environmental issues when buying foreclosed properties and notes rpls summer conference presented by...

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Email: [email protected] Web: www.associatedenvironmental.net

6001 North Adams Road, Suite 205 Bloomfield Hills, Michigan 48304 Tel: (248) 203-9898 Fax (248) 203-9372

Environmental Services Land Development Real Estate Consulting

Copyright©2011 Associated Environmental Services, LLC. All rights reserved.

State Bar of Michigan

Environmental Issues When Buying

Foreclosed Properties and Notes

Presented By:

Nicholas G. Maloof, Esq., RPG President and General Counsel

Associated Environmental Services, LLC

July 20-23, 2011

Grand Traverse Resort and Spa Traverse City, Michigan

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Environmental Issues When Buying Foreclosed

Properties and Notes

Workouts, Foreclosures and Bankruptcies are the ugly side to the commercial real estate industry.

They happen in both good times and bad; however, their presence and impact are most distressing in

the midst of financial crisis and recession such as we have experienced the past several years.

General Terms used in today’s discussion:

Distressed Property – Commonly viewed as a property that is the subject of a workout, foreclosure or

bankruptcy proceeding. Definitions of “distressed property” on the Web via Google Search:

A. 1. Property that is in poor physical condition. 2. Property owned by an individual who is in

poor financial condition. debbie.canequity.com/mortgage-resources/

B. A property which is to be sold in order to pay arrears on a mortgage. www.gibbons-

realty.com/dictionary/D.html

C. Property which either is in a dilapidated physical condition or is owned by an individual who is

undergoing a period of economical instability. www.dreamtown.com/mortgage/mortgage-

terms.html

D. A mortgaged property which has been foreclosed on. www.bettisu.com/

E. Real estate that is under foreclosure or impending foreclosure because of insufficient income

production or mortgage payment. www.propertyaxess.com/GlossaryofTerms.htm

F. Property that is under a foreclosure order or is advertised for sale by its mortgagee. Distressed

property usually fetches a price that is much below its market value.

http://www.businessdictionary.com/definition/distressed-property.html

Mortgage-Backed Note (or Note) – “A type of promissory note that is associated with a particular

mortgage loan. Mortgage-backed notes represent the legal promise to repay a mortgage loan. These

notes specify the terms of the loan, including the amount of interest and principal that must be repaid.

They also obligate the borrower to make the payments.”

http://www.investopedia.com/terms/m/mortgage-backed-note.asp

Default by a Borrower – Commonly viewed as the failure to perform a task or fulfill an obligation,

especially failure to meet a financial obligation. Two general types of default are appropriate to our

conversation today:

1. Technical Default – “A deficiency in a loan agreement that arises not from a failure to make

payments as promised, but from a failure to uphold some other aspect of the loan terms.

Technical default indicates that the borrower may be in financial trouble, and can trigger an

increase in a loan's interest rate, foreclosure or other negative events.”

http://www.investopedia.com/terms/t/technical-default.asp; and

http://www.google.com/url?sa=X&start=0&oi=define&q=http://debbie.canequity.com/mortgage-resources/%3Fd%2BD%2B20%2B21%2B40&usg=AFQjCNHMS1Nk0sVRPnB21Mn6o4CTPtQIwQ

http://www.google.com/url?sa=X&start=1&oi=define&q=http://www.gibbons-realty.com/dictionary/D.html&usg=AFQjCNGrk8zWwvbPErCzPc8WrUtWe6gXwQ

http://www.google.com/url?sa=X&start=1&oi=define&q=http://www.gibbons-realty.com/dictionary/D.html&usg=AFQjCNGrk8zWwvbPErCzPc8WrUtWe6gXwQ

http://www.google.com/url?sa=X&start=2&oi=define&q=http://www.dreamtown.com/mortgage/mortgage-terms.html&usg=AFQjCNGMt2D517Ttbk8vMPF48q0Q04cP3A

http://www.google.com/url?sa=X&start=2&oi=define&q=http://www.dreamtown.com/mortgage/mortgage-terms.html&usg=AFQjCNGMt2D517Ttbk8vMPF48q0Q04cP3A

http://www.google.com/url?sa=X&start=3&oi=define&q=http://www.bettisu.com/%3Fpage%3Dglossary%26ID%3D4&usg=AFQjCNGGFXj2l5QSAoqCH1m_PrzQGDmHkQ

http://www.google.com/url?sa=X&start=4&oi=define&q=http://www.propertyaxess.com/GlossaryofTerms.htm&usg=AFQjCNFOqlMHZBMukEdxt7nW3yxD5exK0w

http://www.businessdictionary.com/definition/distressed-property.html

http://www.investopedia.com/terms/m/mortgage-backed-note.asp

http://www.investopedia.com/terms/t/technical-default.asp

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2. Financial Default – “The failure to promptly pay interest or principal when due. Default

occurs when a debtor is unable to meet the legal obligation of debt repayment. Borrowers may

default when they are unable to make the required payment or are unwilling to honor the debt.”

http://www.investopedia.com/terms/d/default2.asp

In the event of Default by a borrower (whether financial or technical), the lender has several alternative

courses they can pursue:

1. Take no action and hope that the default remedies itself;

2. Require additional collateral and/or guarantees from the borrower;

3. Restructure the indebtedness with a longer amortization, lower interest rate, principal only

payments or other loan alteration(s);

4. Temporarily suspend pursuing additional remedies against the borrower by agreeing to a

forbearance. Forbearance is refraining from doing something that one has a legal right to do.

In this case, it would be to not to enforce a claim(s) upon loan maturation and/or provide

additional time for repayment of the loan;

5. Accept a discounted payoff of the indebtedness;

6. Foreclose on the loan and sell the collateral (real property) by taking physical possession and

title and marketing the property;

7. Another alternative is to have a Receiver appointed by the courts to manage, marshal and/or

sell the asset(s); or

8. Selling the Note (typically at a discount) to another party. These other parties can include

another lender, an investor and, yes, sometimes the debtor itself.

Items 1-5 referenced above are typically encountered in the “workout” phase of a potential foreclosure

and are a joint attempt by the borrower and the lender to salvage a valuable property and avoid the

delays and expense generated in a foreclosure. If a deal can be made, it will likely benefit both parties

to the loan (lender and borrower).

A workout can also preclude any potential harm that may mar a project's reputation due to a default.

The risk of harm to a project from a default due to lost sales or shaken confidence may eventually lead

to a foreclosure or a bankruptcy filing.

An effective and successful workout requires that both parties take reasonable steps to protect the

value of the collateral in order to maximize its ultimate worth and thereby protect the investments of

both the borrower and the lender in the project.

In the event that both parties determine that a workout is appropriate, it is imperative to act as

expeditiously as possible or there is a risk of one or both parties changing their minds or the value

further declining and throwing off the deal parameters. The longer it takes to get the deal closed the

higher the likelihood of losing the purchaser due to market forces, changes in value of the

collateral or both.

http://www.investopedia.com/terms/d/default2.asp

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Bankruptcy – Commonly viewed as a legal mechanism to erase legitimate debts and allow a

corporation or person a “fresh start.” The process assumes the corporation or person is honest and is a

“victim of unique circumstances.”

Definitions of “Bankruptcy” on the Web via Google Search:

I. “The condition of being unable to pay debts, with liabilities greater than assets. There are two

types of bankruptcy: involuntary bankruptcy, where one or more creditors bring a petition

against the debtor; and voluntary bankruptcy, where the debtor files a petition claiming

inability to meet his or her debts.” BNET Business Dictionary

http://dictionary.bnet.com/definition/Bankruptcy.html

II. “A legally declared inability or impairment of ability of an individual or organization to pay its

creditors. Creditors may file a bankruptcy petition against a debtor ("involuntary bankruptcy")

in an effort to recoup a portion of what they are owed or initiate a restructuring. In the majority

of cases, however, bankruptcy is initiated by the debtor (a "voluntary bankruptcy" that is filed

by the insolvent individual or organization). http://en.wikipedia.org/wiki/Bankruptcy

III. “Legal process that is available for an individual who is overextended financially and is unable

to pay his debts. The individual can file for bankruptcy in order to seek to legally eliminate

some or all of his debts.” http://en.mimi.hu/business/bankruptcy.html

IV. “…provides a legal method for an individual or commercial enterprise (business) to either wipe

out (discharge) the debts by liquidating assets and distributing them among creditors or resolve

them by developing a court-approved reorganization plan, or other plan involving the

repayment of creditors over time.”

http://www.statelawyers.com/Practice/Practice_Detail.cfm/PracticeTypeID:13

Remember that a Bankruptcy filing may allow a borrower to discharge its obligation to repay the Note.

Due Diligence – is generally defined as “1. An investigation or audit of a potential investment. Due

diligence serves to confirm all material facts in regards to a sale;” and “2…the care a reasonable person

should take before entering into an agreement or a transaction with another party.” Due diligence is a

way of preventing unnecessary harm to either party involved in a transaction.”

http://www.investopedia.com/terms/d/duediligence.asp

There are also legally required instances of due diligence that if not undertaken by a purchaser or

lender, may result in status liability. An example of this type of due diligence is environmental

liability arising from a party failing to take advantage of legal “safe harbors” for existing

environmental contamination or conditions on a real property.

http://dictionary.bnet.com/definition/Bankruptcy.html

http://en.wikipedia.org/wiki/Bankruptcy

http://en.mimi.hu/business/bankruptcy.html

http://www.statelawyers.com/Practice/Practice_Detail.cfm/PracticeTypeID:13

http://www.investopedia.com/terms/d/duediligence.asp

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Questions and Answers Related to Foreclosed Assets and Notes What is an REO property? What does that term really mean to a lender/bank? What does it mean to a potential buyer?

An REO property is any real estate that a lender/bank owns that it is not using for operation of

the lender/bank;

Lenders are motivated to sell these properties, as a lender’s income is derived from collection

interest on loans. These are non-income producing assets, and a drag on lender earnings;

Lender REO departments are responsible for marketing and selling these properties at the

highest reasonable value to the lender.

How does a Lender typically acquire title to a property?

Non-payment or technical default on a loan leading to foreclosure of the collateral;

Borrower offers to deed property to lender (deed-in-lieu of foreclosure) as part of a

resolution of a troubled loan;

Lender decides to close one of its branches or other buildings.

Why would a Receiver be appointed to dispose of an asset?

A Receiver is used to insulate the lender from liability as well as allow the lender to usurp operational

control from the borrower/operator through a court sanctioned process.

A Receiver who is appointed by the court is charged with preserving value of the estate. The court

may or may not empower the Receiver to sell the asset. If empowered to sell the asset on lender’s

behalf, the lender avoids ownership issues such as liability for environmental concerns, unpaid claims,

and other responsibilities inherent in owning property.

My personal experience has been that the lender typically requests the court to appoint a Receiver

based upon the Receiver’s relationship with the lender and lender’s legal counsel as well as the

Receiver’s ability to manage the specific asset class and, hopefully, maintain or create new value for

the lender.

Many times there are environmental or other liabilities, whether ripe or contingent, associated with a

particular property. By having a Receiver appointed through judicial process, the lender can avoid

dealing with the liability directly and the risk for additional loss that may be associated with the

liability.

In addition when the asset is disposed, the lender avoids being placed in the chain-of-title as the

Receiver directly transfers title to the purchaser, typically through a Fiduciary Deed offering limited or

no warranties (Quit Claim in disguise?).

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Disadvantage of receivership is it can be expensive and a lender does not ultimately control who the

judge picks to be the Receiver. A lender may request an individual, but the judge may decide to go a

different direction, and the lender will be stuck with that decision.

If a property becomes REO, how will that affect value? REO property is typically not well managed or maintained as asset managers are overworked, have too

many properties to manage, are inexperienced, retain the wrong firms to assist them manage and

market the asset or a combination of any of the foregoing issues.

As the property is not well managed or maintained, occupancy will typically fall and additional repairs

are then deferred due to a downward spiraling of cash flow. This can create valuation issues from a

cash flow analysis standpoint as well as from a cost to cure the deferred maintenance. In addition,

some problems can compound others (e.g., poor HVAC operation leads to roof stress or frozen pipes

leading to water infiltration leading to mold growth).

How can a buyer best position itself to purchase a bank asset? What are the important factors to consider so that the chances for success are improved?

Contact real estate brokers or lenders directly, search websites, etc. Most lenders retain a property

manager and a broker – sometimes they are the same firm.

Have your financing squared away before contacting the lender – cash is king! I have seen assets

worth $2-3M based upon current cash flow sell for 1/3 the value for an all cash offer.

Lenders say that a buyer should be willing to buy the property “as-is, where-is.” Expect that the lender

will provide as little reps and warranties as possible – often none. This can be dangerous for a buyer –

be very careful…the lender is looking out for its own best interests!

Show your ability to close, either in terms of bank statements, letters of comfort from a lending

institution, etc.

The lender views the deals that are quicker to close and having less in the need for due diligence and

inspection periods as more attractive than offers requiring lengthy due diligence.

What information can be obtained regarding the condition of the property? What due diligence will the bank allow? Buyer will be expected to do their own due diligence. Some Lenders are reluctant to share their third

party reports (Environmental Assessments, Property Condition Assessments, Appraisals, Land

Surveys, Title Work, etc.) because of potential liability from the buyer if one of lender’s reports turns

out to be wrong. The Lender will try to protect itself by having purchaser sign a broad release of all

liability should there be errors in the third party reports.

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Two recent cases regarding the transfer of an interest in real property and failure to disclose the

“facility” status of that real property are a shot across the bow for anyone purchasing, selling, leasing

or financing real property. 1031 Lapeer, LLC v Rice (Mich. Ct. App. No. 290995; August 5, 2010,

assigned for publication October 7, 2010) is a published case establishing a clear remedy for violation

of Section 324.20116. A very short time later A. D. Transport, Inc. v Michigan Materials &

Aggregates Company, Inc. (Mich. Ct. App. No. 290236, September 30, 2010, Unpublished) an

unpublished case discussed the differing causes of action and remedies for failure to comply with a

statutory obligation.

These two court cases greatly impact a lender or any other owner of real property if they are leasing or

selling contaminated property. Essentially the lender MUST disclose the fact, if it knows or has

sufficient reason to know, that the property is contaminated or may be contaminated in excess of

MDEQ Generic Residential Cleanup Criteria. The remedy under the 1031 Lapeer, LLC v Rice

case for failing to disclose is that the transaction was void and damages were payable to the

injured party!

What hurdles will buyers face when looking to purchase a bank owned retail or other development? How can these hurdles be addressed?

Low occupancy

Poor management

Deferred maintenance

Possible environmental issues from dry cleaner tenants (either past or current)

Lender not likely to re-loan on asset – wants it “off their books.”

Summarize the available financing options for purchasing bank owned property. Slim to none…no matter what the federal government says, large lending institutions are still not

lending on investment properties in large volumes!

Some Community Banks, Credit Unions and Life Insurance Companies are lending on investment

properties, but they are scrutinizing deals closely.

If owner occupied, SBA lending is occurring, but lead time is long and paperwork intensive.

Some lending is coming back into the market with the CMBS market just starting to re-open. A

borrower will need, at a minimum, 60% LTV with a DSCR of 125%. Need highly qualified sponsors

with strong balance sheets and liquidity.

What information can be obtained regarding the condition of the property? What due diligence will the bank allow? As part of an REO purchase, depending upon whether you are purchasing the Note or the Asset itself, you need to perform the proper due diligence in order to identify the property's

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difficulties and whether they can be overcome. Due diligence activities must include a review and analysis of the following in order to better understand the property:

1. loan documents; 2. leases, if any; 3. construction documents, if any; 4. development and construction financing documents, if any; 5. current title and available land survey; 6. environmental reports; and 7. engineering reports.

Always do your own due diligence – the lender has conducted due diligence for its own purposes that may directly conflict with your best interests! What consultants should be used for the purchase?

The single most important thing is conduct thorough due diligence. Lenders sometimes don’t give a

large window, so you need to have a solid team you trust at the ready. Your team should include the

following skill sets (some areas of expertise may be covered by the same professional):

Legal Counsel

Valuation Specialists

Financing Specialists

Physical Due Diligence

o Environmental

o Property Inspection/Building Contractor

o Structural/Civil

o Land Surveyor

Property Manager

Title Company

Real Estate Broker

What types of properties are available in Michigan? How does the Michigan market differ from other parts of the country?

We have been involved in all types of properties on behalf of foreclosing lenders:

Industrial

Warehouse

Office

Medical

Retail

Multifamily

Mobile Home Parks

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Environmental Due Diligence Questions

What is the current condition of the collateral?

Was environmental due diligence conducted when the loan was made? Was it conducted properly (was all of the research conducted or was it a “white wash”)?

Was the collateral contaminated when the loan was made? o If so, by the borrower or a prior owner/operator (historical impact)? o If the impact is historical, did the borrower conduct appropriate due diligence

(Phase II ESA, BEA, 7a Due Care Plan, etc.)?

Are the current operations of a high-risk nature (gas station, dry cleaner, industrial, etc.)?

Are there any adjacent high-risk uses to the collateral that could have a direct or indirect impact?

Are there any issues that could impact the value of the collateral or require out of pocket costs by the lender if the property is foreclosed upon?

o If there is impact, can the impact be used as a selling feature to attract a new developer or purchaser by positioning the property for development incentives?

Is the lender planning to take title, is a Receiver going to be appointed or is the Note being sold at a discount?

o If the Note is being sold, the lender may only need a cursory investigation to evaluate the value of the underlying collateral;

o If a Receiver is being appointed, it may make sense for the Receiver to conduct pre-acquisition due diligence to determine the condition of the collateral prior to or within a short period of time of being appointed Receiver;

o If the lender is foreclosing and taking title, a thorough investigation should be undertaken to determine the condition of the property and whether the lender needs to prepare a Baseline Environmental Assessment (BEA) prior to taking title, possession or occupancy.

Are there any issues that could impact the value of the collateral or require out of pocket costs by the lender if the property is foreclosed upon?

o If there is impact, can the impact be used as a selling feature to attract a new developer or purchaser by positioning the property for development incentives?

When should the buyer bring in its professional team when looking at a distressed asset?

a. As early as possible. If we are contacted early in the process, we can help them with identifying potential issues, possibly deal killers, price reduction points, and sources of grants, loans and other funding/reimbursement

b. We just obtained a grant for one of our clients purchasing an industrial property to conduct a Phase II ESA, BEA and 7a Due Care Plan (worth about $23K) with no additional out of pocket cost to our client (he hired us to conduct a Phase I ESA and we prepared the application for the grant)

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c. We also just obtained a grant for one of our clients developing a retail property to conduct a Phase I & II ESA, BEA and 7a Due Care Plan (worth about $30K) with no additional out of pocket cost to our client (he hired us to prepare the Brownfield Plan and we prepared the application for the grant at no additional cost)

Why should a buyer conduct environmental due diligence and a property condition assessment?

a. Legal protection under both State of Michigan and Federal Law b. Determine the condition of the asset c. Identify issues that can be used as negotiating points d. Make sure you are not overpaying for the asset e. Why is bank selling note vs. foreclosing? Many times a receiver is appointed or

the note sold to avoid known environmental issues or potential tort liability for existing conditions!

Case Studies in Foreclosure, Workout and Receivership Properties

Example #1 - Multi-family Residential Rental Complex

Scenario: AES was retained by a foreclosing lender to review a previously prepared Phase I

Environmental Site Assessment (ESA) and determine whether a Phase II ESA was necessary for pre-

foreclosure due diligence purposes. AES reviewed the report and concurred with the Phase I ESA

recommendation that a Phase II ESA was necessary to investigate off-site historically contaminated

adjacent sites with known releases of chlorinated solvents, petroleum hydrocarbons and heavy metals

that may have impacted the property. AES prepared a scope of work to assess the suspected areas in

order to determine the impacted areas, if any. In addition, AES was requested to prepare a rough cost

estimate for further investigation and remediation of the impacted areas.

From a non-environmental standpoint, AES also observed the property to be poorly managed and

maintained by the debtor in possession with water infiltration issues, low occupancy and some units

with mold or other impacts.

Issue: No effective Property Management (PM), high vacancies, needed repairs were not being made

further de-valuing the asset.

Buyer Opportunity: Provide PM services to manage asset, possible redevelopment of asset, project

manage repairs, reposition asset, redevelop asset for LIHTC/Section 8, redevelop entire site to new

use, etc.

Example #2 - Recreational Property

Scenario: AES was retained by legal counsel representing a Court Appointed Receiver, appointed

at the request of a lender, to prepare a Phase I ESA for a potential sale of the collateral, a recreational

property. AES did not identify any RECs related to the property and recommended no further site

investigation.

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Issue: Property being well managed by Receiver and increasing its’ value, but has limited marketing

capabilities.

Buyer Opportunity: Purchase a well managed asset that is increasing in value at a substantial

discount to the original debt as well as to the replacement cost for the improvements.

Example #3 - Multi-tenant Industrial Property

Scenario: AES was retained by a foreclosing lender to prepare a Phase I ESA, Phase II ESA,

Baseline Environmental Assessment (BEA) and 7a Due Care Plan for a multi-tenant industrial

property as part of pre-foreclosure due diligence.

From a non-environmental standpoint, AES also observed that there was no local person/entity charged

with managing the property. The current broker was a “sign only” and not paying attention – doors

unlocked, maintenance issues, etc. All of the remaining tenants were in the dark on the situation and

still sending rent to the former owner who lost property via foreclosure. The special servicer is

overwhelmed and needs local help.

Issue: No effective PM. Property is 50% occupied and maintenance was being deferred.

Buyer Opportunity: PM services (collect rents, maintain and repair property), market property, likely

opportunity for leasing fairly high due to location of nearby national defense hub. Purchase asset at a

substantial discount to (1) original debt; (2) the replacement cost for the improvements; and (3) a very

high Cap Rate based upon the current NOI at 50% occupancy.

Remember that each deal is unique and that the asset condition, type of investment being made,

motives of the parties, timing and a multitude of other factors are never the same.

Critical Take Away Points for the Potential Buyer of Foreclosed

Properties or Notes

Understand the motives of all parties in a Workout, Foreclosure or Bankruptcy transaction;

Understand the needs of the party you are approaching for representation – if you are working

for the Special Servicer their needs and motives may be different from that of a Receiver. If

the debtor has filed bankruptcy, this adds another layer of complexity to the representation as

well as motivations due to the Bankruptcy Trustee’s involvement to maximize recoveries in an

expeditious manner;

It is imperative to have a team of trusted advisors to assist you in understanding the myriad of

issues with a Workout, Foreclosure or Bankruptcy transaction. Remember each representation

opportunity is unique and requires a team of advisors to identify the service opportunities for

the team (just make sure to vet each member to ensure that they really know what they are

talking about!).

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Understand the current market conditions, the property, its condition, and the process track the

property is following – know that it could change at any time;

Make sure to understand the position of all parties involved in the transaction and know whom

they are working for (i.e., where does their fiduciary duty lie?)

Remember, even if you are buying the Note, the underlying value of the real property directly

impacts the value of the Note. If there are known or potential liabilities, they can substantially

impact the value!

Also, as a Note purchaser you are stepping directly into the shoes of the lender – whys I the

lender not foreclosing? Do they know something that you don’t?

Explore the options available for the property from an Economic Incentive standpoint – what

about this property (its location, condition, etc.), the deal, the parties, etc. make the property

unique, the deal unique, or make the property eligible or could make the property or deal

eligible for incentives?

For questions or to discuss a matter in confidence, please feel free to contact me at (248) 203-

9898 or via email [email protected].

Nicholas G. Maloof, RPG, Esq., is President and General Counsel of Associated Environmental Services, LLC (AES), an environmental services, land development and real estate consulting firm based in Bloomfield Hills, Michigan. Mr. Maloof is an active member of the State Bar of Michigan and has over thirteen years of experience as a transactional real estate and development attorney and over twenty-two years of experience in the field of environmental and real estate consulting. A majority of his work is conducted with or on behalf of attorneys, financial institutions, real estate brokers, developers, investors and property owners. Mr. Maloof is a licensed Real Estate Broker (Associate Broker), a Registered Professional Geologist in the State of Tennessee and a licensed Title Insurance Resident Producer in the State of Michigan. Over the past 20 plus years, Mr. Maloof has been involved in thousands of real estate transactions and land development projects from a site selection, due diligence, development incentive and development entitlement standpoint, as well as numerous Workout, Foreclosure and Bankruptcy related real estate transaction throughout Michigan. Workout, Foreclosure and Bankruptcy related transactions have included retail centers, industrial and warehouse sites, multi-family residential, mobile home parks, medical facilities and office buildings on behalf of CMBS servicers, CMBS special servicers, Court appointed Receivers, banks, legal counsel and purchasers.

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