Publications & Resources

January/February 2010
Managing Troubled Assets

Risk Management and Transition Strategies for OREO Assets

By Don Neff

Pro-active and successful transitions between lenders and their borrowers for various types of non-performing and OREO assets can be challenging in a down market. Good risk management practices combined with open minded creativity are necessary to either successfully work-out a project or effect the successful re-positioning and disposition following either a deed-in-lieu or outright foreclosure.

Three Primary Risks

OREO properties have three primary risk profiles: development, construction and operational risks. The first of these, development risk, largely revolves around land use entitlement issues governed by local, regional, state and federal agencies. Particular attention must be paid to dates here, as there is a finite life for these entitlements. The second risk is more complex, possibly requiring direct construction of the real estate assets, which may be partially completed and possibly abandoned. Multiple trade contractors with their potential liens on title are difficult to manage in a recessionary economy, and often exacerbate the lenders desire to bring closure to the myriad of issues which may be clouding title. Finally, once properties are fully constructed and leased-up, normal ongoing building operation and maintenance are then necessary to protect the assets’ values.

Commercial Properties

Each of the above mentioned risks will differ based on OREO asset types. Commercial properties will include office, retail, industrial, research & development, and other specialty use structures (hospitals, surgery centers, etc). The tenant type will also vary, from small single tenants to large single tenants and multi-tenants. Fortunately, all of these commercial property types carry similar development risks and construction risks. It is the operation risk which will be different, property to property, as a function of the inherent building construction type (per building codes) and internal control systems specific to the type of occupancy and tenant mix. Examples of internal control systems include heating, ventilation, air conditioning equipment, fire protection assemblies, elevator conveyances, etc. Current functionality reviews of fixtures, furniture, and equipment (“FF&E items”) and detailed risk assessments are critical in the lenders’ decision process relative to disposition strategies.

Mixed-use properties which include a rental or for-sale residential component of medium or high density pose a different set of issues and require special analysis due to the multiple occupancy types. As such, the development, construction, and operational risks are more intricate and pose multiple challenges to lenders. For example, the ownership and maintenance of common areas in the project, which are frequently shared between multiple tenant types, require thoughtfully prepared HOA governance documents and service contracts. The success or failure of these projects often goes back to the architects and engineers originally retained to create the concept, which is frequently a three-dimensional puzzle of critical construction assemblies.

Residential Properties

The residential assets may fall into any of the following five major categories: paper lots, blue-topped lots, finished lots, partially completed homes, and completed inventory homes. Lender risks vary dramatically with the size of the project, and can range from single family homes all the way to large master-planned communities in multiple neighborhoods, representing different product types with extensive regional infrastructure and common area amenities. Due to the multiple year construction phasing of such a community, these are the most difficult asset class to manage in an OREO portfolio. The complexity of multiple development, construction, and operational risks require a team of experienced construction managers and engineers to assist the lenders in evaluating their options. There are three options lenders are left to grapple with. Whether to hold onto the asset and work to preserve its value, sell it off as-is (in part or whole) at a substantial bulk discount, or build out the asset to maximize future value.

Property Condition Assessment Reports (“PCARs”)

The gold standard due diligence process in which lenders can quantify their property portfolio risk is via one of three levels of PCARs: A, B or C (the later of which being more detailed than the first). The American Society of Testing & Materials (ASTM) “E2018-08” provides guidance for the risk assessment industry relative to the form and substance provided within these reports. Such topics as those outlined below are helpful for lenders to chart their course of action in managing these OREO assets.

Site reconnaissance & control
Existing conditions analysis
Deferred maintenance
Life Safety issues
Costs to complete
Long term reserves
Clearing up clouds on title
Valuations & dispositions

To mount a successful OREO strategy specific to one asset or a portfolio of assets, a pro-active and complementary team approach is best. The “four horsemen” necessary to shoulder the burden of this responsibility typically include: 1) legal advisory talent to assist with isolating project risks; 2) risk assessment expertise with extensive construction knowledge; 3) comprehensive insurance solutions (specific for the mixed use and residential assets) to cover the 10-year tail of construction defect litigation risk; and, 4) experienced land and new homes sales brokerage for successful project dispositions. With this assistance, regional community banks will be adequately equipped to manage the myriad of issues surrounding their OREO assets.

Don Neff is president/CEO of La Jolla Pacific, a leading real estate consulting company assisting builders and banks with non-performing and OREO assets. He can be reached at drneff@lajollapacificltd.com.