The Property Condition Report is a due diligence tool that helps buyers and lenders of real estate to understand the condition of the asset they are buying.   The most important section of the Property Condition Report is the Immediate Repairs table and the Replacement Reserves Table, where we express to the report user the capital spending that needs to happen in the near term and long term respectively.  

Often a Property Condition Report (PCA) is required by lenders during the financing of commercial real estate.   Buyers may call the report a Property Condition Report, a Property Condition Assessment or a Commercial Building Inspection.   

In this blog we discuss a wide range of types of Property Condition Assessments done for a variety of users.

ASTM E2018- Standard for Property Condition Assessments

The American Society of Material Testing (ASTM) published the standard “ASTM E2018 Standard Guide for Property Condition Assessments: Baseline Property Condition Assessment Process,” originally in 1999 and updated the Standard in 2001 and 2008 (now called E2018-08).       

According to ASTM E2018, the goal of the Property Condition Report is to identify and communicate physical deficiencies to a user. The term physical deficiencies means the presence of conspicuous defects or material deferred maintenance of a subject property’s material systems, components, or equipment as observed during the field observer’s walk-through survey. This definition specifically excludes deficiencies that may be remedied with routine maintenance, miscellaneous minor repairs, normal operating maintenance, etc., and excludes de minimis conditions that generally do not present material physical deficiencies of the subject property.

The ASTM guideline is careful to point out that the Property Condition Report is a Walk-Through Survey. Users are wise to appreciate that many building deficiencies are hard to find in a walk through survey.  If the user is not comfortable with such limitations, they should ask for a more comprehensive inspection including sub-specialists such as an MEP engineer, a structural engineer, roof inspector, ADA specialist, etc. (refer to the Equity Property Condition Report section below).

The building inspector will opine on the expected useful life (EUL) and remaining useful life (RUL) of each major system.   The EUL is the average amount of time in years that an item, component or system is estimated to function when installed new and assuming routine maintenance is practiced.  The RUL is a subjective estimate (based upon observations, or average estimates of similar items, components, or systems, or a combination thereof) of the number of remaining years that an item, component, or system is estimated to be able to function in accordance with its intended purpose before warranting replacement.  

The Property Condition Assessment Focuses on Large Issues.

Unlike a home inspection, a property condition assessment ignores small repairs.   ASTM E2018 requires the building inspector to identify material physical deficiencies.  The standard states that “opinions of probable costs that are either individually or in the aggregate less than a threshold amount of $3,000 for like items are to be omitted from the PCR. If there are more than four separate like items that are below this threshold requirement, but collectively total over $10,000, such items should be included.”  So an inspector could ignore graffiti on a window or a hole in a wall.   The inspector may include an item below $3,000 if it represents a life safety issue.

Qualification of the Property Condition Assessor

As with any consulting product, the qualifications of the consultant are directly related to the quality of the product.  The ASTM Standard does not contain requirements for the qualifications of the inspector.   Some clients may request that the inspector is a Professional Engineer or a Registered Architect.   I support clients that insist on particular qualifications of their inspectors; however, some of the best inspectors in the field are professional commercial building inspectors and don’t necessarily have an engineering or architectural degree. 

Property Condition Report for CMBS Lenders

Many lenders require their own type of Property Condition Reports.  Commercial Mortgage Back Security (CMBS) Lenders are one of the largest classes of users of Property Condition Reports.   CMBS Lenders are generally required to provide a Property Condition Report as part of the underwriting package submitted to rating agencies.  Standard and Poor’s guidance document entitled “STRUCTURED FINANCE RATINGS REAL ESTATE FINANCE PROPERTY CONDITION ASSESSMENT CRITERIA” defines S&P’s expectations in a Property Condition Report and their expectations are rather similar to ASTM E2018. 

Physical Needs Assessment – Fannie Mae DUS Lenders

Fannie Mae DUS Lenders require a Physical Needs Assessment which is essentially their version of the Property Condition Report.   The Physical Needs Assessment is defined in the Fannie Mae Delegated Underwriting and Servicing guide, Part 111, Chapter 3, 308.  The PNA is required for Fannie Mae financing on many types of residential properties, including apartment communities, assisted living facilities, skilled nursing facilities, student housing, and manufactured housing communities.   While the PNA is similar to an ASTM 2018 PCA in many respects, there are distinct differences in several areas.   Fannie Mae requires more detail on the replacement of apartment appliances and finishes as these replacement schedules are significant capital events for the owners of multifamily assets.

Other key items to consider include the following:

• Fannie Mae has designated several building materials / conditions that are deemed critically important when completing a PNA. Particular items of concern include the presence of fused subpanels, electrical service less than 60-amp capacity, presence of fire retardant treated plywood, and the presence of aluminum branch wiring.
• The PNA does not distinguish between “Short Term” and “Immediate” repair items. Typically, all life safety issues and deferred maintenance items above a designated cost threshold are included in the Immediate Repairs table. Furthermore, Fannie Mae and DUS lenders are sensitive to major capital expenditures in the first two years of a Replacement Reserve schedule. It is common for these items (other than typical spread cost items) to be moved to the Immediate Repairs table.
• Fannie Mae dictates specific requirements on termite inspections at the property. The DUS Guide currently requires the Lender to provide a termite inspection report or a termite bond or other evidence of adequate coverage. This “other evidence of adequate coverage” can be satisfied in two ways: “1) A letter from the current pest control company providing regular service to the Property, stating that the Property has been regularly treated to prevent termite and other wood boring insect infestation and, to its knowledge, there is no current infestation”; or 2) “A letter from a qualified engineer (which must be the same engineer performing the physical needs assessment) indicating that there is no evidence of termite or wood boring insect infestation. In order to be a “qualified” engineer, such engineer must have completed termite inspection training and certification and must provide evidence of such”.

Property Condition Report – Freddie Mac

Freddie Mac also has its own requirements for their version of a Property Condition Report.  The scope of work, as specified in the Freddie Mac Multifamily Seller/Servicer Guide and Chapter 15 Engineering and Property Condition Requirements, is similar to an ASTM 2018 PCA, but also requires more detail on apartment appliances and finishes.  Additionally, a few hot button items for a Freddie Mac PCR include the following:

• In a fashion similar to Fannie Mae, Freddie Mac has designated several building materials / conditions that are deemed critically important when completing a PCR. Particular items of concern include electrical service less than 60-amp capacity, presence of fire retardant treated plywood, and the presence of aluminum branch wiring. In addition, Freddie Mac requires the consultant to inspect for evidence of “problem drywall”. Such evidence may include deterioration of other building components caused by the problem drywall such as blackening of copper electrical wiring or other metallic components, blackening of air conditioner evaporating coils or a pattern of early failure of these coils, the presence of a sulfur odor within the building, confirmed markings of known manufacturers of problem drywall, or other corroborating evidence that is readily available to the consultant.
• Freddie Mac requires the consultant completing the PCR to inspect interiors at 10% of all dwelling units, including 50% of vacant units and 50% of down units. For larger properties (generally over 400 units), the lender is often granted waivers to reduce the 10% requirement.
• For all PCRs, the consultant must complete Form 1105 Multifamily Property Condition Form. The Form 1105 is designed with distinct sections that include a summary of the property systems, details regarding the inspection and units accessed, immediate repair needs, and capital needs over the loan term (replacement reserves). While the general industry standard for inflation rates of replacement reserves is considered to be 2.5%, the Form 1105 differs in that it dictates an inflation rate of 3%. Freddie Mac is sensitive to the completion of this form and can be critical when they deem that consultants are not properly completing the form. Freddie Mac maintains that the reserve analysis should not be manipulated merely to produce a number that works with the underwriting analysis. For instance, Freddie Mac will no longer accept a consultant’s opinion that the remaining useful life of a system is “12+ years” as it appears to be an effort to simply move that component out of the replacement reserve analysis.

Project Capital Needs Assessment – FHA Lenders

Housing and Urban Development (HUD) / Federal Housing Authorities (FHA) Lenders require a Project Capital Needs Assessment in place of the Property Condition Report.  The HUD Multifamily Accelerated Process (MAP) and Lean Healthcare Process Guides contain detailed guidelines for the Property Condition Assessor.  

There are some distinctions that clearly define a FHA/HUD Physical Inspection Report (PIR – a part of the Project Capital Needs Assessment).  A significant difference is the capital replacement reserve analysis requirements.  A FHA/HUD loan typically requires a 37-year loan term (as opposed to the standard 10+2 or 20-year loan term for Fannie Mae or Freddie Mac), and also requires a higher Initial Deposit and Annual Deposits for reserves with a “healthy” remaining balance. The additional years mean that items that would not typically require replacement within the 12- or 20-year loan term scenarios, such as windows, cabinetry, etc., will need to be budgeted for replacement, adding to the overall capital reserves. 

Other key distinctions of a HUD PCNA include:

• Tables:

1. Critical and Non-Critical repairs. Comparable to Immediate Repairs, but HUD distinguishes between life safety and non-life safety repairs).
2. Capital Replacement Reserves. Much longer term (37- or 42-year).

• Accessibility issues are always critical repairs.
• Accessibility reviews must encompass FHA, ADA & UFAS.  Consultants need to understand each of them, when they apply, and know the differences between them.
• Smoke Detectors must be inside all bedrooms, outside every sleeping area in the immediate vicinity of the bedrooms, and on all levels of the dwelling unit, including basements.  If they’re not, they must be added to the critical repairs.
• Sub-rehab analysis.  If a property has a lot of needed repairs to sub-rehab may be required.
• Unique HUD Forms. There are several required.  Not all of the sections are intuitive but the form instructions are helpful.
• Net rentable square feet (SF) vs Gross SF.  HUD considers net rentable SF as paint-to-paint, which is typically less than the values provided by the leasing office via the rent rolls or marketing brochures.
• Coordination with Appraiser to complete the Property Insurance Schedule form,

Green Property Condition Reports

Recently clients have begun requesting Green Property Condition Reports.  However, all clients don’t mean the same thing when they ask for “green”.   Three common goals in Green PCRs:

• Property Condition Report plus Energy Audit (or Energy Benchmarking);
• Property Condition Report plus an analysis of a wide range of sustainability issues.
• Property Condition Report plus a LEED check list.

In our practice, we see clients asking for the Energy Benchmark most often.  Clients buying a building rightly want to know how energy efficient the building is.  Click here for further discussion of Green PCRs.

Equity Property Condition Reports

For clients buying significant assets that want a high degree of certainty that they know all of the investment and repairs property will require, then they should look for a more detailed evaluation than the walk-through report defined by ASTM E2018-2008.   The basic difference between Equity Property Condition Reports and Property Condition Reports typically done for lenders is the number of people that we send to the site.   For ASTM E2018-2008 / lender assessments, we send one architect, engineer, or commercial building inspector to the site.  For our Equity Property Condition Reports we send a generalist (one of the above), and additional specialists.   Commons specialists are:

• HVAC Specialists / MEP Engineer
• Structural Engineer
• Elevator Inspector
• ADA Surveyor
• Roof Specialist
• Building Envelop Specialist
• Pavement Specialist

Appreciate the difference between the generalist and, for example, the elevator specialist.  The generalist will ride the elevator, look at available records, and interview available staff.  The elevator specialist can shut the elevator down and go down into the elevator pit.  If there is a hydraulic leak in the pit, the generalist will have a hard time discovering this issue.

As you can see there are several types of Property Condition Reports and a client must express their needs to the engineering firm prior to ordering a report.   At Partner we have a robust Property Condition Assessment practice and we have groups that focus on each type of PCR discussed above.   Other firms specialize in one or the other type of report.   For any questions on Property Condition Reports feel free to contact me or Bruce Dalton, Technical Director of our Building Sciences Group at 800-801-4923.

The Green Property Condition Assessment (PCA), also known as a Green Physical Needs Assessment, offers the user advice on how to optimally run the asset that he or she is buying.  A Green Property Condition Assessment essentially combines a standard PCA and an Energy Audit to provide in-depth information on the building condition and increasing operational efficiency.

A standard PCA provides the user with Immediate Repairs and Replacement Reserves over a given term.  All of these costs are provided under two assumptions:  1) replace like with like; 2) replace equipment at the end of its useful life.  The Green PCA takes a much more real world approach—replace equipment when it is costing more to run than makes sense and replace equipment with new equipment that will maximize return on investment (ROI).  The “green” could just as easily symbolize more money as the environment. 

My sister company, Partner Energy, does hundreds of energy audits per year on commercial buildings.   The energy audits identify Energy Efficiency Measures (EEMs).  Many of these EEMs amount to replacing old, but functioning, HVAC equipment with newer higher SEER rated HVAC equipment (Seasonal Energy Efficiency Ratio).  These capital events have a very measurable ROI.  The Energy Audit might identify 6 to 18 EEMs and we will rank these in terms of ROI.  Most clients consider ROIs greater than 30% an obvious opportunity, and it is not uncommon for EEMs to result in such high ROIs.

What is a Green PCA?

Combining the energy audit with the PCA has obvious advantages.  We can provide more real world advice on the equipment replacement.  Replace the equipment either: 1) when it reaches the end of its useful life; or 2) when the energy saving associated with replacing the equipment meets the client’s ROI requirement.  

There are other financial incentives for conducting Green PCAs or implementing the recommended EEMs, such as incentives from the SBA, FHA and Fannie Mae. 

Small Business Administration (SBA) 504 Loan Program: Qualify for More by Going Green

Borrowers can increase their SBA 504 loan amount by up to $4 million by implementing projects that meet the SBA 504 new public policy goals of reducing energy consumption by 10% or generating renewable energy.  Click here for more info on the SBA energy program.

FHA/HUD and Fannie Mae: Green Refinance Plus

Green Refinance Plus is a program between HUD’s Federal Housing Administration (FHA) and Fannie Mae to allow owners of existing affordable rental housing properties to refinance into new mortgages that include funding for energy- and water-saving upgrades, along with other needed property renovations.  Under this program, borrowers must obtain a Green Physical Needs Assessment to identify property improvements that will reduce energy use and operating costs.

Additionally, many cities and states are requiring that building owners disclose their building’s energy efficiency or consumption. Click here to see the cities and states with energy disclosure requirements. This energy disclosure information can be identified during a Green PCA and/or an energy benchmarking study.

Making your Property Condition Assessment or Physical Needs Assessment a Green one really just makes dollars and sense.

Our latest video is on Probable Maximum Loss (PML) Reports or Seismic Damageability Assessments, which evaluate a building’s seismic risk. Check it out!

The California Energy Commission delayed the implementation of AB 1103, California’s landmark energy disclosure law.   This is the 4th time that the law’s implementation has been delayed in the past two years.   Now the first set of buildings will require energy disclosure in January of 2012–unless the law is delayed again.   

No doubt the law has serious opponents.  

There is still plenty of activity in the world of energy audits and energy benchmarking on the local level and the Federal level. 

Keywords

energy disclosure, ab 1103, energy audit, energy disclosure

I participated in a conference call a few weeks ago sponsored by the Environmental Bankers Association (EBA) that discussed “Chinese Drywall”.  An attorney and a consultant both provided presentations and their perspective on the issues and how they are dealing with it. 

A quick summary:

• Chinese drywall was generally used in the southeast U.S. after the hurricanes/storms in the early to mid 2000’s in response to repair/rebuild of structures.  At the time, the U.S. did not have adequate inventory of drywall, could not manufacture it fast enough and the cost of Chinese drywall was much less expensive.  There are some case studies that have shown it present as far north as Virginia (coastal areas). 
• Chinese drywall contains elevated levels of sulfur and strontium (potential radiation that may be cancer-causing).  Sulfur can off-gas into a variety of substances such hydrogen sulfide, carbon sulfide, etc.  These off gases can cause health issues with residents/tenants/occupants and also may cause significant corrosive damage to HVAC and plumbing systems (particularly copper components). 
• There are subjective procedures in-place for the assessment/evaluation of potential Chinese drywall systems and include visual observations (keying on specific components, looking for drywall markings, etc.), on-site sampling (intrusive), analytical testing and reporting.  Full and comprehensive evaluation can be fairly intrusive (need to often open up walls, cavities and chases to access/observe systems). 
• Generally, evaluation/testing is a fairly expensive option (compared to asbestos/lead testing).  Analytical parameters are building material and site-specific. 

I would estimate that we will see more data and information upcoming.  More to follow.

To what extent should a Property Condition Assessment focus on ADA Compliance?    In our practice, some clients want a robust ADA Compliance Audit and other clients are happy with a brief paragraph discussing the building’s compliance on a general level.   The purpose of this blog is to make clients aware of the ADA options that can be included in a Property Condition Assessment (PCA).

Most commercial building inspectors do not have sufficient training to conduct an ADA Survey; however, if the client expresses the importance of the ADA Compliance to the PCA firm early on, the firm can staff a building engineer or architect with ADA training.

We recommend that the client consider the following options when ordering a PCA Report:

• Option 1: Full ADA Survey included as part of the Property Condition Assessment;
• Option 2: Require Property Condition Assessment Report to include an ADA Checklist;
• Option 3: Require only a general discussion of the ADA in the Property Condition Assessment Report;

Of course, the first option is the most expensive and the third option is the least expensive.   I encourage equity clients who are buying hotels or multi-tenant office buildings to choose Option 1.

Barry McPherson, an Architect and long time commercial building inspector, has developed a specialty practice in assessing complex assets for ADA Compliance during Property Condition Assessments.  He can be reached at 214-234-9566.

As I mentioned in my first posting, I took a survey of the Environmental Bankers Association Membership as to what is and is not a recognized environmental condition.  The results were presented at the Environmental Bankers Association Conference in Utah on June 9th.   The survey results are posted on the EBA’s Website and my website (www.partneresi.com).