Physical Due Diligence: Third-party assessments ordered by Freddie Mac to evaluate physical condition, environmental risk, and seismic exposure. These reports can trigger repair escrows, reduce proceeds, or kill deals entirely.
What Is Physical Due Diligence?
You've passed eligibility, the underwriting math works, and your documentation is clean. Now Freddie Mac sends engineers to look at your building.
This is where deferred maintenance becomes real debt. Every item flagged must be addressed—fix it before closing, or Freddie holds money in escrow until you do.
What Reports Are Required?
Every SBL loan requires at least three assessments. Seismic zones add a fourth.
| Report | Form # | What It Evaluates | Cost |
|---|---|---|---|
| Property Condition Assessment | Form 1104 | Building systems, deferred maintenance, remaining useful life | $2,500 - $4,000 |
| Phase I Environmental (ESA) | ASTM E1527 | Environmental contamination risk | $2,000 - $3,500 |
| Appraisal | Form 1025 | Market value and income approach | $2,500 - $5,000 |
| Seismic Risk Assessment | Form 1105 | Earthquake damage probability (CA, Pacific NW, etc.) | $1,500 - $3,000 |
Who Orders These? You don't order reports yourself. Freddie Mac uses approved vendors. You pay $8,000-$15,000 upfront, non-refundable if the loan doesn't close.
What Does the PCA Evaluate?
The PCA is where deferred maintenance gets priced. An engineer walks your property, documents every deficiency, and estimates repair costs.
| System | Key Items | Red Flags |
|---|---|---|
| Roof | Age, condition, remaining life | Ponding, patches, age >15 years |
| HVAC | System age, efficiency, refrigerant type | R-22 systems, age >15 years |
| Plumbing | Pipe material, water heaters, fixtures | Galvanized pipes, polybutylene |
| Electrical | Panel age, wiring type, capacity | Fuse boxes, aluminum wiring |
| Structure | Foundation, framing, load-bearing walls | Settlement cracks, water intrusion |
| Site | Parking, drainage, landscaping | ADA non-compliance, drainage issues |
What Is the Replacement Reserve Study?
The PCA includes a capital expenditure projection for the loan term.
| Item | Typical Useful Life | Replacement Cost (20 units) |
|---|---|---|
| Roof (flat/commercial) | 20-25 years | $40,000 - $80,000 |
| HVAC systems | 15-20 years | $60,000 - $100,000 |
| Water heaters | 10-15 years | $15,000 - $30,000 |
| Parking lot resurface | 10-15 years | $25,000 - $50,000 |
| Exterior paint | 7-10 years | $15,000 - $30,000 |
The Reserve Trap: Freddie Mac requires minimum $250/unit annual replacement reserve. If the PCA shows higher needs, the reserve increases—reducing your NOI and loan proceeds. A $400/unit reserve on 20 units = $3,000/year lower NOI = ~$39,000 less loan proceeds.
What's the Difference Between Immediate and Deferred Repairs?
The PCA categorizes findings by urgency:
| Immediate Repairs | Safety issues, code violations, active water intrusion | Fix before closing OR PR-90 Escrow at 125% |
| Short-Term (0-1 year) | Items that will fail within 12 months | Typically escrowed |
| Long-Term (1-5 years) | Items approaching end of useful life | Covered by replacement reserves |
The PR-90 Escrow: Can't complete immediate repairs before closing? Freddie requires a PR-90 repair escrow—125% of estimated repair cost held at closing. A $20,000 roof repair = $25,000 escrowed, released only after repairs are verified by re-inspection.
The Moisture Management Plan (MMP) Trap
If the Form 1104 inspector finds evidence of water intrusion—a single ceiling stain, mold, or moisture damage—you don't just pay to fix it. You may be sentenced to an MMP (Moisture Management Plan).
| What It Is | Mandatory operational plan requiring ongoing moisture monitoring |
| Duration | Life of the loan (5, 7, or 10 years) |
| Requirements | Quarterly inspections, photo documentation, maintenance logs |
| Reporting | Annual reports to servicer with inspection results |
Prevention is Easier: Paint your ceilings. Check your downspouts. Fix that slow roof leak before the inspector arrives. The repair might cost $2,000. The MMP paperwork burden lasts a decade.
What Does the Phase I ESA Evaluate?
The Phase I evaluates environmental contamination risk. Records review and site inspection—no soil samples unless something triggers further investigation.
Phase I Scope
- Historical Use: Was the site ever used for industrial, gas station, dry cleaning, or other contaminating uses?
- Adjacent Properties: Are there gas stations, dry cleaners, or industrial sites nearby?
- Database Search: Is the property listed on EPA Superfund, state cleanup, or underground storage tank databases?
- Site Inspection: Visible signs of contamination (staining, drums, distressed vegetation)?
- Regulatory Records: Open violations or cleanup orders?
What Are Recognized Environmental Conditions (RECs)?
If the Phase I finds potential contamination, it's classified as a REC:
| REC Type | Meaning | Impact |
|---|---|---|
| REC | Likely contamination present or likely to be present | Phase II required (soil/groundwater testing) |
| CREC | Controlled REC—contamination exists but is managed | Ongoing monitoring requirements |
| HREC | Historical REC—past contamination, cleaned up | Usually acceptable with documentation |
| De Minimis | Minor condition not requiring further action | No impact |
The Phase II Trigger: A REC means Phase II ESA (soil and groundwater sampling). Add $5,000-$15,000 and 3-6 weeks. If contamination is confirmed, the loan may be declined entirely.
What Environmental Issues Kill Deals?
| Former Gas Station | Underground storage tanks are almost always a problem |
| Adjacent Dry Cleaner | PERC contamination migrates through groundwater |
| Industrial History | Manufacturing sites often have soil contamination |
| Active Violations | Open EPA or state cleanup orders |
What Is the Seismic Risk Assessment?
Properties in seismic zones require earthquake damage probability evaluation. Primarily California, Pacific Northwest, and parts of the Midwest and Northeast.
What Are PML and SEL?
| PML | Probable Maximum Loss—estimated damage as % of building value from a 475-year earthquake |
| SEL | Scenario Expected Loss—mean damage estimate |
What Are Freddie Mac's Seismic Thresholds?
| PML Result | Requirement |
|---|---|
| <20% | No additional requirements |
| 20-40% | Earthquake insurance required OR detailed engineering study |
| >40% | Deal typically declined |
The Earthquake Insurance Trap: PML above 20% means earthquake insurance required. For California properties, that's $3,000-$10,000+ added to annual insurance—a direct hit to NOI and loan proceeds.
Which Building Types Have Higher Seismic Risk?
| Construction Type | Seismic Risk | Typical PML Range |
|---|---|---|
| Wood Frame (1-3 stories) | Lower | 5-15% |
| Wood Frame with Soft Story | Higher | 20-35% |
| Unreinforced Masonry | Highest | 35-50%+ |
| Reinforced Concrete | Lower | 10-20% |
| Steel Frame | Lowest | 5-15% |
Soft Story Buildings: Apartments with ground-floor parking (tuck-under) are "soft story" structures with known seismic vulnerability. Many California cities require retrofits. No retrofit? Expect the seismic report to flag it.
How Do Report Findings Affect Your Deal?
Every finding has a direct financial impact:
| Finding | Impact | Mitigation |
|---|---|---|
| Immediate repairs needed | 125% escrow holdback | Complete repairs before closing |
| High replacement reserve | Lower NOI, lower proceeds | Address deferred maintenance pre-sale |
| Phase I REC | Phase II required, timeline delay | Get Phase I before listing if concerned |
| PML >20% | Earthquake insurance required | Budget for insurance in underwriting |
| Appraisal below contract | LTV exceeds limit | Increase equity or renegotiate price |
How Can I Prepare Before Reports Are Ordered?
You can't control what the reports find, but you can anticipate likely findings:
Before Third-Party Reports
- Walk the Property: Identify obvious issues (roof damage, HVAC age, deferred maintenance) that will appear in the PCA
- Research History: Check if the site or adjacent properties have environmental red flags
- Know Your Zone: If in a seismic zone, understand building construction type and likely PML
- Budget for Escrows: Assume 5-10% of loan amount may be held for repairs
- Get Quotes: If you know repairs are needed, get contractor quotes to negotiate escrow amounts
The Bottom Line: Physical due diligence is Freddie Mac's reality check on your property. The reports find what they find—your job is to anticipate issues, budget for escrows, and have a plan to address deficiencies without derailing your timeline.