In this section of INVIZEN we discuss commercial real estate foreclosure issues, prevention issues and the remedies. Losses on commercial real estate loans and investments are expected to exceed $500 billion worldwide this year, so this is definitely a topic that needs more information and action. If you think you will solve this by simply increasing the frequency of your loss exposure calculations, you have already missed the boat. That’s the old economy way of doing things in a reactive fashion, while the new economy is based upon proactive measures – and the market will (once again) end up picking the winners and losers. Which category will you be in?
The most common cause of commercial real estate foreclosures are administrative issues. The most common administrative issues include:
- Failure to pay ad valorem taxes on time.
- Failure to maintain corporate existence.
- Failure to pay employer payroll contributions (local, state and/or federal).
- Failure to maintain adequate property and business insurance.
- Failure to provide timely financial reports.
- Failure to provide timely operating reports.
- Failure to maintain required business licenses.
- Failure to maintain the premises.
- Failure to maintain required financial covenants – debt service coverage, quick ratio, current ratio, reserves, etc.
The sum-total of these are known as, “administrative foreclosure” defaults. With the exception of the last failure on the list, these are avoidable issues and the CRE industry really doesn’t have a good excuse for this nightmare.
The second – and much more dangerous – issue is the property failure due to market conditions where management is not found to be negligent. The cause is a market disruption. Market disruptions are the outcome of changes in the purchasing preferences of consumers of the products/services of the operating business. This is due to the natural action of a market economy where Rational Choice plays out in the form of technological advances that create asset obsolescence. In the CRE vertical, the issue becomes market saturation where competing business operations provide a more cost-efficient set of means for delivery of the products/services the consumer seeks. The key to understanding market disruptions lies in the following issues:
- Periodic market analysis – the analysis of consumer spending preferences and their related demographics (called “analytics”) on a periodic basis provides important clues as to what may be coming based upon what has already happened. If a complete market feasibility analysis is not undertaken each month, then the identification of potential market disruption events becomes statistically more and more problematic as the interval between analyses widens.
- Periodic intended-use analysis – the analysis of other potential intended-use scenarios for the given site and market is also required on the same timeline as the periodic market analysis. Quite frequently, management waits until the proverbial “train wreck” has already happened before the light bulb goes on and someone asks whether or not the right assets are being operated. The intended-use analysis has to take into account the value of the site to the resulting business deal based upon providing a market return to investors – both current and potential future investors who may be required to create the best possible conditions precedent for obtaining future cash flows from the investment in the property and market.
Discussion of prevention is continued on following page.