Wednesday, March 11, 2009

When Real Estate is a Liability

We are used to thinking of real estate as something of value. This is not always the case.

The first appraisal I saw with a negative value was for a 10 story office building in downtown Minneapolis back in the early 1990’s. I couldn’t find any errors in the analysis, but I felt I had to be missing something – a major office building just couldn’t be worthless. I made a trip to Minneapolis to take a look, and it still felt wrong. Sure, it was old (1920’s), but it was by no means falling down, it had tenants, and it was tied in to the skybridge system. It had to be worth something to somebody.

The issues on the building were all the usual suspects – rents and occupancy had fallen, utility costs had increased, and capitalization rates had climbed, all of which combined to hammer the value (I’ve posted here showing how relatively small changes in these variables can  combine to create a 50%+ loss of value). This building had three additional problems; there was major friable asbestos problem that was missed in the initial due diligence, we had not escrowed for real estate taxes and the borrower didn’t pay them (real estate taxes are very high in Minnesota), and there were mandatory fire code upgrades (primarily sprinklers) imposed after the loan closed which had to be completed. The cost of curing these three items exceeded the value of the building. We ended up releasing our debt ($7M) for a $200K payment from the borrower.

This kind of problem is increasingly common. NPR has a story about lenders refusing to complete foreclosures, and there is an abundance of stories on the median home sale price in Detroit (around $7,000, see here and here) and $1 bargains available (see here and here). This 5 bedroom, 3.5 bath home was available for $8,995:


And it’s not just Detroit.

The combination of low fundamental values, cost to restore the homes to habitability and cure code violations, and real estate taxes are the reasons these “bargains” exist.