Often, when discussing commercial real estate investment opportunities, a positive outcome is implied. For example, it is often assumed that a property can be purchased for a good price, and it will produce positive cash flow for a number of years and then sell for a higher price. While this is certainly possible and it often happens this way, there are times where things do not go according to plan. When they don’t, one investor’s loss can be another investor’s opportunity.
In this article, we are going to discuss distressed commercial real estate assets. We will describe what they are, how to identify them, the benefits and risks of investing in them, and how to partner with a private equity firm to find them. By the end, readers will have the information necessary to determine if a distressed asset strategy is a good fit for their own investment objectives.
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Distressed Assets Defined
The easiest way to describe a distressed real estate asset is as one that is in some kind of trouble.
The more technical definition is that distressed real estate is a property that is sold at a discount due to one (or more) of the following reasons:
The physical condition of a distressed property is deteriorating. For example, they may have a roof that needs to be replaced or they may have suffered significant damage due to a storm. In other words, the condition relative to the market is poor and the costs associated with the necessary repairs mean that it will sell for a below market price.
For a variety of reasons, a distressed property may be priced incorrectly. For example, it may have been purchased by an investor who put a lot of money into it and they need to get a certain price for it, otherwise they will lose money. If there is a significant difference between the market value and the asking price, and the owner has limited flexibility for reductions, the property could become distressed.
To retain their value over time, commercial properties must be actively maintained. The grass has to be cut, air handling systems need to be cleaned, and carpet and paint need to be replaced. If this work is not done in a timely manner, the impact on the property can be significant. If the physical condition falls into a state of disrepair, a new buyer may have to inject a significant amount of capital to bring it to market standards, which also means they probably won’t be willing to pay market value.
An asset could become distressed if there is some sort of environmental condition that makes it unattractive on the open market. For example, suppose that a dry cleaner tenant has an accident and their cleaning chemicals seep into the groundwater, contaminating it. These types of issues can be exorbitantly expensive to mitigate, which can cause a property to sell for a discount.
Finally, market conditions can cause a property to become distressed. For example, one common scenario is that rents decline to a point that a property is no longer cash flow positive. If this condition remains for an extended period of time, the property owner could run out of money and the lender could foreclose on it. This type of “distressed” sale usually comes at a discount because the lender wants to get rid of the property.
While many of these descriptions sound quite negative, and they can be, they may also represent a potentially profitable opportunity for the right investor.
Advantages of Investing in Distressed Assets
There are three reasons why investing in distressed real estate assets may be a good idea.
By far, the most obvious advantage of investing in distressed real estate assets is the price. Because these properties are in some sort of trouble, opportunistic investors are able to purchase them at a price that is very attractive relative to the market.
Second, because the acquisition price is low, the potential return is higher relative to the market.
Finally, because the distressed asset class involves unique scenarios, lenders and financiers may be willing to get more creative with debt structures. For example, if a bank is selling a foreclosed property, they may also be willing to finance the purchase with favorable terms just to get it off their books.
The bottom line is that distressed investing has the potential to yield substantial returns. But, there are a number of noteworthy risks that investors must also be aware of.
Risks of Investing In Distressed Assets
Make no mistake, investing in distressed assets comes with more risk than performing commercial real estate assets. The reason they sell at a discounted rate is that they are riskier. Specifically, there are three risks that investors must be aware of.
The first risk is capital. Often distressed properties are sold “as is” and they may require significant amounts of capital to bring up to market standards. But, the extent of the needed repairs may not be fully known until the property is purchased. For example, a distressed property may have some known environmental contamination issues at the time of purchase. But, once the new owner takes possession of the property, they could find out the contamination is much worse than originally thought and the cost to repair it is 2x or 3x what they originally planned. This could have a material impact on potential returns, even when purchased at a great price.
The second risk is execution risk. Not only do needed repairs require significant amounts of capital, they also require a team of competent general contractors, sub-contractors, lenders, skilled laborers, architects, and engineers to execute. Mistakes and delays can cause budget overages, which again can lessen potential returns.
Finally, the third major risk is financing. Above, we described the willingness of some financial institutions to get creative with financing options for distressed properties. But, that doesn’t necessarily mean that financing is widely available. As a general rule, financing for distressed assets is more difficult to obtain and the terms are less favorable (high fees, high interest rate) for borrowers.
Where To Find Distressed Commercial Assets
There are three places that distressed real estate investors can look for opportunities.
The first place is to foster relationships with lenders in their area to see if they are looking to sell any of their “workouts” or assets that were obtained via foreclosure. Lenders are not in the real estate business and usually want to sell these properties as quickly as possible and may be happy to do so at attractive prices.
The second place is to develop relationships with brokers and operators who may know of distressed properties before they reach the foreclosure stage.
Finally, another common place to find distressed properties is through legal records. When a property goes into foreclosure, there are a number of legal filings that must be made. Those paying close attention may find one or more exciting opportunities.
Before purchasing a distressed asset, it is critical that buyers have a detailed understanding of the amount of debt owed on the property. This is important for two reasons. First, it informs the potential purchase price for the property. But, perhaps more importantly, it provides potential investors with information about who may have a competing claim to the property.
But, verifying debt can be tricky and time consuming. The easiest way to do it is to search publicly available databases for existing liens on the property, since they are filed when a lender makes a loan. Typically this information can be found on the county tax collector’s website or in the judicial records for the local county. It may take some searching, but they are there.
Distressed vs Value Add Real Estate
From the description above, it may sound like distressed real estate and value-add real estate are very similar. They are, in fact, distinctly different.
A distressed property is one that is undervalued, has negative cash flow, and generally underperforms the market. In these deals, the financing terms tend to be a lot less favorable because the risk in the deal is greater due to the seriousness of the impairment.
An easy way to think of a value-add property is as one that is “lightly” distressed. It may be underperforming the market, but the impairment is one that can be fixed relatively easily. For example, a property may have 20% vacancy, but a new owner could come in and perform some light renovations like paint, carpet, and landscaping, and all of a sudden the property is more attractive to new tenants. When this happens, performance improves.
The bottom line is that distressed deals carry more risk than value-add deals and are priced accordingly.
Distressed Assets & Private Equity Real Estate
Perhaps more than any other deal type, successfully investing in distressed properties requires discipline, expertise, experience, and relationships that individual investors may not have. As such, it may be a good idea to partner with a professional real estate operator like a private equity firm. Doing so allows individual investors to access the firm’s expertise to lower the risk in the deal.
However, it is important to note that not all private equity firms pursue a distressed asset strategy. For example, we are a private equity firm and we pursue value-add shopping center deals. For this reason, real estate investors interested in a distressed strategy should seek a private equity firm with specific expertise in this space. When they find one, they should perform a significant amount of due diligence to ensure that the strategy matches their own preferences.
Summary & Conclusion
A distressed real estate asset is one that is undervalued due to one or more factors including: mismanagement, poor physical condition, environmental concerns, poor pricing, or poor market conditions.
Individuals who choose to invest in distressed real estate assets may find that they can acquire a property at an attractive valuation, which boosts their chances for a strong return. In addition, lenders may be willing to get creative with their financing terms, which may also increase the chances for a strong return.
But, distressed properties also come with a significant amount of risk because they can require large amounts of capital, an experienced team to execute repairs and renovations, and a lender who will provide financing with reasonable terms.
Finding distressed real estate assets to invest in can be tricky and time consuming. The best ways to do it are to develop strong relationships with lenders, brokers, and operators. In addition, deals can be found by searching through legal filings to see which properties have gone into foreclosure.
While it can certainly be profitable, distressed asset investing requires time, expertise, experience, and a detailed business plan to be successful. Often, these attributes can be difficult for individual investors. As such, it may be a good idea to partner with a private equity firm who specializes in distressed property types.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.