The following article appeared recently in the EDR Insight Research Blog. We are re-posting it here for your reading pleasure. Also, we would like to thank Bill Tryon for his contribution to this piece. Bill Tryon is GRS Group’s director of technical quality–and a renowned expert in commercial real estate assessment services.
For the first time since the start of the financial crisis, market barometers are looking better than they have in a long time. The results from EDR Insight’s 1Q13 Quarterly Benchmarking Survey of Financial Institutions indicate that the recovery is slowly moving forward as lenders get more comfortable ramping up new originations and moving past the loan workouts and foreclosures that dominated the past few years. Debt is no longer just available for the top Class A properties, but also Class B, Class C and assets in secondary markets—and from a wider pool of lenders. On the buying side, cash-flush investors are out shopping assets again. Commercial property sales in Q1 were up 35 percent from a year earlier—the second highest quarterly volume post-recession. Banks are moving commercial loans off their balance sheets at a faster pace and at higher prices than at any time since the beginning of the financial crisis (see box below: A Brighter Forecast). The market is in recovery and with it, renewed interest in all types of due diligence, including property condition assessments, the sister to Phase I ESAs. Some say PCAs are more important than ever as the market struggles out of a protracted downturn.
The Role of PCAs in a Recovering Market
As buyers and lenders step up their game amid rising confidence in the state of the market, neglected properties are getting attention for the first time in years. Risk aversion is high, so potential investors are taking a more thorough look—not only at contamination but also at structural issues. Prices are still low enough in many areas that buyers are loath to get caught up in a deal where a property has issues that may devalue it. As a result, PCAs are playing a more crucial role in due diligence as a way to identify any material structural issues as well as to augment the property appraisal process.
“PCAs are more important than ever. In the market downturn, many property owners deferred major maintenance and replacements, which can significantly impact the value and cash-flow of properties.”
~Bill Tryon, director of technical quality at GRS Group
David Drummond, national chief environmental risk officer and national construction engineering manager of Key Bank, notes that the real estate markets post-collapse have focused on more comprehensive and more precise underwriting. “The appraisal was never meant to be a property condition report; it is meant to be a valuation report. Specific property data derived from the PCA is always much more accurate when evaluating a property’s need for capital expenditures versus what has been estimated in an appraisal that typically has been derived from a database of similar properties,” he says.
“By adding the PCA to the due diligence process, the gaps or estimates typically found in the appraisal can be better defined in the form of real data from the subject property.”
~David Drummond, national chief environmental risk officer and national construction engineering manager, Key Bank
PCAs also have value in terms of long-term planning for lenders. During the “lean days,” lenders found themselves in the unfavorable position of having to take back ownership of buildings that were in disrepair or of questionable condition at the very least. This is changing. “Lenders are becoming increasingly more aware of the condition of the assets that they are securing. The PCA is one tool that a lender has available to essentially take a snapshot of the condition of the building and determine the necessary replacement reserves for the future,” says Mike Kulka, P.E., founder and CEO of PM Environmental. He points out that although PCAs may be a relatively new part of the due diligence process in more traditional commercial real estate lending, “Certain lending markets have been using PCAs as a tried-and-true due diligence tool for a long time, including life insurance lenders, government agencies and REITs.”
“A lot of lenders don’t fully understand what a PCA is for, but when you have a third-party expert inspect a property, issues quickly become evident. These are the things that lenders would want to know should they ever have to take the property back.”
~Mike Kulka, P.E., founder and CEO of PM Environmental
Over the next few years, more financial institutions could adopt PCAs as a standard part of property assessments. “In a recent banking panel of ERM and appraisal professionals,” says Kulka, “three large banks all stated they see great value in PCAs, and see this as a growing area in the due diligence group at their institutions.”
The Value of a PCA
There are a number of reasons why lenders or investors may opt to have a PCA conducted. “We recommend PCAs to buyers, sellers and asset managers of all types of commercial real estate, even if it serves to verify what in-house property management estimates for repairs and maintenance,” says Sean Dundon, Principal, Blackstone Consulting LLC. “In addition, we recommend a PCA to anyone buying distressed commercial real estate debt, as this is just as critical a data point as the appraisal in determining an offering price that is reflective of the true condition of the asset.
“A high quality PCA will identify not only routine maintenance concerns, which result in higher operating costs, but any ‘fatal flaw’ that may have been previously unidentified and result in an immediate capital expense,” Dundon continues, “such as building settlement or major code items. These types of issues may cause a building to lose its Certificate of Occupancy and possibly result in tenant relocation, which is typically not covered by insurance and may significantly impact the anticipated return on investment.”
A heightened aversion to all types of financial risk is driving lenders to recommend PCAs more often—and, in fact, some policies require it. As with Phase I ESAs, loan size can also be a key driver with many requiring PCAs on any loans above a certain threshold. “The PCA is pretty much mandatory in the Capital Markets arena—also with agencies (e.g., Freddie and Fannie) and HUD and FHA loans,” says Drummond. “Balance sheet loans are quickly requiring them at Key; we require PCA reports for all balance sheet loans in excess of $5 million for commercial real estate loans. The PCA report allows us to fine tune the underwriting, often to the borrower’s advantage.”
Drummond adds that some property types are more likely to warrant a PCA investigation, such as multifamily properties, “due to their nature of the condition and marketability of the property. Retail and office run a close second and third, respectively.”
PCA Pricing and Turnaround Time
The cost of a PCA is highly variable—even more so than pricing for Phase I ESAs. Variables that exert significant influence on PCA pricing are property type (i.e., trophy property or Class B or C), location (i.e., rural, suburban or urban), asset class (e.g., office, multifamily, industrial, etc.) and size of the property, among others. According to Bill Tryon, director of technical quality at GRS Group, “These reports can cost as little as a few thousand dollars. For more complex sites, and in instances when clients need greater certainty, costs can be tens of thousands of dollars,” he notes. One variable that can drive up due diligence costs is the number of experts required to do the PCA. A property that costs tens of thousands of dollars for a PCA, says Dundon, “may involve a high-rise building that necessitates multiple expertise such as an elevator specialist, roof specialist, MEP or structural services.”
“PCA reports can cost as little as a few thousand dollars. For more complex sites, and in instances when clients need greater certainty, costs can be tens of thousands of dollars.”
~Bill Tryon, GRS Group
Dundon adds that, “Any anticipated destructive testing (e.g. façade inspection, sewer line scoping, opening walls) will also result in higher pricing.”
What is the average turnaround time for a PCA? Again, the answer is “it depends.” PCAs can vary considerably depending on whether they are being conducted for debt or equity clients. “Debt client PCAs are typically very straightforward and usually follow the ASTM E 2018 standard scope of work—or are very similar,” says Kulka. “These types of reports typically have a two- to three-week turnaround time. Their use is, for the most part, to determine how much money the building owner will need to be allocated into replacement reserves to maintain the property over the course of the loan.
“Equity PCAs are an entirely different animal, and scopes of work, costs and turnaround times vary greatly,” adds Kulka. “The purpose of these can vary, but for the most part, building owners (or potential buyers) want a detailed look at the condition of a building. This can include items like functional testing of heating, ventilation and air-conditioning systems, detailed studies of electrical systems, etc. The work is often custom-tailored to the building and the wishes of the building owner. Turnaround times can vary, but depending on the scale and systems analyzed, it can be several weeks or even longer.”
PCAs and Phase I ESAs—A Competitive Advantage?
On some deals, investors or lenders may feel that Phase I ESAs are sufficient for assessing risk, while on others, the two assessments combined provide a more powerful tool for risk management. In today’s competitive market, being able to offer both types of expertise provides a competitive edge. As Drummond notes, “A firm that does both a Phase I ESA and a PCA is attractive to us. There are economic advantages, of course, to a firm doing both.”
But, he adds that an expert with the right resume must perform the PCA. “In general, I want to see engineers, architects or individuals who have an extensive construction background. I do not want to see geologists or environmental professionals attempting these condition inspections, as the disciplines are not universal. Granted, there are some who have the experience to cross over, [but] the resume of the individual must reflect a heavy construction or design background.”
Will PCAs continue to be relevant further into recovery, and if so, are they more likely to be bundled with Phase I ESAs? No one knows what the future holds, but PCAs certainly have a place in today’s recovering market. Says PM Environmental’s Kulka, “At this point, we see that Phase I ESAs are bundled with PCAs on about 50 percent of the PCAs that we perform.” As for GRS, Tryon says, “When a PCA is required, our experience is that the reports are bundled with a Phase I ESA 80 percent of the time or more. Many clients, though, may require an ESA with no requirement for a PCA.” Dundon added that, “In our experience for multifamily sites, PCAs are almost always bundled with Phase I ESAs on Fannie Mae, Freddie Mac and HUD projects, and for varied asset classes such as office, hotel, industrial. The CMBS lenders also typically bundle these services. On the equity side, most commercial real estate investors have their preferred vendors for environmental (Phase I) and PCA services, and they may or may not use a single consultant.”
For some lenders and investors today, PCAs are routinely used as a tool for eliminating or minimizing the uncertainty about the condition of a building and to assess which systems are likely to need replacement over the course of ownership. With deferred maintenance issues coming to the surface as neglected properties move back into play, PCAs are increasingly playing a role in determining the impact that structural issues could have on a property’s cash flow, leasability, operating costs and ultimately, return on investment. PCAs also play an important role as the market approaches the peak of loan maturities on commercial properties. If a property has deferred maintenance issues, the owner may have a difficult time refinancing despite still favorable interest rates. And on many deals, property comparables may not be readily available and PCAs are stepping in to fill the gap and support the appraisal function. In light of these trends, firms that can offer expertise in both PCAs and Phase I ESAs could have a distinct advantage.