When Financial Distress Leads to Physical Distress

In recent months, it appears that lenders, debtors and investors have begun to deploy some of the “dry powder” capital that has been sitting on the sidelines. However, the practice of amend and extend has meant that some of these assets have been sitting dormant or physically unprotected for long periods of time. The lack of TLC can lead to hidden problems. That necessitates increased due diligence, with careful attention paid to the debt structure, market valuation and physical characteristics of the property.

In recent months, it appears that lenders, debtors and investors have begun to deploy some of the “dry powder” capital that has been sitting on the sidelines. However, the practice of amend and extend has meant that some of these assets have been sitting dormant or physically unprotected for long periods of time. The lack of TLC can lead to hidden problems. That necessitates increased due diligence, with careful attention paid to the debt structure, market valuation and physical characteristics of the property.

On the physical side, it is important to identify and mitigate risks associated with construction and environmental issues on both stabilized and non-stabilized assets. Failure to identify hidden risks in these assets may result in parties unknowingly assuming substantial liabilities that could affect the financial viability of the transaction.

Construction-Related Risks

Three key construction-related risks to focus on when assuming a nonstabilized asset are incurred costs, estimated cost to complete and potential defects or rework that will require additional funding.

Incurred costs are sometimes commonly referred to as actual costs paid to date on a project. Understanding where the variances are between what was budgeted (or contracted) and what was actually spent can expose potential risks or inefficiencies in the execution of the work. Some examples of variances include:

■ Billings not in accordance with contractual requirements, excessive costs relative to industry benchmarks or payments ahead of physical work in place;

■ Billings without support, unreported costs or apparent fraudulent costs;

■ Mechanics liens from contractors, subcontractors or other vendors;

■ Work that does not meet building and zoning codes.

The estimated cost to complete is a critical value in order to evaluate whether there is sufficient capital to fund the cost required to complete a project or if additional capital may be required. One method of understanding the cost to complete is to identify any remaining open contracts or uncommitted costs that would indicate where work has not been completed. Once identified, it will be critical to determine if these existing contracts are still valid or will have to be rebid. Another typically overlooked area is whether there are any development obligations for on- or off-site infrastructure work (roads, easements and sewers), as well as investigating whether any permits or insurance policies are still valid. Stalled projects could require additional money to maintain site safety and security, erosion controls or temporary infrastructure.

Potential defects or rework due to poor construction or lack of proper maintenance may also add delays and costs. Say, for example, a lender assumes a property that was represented to be 75 percent complete, only to realize that 25 percent of the work completed has to be removed and replaced due to defects or improper construction methods. An experienced construction manager and/or professional engineer should be engaged to assess the work, evaluate whether it has been completed within quality, safety and industry standards, and consider what may be required to complete the project from a time and money perspective.

Environment-Related Risks

The first thing that any potential buyer or acquirer should do is ask the simple question, Are there any environmental liabilities already identified? As part of the due diligence process and prior to a property transfer, a Phase 1 Environmental Assessment should be completed that lists a summary of environmental risks, such as presence of asbestos or underground storage tanks, past remediation efforts, the property’s past uses, as well as surrounding properties’ environmental issues. It is important to attempt to mitigate the potential risks associated with soil or groundwater remediation and building construction.

Soil or groundwater remediation risks would include any past or current land and water issues that can be related to on- or off-site uses. This may include properties that have already been identified by the state or federal government as impacted and become a Superfund or brownfield site. More important, the costs associated with a property and whether it can be transferred in an expeditious manner depend upon the phase of remediation. For example, a lender might acquire a property for a certain price in the early phases of investigation with the pro forma tied to a cleanup date of one year, only to realize that the data obtained was in such an early phase of investigation that additional remediation is required and delays subsequently postpone and even stop the project while overruns ruin the profit potential of the investment.

Building risks may include issues like lead, asbestos or mold. Lead is particularly a problem in multi-family residential transactions involving older properties, and an owner will need to protect against the risks that arise during common renovation activities like sanding, cutting and demolition, which can create hazardous lead dust and chips by disturbing lead-based paint. This will likely impact the simplest of renovations, not typically associated with remediation.

Asbestos is another concern for owners and may be found in pipe insulation, boiler rooms, flooring and roof shingles, while mold is an issue both during and after construction in buildings that have been poorly constructed or lack adequate ventilation. There are different types of mold that may breed in air circulation and drywall systems. Mold can be very toxic, which can result in both property damage and personal injury lawsuits. Additionally, the presence of moisture or mold can result in physical damage to the structure, requiring removal and replacement.

Don’t forget the basics of acquiring a property in order to mitigate these construction and environmental risks, and recognize that distressed transactions are more complicated and take longer to close than those under normal conditions. Ask the right questions, visit the property, conduct thorough due diligence and use prudent underwriting standards to help ensure a successful acquisition.

Steven Bandolik is a director and Robert Strahle is a manager for Deloitte Financial Advisory Services L.L.P. This article contains general information only and is based on the experiences and research of the authors. Deloitte Financial Advisory Services L.L.P. and Deloitte & Touche L.L.P. are not, by means of this article, rendering professional advice or services.

This article originally ran in the February 2011 issue of CPE’s magazine.