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:
- Critical and Non-Critical repairs. Comparable to Immediate Repairs, but HUD distinguishes between life safety and non-life safety repairs).
- 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.