The “Great Recession” of 2008-2009 has, in many cases, created a buyer’s market in commercial real estate. As the financial panic ensued, many property values plummeted, and opportunistic buyers seeking high returns found significant opportunities in commercial real estate. Depressed demand, weakened fundamentals, and the credit crunch created a substantial market segment for distressed transactions. However, navigating the distressed market is difficult for the enterprising investor and not all distressed transactions represent a good value. Understanding the distressed real estate market is key.
There are two unique perspectives on what constitutes a distressed transaction: a distressed owner versus a distressed asset. While a distressed owner may also be faced with a distressed asset, differentiating between the two yields pertinent conclusions regarding the decision to participate in the distressed real estate market.
Discerning Between a Distressed Owner and Distressed Asset
A distressed owner transaction involves the purchase of a stabilized, performing real estate asset from a seller under duress to liquidate the asset. The property in this scenario is considered to be at market in terms of occupancy and income, and the property is properly maintained without significant outstanding capital expenditures required. However, the seller, for reasons beyond the operation of the asset under consideration, is unduly pressured to liquidate the property. Therefore, this transaction is considered distressed as it does not meet the “willing buyer – willing seller” criterion of a market transaction.
A distressed asset transaction involves the purchase of a property performing below market levels. Generally, the property’s occupancy is below stabilized, and income from the asset is not able to cover costs necessary in maintaining the property. Purchases of distressed properties can be negotiated with the current owner under a short sale, wherein the owner brings the negotiated purchase price to the lending institution for approval to sell the property for less than what was lent, or purchased directly from the lending institution pursuant to foreclosure proceedings.
Causes and Characteristics of a Distressed Owner
A property owner can become distressed for many different reasons, and these reasons impact whether the asset being analyzed represents a good value. Several reasons an owner can become distressed include unfavorable financing terms or maturing debt obligations, cash shortfalls in meeting tenant improvement obligations, drains on an owner from other non-performing assets or ownership bankruptcy. Dissolution of the ownership entity can also cause distress. A member exiting a limited liability company, for example, may require membership units to be bought out, and liquidating assets may be the only option if the other members lack sufficient liquidity. Marital dissolution could also require a real estate asset to be liquidated in order to satisfy the divorce agreement.
A strategy for purchasers seeking high returns involves negotiating with these owners who are under undue influence to sell a normally-operating property. This is the aspect analyzed as a distressed owner transaction. In order to qualify as such, two criteria must be met.
First, the property must be normally operating. This includes occupancy and rent at or near market levels. Further, a normally operating property is expected to exhibit steady net operating income over the past several years.
Second, for the owner to qualify as distressed, sale of the property is required within a timeframe significantly shorter than what is assumed to be a normal marketing period. For example, if a property type is assumed to require 12 months on the market before achieving its market value in price, and the owner must liquidate the asset within three months to stave off bankruptcy, the owner is considered distressed. The owner will likely have to accept a lower price than what the property could achieve in a normal marketing period.
The resulting discount required for a distressed owner to liquidate an asset can often be substantial. It is a function of several factors, including the marketing period differential discussed above, credit market conditions, and demand. During the recent credit crunch and financial panic, real estate financing became relatively scarce, and buyers rife with cash had significant negotiating power over distressed owners. Furthermore, the flight to liquidity and safe assets limited the buyer pool for commercial real estate, providing little competition for the enterprising real estate investor.
Causes and Characteristics of a Distressed Asset
The decline in value of certain real estate assets created significant opportunities for buyers to purchase distressed assets. While overall vacancy increased and rents decreased, the impacts on commercial properties were not equally distributed. Certain properties experienced surges in vacancy greater than exhibited in the overall market, and saw a significant decrease in rental income.
The criteria to be met for a real estate asset to be considered distressed includes subpar performance of the property as compared to other similar properties in the market. The poor performance can be attributed to mismanagement such as insufficient marketing, or an overall neglect of maintenance, causing the flight of tenants to competing properties. Actually an entire market or submarket can be considered distressed, but this article focuses on individual assets that are underperforming the market.
Distressed assets often include significant expenditures due upon sale. These can include deferred maintenance charges in order to bring the property back to operable condition, or delinquent taxes built up as the property was not able to meet fixed obligations.
Anticipation of Distressed Opportunities
The expected wave of distressed assets on the market has not yet been maximized. Participants in the market for distressed properties have raised huge sums of private equity and issued stock, totaling over $20 billion in the last two years. Market participants expected a flood of foreclosed properties, anticipating that opportunities would arise from the $300 billion in commercial mortgages due each year through 2015.1 Although the outstanding dollar amount of defaulted commercial mortgages rose from $8.4 billion at the beginning of the recession to its current level of $46.8 billion,2 less than 10 percent of troubled loans have resulted in lenders taking possession through foreclosure.3 The following chart highlights the composition of distress in the real estate market through October of 2010.
The key reason that distressed assets have yet to hit the market is many lenders’ decisions to turn to restructuring as opposed to foreclosing on assets. Given the current state of the credit market, it is more feasible in many instances to modify loans than to repossess the underlying assets.
The buyer seeking distressed opportunities must be aware of the factors impacting the decision by a lender to foreclose rather than restructure a loan. If the anticipated liquidation price for a distressed property is significantly less than the outstanding loan amount, yet the property’s fundamentals including rent levels, occupancy, and market conditions are relatively stable, it is in the lender’s interests to work out the existing loan. If the fundamentals are weak and the lender anticipates a modest recovery from foreclosing on the asset, the lender is likely to choose foreclosure.
If foreclosure is the route chosen by the lender, a distressed asset opportunity arises for a buyer to either negotiate a short sale prior to foreclosure proceedings or purchase the asset from the lender after the property has been foreclosed upon. The more advantageous opportunities typically lie in dealing with the owner prior to the bank taking ownership. Distressed owner opportunities, however, often occur below the radar. The buyer is likely to have more difficulty in identifying these opportunities.
Assessing the Value of a Distressed Transaction
Given the characteristics of distressed transactions and current market conditions, the enterprising investor can recognize the pros and cons of the distressed asset and distressed owner opportunities.
A distressed asset transaction will generally require more cash in acquisition. Additionally, financing will be more constrained given lenders’ aversion to lending on risky properties. Therefore, the buyer can anticipate a lower loan-to-value ratio in acquiring the asset, which is currently around 70 percent for stabilized, investment-grade assets. Cash will also be required for capital expenditures in bringing the asset to stabilization, including required repairs, tenant improvements, or delinquent taxes and other assessments.
The distressed asset buyer must be certain that the reason the asset is not stabilized is due to the outstanding required capital injections. Other factors that could cause a property to perform below market include a property that does not meet current market tastes, poor locational factors, or legal restrictions. A distressed asset purchase involves significant risk that the buyer will not be able to bring the asset up to stabilized levels, and therefore, the required return should be high.
Another benefit in searching for distressed assets is wide availability and high discounts. While the current supply of distressed assets is below expectations, distressed asset transactions have been on the rise. Distressed real estate transactions have surged as a proportion of total transactions, from less than five percent at the beginning of the recession to currently over 25 percent. Furthermore, while healthy commercial real estate sale prices declined an average 33 percent after the downturn, distressed commercial real estate prices declined 54 percent on average, indicating significant opportunities for buyers of distressed assets.4 The following chart highlights these trends.
While the buyer of a distressed asset will benefit from relatively higher supply, the buyer seeking a distressed owner will likely face more difficulty in identifying opportunities. Distressed assets are typically listed on most multiple listing services, while distressed owners often liquidate properties without marketing via traditional channels. The buyer seeking distressed owners can identify opportunities by talking with market participants such as brokers or property managers who follow the performance of property owners. Additionally, the buyer can connect with local assessors and treasurers who are often aware of potentially distressed owners as taxes and assessments may become delinquent.
Although distressed owner opportunities are not generally advertised, there are databases available for sorting out potential distressed owners. One tool is the Leads and Potential Opportunities Database offered by Real Capital Analytics, which offers searches for property owners with maturing financing or financially troubled owners.5 This subscription service allows searches for specific markets and property types, and allows the buyer to have an advantage in identifying distressed owner opportunities.
Another advantage of a distressed owner transaction is a shorter payback period than a distressed asset. Because the asset from a distressed owner is stabilized, the returns are generally lower as these transactions are not value-add opportunities. The risk involved is lower, and the buyer can expect lower volatility in returns.
While financing should be more easily obtained for distressed owner transactions due to the less risky underlying properties, the distressed nature of the transaction means the buyer will be required to have cash or quick access to credit in order to acquire a property from a distressed owner. It would benefit the buyer of a distressed owner property to secure financing sources prior to negotiations as the owners will favor the bidder providing the fastest liquidity. Less cash will be required overall for the distressed owner transaction as significant capital expenditures should not be required pursuant to the sale, although a buyer bringing cash and secure financing to negotiations will have significant bargaining power over a distressed owner.
Many factors impact the value of a distressed asset and distressed owner opportunity, and the buyer seeking high returns from a distressed transaction should be aware of the characteristics and nature of each. A distressed asset will be more capital intensive and should yield higher returns, yet with more inherent risk and a longer payback period. The risk involved in a distressed owner transaction is lower, although these opportunities are more difficult to identify and yield lower potential returns. In either scenario, the buyer armed with a keen understanding of the current distressed market will come out on top.
Jeffrey G. Pelegrin, MAI, FRICS
Brett M. Suszek
1 Source: MasterPlan Capital LLC.
2 Source: Real Capital Analytics.
3 Source: MasterPlan Capital LLC.
4 Source: Real Capital Analytics and Moody’s/REAL Indices.
5 Source: http://www.rcanalytics.com/Search.aspx?SearchTabSelected=TAS. Subscription required.