PERSON OF THE WEEK: David Tesler Discusses Distressed-Debt Due Diligence

t do you do with a distressed commercial mortgage or asset?[/b] What crucial due diligence steps might even the most savvy professional miss? This week, MortgageOrb spoke with David Tesler, CEO of Real Diligence LLC, a financial due diligence company, and LeaseProbe LLC, a lease abstracting company. Both are affiliates of Lakewood, N.J.-based Madison Commercial Real Estate Services. [b]Q:[/b] What are the most crucial due diligence measures to take when dealing with distressed assets? What are the most important ways in which the process differs from due diligence in non-distress situations? [b]David Tesler:[/b] The challenge with distressed assets is twofold. One has to conduct due diligence on the existing debt, as well as conduct due diligence on the underlying asset. A thorough understanding of the debt stack, the rights and obligations of all the parties, and all the particulars of the loan documents is critical – and something not undertaken in a typical due diligence scenario. [b]Q:[/b] In your loan workout business, how much restructuring/loan modification have you seen? Are you finding this route difficult or impossible in most cases, particularly with commercial mortgage-backed securities (CMBS) loans? [b]Tesler:[/b] The restructuring is happening in bits and pieces. The CMBS loans have inherent issues related to servicing agreements that are tied to the loan pools, but they do have a way to be worked through with the right documentation, distress and structure of the original financing. Some loans were set up with interest reserves or the like and have no leverage to use against the servicer. But every asset is unique and requires an invaluable approach. There is obviously more inherent flexibility with a non-CMBS loan. [b]Q:[/b] Your Web site notes that errors in common area maintenance (CAM) calculations can significantly affect property values. What are the most common causes of these incorrect charges? [b]Tesler:[/b] The most common cause of incorrect CAM charges is a poor understanding of what can and what cannot be passed through to a tenant. The CAM provision within a lease is the most complex part of a commercial lease. While the CAM provision used to be mere paragraphs, today, it can be up to 15 pages in a modern, complex lease. It is critical to have an understanding of what can legally be passed through as a CAM charge and what cannot be. Additionally, very often, a CAM provision requires calculations to be done to determine a base year or an expense stop or floor. Arriving at the correct number is imperative, because a lot of subsequent uses of that number are necessary. Additionally, when leases have a gross-up, the gross-up needs to be calculated properly and can have a disparate impact upon CAM charges. There are many other factors that impact CAM, but suffice it to say that in our experience, CAM is rarely billed appropriately. [b]Q:[/b] Many in the industry have noted that property valuations have become difficult at a time when so few commercial real estate transactions are taking place. How do you overcome this issue? [b]Tesler:[/b] Valuation in a market like this is an art – not a science. When transaction flow remains as low as it is, it becomes exceedingly difficult to conduct a market valuation. In part, this is one of the reasons we remain in a difficult market. It is basically a chicken-and-egg problem. There is no question that a large disparity exists between what a seller or lender thinks an asset is worth and what a potential buyer thinks it is worth. Because there are so few sales, a true market comparison is impossible, so there continue to be very few sales. To answer your question directly, though, it is important to visit the property and all similar properties in a geographically meaningful radius. One then has to take the information learned about similar properties, couple it with the existing facts about the subject asset and build a financial model to arrive at a valuation. Then, one has to make persuasive arguments to the opposing parties about the strength and internal logic of the financial model. [b]Q:[/b] What steps are involved for a client that purchases a distressed note and forecloses on the associated property? What legal snags might the client run into? [b]Tesler:[/b] In addition to all of the steps required for a typical due diligence process, it is imperative that the purchaser do several things. It is helpful to view this as a four-step process, with potential problems at each step. Step One: Due Diligence on the Loan/Note There must be an understanding of the loan documents and the rights and obligations of the borrower and all of the lenders in a debt stack. One also has to ensure the legal enforceability of the note and ensure a proper title policy is in place. In short, conduct much of the same type of due diligence as if one were originating a loan. Step Two: Due Diligence on the Underlying Asset Whether or not there is an expectation of foreclosing and owning, one should proceed as if they will own the asset. That means conducting a full diligence review as if they were purchasing the asset and not the note. Step Three: The Foreclosure Process Ensure that one has good legal counsel to effectuate a valid foreclosure. There are numerous legal snags that could occur. Step Four: The Ownership and Management of the Foreclosed Asset Oftentimes, we see that a client is not well prepared for the foreclosure stage in terms of shifting from a note holder to a property owner. There are obviously a lot of moving parts that need to fall into place, and even companies in the business of asset management do not always handle that transition smoothl