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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   May 2009

Let's Get Physical

By following seven tips, brokers can better assess risks involved with property-condition assessments

Let's Get Physical

Seasoned mortgage brokers know that gathering as much information as possible about a transaction before it closes makes sound business sense. One major consideration is the subject property's physical condition.

Building maintenance can be costly. And if property-owners are unwilling -- or unable -- to pay for preventive maintenance, the property's value may plummet. An improperly maintained building also can spell trouble for lenders, which face a possible loan default if money problems are the cause of neglected maintenance.

Fortunately for all parties, a property-condition assessment is designed to assess these issues, and stakeholders in commercial real estate transactions routinely supplement their due-diligence investigations by requesting one.

Brokers and their clients should know that these assessments don't always tell the full story. By adding seven additional tasks to a property-condition assessment, potential buyers can help mitigate risk for themselves and for the lender that may fund their deal. Here's how.

Property-condition assessments are designed to benchmark the physical conditions of a property's components. They also provide an opinion of the probable cost to remedy deferred maintenance and future capital expenditures, which are usually projected over the term of the loan.

As such, a typical assessment consists of a site walk-through, document review, and research and interviews with facility managers. Its key components include:

  • A general description of the property's components and systems;
  • Identification of physical deficiencies; and
  • Opinions of probable costs to fix deficiencies.

A property-condition report summarizes the gathered information.

Most property-condition assessments follow the guidelines in ASTM International's E2018-08, "Standard Guide for Property Condition Assessments: Baseline Property Condition Assessment Process." Many lenders follow this standard without modification.

But just as the organization's standard for Phase I environmental site assessments is not a catchall for every environmental problem that could impact a property, the baseline ASTM standard for property-condition assessments should be seen as a minimum level of due diligence. Although it's widely used without modification, many borrowers -- particularly those with a low risk-tolerance level -- will find the standard alone won't satisfy their due-diligence requirements.

Brokers should advise their clients that while a property-condition assessment prepared to the current industry standard can provide a lot of useful information, it might not tell the whole story. To get a better picture of what's at stake, it's best to direct the assessment-provider to consider some additional issues.

The following seven issues also should be a part of the property-condition assessment's scope of work. Prudent borrowers will ask the assessment-provider to perform a baseline property-condition assessment, as well as to:

1. Conduct tenant interviews. When it comes to building performance, this obvious source of information often is overlooked or ignored. But it can lead to a wealth of data. A qualified field observer spends a few hours to an entire day at a facility. But tenants occupy that space eight hours or more each workday. As such, they typically are aware of any climate-control problems -- the second-most-common area of complaint after water-penetration issues in a building's envelope. Tenants often can also provide useful information about building-maintenance issues, latent or chronic defects, and historical repairs.

2. Review tenant- or guest-complaint logs. These logs may readily identify latent or chronic problems, and they are especially useful when assessing the condition of hospitality properties. Reviewing these logs may reveal common, chronic complaints such as noisy climate-control units, temperature-control issues, the presence of mold or musty smells, water leakage, and more.

3. Interview building service-providers. The property-condition-assessment provider often can get a schedule of all building service-providers and copies of their service agreements -- including names and contact information. It may be beneficial to speak with each service-provider to determine if there are any pending or outstanding repairs, improvements or code-mandated proposals. Often, service firms can provide the property's repair history and identify chronic defects or problematic systems. These problems may also be flagged in the service firm's invoicing records, which warrant examination, as well.

4. Confer with specialty consultants. Most buildings are complex, and there likely is no single field observer who knows every system or component inside and out. Therefore, it's important to augment the field inspection with experts who have hands-on experience with repairs or replacements of specific systems or components. Depending on the building, these individuals may include boiler mechanics, air-conditioning and cooling-tower technicians, swimming-pool-service technicians, roofers, fire-alarm-panel technicians, parking-structure inspectors, fire- and life-safety-code consultants, façade consultants, and others.

5. Verify rentable square footage. Most commercial property acquisitions occur without independent verification of the net lease area; whatever the seller provides usually is accepted as fact. In the current economy, however, with tenants stressed and leases prone to audits, it is prudent to verify square footage during prepurchase due diligence.

6. Obtain all guarantees and warranties. It is important for buyers and lenders to understand the type of guarantees and warranties the seller presents. Does the contractor, the manufacturer or the vendor issue them? Is it necessary to have a warranty by the manufacturer and another by the installing contractor? Are these warranties for labor and materials or for materials only? Give special attention to the assignability of the warranties upon transfer of the property's title. Many warranties are not automatically assignable to a new owner; some require a transfer fee, a reinspection fee or both. Sometimes, a manufacturer's reinspection will note repair work performed by an unauthorized contractor, which would void the warranty.

7. Check for government-agency approvals. It is important to determine whether there are any zoning-board-approval variances granted for the property and whether the zoning board may have imposed any development or current-use restrictions as a condition to grant the variances. If applicable, the property-condition-assessment provider should obtain copies of the approved site plan, the zoning board's written decision and any variances granted. In addition, planning-board approvals warrant examination because there may be restrictions on signage, colors, design, parking, operation hours, use of space and other issues. Regarding the certificate of occupancy, buyers and lenders should ensure they understand exactly what documentation has been issued for the building. For example, is it a partial or a temporary certificate? Does it expire? Most important, is the use permitted?

In addition to these seven considerations, the property-condition-assessment provider likely should conduct a thorough interview with the building engineer and document the results. Building engineers sometimes are involved in the original construction, and they may have specialized knowledge regarding the building's systems and any problem areas with the construction. They also usually know where everything is located and buried and understand the building's quirks.

Augmenting a property-condition assessment with these issues may uncover issues that would otherwise remain unknown, affecting a property-owner and lender when it's too late to remedy. By working with clients to ensure that their prepurchase due diligence on a property covers all necessary bases, brokers can help assure that borrowers and lenders are entering a deal with their eyes open.


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