Acquiring distressed real estate unquestionably isn’t for the faint of heart. An unsophisticated investor can easily be influenced by the commitment of a project sponsor who doesn’t have a plan for transforming the property. But that doesn’t mean you shouldn’t invest in distressed real estate. It merely suggests you should tread lightly before accepting sponsor equity in a joint venture. Be sure you understand the nuances of a deal before committing your hard-earned capital.

The Promise and Subtleties of Distressed Real Estate

There is any number of reasons why a property might be deemed “distressed.” An owner may be too highly leveraged, for example, and is now underwater on their mortgage. Powerless to afford the improvements needed to increase rents and/or occupancy, the property is now at risk of foreclosure. There are various restructuring, alternative approaches, and strategies that can be considered.

Often forbearance is offered — following an event of default, an arrangement by a lender to refrain from enforcing its remedies under the loan documents for a particularized period throughout which the borrower endeavors to cure the event of default or the borrower and lender attempt to negotiate a restructuring of the loan.

Following a borrower’s default, payment by such borrower—or by another party on such borrower’s behalf (e.g., a subordinate lender)—that corrects or eliminates the default is considered a “cure.” Loan documents may provide that a borrower has a period in which to cure a default (known as a “cure period”) before a lender declares that an “event of default” has occurred and/or begins to exercise its remedies on account of the event of default. An inter-creditor agreement between lenders may grant a mezzanine lender with a supplementary cure period following the occurrence of an event of default, before which a mortgage lender is prohibited from exercising its remedies. 

Sometimes conveyance-in-lieu of foreclosure can happen—a transaction in which a debtor voluntarily transfers title to the collateral securing debt to its lender to satisfy such debt, usually following the occurrence of an event of default. A “conveyance-in-lieu” is ordinarily more expeditious and less expensive than a foreclosure but, unlike a foreclosure, does not extinguish subordinate liens against the collateral. A conveyance-in-lieu transaction in which the collateral securing the debt is real estate is generally referred to as a “deed-in-lieu of foreclosure” proceedings. Note, however, that, in a conveyance-in-lieu of foreclosure involving ownership interests in an entity, such as in a mezzanine loan, the transferee to which the collateral is transferred acquires the collateral subject to both subordinate liens against the collateral, as well as the liabilities (e.g., liens, litigation, mortgages, third party agreements, etcetera.) of the acquired entity and its subsidiaries.

Lastly, there is foreclosure. A legal procedure whereby collateral securing debt is sold to satisfy such debt following the occurrence of an event of default. In a foreclosure, all subordinate liens against the collateral are extinguished, and title to the collateral is transferred to the holder of the debt (or its nominee) or a third-party purchaser of the collateral. State real property laws govern foreclosures of mortgages against real estate, and a state’s Uniform Commercial Code regulates foreclosures of pledges of ownership interests.

Another instance we often see is when an aspirant owner overpays for a property and then strives to manage it passively. Commercial real estate is an excellent way to earn passive income, but that doesn’t indicate it can survive without comprehensive management. Someone, even if not the owner, must keep a close eye on the day-to-day operations of the property. In conditions like these, a property often experiences delayed repairs and maintenance, which turn into more significant difficulties down the road.

Consider the case of a small roof leak that gets ignored. Well, as it turns out, what seemed like a small leak was a sign of a rotting roof deck and sheathing. All it would take is an intense rainstorm to roll through for the roof to collapse. The absentee owner quickly learns that it’s challenging to lease out a property with a collapsed roof, and now must survive high vacancy while the repairs are made, putting the property into further danger.

Believe it or not, circumstances like these are not unusual at all. Folks often get excited about investing in commercial real estate, but regrettably, lack the knowledge or skills to maintain and operate it effectively. It’s often the case that distressed real estate is a fantastic buy, despite the condition of the property. Here are five keys to investing in distressed real estate.

1. Understand the property history.

Start by learning why this property is distressed to begin with. Specifically, you’ll want to know whether it had something to do with inadequate management, specific and surprising property deficiencies, or whether it had something to do with the economics of the transaction. For example, does the owner need to realize $1500/month in rent per unit for this project to be viable, yet market rents only support $1200/month? Does the property need $2 million in improvements to bring it in line with market conditions—and if so, is that something the project can bear? Before investing in distressed real estate, be sure you realize how the property wound up in this position so you can avoid ending up in an identical situation down the road. 

2. Learn about the underlying market drivers. 

Let’s say a property is in foreclosure and being sold for pennies on the dollar. It is tempting to buy distressed real estate when you think you’re arranging a “steal” compared to what it’s sold for previously. This shouldn’t be the foundation for your investment. Instead, look at the underlying market drivers. Is the property located in a decent area? Is there a healthy local economy? Is the population expanding? What would bring people here? Why would someone want to lease from you, and how much would they be prepared to pay for rent? 

Now, if you’re buying a property in a prime location and buying the structure for the price of the raw land, you can’t lose – it’s only upside from there. With a few cosmetic improvements, you can go in and lease the place up – even for 50% below market – and still make your money back. When the underlying market drivers are sound, distressed real estate can have an exponential upside.  

3. Get to know the project sponsor.

Before investing in distressed real estate, get to know the person who’ll be in charge of turning the property around. Have they done this before? What is their proficiency? How familiar are they with this asset class? For example, you wouldn’t necessarily want to partner on a multifamily value-add deal if the sponsor has solely flipped retail centers. These are two different product types. You want to be sure the sponsor has sufficient background in the product type you’re contemplating investing in—ideally, in the same market where this deal is located. Commercial real estate can be hyper-local, so having local expertise (including having local market knowledge, relationships with local lenders and contractors, etcetera.) can significantly impact the success of a deal. 

4. Evaluate the exit strategy.

Someone has approached you to invest in distressed real estate, and based on what they’ve told you; it seems too good to be true. Is it? Evaluate the sponsor’s business plan, paying close consideration to their exit strategy. What is the approach around renovating, leasing, and stabilizing the property? Does the syndicate plan to buy and hold the asset, refinance, or flip and sell? Investing in distressed real estate can be highly lucrative, as long as you agree on the exit strategy and how and when you’ll be paid back (with profits). 

5. Weigh potential risks and returns.

 As with any investment opportunity, you should assess the potential risks and returns associated with distressed real estate. Every investor has their risk tolerance. Generally, those with a higher risk tolerance will be more amenable to investing in distressed real estate, given the potentially higher risks associated with these projects. Naturally, a competent project sponsor will be able to mitigate those risks, but the uncertainties persist.

The risks must then be weighed concerning potential returns. Let’s say you can earn a 20% cash-on-cash return by investing in a particular distressed asset. Could you achieve that same rate of return elsewhere? Over what time horizon? Of course, any purchase should be made in the context of your broader investment portfolio.

Conclusion

Commercial real estate can become distressed for several reasons, some of which are harder to overcome than others. With strong familiarity with project management and oversight, an adept sponsor will find creative ways to turn these properties around. Yet that process can take time and is usually far from a slam dunk. Anyone contemplating investing in distressed real estate should be sure to go in eyes wide open. The five factors outlined above will help you do just that.