One area few people have had exposure to is Distressed real estate investing.
Distressed real estate investing is a form of investing in commercial real estate. Typically commercial real estate investors buy properties such as office buildings, strip centers, warehouses, larger residential buildings such as apartments, and developments. Investors then expect to earn money from either: (a) rents received on the properties and/or (b) appreciation in the underlying asset.
Some common risks investors face when investing in commercial real estate things such as loss of tenants, decreasing rent values, decreasing property values, and property repairs. Despite its name, investing in distressed real estate actually can, when done properly, reduce these risks and increase profits. Distressed does not mean "falling over" or "gamble."
Rather, Distressed Real Estate Investing consists of buying assets in unique real estate situations. A property may be in pre-foreclosure or foreclosure, the owner may have a note that has a large lump sum coming due, the property may have lost one of its key tenants, the property owner may have a collateral problem with a different property that was pledged as collateral for the property being analyzed – there are all kinds of such situations which would make a property “distressed.”
For the majority of investors this type of investment is not available to them. Most investors think that investing in this type of real estate means you are scraping the bottom of the real estate barrel and therefore the investment is riskier. In reality, private equity funds, hedge funds and savvy real estate investors have actually been able to purchase distressed real estate at attractive discounts to current market value.
To give a simple example, let’s assume an office building owner borrowed $5,000,000.00 and invested $1,000,000.00 of his own money to build the building. The bank's financing was given on the assumption that within a year of competition, the building would be 80% occupied. Well two years later, this building is only 50% occupied and the owner cannot make his loan payments. The bank declares him in default and threatens foreclosure. There is nothing wrong with property - it is a brand new $6 million dollar property that is 50% occupied - but the underlying assumptions on the original loan were simply wrong. An investor in distressed real estate can then enter.
They will look and value the property, which cost $6,000,000.00 to build, as the property then currently exists – at 50% occupancy. These investors may think the property is only worth $4,000,000.00 and offer to buy it at $3,500,000.00. If successful, they have just bought a property for $3,500,000.00 that (a) is valued currently at $4,000,000.00, (b) is cash flowing at 50% occupancy and a $3,500,000.00 purchase price, (c) has room for appreciation in property value, and (d) can increase in value if occupancy rates can be improved. This is a dream scenario for many real estate investors – buying a property for 1/3 of what it cost to build, for under market valuation, that has significant upside. So while the property is “distressed” because it is in pre-foreclosure, it actually is a safer investment than simply buying a 95% occupied office building for cash flow.
Between the discount, the economic drivers, the massive room for property improvement, and the cash flow from the property, investors significantly reduce risk. Even if lease rates cannot be improved and there is slight market downturn, the asset can still have a positive return - a situation that really does not exist in traditional commercial real estate. If there is one definition of distressed real estate investing it would be “buying secured real estate at significant discounts to market value to drive outsized returns.” Which leads to the question, why doesn’t everyone do it?
The first reason is high barriers to entry. The “retail” investor (high net worth individual or local group of investors) typically looks at a property that is being mass marketed and puts in an offer. These are the properties that are listed by brokers, are seen on websites such as LoopNet, and which have advertisements run for them in local publications. The seller then looks at all the offers and picks the best offer based on be price, timing of close and certainty of execution. The buyer then has 30 days of due diligence and 30/45 days after that to close. This 60 to 75 days is used to complete all due diligence items and to get bank financing lined up. When investing in distressed real estate the process is turned around, the investor has a few weeks of due diligence then puts in a “hard” (binding) bid on the asset. Once the asset is awarded to the investor with the highest price the investor must then turn around and put down 10% in a non-refundable earnest money deposit and close about two weeks later. There is usually no due diligence period after contract and no time to get bank financing. Therein lies the high barrier to entry -- an investor must have the liquidity (cash in a bank account) to even be qualified to make an offer on the asset.
Why would a group sell an asset at a discount to current market value? Investors can get meaningful discounts to market value due to a seller’s motivations or banking requirements. If a buyer is astute enough to find a seller’s motivations they will find discounts at various points. In the current market the two best illustrations are management’s strategic incentives and regulatory compliance. Real estate private equity funds are generally closed end, which means there is an investment period where the money goes out, there is a harvest period where the assets are sold, the money comes in and is returned to the investor (profits are split between the investor and the private equity firm). As the harvest period of a fund is winding down often there are legacy assets that need to be liquidated. If the private equity fund is $500 million then selling $10 million of assets at a 15% or 20% discount does not move the needle for the private equity firm or their investors. Management will make a strategic decision to sell assets, gain certainty of execution and close the fund.
The other example comes from regulatory compliance. There are a wide variety of financial institutions and various regulatory bodies that oversee banks and financing entities. Regulatory requirements in Basel III in the banking field or REMIC status in the CMBS (mortgage) world can motivate sellers to sell at a discount. For example, banks are only allowed to have certain loan default rates without drawing regulatory scrutiny. If their loan-loss rates get too high, it is more advantageous for the bank to sell at a discount, realize the loss, and eliminate a bad loan from its books then to hold the asset trying for a fair market sale and negatively impact certain regulatory rules.
The networks where these assets are marketed tend to be smaller, more private, and less generally known to individuals and normal retail investors. Rarely are these properties and note marketed to the extent a broker from a major real estate firm would advertise a class A downtown office building that was simply up for sale. Large institutions avoid smaller properties and loans (under $10m in value), as those loans would not be large enough for them to expend time and resources evaluating.
Another reason that retail investors have a hard time investing in distressed investing is the vehicle which you purchase these assets might be through the purchase of a loan out of an insurance company, bank, CMBS trust, or other financial institutions. You may not purchase the physical property, rather the loan itself. The underlying collateral for the loan is commercial real estate but the investor does not hold the fee simple title to the real estate. Most people understand owning a small building but if you change perspective to buying a note secured by property and you lose many investors even though the note is secured by the building. One massive pitfall can be a lender liability lawsuit in which the borrower sues the lender (the investor in this case) for not handling the loan correctly. This can be from sending wrongful default letters, improperly instituting foreclosure proceedings, or mismanaging an escrow account. Losses that a novice investor can incur could be multiples of the original investment. If the borrower stops making payments the investor must understand all the legal remedies at their disposal, such as foreclosure. This is a large capital expense due to the time and legal services that an investor must incur. Investors need to be familiar with the foreclosure process, its costs, and factor that into bidding on distressed assets. Often the mere possibility of having to deal with a foreclosure proceeding will scare off numerous investors, leading to even more attractive discounts for the savvy distressed debt investor. Investors who have experience in managing an office building may not have experience in managing notes, even though the underlying assets are identical, leading to the market inefficiencies existing for distressed real estate investors to take advantage of.
Lastly, distressed real estate funds tend to have an edge over the individual distressed real estate investor from a risk point of view. A fund can purchase numerous distressed properties, diversifying risk across various assets. An individual investor looking for a single investment incurs a significant amount of additional risk.
In order to gain exposure to this unique market, an investor must be spend years developing a purchasing network, learning how to manage distressed properties and/or loans to maximize their value, and how to build a proper safety cushion into an acquisition. Or, an investor can simply invest in a fund that specializes in this market.
If anyone has any interest in learning more about distressed real estate investing, or actually making an investment into the sector, Lorintine Capital has an active fund in the sector and is launching another. We would be happy to discuss the existing fund’s performance, investment in the newest version, or generally provide more education on the topic. Feel free to contact Christopher Welsh at firstname.lastname@example.org with any questions.
Christopher Welsh is a licensed investment advisor in the State of Texas and is the president of an investment firm, Lorintine Capital, LP which is a general partner of three separate private funds. He is also an attorney practicing in Dallas, Texas. Chris has been practicing since 2006 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. He offers investment advice to his clients, both in the law practice and outside of it. Chris has a Bachelor of Science in Economics, a Bachelor of Science in Computer Science from Texas A&M University, and a law degree from Southern Methodist University. Chris manages the Anchor Trades portfolio, the Steady Options Fund, and oversees Lorintine Capital's distressed real estate debt fund.