By Nicholas Minoia, owner, Diversified Properties
Changing consumer behaviors and financial pressures stemming from the COVID-19 pandemic, coupled with an inevitable rise in interest rates, will soon trigger the release of a wave of distressed real estate assets that will hit commercial markets across the nation.
As this wave of distressed assets begins to crest in the months and years to come, creative and experienced investors will be afforded rare opportunities to uncover value across asset classes in some of the most competitive regions in the country.
However, as these properties often represent the most complicated and high-risk types of investments, it is important that investors fully understand not only how to identify and value distressed assets, but also how to create a strategy that will allow them to unlock the value hidden in these unique properties.
Identifying Distressed Assets
The complexity of modern real estate ownership means that stress can come at any point for a property, and from countless directions.
Family or joint venture ownerships might run into partnership disputes or estate issues. A developer might suddenly face costly environmental concerns, legal challenges, significant supply chain shortages, price
increases or problems with a contractor. A long-term owner could suddenly encounter financial distress stemming from tenant departures, a changing rate environment or unpaid real estate taxes.
The factors that cause properties to become distressed are complex and multifaceted. More often than not, a property will have several, often compounding reasons that it has earned the distressed moniker.
For owners of these assets, the “distressed” label brings with it a subsequent devaluation and further headaches down the road. While “opportunity” is perhaps the last word that comes to mind for an owner of a distressed asset, these properties do provide creative real estate professionals with unparalleled chances to find value in markets where traditional new construction or redevelopment might be difficult.
In hypercompetitive markets, the potential for finding yield can offset the uptick in risk that often accompanies investment in distressed assets.
Unfortunately, the myriad ways by which these types of assets become distressed means that there is not an easy and foolproof method for identifying them. Additionally, as they are often off-market, finding a distressed asset is not as simple as combing through properties on listing services. Therefore, the forming and leveraging of relationships are key in identifying these assets.
Whether it is with brokers, lenders, municipal leadership or vendors, these relationships represent the most surefire way to find currently distressed assets or assets close to becoming distressed. While establishing the relationships is the first step, it is also vital that investors reinforce their expertise in and understanding of how to execute a distressed real estate strategy with these contacts to remain top-of-mind should an opportunity arise.
Investors should have a concrete strategy to address each of the following questions:
• Do you have the depth of construction knowledge required to complete a half-built project?
• Do you have the legal team in place to unwind a complex estate issue or bankruptcy?
• Do you understand the real estate financing needed to work through a complex capital issue, including negotiating with existing lenders?
Just as a developer would market his or her expertise in ground-up construction, investors should consistently communicate their distressed asset capabilities to those who might possess knowledge of these opportunities.
If an investor lacks direct experience with distressed assets, finding a more experienced partner can provide economies of scale and allow the investor to leverage the partner’s expertise in the execution of a distressed asset strategy.
Valuing Distressed Assets
Once an asset has been identified, a determination needs to be made of its ultimate value. Valuation represents another facet in which distressed assets present challenges.
For example, whereas a modern industrial building that is fully leased to a credit-grade tenant has an established market value, an older industrial building sitting on top of a contaminated site with a bankrupt tenant does not. The use of the standard umbrella term “distressed” should not imply that every distressed property is created equal. Once again, experience and relationships provide valuable clarity during the valuation phase.
Through an understanding of the construction process, financing, entitlements, environmental issues and nuances of the local markets, investors can make informed decisions as to what the projected cost will be to bring a property out of its distressed status and subsequently, what the ultimate value will be. This experience also provides insight into common pitfalls or concerns that a less-experienced investor might overlook.
A lack of understanding of what to look for or how to evaluate the various components of an asset can often cause an investor who is hoping to turn around a distressed property to become just another owner of an underperforming property.
Tangible issues — substandard, partially completed construction, leasing challenges, unresolved environmental problems — can cause headaches from day one. Less-tangible concerns such as changing market dynamics or a less-than-receptive community that might be missed before an acquisition often bring longer-term problems in the life of an asset.
Even if an investor identifies a property and determines that it can be acquired for what seems like a bargain-basement price, if the value-add premium is only slighter higher than the distressed price, the time, money and energy spent on the property will not be worth it.
As investors craft strategies for turning assets around, understanding the property’s zoning, environmental status and other less-fluid determinants of its future usage should not be taken lightly. For example, if the strategy for a deeply contaminated former industrial site hinges on the construction of multifamily units, investors should be prepared for a massive outlay in remediation costs and a lengthy approvals process.
Additionally, every state’s entitlement process differs wildly. If an investor is hinging his or her plan on a dramatically different usage for a property with variances and multiple planning board meetings, he or she could be looking at a costly, multi-year process in a state like New Jersey versus a shorter and smoother process in a state like Texas with a softer regulatory environment. The costs associated with zoning challenges, neighborhood opposition and financing hurdles alone can sink a project.
Similarly, the lack of understanding of the more fluid aspects — macroeconomic forces, construction costs, technology, consumer demands — of a project can be equally damaging to a distressed real estate strategy.
For example, if a plan for a distressed big box retail space involves simply finding a new big box retail tenant, the prospects for profit would be dim. However, if that same property is being eyed as a last-mile distribution center for a large e-commerce firm, the developer’s prospects for profit are built on a solid understanding of the trends and forces driving the market.
While the opportunities for profit from distressed assets are significant, the challenges presented by these deals can be daunting. However, through a strategic and careful approach to the identification, valuation and execution processes of a distressed asset, investors can find rare opportunities to create value in many of the nation’s most competitive markets by bringing unique and in-demand properties to the market.