Counting the consequences of financial impairments
Owners of fractional units in a new resort development got a big surprise the day their purchases closed – their interests came with liens attached. A few months later things got worse when the developer missed the first (rather large) HOA payment. It sure looked like the value of the interests had been impaired, but by how much?
The amount owed to contractors was in dispute, somewhere between $7 and $12 million. The developer had not filed for bankruptcy at the time, but had more than $20 million in secured debt coming due, and there was no possibility that he could refinance the obligation. As seller of the units, he had no duty to disclose financial status per sé, but did have an obligation to hold funds received from the owner/claimants, almost $40 million, in trust for payment on the construction contracts.
The liens were against the entire project, but before any foreclosure, they would have to be apportioned between interests; however, not all liens applied to the fractional interests at issue. Thus, a cure amount would not be known until the litigation process had resulted in the apportionment, and there would be substantial uncertainty regarding how apportionment would be handled. The lien claimants were not willing to entertain individual settlements.
Counsel represented nearly 170 claimants, and brought us in to develop an opinion of damages to the ownership interests from the two causes. The value opinion was needed to support a claim before the Bankruptcy Court.
THE VALUATION PROCESS
Financial impairments due to detrimental conditions are most effectively valued by breaking down the discrete steps from the date of value to date of cure; they are generally discovery, assessment, repair and then any market resistance issues. The process for this sort of valuation is well-understood as it applies for physical conditions (affecting land and building, such as contamination, construction defects), external conditions (nuisances), conservation issues and many others . What is not as well-understood is that ownership and financial damages will yield to the same valuation process. Marketability impairments are often viewed as existing on a different planet, but the process and its elements are much the same . Simply put, the degree of value impairment is directly related to time, and inversely related to risk.
Working closely with counsel, we developed multiple scenarios for possible future events and their timelines, the risk they represented, and weighted their likelihood of occurring. The base was the unencumbered unit value (based on the purchase price), and we were looking for the market impairment of this base. The impairment is a function of the restriction period of each scenario, and the risk to the interest holder during that period. Put another way, the impairment can be understood by observing the multiple phases of each scenario: 1) discovery, 2) assessment, 3) repair (in this case settling outstanding obligations) and 4) any market resistance issues.
Valuation models included present value and options pricing. The impaired positions are riskier than the base, and this risk is accounted for by adjusting the investor’s required return, or yield. The unimpaired, base level yield is the real estate (hotel) rate, which is the return required by the owner of the entire project, with no impairments. Next, this yield is increased for conditions associated with individual unit interests, including acquisition conditions (sales pressure) and personal use (intangible) benefits. Yield increases again for specific impairments, including uncertainty of the holding period and lawsuit risk. The models also factor in value growth over the period and costs associated with events during the period. Escrows closed in month 0. Liens were (expected to be) filed in month four.
Scenario A: Claims are settled in month four and liens are not filed. Concluded discount 7%.
Scenario B: Liens are filed and litigation commences, but the matter is settled four months later and the liens released. Concluded discount 17%.
Scenario C: Liens are filed and litigation is protracted. The matter is settled 17 months later and the liens released. Concluded discount 31%.
Scenario D: Same as C except that rather than being settled, the liens are apportioned at 17 months (necessary before foreclosure), then both liens and HOA deficiencies cured by claimants. Concluded discount due to delays and risk 32%, add effect of costs and uncertainty at 38%, concluded discount 70%.
Scenario E: The same as D except that an appeal period is added, and liens are finally apportioned at 30 months. Concluded discount due to delays and risk 44%, add effect of costs and uncertainty at 37%, concluded discount 81%.
The scenarios were weighted mostly toward B and C, with very little likelihood of E occurring. The concluded discount was 22.5%, and this percentage multiplied by the base value of the interests was the value impairment.
This sort of analysis can be almost infinitely complicated, and there are indeed probabilities within probabilities. The problem can appear quite daunting at first, but mapping them from discovery to cure, then assigning risk-adjusted returns to each scenario, can bring a great deal of clarity. The interest holders indeed suffered when blindsided with liens and developer failures. Their interests were quickly loaded up with potential liability and an uncertain future.
The arguments need to be easily followed, and in the end, must bend to common sense. In this case, Counsel had the advantage of our comprehensive analysis and persuasive narrative. The claim was accepted by the bankruptcy court, and the claimants received a significant payout; a very successful result. “Nonphysical Damage–Fractional Discounts,” a case study included in a book by Randall Bell, MAI, “Real Estate Damages: Applied Economics and Detrimental Conditions” (The Appraisal Institute, Chicago: 2008): pages 266-269. This book is the most current and authoritative on real estate damages.  Ibid, Dennis A. Webb, ASA, MAI, FRICS “Nonphysical Damage – Fractional Discounts Case Study.”