Publications & Resources
January/February 2010
Managing Troubled Assets
OREO Assets: Best Practices for Pre-Foreclosure Due Diligence
By Jeffrey D. Masters
In OREO operations, surprises are both unwelcome and potentially expensive. As a result, the bank must have early answers to two critical questions: What is the bank acquiring? What must be done to maximize the value of the asset and reduce the bank’s risk? Effective pre-foreclosure due diligence is essential to answer these questions and to position the bank for successful ownership, management and disposition of real estate assets.
The bank’s due diligence procedures should be driven by the type of asset in question. Western banks now are confronting a wave of troubled real estate projects, particularly residential condominiums, mixed used developments and tract housing. This article offers a brief overview of best practices for pre-foreclosure due diligence as to these asset classes.
For several reasons, residential and mixed use projects present special challenges for the foreclosing bank. First, by stepping into the role of project owner and potentially, builder and seller, the bank may be subject to new and unfamiliar legal exposures, including extended construction defect liability under state law. Second, the bank must be prepared to successfully guide the project through a complicated process to obtain or amend regulatory approvals, prepare legally-compliant consumer documentation and provide for appropriate homeowners association (“HOA”) governance structures and documents. Third, if the bank elects to complete the project and sell units to consumer end-users, the bank as seller must provide for long-term customer service and warranty attention.
These and other challenges require that the bank be thoroughly knowledgeable about the asset before foreclosure. It is recommended that the bank focus on three main due diligence information sources: the bank’s internal files, the borrower’s files and third party documentation.
The bank’s own files should be reviewed first. Important documents to obtain and review include existing insurance information; an updated title report, to reveal potential title issues, liens, easements and similar encumbrances; an updated appraisal; and fresh market feasibility studies.
The borrower’s files will contain critical project-specific data. Banks are urged to obtain the borrower’s relevant documentation early in the workout process, before the relationship becomes adversarial. Among other things, the bank should carefully analyze environmental reports; entitlements and agency approvals (including development agreements with local agencies, the condominium map or tract map conditions and the status of satisfaction of the conditions of approval); design and construction contracts and bonds, together with the status of performance under the contracts; and design and construction quality assurance (“QA”) reports.
If construction is underway, the bank will want a solid analysis of the cost to complete the project. If the project is partially sold, the bank needs to understand the status of sales activity in order to plan for further marketing of the units. For condominium projects, the bank should assemble the existing regulatory approvals, public reports, HOA budgets, governance documents and consumer sales documents to determine if extensions of the approvals, or modifications of the documents, are needed.
Finally, third party documentation relating to the project should be collected and analyzed. Typically, this documentation includes both local and state agency data. In some cases, information also should be obtained from federal agencies, such as the Army Corps of Engineers. Property condition assessment reports (“PCARs”) should be commissioned and reviewed by the bank to determine whether immediate issues, such as weather protection, need to be addressed. The PCARs also may reveal deficiencies in construction that should be addressed prior to completion of the project.
Comprehensive pre-foreclosure due diligence minimizes costly OREO surprises. Armed with the necessary information, the bank can make informed decisions about how best to mange and dispose of its OREO assets.
Jeffrey D. Masters heads the Development Risk Management Practice Group at the law firm Cox, Castle & Nicholson LLP in Los Angeles. He may be reached at (310) 284-2239 or jmasters@coxcastle.com.
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