisco and Los Angeles,” said Ben Carlos Thypin, director of market analysis at Real Capital.
Nationally, prices for commercial real estate, except for office properties, have passed their 2007 peak, according to a report by Green Street Advisors Inc., a Newport, California-based research firm. A commercial-property price index calculated by Green Street has risen 7 percent in the past 12 months.
Sales of Chicago-area industrial properties have risen 55 percent, according to Real Capital, buoyed by renewed demand for “higher-grade” buildings by institutional investors, said Britt Casey, an executive director in the Rosemont office of real estate brokerage Cushman & Wakefield Inc. With 13.5 million square feet sold here in the first half of the year, Chicago was the most active industrial market in the nation, according to New York-based Cushman & Wakefield.
The recovering economy should help boost demand for commercial space, and support sales and prices in turn, Mr. Thypin said.
“Whether (the economy) continues to grow at the pace it seems to be growing this year remains to be seen, but the bottom falling out anytime soon is pretty unlikely,” he said.
Expecting a typical increase in activity in the fourth quarter, Mr. Thypin expects Chicago-area commercial property sales to exceed last year's total of nearly $14.6 billion.
Significant sales so far this year include the record $850 million paid for the office tower at 300 N. LaSalle St. and the $85 million deal for the 1.6-million-square-foot Solo Cup warehouse in the south suburbs. Other deals include the $60 million sale of the Golf Mill Shopping Center in Niles and the $132 million sale of a Gold Coast apartment building.
Friday, September 12, 2014
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