Small loan due diligence creates opportunity in community markets

Real Estate Weekly, June 24, 1998

The small loan market - loan values under $2 million - is a growing opportunity for conduits and Wall Street. Yet many national lenders have not succeeded against well-entrenched local and community lenders.

"Competing with local banks is not an easy market to enter. Many national lenders have tried and failed because they've used the same full-blown due diligence and legal formats they use on large transactions," said Evan Denner, senior vice president for Daiwa Real Estate Finance Corp., New York, a subsidiary of Daiwa Securities. Daiwa has closed more than $150 million in small loan multi-family and commercial transactions since 1997.

To keep fees low on small loans, must lenders forego careful due diligence and risk serious issues that may affect a property's value? "No," Denner said.

To support its successful entry into the small loan market, Daiwa worked with EMG, a national engineering, architectural and environmental due diligence consulting firm headquartered in Baltimore. EMG's small loan due diligence package meets the requirements of rating agencies, secondary market investors and Daiwa.

"With the stringent due diligence guidelines imposed on CMBS transactions, the total fees for third-party reports and legal services can render conduits uncompetitive on smaller loans," said Michael Logsdon, founder and president of EMG. "To help lenders keep fees competitive, our streamlined small loan program protocols satisfy lenders' risk tolerances."

Whereas third-party fees for a large transaction can exceed $25,000, Daiwa holds small loan fees to $10,000 or less. "Yet the risk tolerance is the same, despite the loan size," Denner said. "Having the same property condition surveys and borrower histories as with a larger loan is very important for us. From an asset point of view, a five-unit multi-family having two vacant units is a greater risk than a 100-unit property with two vacancies. We need to know about those vacant units up-front, because they affect the property's cash-flow," Denner said.

To help Daiwa, EMG streamlined its due diligence reports, summarizing information in succinct tables and condensing narrative to need-to-know information only.

"We spent countless hours with EMG reviewing our program and exactly what we wanted from the due diligence. If an out parcel is part of our transaction, EMG needs to know this up-front. It gets too costly for us if EMG has to return to a property to survey something we should have told them about in the first place," Denner said.

"We worked with Daiwa and other clients to understand their lending goals, risk tolerances and exit strategies, and developed due diligence approaches to address each of their requirements. This is not some 'one size fits all' solution," Logsdon said.

Small loan due diligence approaches include:

Warranted Transaction Screen: An abbreviated environmental assessment that includes visual site inspection and limited records research. The Warranty shields lenders from exposure to undiscoverable environmental liabilities.

Custom Phase I Environmental Assessment: The guideline for this assessment allows for interpretation that permits streamlined inspection and reporting. Working with lenders, EMG has eliminated some costly "frills" that are typically done on due diligence for larger loans.

Streamlined Physical Condition Analysis: Frequently, a reasonable picture of a property's future capital needs can be drawn from analysis of maintenance histories and prior capital improvements. This can often be completed successfully without the expense of a licensed architect and detail of a complete property condition assessment.

Streamlined engineering, architectural and environmental due diligence keeps small loan fees competitive - and more.

"Fast turnaround is key. At Daiwa, small loan transactions close in five to six weeks and at a fraction of the costs of larger loans," Denner said. "These small loan due diligence services are an important competitive edge for us in this growing market."