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When to Go Deep: The Benefits of Forensic Diligence

Distressed commercial real estate loans pose unique challenges for lenders and asset managers. In the stage between the last timely mortgage payment and default, a range of issues can occur, which are hidden from the asset managers’ scope of work. Unless managers have expertise in forensic accounting and specialization in distressed CRE assets, they can't be expected to know where to look for red flags. 

Sandra Adam, CPA, Director of Financial Diligence & Forensic Analysis at SitusAMC, describes the warning signs that call for a deeper dive into borrowers’ situations -- and the risks and costly surprises she discovers inside their financials. 

What red flags trigger the need for deeper financial diligence or forensic analysis? And where do you dig?  

When distress occurs, and loan covenants are not met, it typically triggers cash management.  All revenue, including tenant rents, are swept into a lender-controlled lockbox. Funds are disbursed to the borrower, typically based on an approved budget, on a monthly basis to pay operating expenses. Lenders often feel confident they have trapped the cash and trust that it will be spent as agreed. But sometimes that doesn't happen.  

Sometimes, funds are simply mismanaged; other times, they are misappropriated. We've seen borrowers fail to pay certain vendors or misdirect funds to pay for unapproved travel and entertainment or legal fees. Borrowers may spend the funds to pay expenses of other properties they own to avoid additional distress in their portfolios. To prevent these losses, we do a deep dive into the accounting records that support the monthly financial statements to track what's being paid from operating cash. 

How much money can be involved in situations like this?  

It depends on how big the property is and how long the situation drags on. I know of some properties that have been in default for over 18 months, and the foreclosure hasn't happened yet. So, lenders could potentially be working with borrowers in a default situation, releasing cash to them for months, and the leaks snowball into hundreds of thousands of dollars. 

Talk about timing. When do you typically hear from lenders? At what point should a lender start looking for irregularities? 

In general, it's critically important to dig into financials when loan covenants aren’t consistently being met and continue to monitor through deed-in-lieu or foreclosure. Timing may vary, but clients typically engage us six to twelve months prior to taking the property back to review draft deed-in-lieu or foreclosure agreements. We validate the assets and liabilities reflected in the property-level balance sheets as well as evaluate any potential unrecorded assets and liabilities.  

Our engagements typically kickoff with a phased approach and scope to determine what level of financial diligence is required. Some begin when asset managers feel something is awry: The conversations with the borrower have been different lately; they're avoiding emails; they’re evading questions about financial reports, occupancy or other issues. The asset manager senses something could be wrong, so they engage us to begin scanning monthly bank statements and reconciling them to financial reporting -- to help confirm or refute their hunch.     

Can you give an example of a hidden potential liability?  

Accrued sick time, PTO, vacation, etc. must be on your books for property employees who are entitled to that. Often books and records are not up to par, and we will uncover a paid-time-off liability for which the borrower has not properly accrued. Financial responsibility for that depends on the structure of the deed-in-lieu or the foreclosure agreement, but I've seen a few situations that resulted in six-figure liabilities to the lender when union labor is present. In other situations, unions went on strike. No institution wants that financial and reputational damage.   

Are there financial shortfalls that occur in the other direction? For example, income outside of rents that escapes the lockbox? 

Definitely. We recently caught a $150,000 deposit that came from the settlement of a legal suit filed years before the default. The borrower had the settlement wired to the property’s operating account instead of the lockbox. The lender was not aware that this lawsuit was out there, and they would not have caught if we weren’t combing through bank statements. Finding that anomaly allowed our client to reduce the next month's cash release by $150,000. In other cases, there may be a real estate tax appeal in process that yields a refund. Because of the Covid-19 disruption to county government offices, I've seen some appeals take years to resolve. Those types of situations won't be discovered without reviewing the property’s bank statements.    

Anything else you watch for in distressed situations?   

We are doing deep dives into the financial statements of sponsors and guarantors. At the inception of a loan, lenders will typically validate guarantors' net worth and liquidity, to be sure they can jump in and support the loan, if needed. We're getting called in to validate the guarantors' current liquidity and net worth by scrutinizing bank and investment statements, cash positions, partnership interests, mortgage statements, property appraisals, tax returns, etc.   

What are the primary benefits of financial diligence to lenders?  

As financial institutions are not in the business of owning properties, our accounting and investigative mindset is needed in distressed situations. Our forensic diligence work helps everyone understand what's out there, so we can minimize lender exposure to the risks of distressed assets, set the table for a potential workout conversation and minimize financial risk when the lender decides that taking back the property is the only option. For banks, our in-depth financial diligence can assist in determining reserves or estimating loan losses. Overall, we help identify deeply buried risk factors that could negatively impact loan value and business profitability. 

SitusAMC's Financial Diligence & Forensics Analysis provides CPA-led financial diligence to proactively identify and mitigate risk in large, complex loans and portfolios. Our team works hand-in-hand with participants across the debt and equity spectrum, including CRE operators, banks, management companies, special servicers and law firms, to conduct comprehensive analysis. We scrutinize financials and identify deeply buried risk factors that could negatively impact loan value and business profitability. For more information, contact Sandra Adam at