Whether you work at a financial institution, develop real estate, invest in property, or act as a broker, there’s a common thread that binds all facets of the real estate world together. It’s highly likely that you have one or more financial products like a credit card, debit card, deposit account, car loan, commercial real estate loan, and/or checking account. Sometimes one or more of these products are held with the same bank, credit union, or issuer.
As it relates to commercial real estate specifically, it is very common for a lender to require a borrower to open a checking account as part of the transaction. Because of this, it is critical that borrowers have awareness of a lightly understood and rarely enforced, but potentially devastating clause in a typical retail bank’s deposit account agreement known as the “Right of Offset.”
You may be thinking, what does a bank account have to do with my real estate loan? It is a fair thought, but whenever you have a loan and a checking/savings account with the same bank, understanding how the Right of Offset works is important, particularly if the loan repayments fall into a state of delinquency.
In non-legalease, the Right of Offset gives a bank the legal right to withdraw funds from your checking account, savings account, or any other account without any advance notice, to repay a delinquent loan, outstanding debt, or other fee. The terms of the Right of Offset are agreed to when deposit account agreement is signed and they are usually buried in tiny font and confusing language. To illustrate this point, consider the actual legal language from a national bank’s deposit agreement:
“Except to the extent otherwise agreed by you in writing, any loans, charges, service or analysis charges; overdraft or other obligations; or other indebtedness now or hereafter owed to us by you may be charged in whole or in part to the Account, to any other account(s) in your name, or to accounts of co-owners and of certain individuals, to the extent permitted by law.
You grant us a security interest in the balance of the Account and in any other account(s) in your name to pay all loans, charges, service or analysis charges; overdrafts or other obligations; or other indebtedness now or hereafter owed to us by you. In addition, we may exercise our right of set off without any advance notice to you and without regard to any other right that we may have against you or any other party. Such setoff shall be effective immediately upon the occurrence of the event giving rise to the set off rights, even though we may enter the set off on our books at a later date.
Our security interest and right of set off shall prevail and take priority over any adverse claim, change of ownership, pledge, attachment, garnishment, levy, court order, or other legal process of any kind whatsoever. Should one of these events occur, we may take any action permitted or required by law.”
Take a moment to let that soak in. By signing a deposit agreement, the account holder agrees to allow the bank to take funds from any individual account in their name or from joint accounts with co-owners and other individuals at will. Granted, this is rarely enforced, but when it is, it can drive a business or real estate project into insolvency.
In a typical commercial bank, the sales staff (usually called Relationship Managers) tends to lead with loans, but are often responsible for meeting deposit goals as well. To meet those goals, they will leverage a loan approval into requiring the borrower to open one or more checking accounts with the bank. These may be an operating account for a business or a personal checking account, or both. In either case, the relationship manager will push the borrower to bring as many deposits as possible as a condition of loan approval. In the vast majority of situations this strategy is perfectly fine, but the cautionary tale below outlines the risk of this approach.
In the market downturn of 2006 – 2008, I worked at a bank as a Commercial Real Estate Underwriter and we had a client who was a well-regarded custom home builder. As the housing market turned south, they had increasing difficulty making required loan payments because their homes weren’t selling. After an extended period of delinquency, multiple failed efforts to restructure the loan, and many missed payments, the bank foreclosed on the properties/loans outstanding under the line of credit. In the march up to foreclosure, bank officials exercised their Right of Offset and, with little advance notice, withdrew a six-figure sum from the borrower’s personal checking account. They used the proceeds to repay the delinquency on their line of credit.
To say that the borrower was shocked and upset is a massive understatement. They had allocated the money as a “rainy day fund” and the sudden disappearance of it placed a major strain on their personal finances, credit score, and ability to support their homebuilding business. Worse, they had to learn a very hard lesson about the Right of Offset because they’d never heard of it before.
Start with the assumption that it isn’t possible to negotiate away the Right of Offset in a loan or deposit transaction. It is a foundational principle that the bank likely isn’t going to budge on. Also assume that not opening an account isn’t a likely option either. As part of loan closing, many banks require it.
So, commercial real estate borrowers are left with two options to protect themselves from an unannounced withdrawal by their bank. The first is simple, make the required loan payments on time. As long as this happens, the existence of the Right of Offset is a non-issue. If you fall behind, be transparent and realistic with the lender about your plan to get back on track.
The other option is to always be aware that the Right of Offset exists and manage cash accordingly. To the extent that it’s allowed under the terms of the loan, keeping separating personal and business checking at two different banks is a best practice. In addition, it can also make sense to have credit card accounts and personal loans with separate banks as well.
This article is not meant to instill fear. Instead, it is meant to inform readers that the Right of Offset exists in almost all banks. To be clear, the Right of Offset is rarely enforced and the kindest banks will provide some level of advance notice before exercising it. However, it is an important concept for commercial real estate borrowers and investors to be aware of should they ever become delinquent on their loan payments.
Disclaimer: This article is illustrative in nature only and not to be taken as legal advice. For questions about your specific loan and deposit situation, it’s best to consult with your banker. For legal questions, it’s best to consult with a qualified attorney who can provide advice specific to your situation.
Source: Understanding The Right of Offset
https://www.creconsult.net/market-trends/understanding-the-right-of-offset/
When real estate investors are evaluating a potential rental property purchase or a bank is underwriting a potential loan, one of the first documents that they will ask for is the property’s “rent roll” or “rent roll report.”
In this article, the rent roll document is described in detail and its utility in the CRE due diligence process is highlighted. Let’s start with a simple definition.
A rent roll is an important document that lists all the tenants in the property. In real estate investing, it is an indispensable part of the due diligence process, and it is typically provided by the current owner or property management company. The format of the rent roll can vary – sometimes it is an Excel file, other times it is a printed report – but they all contain the same general information:
A rent roll is typically stored in a spreadsheet, so each of the above elements represents a column. It could look something like this (again, the actual format can vary greatly from one rent roll to the next):
There is no question about the importance of the rent roll, but its utility varies based on the perspective of the individual viewing it. For an investor, analyzing it is a critical part of the pre-purchase due diligence process. For a banker or lender, it is a critical part of the loan underwriting process. In either case, there are several key insights that can be obtained from a rent roll:
Although it may seem like a humble spreadsheet document, the points above support the idea that a rent roll is a critical tool that can be used to understand the health of a property.
A rent roll is a document that provides key information about the tenants that occupy a commercial rental property. Its format can vary by property owner or property type, and it is typically provided by the existing property manager as part of the pre-purchase and pre-loan due diligence process.
Despite potential differences in format, all rent rolls contain the same basic data points including things like tenant name, SF leased, rental rate, lease start date, lease end date, and the unit number.
Analysis of the rent roll can provide key information like tenant concentrations, property vacancy, potential rental income, and how the lease rental rate compares to the market rent for comparable properties in the same market.
Source: What is a Rent Roll?
https://www.creconsult.net/market-trends/what-is-a-rent-roll/
One of the unique challenges of commercial real estate investment is that markets, types of property, return expectations, and physical environments are in a constant state of change. As a result of these changes, a commercial property could be cash flow positive one day and undesirable the next due to shifts in tenant desires or some other factor.
The real estate term for this type of risk is “obsolescence” and there are three types that CRE investors should be aware of.
Functional Obsolescence is the impairment of a real property’s functional capacity due to changes in market tastes and/or standards. In other words, a property could become functionally obsolete when its design, style, amenities, or technology no longer meet the needs and/or expectations of modern tenants. There are no clearer examples of functional obsolescence than in the realm of technology. Modern tenants require high speed internet connections, strong cellular reception, advanced security features, and modern audio/video capabilities. Could you imagine an office building without videoconferencing or high speed internet? Properties that do not have these features could be well on their way to becoming functionally obsolete.
Depending on the situation, there are two types of functional obsolescence, “curable” and “incurable.” If there is curable functional obsolescence, it means that the property could be renovated or upgraded in a cost efficient manner to bring the property up to modern standards. For example, it is possible to retrofit a property with high speed wireless internet or badge scanners for increased security. If there is incurable functional obsolescence, it means that the property cannot be upgraded or that it is not economically feasible to do so. For example, it would be nearly impossible to retrofit an older 10-story building with a modern elevator system.
It should be noted that there is a subset of functional obsolescence known as “superadequacy.” It may seem counterintuitive, but it is possible to improve a property too much and that is where the concept of superadequacy comes into play. For example, if a multifamily developer purchased a property and renovated it with luxury finishes in a market that cannot support them, the property could be considered “superadequate.”
Economic obsolescence – sometimes called external obsolescence – is the depreciation in the market value of a property due to external factors that cannot be controlled by the owner.
Common causes of economic obsolescence are things like: traffic pattern changes, zoning changes, flight pattern changes, construction of public nuisance projects like a jail or sewer treatment plant, rising crime, or job loss. For example, imagine a successful apartment complex that is located in close proximity to a major airport. The property is full, cash flow positive, and residents like to live there due to its proximity to the airport. But, one day the FAA decides to change the approach path to the airport. The new pattern brings aircraft directly over the apartment complex at a low altitude at all hours of the day and night.
The property owner had no input on the change, but they will likely suffer the consequences of it in two ways. First, tenants are likely to leave, causing increased vacancy in the property. Second, the increased vacancy will require rents to come down to a point where they are perceived to be a good deal, despite the aircraft noise. Combined, these economic factors can create a shortfall in operating income and drive the property value lower, perhaps to a point where it is considered economically obsolete.
Unfortunately, economic obsolescence is incurable in most cases. In the example above, there is little, if anything the property owner could do to get the flight path changed other than to log their complaint with local authorities. In many cases, they may have to sell the property at a loss or find other ways to deal with the erosion of value.
Physical obsolescence is the decline in a property’s valuation due to physical depreciation or gross mismanagement. It is a given that there will be physical deterioration in all real estate assets over time, but it can be managed with a proactive maintenance and replacement program. True physical obsolescence happens when maintenance requirements are ignored and the property physically degrades to a point where it has no desirability. For example, suppose that a property owner never changes the air filters in the HVAC system. Over time, this allows for the growth of mold and mildew throughout the property to the point that it isn’t safe for occupancy. This would have a negative effect on the value of the property and would likely result in decreased occupancy, decreased economic life, operating losses, and potential capital losses.
The question of whether or not physical obsolescence is curable is a function of the replacement cost to fix it. If the pricing is such that it is either cost prohibitive or the cost can’t be recovered through improved occupancy or higher rents, it is likely incurable. However, if the cost is relatively minor, it could be cured with ease.
From an investment standpoint, the threat of obsolescence is that it happens quickly and the property owner never sees it coming. For this reason, it is important to consider each of the above types prior to purchasing a property.
The first line of defense for recognizing obsolescence is the real estate appraisal. Appraisers/assessors are trained to look for it in the subject property, to quantify the cost of fixing it (if possible), and to summarize the obsolescence results in their lenders reports. If it exists, it is up to the property owner/investor to assess the cost of repair/renovation versus the benefits that they will receive from it. Quantifying this cost/benefit metric can be tricky because it is dependent upon certain locational characteristics of the property, its capitalization, operating costs, effective age, and the useful life of potential upgrades. There is no “right” way to do it because it varies widely from one property to another, but looking at the cost for comparable properties may be helpful.
The more important point is that all types of obsolescence be considered prior to purchasing a property and a plan to address them if/when they arise should be developed.
Source: Three Types of Commercial Real Estate Obsolescence
https://www.creconsult.net/market-trends/three-types-of-commercial-real-estate-obsolescence/
Every investment involves a certain amount of risk. There are certain general sources of risk that influence all assets – things like geopolitical risk and global macroeconomic risk. What makes each asset unique is the level of sensitivity that its rate of return has to those risks. In addition, specific types of assets have risks that are uniquely their own. In this article, we’ll look at eleven types of risk in commercial real estate investment.
Credit risk, or default risk, is the risk that someone will not be able to meet a financial obligation. Lenders face default risk that a borrower will not be able to make a monthly loan payment on time. Similarly, leased property includes a risk that tenants will not be able to make timely lease payments as expected. Late payments can create cash flow problems for the property owner, but the situation can be worse if the tenant goes out of business and moves out of the space. Then, the property owner faces an unexpected shortfall in lease income along with additional costs to get a new tenant in the space.
Inflation is the general increase in prices and decrease in purchasing power that happens over time. In the United States, the inflation rate has been around 2% per year since the year 2000. So, planning for 2% inflation each year would be a reasonable estimate in this market. Property owners, therefore, can set lease rates that allow for this 2% annual growth in overall market prices. Inflation risk, however, is the risk that this expectation is wrong. What if a tenant just signed a 10-year lease with an expectation of 2% inflation, but one year into that lease inflation goes up to 12% annually? The tenant ended up with a pretty great deal, but the property owner may not be able to keep up with the rising cost of operating expenses if inflation rates are this much higher than expected.
Macroeconomic risk refers to how broad, national level economic activity impacts property cash flows and valuation. For example, during a period of high growth in GDP, most businesses have ample cash on hand and low unemployment. Property owners can increase rental rates and expect low vacancy rates and collection loss. These factors also cause property valuation to increase. On the other hand, businesses may struggle to stay in business during a recession, and unemployment rates increase. Property owners may have a more difficult time collecting rent on time from tenants, and in the worst case have tenants go out of business entirely. Vacancy rates increase, and finding a new tenant is challenging. These factors all result in lower property valuations.
The type of interest rate risk that most people worry about is the risk of increasing interest rates. Borrowers holding a mortgage with a floating interest rate are negatively impacted by rising interest rates. As interest rates increase, so do the monthly mortgage payments. Borrowers could also be negatively impacted by higher rates when refinancing debt at the end of a loan term.
Rising interest rates also impact the net present value of investment cash flows. When market interest rates increase, the required rate of return or discount rate also increases. This change causes the present value of future cash flows to decrease. In some cases, this can result in the cash flows no longer creating an acceptable return for an investor.
Real estate is a highly illiquid asset. A liquid asset is one that can be sold immediately at market value. If an owner had to sell a piece of real estate by the end of the day, chances are that it would be for a price far below market value. So, real estate is illiquid compared to most other types of assets. The degree of illiquidity varies according to location, property type, and market cycle.
Legislative or regulatory risk refers to any change in regulations or law that can impact real estate owners or tenants. These changes may take place at the local level or the national level. These may include direct risks such as zoning changes, building codes, or access to public goods and utilities. More indirect risks could be changes to local or federal tax rates, mortgage deductibility requirements, banking regulations, etc.
Increases in tax rates not only impact the property owner’s taxable income but also cash flow of the tenants. Additional limitations on mortgage deductions on federal taxes reduce the property owner’s after-tax income and the overall rate of return on the investment. Changes to bank regulations could influence the cost of borrowing and ease of obtaining financing for a property owner. Even if changes to laws and regulations do not directly impact real estate, they may indirectly impact property investment through financing or business cash flows.
Real estate investment ultimately depends on having the right type of property in the right location. Cities, however, act as dynamic and evolving organisms. What is a prime location for office and retail space today may be empty 20 years from now. Location risk comes from the external environment and the contribution that the neighborhood makes to a property’s value. Changes in city growth or transportation patterns or reductions in public goods and services can all negatively impact the desirability and value of a particular property.
Property owners purchase real estate with a specific expectation about market rental rates and the demand for space over the investment holding period. Space market risk refers to the probability that those expectations are incorrect. As an example, consider the potential impact of a global pandemic on long-term corporate behavior with respect to remote working. If corporations suddenly start allowing a large percentage of workers to engage in remote working contracts, the market demand for office space will dramatically decrease from previous forecasts. This unexpected change in demand conditions is space market risk and uniquely impacts real estate assets.
Any time a property undergoes construction, there is an additional source of risk to the property owner. Construction risk applies whether there is a new development or a significant renovation. The construction project may take longer than expected and delay expected rental income, cost more than the budget estimate, or expose previously unknown defects in the property that require additional time and expense to remedy. All of these scenarios result in a reduction in expected cash flow for the property owner.
Environmental risk can come from land use regulations and environmental protection concerns. It can also come from the environmental conditions of a property. The first type of environmental risk can be hard to anticipate and to mitigate. The second type of environmental risk may be limited with a thorough inspection of the property and all historical records about the prior use of the land. Specific environmental risks vary a bit with the region but may include problems such as asbestos and lead-based paints, radon or other hazardous chemicals, groundwater or soil contamination, wetlands, and protected wildlife. Environmental mitigation can be extremely expensive, so property owners should take the time to do their due diligence about potential sources of problems.
Even the nicest property in the best location can be an unprofitable investment without the right management. Property managers establish relationships with tenants and make decisions about lease rates and concessions as well as the operating budget. Poor management can result in high vacancy rates, below market rental income, and high operating expenses. All of these factors reduce the property income for the owner and the return on investment. Thus, knowledgeable and competent property management is essential to success in real estate investment.
Investment commercial real estate has many risks that must be weighed against potential returns. In this article we discussed eleven types of risk in commercial property. These include credit/default risk, inflation risk, macroeconomic risk, interest rate risk, liquidity risk, legislative/regulatory risk, location risk, space market risk, construction risk, environmental risk, and management risk.
Source: Eleven Types of Risk in Commercial Real Estate
https://www.creconsult.net/market-trends/eleven-types-of-risk-in-commercial-real-estate/
