Hot issues in today's real estate market.
Thoughts on Securitization: Commentators have focused frequently on the restrictions which the Faustian bargain called securitization impose on the operating side of the real estate business. They have dwelled typically, for example, on the size and dispersal of escrows and reserve funds which are carved out of loan proceeds to cover deferred maintenance; "TI" reserves for tenant fit-outs and leasing commissions; so called "rent-up" reserves; and reserves for such distractions as the perceived cleanup problem relating to a long-gone dry cleaner. But little focus has been given to the underwriting and closing process itself and how it takes its toll on the borrower and its team.
Anyone who has recently closed a loan headed for securitization will bear ample witness to the mind-numbing changes which have taken place in the closing process. An old tale has it that a legendary closing attorney remembered by most of us never feared for no-shows at the closing, for if the client failed to show, he would sign the papers The title company? He would write the insurance. The bank? You guessed it - he would fund his own money. Today, all chairs might be filled, but there is an empty one, albeit invisible, that no legend can fill, namely, that of the rating agency. The thirst for yield which spawned the securitization technique now drives it, and with it every decision, even those seemingly remote to the loan's salability.
In the past, no one ever expected a loan officer, no matter how many bar mitzvahs or Yankee games you attended with him or her, to renegotiate rate, debt service, maturity or collateral requirements. Yet one could always go back with such requests as changes in the loan papers, concessions in reserves and related enhancements. Now it seems that lender's counsel is required to discuss with Moody's the rating effect from a change from yellow paint to green.
In a recent transaction, it was the rating agency, not the senior partner, who had to determine whether a 1,000 square-foot dry cleaning location whose occupant moved out in 1971 required a $10,000 clean-up escrow. Another one was whether a change in the mortgage text governing sale of the property from "assume" to taking "subject to" required rating agency approval.
No one doubts that the capital markets have been a savior for many owners and creditors strangling under bank credit, but serious thought should be given to bringing a sense of practicality to the funding process.
Building the Deal
In an ironic twist to what's been said above, the analysts riding herd over the rating agencies have brought a much-needed sense of caution to the acquisition process by emphasizing how numbers and paperwork can flush-out hidden costs and pitfalls affecting pricing. Real estate practitioners speak of "building a deal" as the process of computing a true coming-in yield on investment. By taking a rent roll, netting out expenses and the cost of capital, and dividing through by the equity portion of the purchase price, anyone can compute their supposed going-in yield. In truth, this is but the beginning in analyzing true capital needs, since what may walk and talk like a nine cap, isn't. We are not talking here about additional cash calls to cover recording, title and filing costs; legal fees; payments for prepaid real estate taxes; tenants' securities adjustments and the like, which themselves may drive down yields more than a few basis points. Our focus here is on the hidden capitalized costs that only the most thorough due diligence can disclose.
A common strategy today is to acquire a property and improve the size and quality of the rent roll through vigorous promotion, capital upgrades, rent incentives and so on. Our recommendation in this type of transaction is to pick the losers, not the winners. By knowing intimately a property's weaknesses, as well an its strengths, a window to its true cost will emerge.
Has the property slipped to a looser grade because of physical mismanagement or deterioration of the area at large? To assess the answer, it is essential to obtain the seller's operating budgets and maintenance programs alongside the appraisal report, demographic searches and physical inspection reports. Don't take no for an answer or accept a wave of the hand by the clerk at the building department - the "lost" files are sure to appear.
Services and management may have been performed under sweetheart deals with the current owner which are sure to increase after the sale - and it is also pays to investigate the status of labor peace. In a leased property, obtaining estoppels on a proper form and examining them closely will reveal volumes about the tenants' expectations. Many localities have taxing and licensing regulations that are triggered upon sale. Also, title issues (rights of first refusal and reciprocal easements, for example) may cut into yield.
The sum total of the due diligence can then be translated into the legal context where tax planning, need for representations and warranties, investor participation, form of entity and financing issues will assume contours etched by the forces of due diligence.
It is essential to bear in mind that these efforts have a price - they are conducted in a given rate environment, and the importance of digesting the material quickly and translating it into financial and legal reality cannot be overemphasized.
Whether a securitization loan or conventional bank mortgage, the analyst or lending officer will require a hard-nosed assessment of the actual dollars which will he needed to ensure that the outcome of their efforts will not be a problem loan. In short, know the market as well as your lender does.
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|Publication:||Real Estate Weekly|
|Date:||Jun 3, 1998|
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