In the last several months, our country has seen unprecedented changes in the economy and staggering unemployment rates due to business shutdowns across several sectors. Consequently, many lenders have been working with businesses to keep them operational including payroll protection loans and providing payment relief options such as forbearance. Unfortunately, as the recession drags on, the time will soon come when payment relief and loan accommodations will likely come to a halt and a large volume of distressed loans will be in danger of foreclosure.

As lenders consider their options and strategies to recover value from these assets, it is critical to perform thorough due diligence.  While most loans will have had due diligence done at origination, pre-foreclosure due diligence should go above and beyond what was completed during loan origination and should consider environmental concerns, building condition issues, and construction status for sites under development or rehab.

“In any foreclosure, there is a minefield of potential liabilities a lender can step into,” shared Kathryn Peacock, a Principal and National Client Manager with Partner Engineering and Science, Inc. “Something as simple as disposing of a drum of oil from an auto shop can expose a lender to significant liability.”

But this time around, lenders will find the troubled loans landscape to be unique with a litany of special circumstances to take into consideration. “This wave of foreclosures is certainly going to look different from the last wave in several ways,” Ms. Peacock says. “For one thing, there are different players now. The previous wave occurred over a decade ago. Since that time, there has been a fair amount of turnover in the special assets groups that are accustomed to dealing with these unique situations. There is now a whole generation of lenders who have never experienced a significant downturn.”

Compared to 2008, debt funds and credit unions have been more active CRE lenders lately. “These types of lenders may not have appropriately robust protocols, policies and procedures in place to address the unique nature of properties in foreclosure,” says Ms. Peacock. “This is a great time to firm up the battlements and create or refine those policies and procedures.”

It also important to consider the impetus of this downturn: an ongoing pandemic, which raises health and safety considerations for onsite inspections, which are critical to the foreclosure process. “Because of COVID-19, the process looks different from an on-the-ground perspective,” Peacock says.

In some instances, consultants may not be able to access the properties for onsite assessments. “We have to be creative and think outside the box in terms of how we’re going to assess these properties safely and thoroughly to provide a clear picture of asset risks.”

Modified and virtual site assessments represent one solution. The pandemic, and the extended vacancies that may result from shutdown orders, also play into another consideration: the need to assess the habitability of a building that may not have been occupied for a long period of time.

“It’s common to see problems like moisture, mold, safety issues and other poor conditions in buildings that were not shut down properly or have been vacant for a long time. These issues can degrade asset value and present liabilities, which are all things that lenders are going to need to be thinking about,” says Ms. Peacock.

To provide guidance to lenders who could find the sheer volume and complexity of a foreclosure wave overwhelming, Partner Engineering & Science, Inc. has scheduled a webinar for September 1 on the importance of conducting due diligence pre-foreclosure, focusing on environmental, construction, building and legal concerns, among other matters. Kathryn Peacock, national client manager at Partner, will address the subject along with partner David Quigley at law firm Akin Gump.

It’s important to start the pre-foreclosure due diligence process early, says Ms. Peacock. “Due diligence is best when started before the official foreclosure process, either during the workout process or even during a red-flag period after forbearance has come to an end. This gives lenders time to customize the type of due diligence to the property type with the goal of catching the issues that may be unique to that property, and minimize risks, expenditures and liability to the bank when title is taken.” The webinar will provide some guidance on how to develop these policies.

The webinar will also touch on what happens when an under-construction property goes into foreclosure. “Stalled construction due to lack of funds is one of the more unique challenges a lender can face during foreclosure,” Peacock says. “Once construction stalls, problems can really start compounding – materials can degrade or walk off the site, erosion and associated fines can be a concern, just to name a few – unless good safeguards are put in place. The lender also must evaluate what costs are associated with taking over a project midway through. Fortunately, there are several tools to help lenders quickly assess the status of a site and the cost to complete construction and stabilize the site to minimize loss.”

Lenders don’t want to be in this position, Ms. Peacock shares, but when working through a trouble loan the most important thing is having a good playbook. “Once you get to this stage, it’s all about avoiding risks, limiting loss and recovering value.”

For comments, questions or concerns, please contact Paul Bubny