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.

Phase 1 Environmental Site Assessment

 The Phase 1 Environmental Site Assessment is a report that illuminates the environmental liability associated with a real estate asset.   A Phase 1 Environmental Site Assessment (ESA) is required by lenders during the financing of commercial real estate.   The environmental consultant providing the Phase 1 ESA is required to inspect the property, review historical records on the property and research records available at government agencies.   This information is evaluated and an opinion is made as to whether past or present activities may have caused contamination of the soil or groundwater at the subject property.

In the event that the Phase 1 ESA uncovers a recognized environmental condition (REC)*, the environmental consultant will typically recommend a Phase 2 Environmental Site Assessment, which involves invasive soil or groundwater testing.   The geologist or engineer designing the Phase 2 Environmental Testing scope of work will rely on the Phase 1 Environmental Report to understand Areas of Concern and Chemicals of Concern. 

ASTM E1527-05

In 1993 the American Society for Testing and Materials (ASTM) published the first ASTM Standard: ASTM E1527-93 Standard Practice for Environmental Site Assessments: Phase I Environmental Site Assessment Process.   Since then the standard has been updated several times, with the most recent update occurring on in 2005.  

The ASTM E1527-05 standard outlines the purpose and use of the Phase 1 ESA as well as the scope of work to be conducted, including: records review (historical and governmental records); site reconnaissance (inspection of the property and adjacent sites); interviews (with owners and occupants and local government officials); evaluation and report preparation.

Certain items are considered out of the scope of work for an ASTM Phase 1 ESA, such as asbestos, lead-based-paint (LBP), mold and radon; however, many consultants take these potential concerns into consideration during the Phase 1 process (discussed further below).

US EPA’s All Appropriate Inquiry Standard (AAI)

Federal law requires purchasers of real estate to do “all appropriate inquiry” to qualify for the innocent landowner defense under CERCLA*.  Ordering a third party Phase 1 Environmental Site Assessment has traditionally been the method by which landowners qualify for the all appropriate inquiry standard.  In 2005, the EPA published its final rule on requirements for all appropriate inquiry.

To a large extent the all appropriate inquiry (AAI) standard for Phase 1 Environmental Site Assessments mimicked the existing ASTM E1527-00 Standard.   The new AAI Standard for Phase 1 Environmental Site Assessments required a few new scope items, including:

1)      A more stringent definition of who qualifies as an Environmental Professional*, the person under which an AAI Phase 1 ESA must be conducted

2)      The AAI Phase 1 ESA allows either the user or the environmental professional perform a search for environmental liens (however the updated ASMT E1527-05 standard designates this as the user’s responsibility)

3)      Mandatory interviews, some of which were not previously mandatory

4)      Documentation of data gaps or uncertainties     

To a large extent the industry quickly adapted the AAI ruling for Phase 1 ESAs, which went into effect on November 1, 2006.   In 2005 the ASTM E1527 standard updated to include the major elements of the final AAI ruling.   The one exception is the environmental lien search requirement.  Many lenders have developed a “business risk” scope of work for Phase 1 Environmental Site Assessments that exclude the environmental lien search, as the environmental lien search is considered by some to not be worth the extra cost.

Today the EPA recognizes two ASTM standards as being AAI compliant: the ASTM 1527-05 Standard, as well as ASTM E2247-08 Standard, discussed below.

ASTM E2247-08

An additional ASTM standard for conducting Phase 1 ESAs was created in 2008 specifically for large tracts of primarily undeveloped land: ASTM E2247-08 Standard Practice for Environmental Site Assessments: Phase I Environmental Site Assessment Process for Forestland or Rural Property.  The standard is very similar to the E1527-05 standard, with a few key exceptions: the approach to site reconnaissance (makes provisions for limited inspection/access), the regulatory records search (additional records requirements) and historical sources (fewer “standard” sources).

Other Custom Scopes of Work for Phase 1 ESAs

Most buyers must do the Phase 1 Environmental Study for a loan and many lenders and government agencies have developed custom scopes for work for Phase 1 Environmental Site Assessments.   A few examples are below:

SBA Phase 1 Environmental Site Assessments—SBA SOP 5010

The US Small Business Association (SBA) requires an environmental investigation of all commercial real estate loans, and has specific requirements for what kind of investigation is required and when. The requirements are based on a property’s environmental risk (determined by its NAICS Code*).  Some of the main particular requirements are: 

-          Environmental Questionnaires and/or Records Search with Risk Assessments (RSRAs) are required on “lower risk” sites (no NAICS Code match)

-          “Higher risk” sites (with NAICS Code matches), must do a Phase 1 to start, except for “Car Wash Only Facilities”, which must do an Environmental Transaction Screen to start

-          Requirements for gas stations: Phase 1 and equipment testing compliance review

-          Requirements for dry cleaners: Phase 1, and automatic Phase 2 if the facility is 5 years or older

-          Requirements for pre-1980 day cares/schools/residential care facilities: lead-based-paint risk assessment and lead testing in drinking water

-          Phase 2s on gas stations and dry cleaners must be conducted by an environmental professional with a current professional geologist’s or engineer’s license

-          Require the consultant to grant the SBA reliance on the reports

The SBA generally recognizes the ASTM Standards for conducting Phase 1 ESAs.  Each October the SBA releases any new changes or updates to its standard operating procedures.

Fannie Mae Phase 1 Environmental Site Assessments

Fannie Mae has specific requirements for Phase 1 ESAs on its loans, which are detailed in the Environmental Hazard Management Procedures and Sections 209-310 of the Fannie Mae Guide. Fannie Mae generally recognizes the ASTM Standards for Phase 1s with some modifications, the main components of which are:

-          Site inspection is required to cover 10% of a property’s units, and 50% of any down units

-          Requires testing for asbestos, lead and radon in some circumstances:

• Considers building materials from 1979 or earlier as suspect asbestos-containing-materials (ACM). If consultants suspect ACM, they can either test for asbestos or recommend creating an ACM Operations & Maintenance (O&M) Plan (and assume that ACM is present)
• Requires testing for LBP on buildings constructed before 1978 unless it gives the lender a waiver, in which case LBP must be assumed present and an LBP O&M Plan be implemented
• Requires testing for lead in drinking water when a property has a private, non-municipal water supply
• Leaves radon sampling to the discretion of the consultant; however, it is prudent to conduct at least minimal sampling at properties in Zone 1 radon areas

Freddie Mac Phase 1 Environmental Site Assessments

Freddie Mac environmental assessments are conducted in accordance with the Freddie Mac Multifamily Seller/Servicer Guide and Chapter 14, “Environmental Requirements.”  Freddie Mac generally recognizes the ASTM Standards for Phase 1s with some modifications, the main components of which are:

-          Site inspection is required to cover 10% of a property’s units, and 50% of any down units

-          Check for State Super Lien Law, which would allow the state to place a first priority lien on a property in response to contamination

-          Requires testing for asbestos, lead-based-paint (LBP), mold and radon in some circumstances:

• Freddie leaves it to the consultant to determine the potential for ACM; however, prefers that consultants do not use a cutoff date for determining ACM potential. If consultants suspect ACM, they can either test for asbestos or recommend creating an ACM O&M Plan (and assume that ACM is present)
• Requires that borrowers either test for LBP on buildings constructed before 1978, or assume LBP is present and implement an LBP O&M Plan
• Requires testing for lead in drinking water when a property has a private, non-municipal water supply
• Requires that consultants investigate for mold-related hazards
• Requires radon sampling in Zone 1 radon areas: 10% of the lowest level units, or 1 sample per building, whichever is greater

HUD Phase 1 Environmental Site Assessments

HUD requires ASTM Phase 1 ESAs with additional Environmental Reviews (HUD Form 4128), which go well beyond the ASTM requirements. The 4128 Form covers a range of potential impacts of a project including:

-          Zoning

-          Air quality

-          Coastal barrier resources

-          Floodplains/wetlands and other natural features

-          Historic preservation

-          Noise abatement

-          Hazardous operations/toxic and radioactive chemicals (determined by the Phase 1)

-          A range of other concerns regarding the site location, suitability, stability, social/municipal services and transportation

If a potential issue is identified in the 4128 checklist, then further study may be required, such as formal Noise Surveys for properties in potential high-noise zones (an initial noise analysis is required on all projects). 

During the environmental review process, HUD also goes beyond ASTM by requiring lead paint surveys or Operations & Maintenance Plans (based on the age of the property), and vapor encroachment screenings (for all projects).

Foreclosure Phase 1 Environmental Site Assessments

Phase 1 ESAs done during pre-foreclosure process are similar to normal Phase 1s; however, strict adherence to the AAI/ASTM requirements is critical in order to maintain the secured creditor exemption or innocent landowner defense under CERCLA.  This includes conducting an Environmental Lien and/or Chain of Title search, which many lenders forego at loan origination. Some other concerns to consider:

-          Site access can be difficult due to recalcitrant site contacts

-          Asbestos, lead paint, radon, mold and other non-scope issues must be managed in order to maintain an assets’ safety and value

-          Erosion control at unfinished construction sites and other compliance concerns (not covered by AAI/ASTM)

-          A lender should evaluate any potential environmental liability and cleanup costs in comparison with the asset value when deciding whether to foreclose

Common Scope Additions to our Phase 1 ESAs

ASTM E1527-2005 recognizes several common additional scope items.  In our practice of environmental due diligence, we find that a lot of our clients are interested in investigation other environmental concerns under the cover of the Phase 1 Environmental Site Assessment.   The most commons additional scope items are:

1)      Asbestos Survey:  an asbestos survey is particularly important to buyers of old buildings or buyers who plan to demolish the buildings;

2)      Lead Paint Surveys: important in residential settings, for schools, and when a building is going to be demolished;

3)      Environmental Compliance Audits:  clients buying complex industrial operations are concerned about recognized environmental conditions as defined by ASTM E1527 as well as material non-compliant practices.    A Phase 1 ESA/Compliance Audit is the best way to understand all of the environmental liabilities associated with a manufacturing facility.

4)      Mold Survey: common for residential and hotels users of our service;

5)      Indoor Air Quality Survey:  common for high end office buyers and hotel buyers;

6)      Phase 2 Environmental Site Assessment:  clients buying property with known environmental concerns may want to do the Phase 1 & 2 Environmental concurrently.

For any questions on Phase 1 Environmental Site Assessments feel free to contact me or our Nicole Moore, our Technical Director of Environmental Due Diligence at 800-801-4923. 

Definitions

*A REC is defined as “the presence or likely presence of any hazardous substances or petroleum products on a property under conditions that indicate an existing release, a past release, or a material threat of a release of any hazardous substances or petroleum products into structures on the property or into the ground, ground water, or surface water of the property.”

*CERCLA stands for Comprehensive Environmental Response, Compensation and Liability Act, commonly known as the Superfund law

*Environmental Professional:  Someone who possesses sufficient specific education, training and experience necessary to exercise professional judgment to develop opinions and conclusions regarding conditions indicative of releases or threatened releases of hazardous substances (or petroleum products) on, at, in or to a property. An EP must have:

-          A state or tribal issued certification or license and 3 years of relevant full-time experience; or

-          A Baccalaureate degree or higher in science or engineering and 5 years of relevant full-time work experience; or

-          10 years of relevant full-time work experience.

*NAICS Code: North American Industry Classification System. The SBA maintains a list of NAICS Codes of environmentally sensitive industries.

On Monday, Freddie Mac released guidance on best practices for engineering and environmental reports. 

The guidance notes common report issues, advises methods for selecting the best consultants and evaluating environmental and engineering consultant reports, and notes specific responsibilities. Common errors noted include failure to follow requirements of the Freddie Mac Multifamily Seller/Servicer Guide such as not testing for asbestos and radon, and lack of risk evaluations, recommendations and cost estimates.

The issuance of this document begs the question: has Freddie received a slew of bad reports from unqualified servicers?  How well does your consultant know Freddie Mac?

Partner Engineering and Science, Inc. specializes in Freddie Mac due diligence including Phase I ESAs and Property Condition Reports.  Having conducted hundreds of them, Partner is well versed in their particular requirements and stays current with the changing guidelines.

Freddie Mac lenders and servicers should review this guidance to ensure that they are avoiding common mistakes and fully meeting the requirements of the Guide.