Distressed Real Estate Due Diligence using Virtual Data Rooms

Many readers are aware of the effect that the bursting of the residential real estate bubble has had on the US economy. It is less widely understood, however, that the commercial real estate sector appears to be headed in the same direction that residential real estate was moving in roughly one year ago, for many of the same reasons– easy credit, risky lending practices - and with many of the same results, not least among them the vicious cycle of increasing defaults leading to lower values across the board.

Evidence of a coming collapse in commercial real estate is already mounting. The national commercial property pricing index compiled by Moody's and Real Estate Analytics dropped 22.8 percent between its peak in October 2007 and March of this year. As of April, 64 publicly-traded companies had filed for either Chapter 7 or 11 bankruptcy protection, twice the 2008 number, and up three times from 2007. These 64 companies held a pre-petition total of $100.96 billion in assets; the GM bankruptcy of early June almost doubled that figure; GM reported a total of $91.5 billion in assets on its most recent 10-K. Reis, Inc. reports that delinquency rates and defaults on office buildings, retail buildings, and hotels have increased by over 100% since December, and according to Real Capital Analytics, almost $73 billion worth of commercial real estate loans face financial distress in one form or another.

Corporate Bankruptcy’s tie to Distressed Commercial Property

GM was not the only high-profile bankruptcy to make headlines recently. On April 16th, General Growth Properties, the second-largest mall developer in America, with over 200 shopping malls, filed for Chapter 11 bankruptcy protection because the company couldn’t refinance its short-term mortgages. Circuit City, Linens ‘N Things, and Steve & Barry’s have also all filed for bankruptcy in 2009. According to the Federal Reserve’s April 15, 2009 ‘Beige Book’ report:

“Nonresidential real estate conditions continued to deteriorate…Demand for office, industrial and retail space continued to fall, and there were reports of increases in sublease space. Rental concessions were rising. Property values moved lower as reality “set in.” Construction activity continues to slow, and several (Federal Reserve) Districts noted increased postponement of both private and public projects.”

Like the residential ARM loans made in the real estate bubble, commercial real estate loans are generally expected to be refinanced after three to five years. Also like many residential ARM loans, many of the commercial loans issued in 2005, 2006, and 2007 were for upwards of 90 percent of the property’s value, and used very optimistic rent and occupancy projections. As long as values continually rose, this was a workable system. If a loan cannot be refinanced for any reason, however, the buyer is likely to default. However, as the economy has slowed, occupancy rates have dropped, and defaults are already rising. Considering that roughly $270.5 billion worth of commercial real estate loans are expected to come due in 2009, if even a tiny percentage of these loans go into default, buyers of commercial real estate are going to be in a very enviable position.

Potential purchasers of distressed commercial real estate face considerable due diligence burdens

While these conditions do create a potential opportunity for buyers, the due diligence requirements of any commercial real estate transaction are considerable, and the due diligence involved in a potential purchase of distressed commercial real estate is even more complex. More and more purchasers are using a virtual data room to make the process of purchasing commercial real estate much simpler, faster, and more efficient than the traditional practice involving boxes of documents on a table in a conference room. Virtual data rooms have a number of features that provide increased convenience and security versus the traditional paper-based due diligence method.

Virtual data rooms

What is a virtual data room and how can a it streamline the due diligence purchase process?

A virtual data room is a secure, password-protected website located on a secure server. Virtual data room technology first emerged as Internet usage became widespread, and although the state of technology initially made for low adoption rates, as technology has developed, they have been used extensively by financial and legal professionals in M&A, corporate restructurings, private equity portfolio company reporting, as well as other financial and litigation-related matters. Virtual data rooms replace the traditional practice of assembling boxes of documents in a conference room, as well as the need to email or send documents back and forth by overnight mail, enabling parties to a transaction to focus on its substantive aspects, instead of its information management and other procedural aspects.

Increased convenience and security – a win-win scenario

In terms of convenience, virtual data rooms enable all potential parties to a transaction to conduct their due diligence simultaneously, instead of in one-firm-at-a-time blocks of consecutive days or weeks. By using a virtual data room, all interested parties can access the relevant documents, spreadsheets, PowerPoint presentations, etc. over the Internet. In other words, using a virtual data room for due diligence:

• Reduces time and money spent to travel to the documents in order to view them
• Increases productivity because employees can stay in the office, instead of living in hotel rooms and losing days traveling

Leveraging virtual data room technology to conduct due diligence is clearly faster, less expensive, and more efficient than using a hardcopy data room. By speeding up the pace of the transaction, there is also less time for transactions to be delayed as a result of market forces or other changing conditions.

Additionally, most virtual data room providers offer powerful search capabilities, enabling a user to search for a given word or term within a single document, or even across an entire document collection. The value of a strong search function will be obvious to anyone who’s ever tried to remember which document contained the term or concept they were looking for, or, because documents are not typically titled, ‘Look here for the fatal flaw in the deal,’ to anyone who’s ever had to conduct the proverbial search for ‘asbestos’ across a document collection.

A one-stop document depository – documents are always updated and centrally located

Virtual data rooms also function as an online document repository, eliminating the need to email documents back and forth, a notoriously insecure method of communication, or to spend time and money on sending documents by overnight mail or courier. By using a virtual data room, all parties to a potential transaction can be assured that they are always viewing the most updated version of a document; documents are also accessible on a 24/7 basis. And if a document or document collection is updated, email alerts can be automatically sent out alerting all parties.

Real Estate Due Diligence Summary

Virtual data rooms have become increasingly useful as their technology has evolved. At this point, many users consider them to be critical tools for managing the administrative burdens that can make an already complicated transaction more cumbersome, less efficient, and take longer than necessary. With no upfront software or hardware requirements, setting up a virtual data room is an easy and straightforward process. Virtual data rooms provide benefits in terms of cost, security, and convenience that make transactions faster, cheaper and more efficient.