February 2009

The Vultures Are Coming: 10 Things You Need to Know About Acquiring Distressed Properties

Holland & Knight Newsletter
Jonathan S. Marcus

Given the recent turmoil in the financial markets and the downturn in the real estate industry, real estate developers and investors are increasingly looking toward acquiring distressed properties. Although many of these properties are for sale at bargain basement prices, as the old adage goes: “Sometimes you get what you pay for.” Therefore, it is critical that potential buyers perform the necessary due diligence to protect their investment, especially since many distressed properties are neglected due to the owners’ reluctance or inability to put money into the properties. This article lists 10 things that buyers need to consider when acquiring distressed properties:

1. Identifying and Paying Off Existing Mortgage Holders

In order to have clear title to the property, of course all existing mortgages on the property must be satisfied at or prior to closing. However, given the current chaos within the financial community, can all institutional lenders and their holdings be easily identified and located and do these lenders have the authority to deal with the property as they see fit, regardless of additional participants in their loans or the FDIC? If individual mortgage holders are involved, it is imperative that the executed satisfaction of mortgage and the original canceled note be available at closing. Again, it is critical to identify early in the due diligence process who these people are and if and where they can be found.

2. Existing Judgments, Claims and Mechanics Liens

If the prior owner abandoned the property to a lender, it is likely that the prior owner was not current in paying any contractors, materialmen or suppliers before exiting the scene. Whether these lien holders can be located and just how much it will cost the buyer to obtain releases from them are major considerations, particularly if there is unfinished construction on the property.

3. Land Use Issues

It is likely that the buyer is not acquiring the distressed property for exactly the same use as its previous owner. After all, if the prior intended use was the most advantageous use of the property, it likely would not be distressed. Therefore, a buyer must fully explore sooner rather than later all potential rezoning and replatting issues in connection with the development and redevelopment of unfinished projects.

4. Permits and Residual Liabilities

Buyers are often enticed by the words “fully approved.” The initial question is obviously, “Fully approved for what?” In connection with item 3 above, the full approval may be for a use much different than that contemplated by the buyer. Additionally, assuming that the anticipated use is the same or very similar to the approved use, are the approvals, permits and licenses that have been obtained by the prior owner transferable and assignable to a future owner, and if so, what are the potential costs and residual liabilities that may be associated with the issuance of those approvals?

5. Code Enforcement Issues
A distressed property may not be a well maintained property. Virtually all municipalities enforce code violations by assessing fines, together with penalties and interest if not timely paid, for various types of code violations, from failure to cut grass to faded paint, and for much more serious offenses such as the destruction of vegetation or harm or failure to properly relocate endangered species or wildlife on the property. Whether such violations exist and the cost of remedying them are issues that must be considered when acquiring any property, and in particular a distressed property.

6. Unpaid Property Owners’ Association Fees
Just as unpaid code enforcement fines can quickly escalate, so too can the unpaid association fees for distressed properties, whether residential or commercial. The liabilities of financial institutions and subsequent owners in regard to these fees are the subject of entire chapters within various state statutes and cannot be ignored in considering the potential acquisition of a distressed

7. Unresolved Homestead or Other Protected Property Rights

Many jurisdictions, particularly Florida, protect certain rights of parties in residential properties even if those parties merely reside in what is classified as “homestead” without an ownership interest. Homestead rights are of such high esteem in Florida, for example, that they cannot be easily waived, if at all, even if voluntarily done so. Thus, any lingering rights to the property, particularly residential property, by any party that may have previously resided in the property or had any prior rights to the property, should always be considered.

8. Title and Survey Issues

Similar to being unable to develop the property for its anticipated purpose because of the inability to obtain the appropriate governmental approvals and permits, there is a mountain of pitfalls related to title and survey matters that may have caused the property from being successfully developed in the first instance and will further prevent it from being successfully developed in the future.

9. Environmental Issues

While it would seem to be pretty basic due diligence to obtain, at a minimum, a Phase I Environmental Site Assessment in acquiring any piece of real estate, buyers of distressed properties often do not have sufficient time to obtain such a report, particularly if financing is not being obtained and thus not required by a lender. The potential costs and liabilities are often just too great to compromise on this evaluation of the property, regardless of the need to close quickly or the limitations placed by a seller on the level of due diligence performed. One’s “What are they trying to hide?” antenna should immediately go up if a seller will not permit at least a basic Phase I Environmental Site Assessment of the property.

10.Building Systems for Improved Projects

Is the improved property in such a state that upgrading to code would prove to be a monumentally expensive task and that “gutting” the property would be more economical? If so, then the cost savings of buying the property may soon be offset as the internal improvement costs mount. Current building codes often only protect existing owners in not requiring immediate upgrades. Once the property changes hands or is redeveloped, a significant expense is to be expected for the upgrades, regardless of how minimal they are anticipated to be.

It’s a Buyer’s Market

There is no doubt that, given the current state of the real estate market in virtually all areas of the United States, it is truly a buyer’s market for those with the resources or access to financing to obtain properties that were once deemed unobtainable. However, it is always best to remember when buying anything that something that is too good to be true, often is. A buyer of distressed real estate would be wise to be extra-vigilant in its due diligence in acquiring the property.

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