Printer Friendly

Practical REO management.

Institutional owners of commercial real estate can limit losses on REO through a proactive approach to property management.

When investment-grade, commercial real estate derives value from the sufficiency and durability of lease income, a passive real estate management stance is often costly. On the other hand, making sure there is skilled management in place to preserve the appeal of these properties to tenants will yield significant rewards.

A proactive approach to the management of real estate owned (REO) can limit losses for its institutional owners. Developing positive operating incomes from assets acquired by foreclosure is possible. Still, risk-limiting steps and effective management methods need examining.

The dynamics of current markets suggest that swift and effective effort is needed to seize control of real estate when foreclosure occurs. By doing so, not only is it possible to hold losses to a minimum, but future gains on resale can even be realized.

Enhancements to net operating incomes during holding periods can minimize perceptions of taint in the real estate portfolio. Real estate remains a unique class of collateral. Few "marketable securities" are burdened with the twin characteristics of illiquidity and intensive management need.

The "illiquid" characteristic of real estate represents the months or even years that usually will be needed before converting the asset to cash, for alternate investment. And where there is negative or no cash flow, the opportunity cost of ownership clearly is measured in infinite terms.

"Capturing the asset," that is, seizing control of the asset and implementing effective management procedures may only result in modest current income. Capitalization of future income enhancements, however, can yield future gains in value over cost.

The institutional lender is obviously constrained to some extent in the amount of control it can exercise during the early stages of foreclosure--I call it the "REO-in-transition" phase. But some early steps to seize control remain available.

Clearly, the earlier one gains knowledge of the asset characteristics, the greater the opportunity one has to limit losses or improve income. And certainly, preparation for handling of the property ("management of the asset") can begin with review and abstracting from the loan files on hand. Early, speedy, information-gathering can pay off in greater returns to the lender who becomes an owner.

A passive approach to real estate management is often explainable. There are several reasons for delayed action in seizing control of the asset:

* unclear management

guidelines; * inexperienced, low-level

staff in charge; * unbudgeted expense; * the legal processes that

are involved in

recovering a property through


Even so, the information-gathering part of the process is helpful in the early stages. Institutional managers armed with information are thus able to move effectively, knowledgeably and profitably to superintend real estate under their administration. Then, the transition can quickly be made from "passive" superintendency to active management.

REO in transition

Let us try to define the point at which the income-producing asset goes into a condition of distress. The following hypothetical situation is common:

The billing department has sent the required number of late notices. Periodic payments have filtered in irregularly and some have been credited while others have not. Meanwhile, taxes have gone unpaid and/or notices have been received of pending cancellation of insurance. Correspondence (but little money) has been received from the borrower, and sometimes the borrower has outlined plans for timely resumption of payments in the future. Further, the borrower has requested forbearance or even loan modifications and additional advances "in view of the fact that the collateral is worth so much more today than when the loan was made," and "your records will show our payment record in the past has been impeccable." Marvelously creative reasons for late or overlooked or omitted remittances are offered. (Blaming "the computer" seems pretty much old hat now, but there seem to be a tremendous number of "recently fired" bookkeepers out there.) Still, wonderfully imaginative scenarios are described for skyrocketing property incomes and, hence, values. In the final analysis, the property is found to be 50 percent vacant, landscaping and signs unkempt and janitorial supplies only obtainable through cash-in-advance. In the worst-case scenario, the owner/manager has been recently and bitterly divorced, the partners only "want out" and the notes are overdue on both their Mercedes.

Is there any doubt where responsibility for this hypothetical asset's management will soon vest? The early decision to be made, then, is: Shall the institution act as caretaker or as manager?

An early-used definition of "property management," sometimes called "asset management," is useful for this discussion. As noted in the National Real Estate Investor, (June 1990, vol. 32, no. 6), "Property management companies across the country generally agree that owners benefit in combining management and leasing. With both sides working together, they ensure a steady income stream."

It is not clear to me where, or when, a division of duties between management and leasing arose, but it somehow did--and unfortunately so. To manage has become, in the minds of many, a "caretaker" role--the tasks of arranging performance of periodic maintenance and paying utility bills, with an occasional swipe at a tax reduction effort. A highly unimpressive cadre of "property management" firms quickly have come on the scene, but they provided little more than "caretaker" duties--albeit with the addition of some high-tech computer equipment in the office.

When linked with the leasing and-sale functions, full-service property management firms and professionals can furnish services that will help attain the desired goals of property protection, boost incomes (or reduce operating costs) and dispose of the asset at optimum price.

Typically, the institutional owner (or owner-to-be) will seek outside property management expertise. While preparing for ultimate property management assistance, early preparations can be made to gather needed information. Outside of the loan file itself, REO-in-transition files may include:

Folder A:

* a ledger listing foreclosure

expenses as incurred; * expense budgets and forecasts; * foreclosure correspondence with

counsel; filings.

Folder B:

* insurance; * property inspection reports; * appraisal(s); survey; as-built

drawings (current); * environmental reports and

subsequent evaluations; * leases; rent roll; * correspondence unrelated to

previous items.

Folder B will be the source of property management information for in-house personnel and outside-retained managers. The following describes the documents in detail that should appear in each file.

Insurance--Either an in-house risk manager, corporate "blanket" coverage or selected agencies can furnish ongoing coverage. They should be advised of required coverage, including annual loss-of-rents. (Use of an existing insurance agent should be considered, both for the agent's likely familiarity with the property and for added input about the local area.)

Property inspection reports--Includes those purged from loan file and the initial report of inspector when collateral was being reviewed in contemplation of likely takeover.

Appraisal; survey; as-built drawings--In addition to a copy of appraisal made at the time of loan origination, a new, first-quality narrative appraisal should be requested. This should include the appraiser's evaluation of current market conditions. The appraisal should be relied upon not as a conclusive index of value but as a resource for future plans and decisions. The appraisal will furnish: currently attainable rents (per suite, per-square foot, etc.); current burden of costs, typically on per-square-foot basis; and projections of rate of rent-up.

Unless releases were made during the loan term, original surveys can usually suffice for early informational purposes.

"As-built" drawings of premises should be ordered and obtained from a local surveyor or architect. In all likelihood, the interior build-out of the premises will have changed from the condition at the inception of the loan. (Note: In the case of office buildings, have the architect calculate the gross and leasable areas according to current Building Owners and Managers Association [BOMA] standards. An office lease understated as to size but negotiated at $11 per square foot may well be equivalent only to $8 or $9 when properly sized.)

Environmental evaluations--File should contain copies of an initial environmental evaluation, and it is advisable to include an update or any new environmental evaluation since the initial report. Also obtain bids for and prepare to cure noted exceptions if they are deemed sufficiently non-problematic such that foreclosure should proceed.

Leases; rent roll--A current rent roll will be eminently useful. Preparation is from the rent roll furnished at application and leases and estoppels obtained at closing as well as the personal inspection and borrower-furnished current updates. Prepare a spreadsheet to list: tenant, tenant's address (both property and mailing address, if different), area occupied, rent paid, term of lease, whether gross or net or some combination (detail tenant's and landlord's respective obligations to pay expenses of occupancy).

Correspondence; other miscellaneous documents--Property-related correspondence, municipal notices, and utilities service information are examples. Contact with brokers/managers and contractors unrelated to these should also be maintained.

Capacity of lender to act

Discussion thus far has been of properties that are considered REO-in-transition, which is sometimes unclear and even treacherous territory. A largely passive role may be played by necessity at this stage, as when a borrower tenaciously clings to the security in the hope of making it well again and hopes to avoid adverse tax consequences. Similar passivity may be expected following sheriff's or trustee's sale and before the redemption period has expired.

Still, there are options. One is a buyout of the borrower's "equity of redemption." This can be a damage-control technique that includes negotiating for a borrower's deed, for cash, prior to the expiration redemption period. It may protect now-hostile tenants whose retention, albeit at substantial cost, is preferable if long-run duration of occupancy by a paying tenant is anticipated. (Estoppels and title insurance to be obtained before consummating, of course.)

Another option is to act as a mortgagee-in-possession, following execution on assignment of rents. Again, this is a somewhat tenuous position and may precede the owner's conveyance by deed-in-lieu if agreeable and insurable. Legal counsel is required to assure proper documentation.

Also, a receiver may be appointed, sometimes with consent of borrower by stipulation. While the receiver is an appointee of the court and "independent" of either the lender or borrower, the receiver likely will be a party recommended by the lender. In the interim--before the completion of foreclosure proceedings--the receiver will expectedly look to the lender for direction and guidance. Property managers often lust after their appointment as receiver--perceiving, and somewhat rightly so--that they act with independence. Their compensation, typically on an hourly or per-diem basis, is assured for whatever property management effort is undertaken and for court appearances or reports filed. Thus, to be appointed as receiver places them in a good position to assume full agency role for the owner once foreclosure proceedings have been completed.

A fourth option is undertaken through actual or constructive abandonment of premises, and assumption by the lender as agent of the borrower, either to make "protective advances" under clauses of the mortgage documents that permit the lender to "preserve and protect" the collateral, or through the borrower's overt consent to accept "protective advances" in order themselves to be able to "preserve and protect."

Implementing effective REO/asset management

One of the exercises undertaken by candidates for Certified Property Manager (CPM), designated members of the Institute of Real Estate Management, an entity of the National Association of Realtors, is to prepare a "management plan." At the outset of managing any asset, it is important to prepare a plan and budget that can provide a roadmap that assists the management and ultimate sale of the asset. Such a management plan should be sufficiently comprehensive to take the following steps:

Look at start-up expense--This should be considered extraordinary, outside of building operating expenses. It would include all those elements of deferred maintenance that likely have accrued as reported by the appraiser, as noted by lender's inspector or property manager, and of course, addressing the initial accrued beefs and requests of the tenants in occupancy. (Note: ask tax counsel about the treatment of these costs--it is likely that repairs performed pursuant to a "plan of renovation" must be capitalized, rather than expensed.)

From the rent roll (as modified to the date of takeover), project rental income at actual, plus projected attainable--Attainable rent can probably be that projected by the appraiser, but rate of rentup on vacant space can be as forecast by the property manager and the lender's representative.

Forecast expenses from income/expense data obtained from borrower--The property manager's experience and the appraisal report can also contribute to these projections.

Summarize--Summaries should include: present start-up expense (often 5 percent to 10 percent of current value); initial annual operating incomes (or shortfalls); perceived future capital improvements expense; leasing goals; and recommended change-in-use, if this appears merited.

Early steps in effective REO management

Upon expiration of the redemption period, some early actions should be undertaken. In some states this will be simultaneous with trustee's sale, or in other states whenever it is confirmed that actual--not prospective--ownership vests in the former lender.

Action taken at this time should be in tandem with outside property management expertise, if any is retained. This should include setting up general journals and ledgers for ongoing monthly and annual financial reporting. Utilities should be notified, and locks and keys changed where necessary. Also, send a letter to each tenant informing them of the new manager and an address where rent should be sent. (Hint: Request copy of tenant's lease agreement--and enclose a check for modest sum--$15, $20--"to compensate you for mailing and copy expense.")

Also at this time, evict any undesirable tenants (this is rarely required, but it is conceivable that some illegal activities may be uncovered as result of earlier inspections). Tenants occupying without estoppel and attornment agreements may be readily removable, but a better idea is sometimes to buy out tenant's "improvements" if an adverse reaction or publicity is deemed likely.

Begin earliest possible signs of improvement of premises, such as landscaping, painting and carpentry repairs. In other words, demonstrate responsiveness to reasonable requests for services to which tenants would normally be entitled but were foregone by previous owner.

Landlord-tenant relationships in investment property

Recovered REO has been presumed thus far to derive value largely from tenancies. But occupancy by tenants under this new institutional owner, now the landlord, presents some unusual management problems.

For example, many tenants will be found to have paid security deposits under leases in effect at the time of takeover. The attorneys may be diligent in their earnest efforts to pursue the now-defaulted borrower for a suitable accounting for, and remittance of, security deposits. Typically, the money has long ago been spent in an effort to survive foreclosure.

Thus the new holder of the REO property will ultimately have to face up to returning security deposits it never received--or risk alienating other tenants who learn of the failure to do so. Actual liability to refund security deposits is often arguable, but the typical one-month's rent refund request is a small cost to pay for the value of a harmonious relationship with renters.

Again the point warrants emphasis. Value is a function of income, and income derives from tenancies. Well-tenanted properties, with the owner sharing a substantial burden of its care, can be productive during ownership, valuable and salable. And particularly during a deflationary period, skilled management of the asset is fundamental.

Applying "TLC" to run-down properties is almost always productive in placing or retaining tenants, particularly when the property manager perceives that, by investing such care, the owner intends to take the property out of an "ordinary" class and make it into a "marketable" property. The outside property manager is seldom going to make money purely from the "management" function but will be seeking commissions on leases and on the property's eventual sale. Perceptions that lease-up can occur and, thereby, a sale can take place, will clearly invigorate the manager to tout your property rather than another's.

Suggested initial steps toward cure of deferred maintenance include new, eye-catching signs that establish the property's new identity; an improvement in landscaping and parking, with new lawns, flowers, restriping and sealing of parking lot; and new exterior paint. New carpeting is also an attention-getter. Where the carpet is still usable may remain a negotiating factor--but use 40-ounce cut pile at least in reception areas, even though 28-ounce, level loop, or a similar grade, may be the "building standard" elsewhere. Replace existing lighting and any stained ceiling tile. Build a "smoker's lounge" that can be modest in size, minimally furnished, but ventilated. Tenants appreciate them--some national credit tenants even require that owners furnish one anyway.

One of the eternal verities in real estate lease or sale negotiations is that clearly noticeable physical deficiencies, in the eye of prospective tenant or buyer, will cost twice as much to cure as the actual fact. The point is that cost-to-cure becomes a non-factor or minimally important, if dealt with at the outset.

And, finally, when the time comes to place (or replace) tenancies, your lease negotiations can proceed, hopefully employing either a standard form of lease commonly accepted in the local market, or possibly with the owner's customized form. One recommendation--keep it as simple as possible.

For instance, in slow markets, it is often ludicrous to employ convoluted "inflation-index" lease clauses. If short leases (one to three years) are in place, rents can be adjusted sufficiently anyway. It is better, in any event, to build in a flat annual dollar increase (if negotiable) or a flat (and modest) percentage factor for increases of base rentals.

Compensation of property managers

Fees paid under property management agreements to outside managers are always negotiable. Standard agreements setting forth a minimum versus percentage of rents collected are common. There is no accepted, "standard" fee that is payable nationwide, or even in a single market.

Fee clauses should also define commissions due on new leases, expansion of an existing tenant into added space, extension of existing tenancies and on ultimate sale.

The full-service, outside property manager will typically seek a clause obliging the owner to offer the property for sale exclusively through the manager for which a separate agreement can be written. Separate listing agreements can, of course, set forth not only a price but the terms by which the premises may be financed. In some states, financing on a contract-for-deed may be preferable to a take-back mortgage or trustee's deed, although the financial terms of the receivable may be the same.

Watch for that "security deposit" question to raise its ugly head once again--when a buyer is found, price is negotiated and the time for closing comes--with the buyer seeking credit for security deposits allegedly held by the seller. The knowledgeable buyer will, of course, have sought and been provided the existing leases or abstracts. The presumption on the part of most will be that security deposits held by the landlord are transferrable to the new owner.

Strategies for success

A deflationary environment for real estate has been created from the excesses of the past. What was once viewed to be a long-term, "structural" inflationary trend meant that too many developers, building for markets that might or might not develop readily, were simply "betting on the come." As a result, there exists years and even decades of inventory in some classes of real estate in many markets.

Yet, the distressed property under institutional management retains the characteristics of real property everywhere: it is discrete as to location and market. Immobile, unique and slow to liquidate, the owner's sole recourse is to skillfully manage the property for current income and control of current expense, until the buyer/user or buyer/investor appears on the market.

Appraiser News, published by The Appraisal Institute, reports, "Banks are resorting to auctions, showrooms and hired deal makers to rid themselves of foreclosed real estate property (June 1991, citing The Wall Street Journal).

This age-old approach to liquidation may be appealing--particularly in the search for quick cash--but there are more satisfactory routes to productive and even profitable treatment of real estate.

While returns on investment in foreclosed property are almost always negative at the outset, and may be mostly modest even after the investment of substantial cost and effort, the argument there is that the application of skillful property management is preferable to "fire sales."

Seeing rewards

The institutional owner is often perceived by contractors and agents as the party with "deep pockets." It is smart for the institutional owner to tap available funds--and to plan for the wise use of funds to optimize returns on real estate assets. Real estate is marketable, if not immediately liquid. But it takes skill and management planning to accomplish the desired goals.

It is rewarding to see what the skilled treatment of property can produce, compared with the impact of shoddy mismanagement--which often is the cause of institutional ownership in the first place. Managers take pride when dealing with tenants, and brokers sense profit opportunities when it comes to market.

We all remember the "runaway inflation" of the early 1980s, which slowed but then gave way to the "structural inflation" of the mid-1980s. Later, when the accelerated cost recovery system (ACRS) was removed from the picture, reality began to return, as tax benefits no longer dictated market activity.

But real estate ownership and investment continues--and will long be a favorite--in the investment plans of many owner/users, as well as investors. It still retains some of its non-cash deductible feature to enhance after-tax returns.

Finally, we are not arguing here that one should "pour perfume on a pig." On the contrary, some underwriter or analyst, and more likely, a loan committee, once judged the real estate recovered by foreclosure to have positive qualities. Restore the missing factor of competent management, linked with sufficient capital, and you can realize value from recovered properties.

During the current interim period, while the absorption of overbuilt markets is occurring, there will be opportunities not just to improve the appearance of properties and the faces of communities, but to show a profit while doing so.

Dean R. Luedders recently retired as a senior mortgage underwriter and is currently a licensed broker-Realtor and certified general appraiser. He operates a practice as an independent appraiser and consultant with offices in Lansing and Frankfort, Michigan.
COPYRIGHT 1992 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Title Annotation:real estate owned
Author:Luedders, Dean R.
Publication:Mortgage Banking
Date:Feb 1, 1992
Previous Article:Preserving frozen assets.
Next Article:The art of auditing ARM portfolios.

Related Articles
Top dollar.
Customized outsourcing.
The premier web marketplace for REO property over 10,000 listings.
Banks readily lending on commercial real estate.
Better REO solutions: a host of new solutions to support REO disposition couldn't have arrived at a more opportune time.
ServiceLink integrates ATM Corporation products.
Vacant homes--the next frontier in mortgage servicing.

Terms of use | Copyright © 2017 Farlex, Inc. | Feedback | For webmasters