Distress in commercial real estate comes in many different shapes, sizes, and colors. The first type is property distress. Property distress occurs when the physical property has problems that lead to a lack of cash flow. The second type is tenant distress. Tenant distress occurs when a property loses a major tenant and cannot service the debt. The third type is leveraged distress. With leveraged distress, a property cannot service or repay the debt, typically because of changing market conditions. Perhaps a sponsor can’t sell their asset because it’s overleveraged, meaning that they owe more on it than what it’s worth; we see this all the time when values decline. Finally, we have sponsor distress, where the equity investors are angry. Sponsor distress includes partnership disputes, divorce, or successor issues. When you hear of a partnership dispute, it’s usually because there are a lot of co-investors who want out of the deal – think syndicated equity – and they have a gun to the sponsor’s head to sell or refinance the property and get them out.
Each of these types of distress arises from different circumstances, but in the end the result is usually the same. We have property owners and investors who are not able to pay the property’s bills, and who face losing these properties.
The figure below displays the distressed asset life cycle. Let’s go over the different stages.
From performing, to distress, to being born again as a cleansed asset, we have the distressed asset life cycle. Just as with any loan, the beginning of the life cycle starts off with the performing loan. Performing loans mean that the terms and conditions of the loans are being met and both the investor and the creditor (or lender) are “happy” about the progress of the loan. As you can see from the figure below, the risk increases over time as the asset becomes more distressed. The next phase in the life cycle is sub-performing loans. When this occurs, the lender exits the deal early in order to avoid the loss on their books. Other issues that can cause a sub-performing loan include document deficiencies or other material documentation which was not originally accurate or which has changed since the beginning of the loan. You’ve likely heard of scratched and dented loans. This occurs in cases where there may have been missing documents missing from the time that the loan was originated; hence, it may affect the enforceability of the loan – should it go into default. Of course, what we’re talking about here is the remedy for default, which is foreclosure. Other reasons a loan may be scratched and dented is because the borrower may be slow at making payments, their personal financials may not be as strong as they were at the time the loan was originated, or the property simply isn’t performing that well. All of these things would spook a traditional bank lender.
The third phase in the life cycle is the non-performing loan. In this stage, most note sales occur. There is also the greatest risk at this stage in the life cycle, as the borrower can still file for bankruptcy. To clarify how important this is: bankruptcy is a right, and it can’t be negotiated away. And, as far as commercial real estate is concerned, this poses the biggest risk to lenders.
The fourth stage occurs when the lender files for foreclosure of the property. During this stage the note sale will take place for certain and the deepest discounts will be offered, since the lender is trying to liquidate the property and obtain as much of the loan amount back as possible. The note buyer will inherit the good, the bad, and the ugly from the lender. Lender reps and warranties are very important during this stage of the process. The fifth stage of the distressed asset life cycle is the bankruptcy period. This is the borrower’s last chance. The lender risks time delays and possible “cram downs” during this stage.
The sixth stage occurs when the foreclosure sale becomes final. During this stage, the borrower can buy back the note, although this rarely happens. This stage is also known as the redemption stage. In many foreclosure actions, you’ll never see anyone bid on a commercial property other than the lender. The final stage is the REO stage, which is the asset sale stage. The property now has a “clean” title and possesses minimum risk. However, the highest price is also paid because the title has been cleaned and the property risk eliminated. There are no more risks like bankruptcy or expensive foreclosure costs for the loan buyer to assume; the property has been cleansed. This is also why you’ll see REOs listed at closer to market value than non-performing loans. It’s because the risk has been removed from the investment.
There are several potential ways in which a real estate deal can become distressed, the first being bad sponsors. Poor management or sponsors who are incompetent and weak can kill the deal quickly. Other issues include a sponsor’s lack of experience and deals that are undercapitalized; sponsors who lack experience are almost always behind these deals. The second way involves there being too much time, and this is often true for “rehab and flip” deals. These are meant to be started and finished in a short amount of time. Usually, the term runs out on their loan or the repairs and expenses have existed for so long that the sponsor will likely never be able to pay them. In this case, the sponsor has passed the point of profitability on the deal – whether they know it or not. Remember: time and expenses ruin all deals and sends them to the graveyard sooner or later. Hopefully you fully understand the importance of sponsor experience now.
The third way involves costs being underestimated. An increase in costs without an increase in revenue raises the asset basis and reduces returns. The investor must have control of all costs. These include the following:
- Acquisition Costs: Do not pay too much on day one of the deal, as the purchase price is where the money is made on these deals. From our experience, those sponsors who have purchased towards the top of the market because a lender was willing to lend them the money will almost always have problems later. Markets work in cycles, and the worst reason to buy anything is because you feel pressured to. This false sense of pressure has killed many sponsors.
- Development and Rehab Costs: Do not over-improve the property. Improvements must add value, such as increasing the rents charged or the occupancy of the property, or they should not be underwritten. This is discussed in great detail in our ACPARE Value Added Mastery course. Not all expenses and improvements add value.
The fourth cause of distress is the absence of key leasing or sales. In value-added transactions, sponsors perform a lease-up on occupancy. These numbers should be reviewed via a sensitivity analysis to understand the magnitude of the risk that will be involved if they are not achieved. Again – only an experienced sponsor who knows how to look at these numbers dispassionately will understand what that means.
The fifth way distress occurs is that the property because overleveraged. What percentage of the business plan needs to be achieved to pay off the debt? Putting too much debt on a property can cause an asset to go into distress. If revenues fluctuate or underwriting criteria change, the owner can be left with a building that is no longer worth the debt amount.
The sixth way involves rising interest rates. Floating rate loans are most affected, along with refinanced loans with cap rates when the interest rates begin to rise. The seventh way involves capital restraints. When capital being used to refinance debt is constrained and the loan matures, the owner may be unable to refinance the property. You can see that when markets fall, banks and traditional lenders become more selective – almost prohibitively so. The final way involves the operating costs. The property must be at a market cost, and over-operating the property causes returns to decline.
There are a range of available opportunities when working with distressed assets. The first opportunity is to buy the non-performing loans. As we saw in the distressed asset life cycle, this can be risky, but the property notes are usually highly discounted to offset the risk. If you are able to obtain these loans cheaply, the risk will already be priced in. People who bid too high on these notes often lose money because they don’t take legal fees to work out the loan into account. The second opportunity is to buy fee-simple assets at the discounted rate. Again, the risk is there because the asset has not been “cleaned” yet, but the discount can offset the risk. The third opportunity is to recapitalize (equity) a transaction where owners are facing a maturing loan, or where they are experiencing a liquidity problem.
The fourth opportunity would be to become the bridge lender at low loan-to-value rates and high yields. In this scenario, you will still experience some risk, but with the lower LTV you are more insulated. When markets change and capital becomes very competitive, bridge loans or hard money loans usually never really go away. There is always a need for them. As a sponsor, you always want to have relationships with what we in the industry call “discretionary capital providers.” The final opportunity involves becoming an advisor to the borrowers, or a workout expert. You can guide them through the process and help them to make the right decision. Alternately, you can also become a special servicer with the lender and then act as a workout specialist at their side.
There are several opportunities that exist in distressed assets; the key is to understand the situation, as well as what leads to these issues, so you do not find yourself in a similar position with the property. It is important to conduct your due diligence and to ensure that the opportunity is right for you, as the investor.