The Value of Property Condition Assessments in Commercial Real Estate Lending; a Property Condition Assessment Can Be Used in Pre-Purchase Due Diligence and for the Life of the Loan as a Reference Point and an Asset Management Tool. with the Proper Scope, It Can Help the Owners Stay in Compliance with Applicable Codes and Regulations

Article excerpt

[ILLUSTRATION OMITTED]

Commercial real estate lending is a complex job. When deciding whether to extend credit, savvy lenders must act like detectives, weighing multiple factors before rendering a decision. For loans secured by real estate, there are obvious considerations such as the borrower's creditworthiness, the property's loan-to-value ratio, and the presence of environmental risks like lead-based paint or asbestos.

But other, less obvious considerations can also impact a commercial real estate deal. One such issue is building maintenance. Borrowers who allow an asset to deteriorate because they can't--or won't--pay for routine upkeep can cause serious problems for lenders. In today's economy, maintenance considerations take on even greater importance because many borrowers are strapped for cash and the cost of building materials is rising. Fortunately, a tool called a property condition assessment (PCA) can help a lender factor these important considerations into lending decisions. Here's what you need to know.

Property Conditions and Commercial Lending Concerns

From elevators and air conditioning to electrical systems and parking lots, building maintenance represents a significant cost of property ownership. If a borrower fails to conduct routine maintenance, it can affect the lender in several ways. First, a property with significant material deficiencies could lead to direct liability for the bank. Second, if the property is not maintained regularly, its value deteriorates--a concern since the property serves as collateral. And third, if borrowers are skimping on routine maintenance, this could indicate that money is tight for them, which could affect their ability to repay the loan.

Owing to the potential exposure an improperly maintained building presents, lenders should include an evaluation of building conditions and deferred maintenance needs into their decision-making process. Because even significant defects aren't always discovered by a layperson during a quick prepurchase property tour, many are turning to property condition assessments to get valuable information on a property's physical state.

Property Condition Assessments: The Basics Similar to the way a Phase I environmental site assessment uncovers real or potential contamination at a given site (or on adjacent properties), a property condition assessment benchmarks the physical condition of a property's structures and provides estimates of deferred maintenance and future capital costs. Banks, lending institutions, bondholders, purchasers, equity investors, and sellers routinely rely on PCAs, although they're most commonly conducted for lenders or owners as part of a commercial real estate transaction's due diligence or asset management functions.

Sometimes referred to as an engineering report, a capital needs assessment, or a physical needs assessment, a property condition assessment consists of a site walk-through, document research and review, and interviews with facility managers and others familiar with the property. The results, which are presented to the client in a property condition report (PCR), include, among other things, an assessment of the property's general physical condition and deferred maintenance status, an estimation of the remaining useful life of the components, recommendations for repair of items important to the property's current operation, and probable costs to remedy observed or predicted material physical deficiencies.

Cost estimates are typically projected over a set amount of time--usually the term of the loan. "If a building is worth $1 million and has $250,000 of deferred maintenance over five to 10 years, the lender should take this into consideration for credit quality," explained Michael Kulka, P.E., a vice president and principal with PM Environmental.

The industry standard for property condition assessments is ASTM E2018-08, Standard Guide for Property Condition Assessments: Baseline Property Condition Assessment Process. …