Distressed debt investing is a strategy that involves purchasing discounted assets from lenders or property owners. Typically the properties are either foreclosed or in the foreclosure process. There may also be opportunities to acquire discounted properties before they begin the foreclosure process.
Why do assets become distressed?
Typically, assets become distressed when their cash flow is disrupted and the borrower can no longer service the debt. For example, in a slow market, rising vacancies, a drop in rents, and an increase in expenses can cause cash flow issues with a property. If the borrower can no longer make payments, the bank will foreclose. In turn, the bank will sell the property, likely at a discount.
Other causes can be mismanagement that creates costly repairs or issues with tenant retention, environmental conditions like contamination, and physical damage from storms or fires. Additionally, new developments with multiple phases can become distressed before being fully completed.
While the concept is simple, the execution can be complicated. Buyers of distressed assets typically have a specialized skill set and strategy. They can identify certain conditions under which they feel they can “right the ship” of a property and produce returns strong enough to significantly outweigh the risk in the equation. Some buyers may be skilled at mitigating physical damage, while others may specialize in repositioning an asset.
For example, in the 2008 recession, many new construction for-sale condominium projects faltered due to a change in mortgage lending. Developers were unable to close units. In many cases, buildings were not yet complete. Experienced multifamily development groups were able to purchase projects at a discount. They completed construction and converted the buildings to rental properties, quickly bringing units to market and creating cash flow.
Current Source of Distressed Debt In Real Estate
Many borrowers are now facing the harsh reality of a changing lending environment. In March of 2022, the Federal Reserve Bank announced that it would raise interest rates for the first time since 2018 to fight inflation. This brought an end to an era of historically low borrowing costs.
In a lot of cases, buyers purchased with high leverage and short-term interest rate caps in the past five years. They are now facing the reality of an interest rate jump and stabilizing market conditions that their underwriting proforma did not account for. Deals will likely require a capital infusion that they may be unable to make, resulting in a distressed situation for the borrower and lender.
Opportunity for Investors
In real estate, as in most businesses, when there is a problem, there is an opportunity. In this
case, when an investor purchases distressed debt in the form of a financial instrument such as a mortgage, they have some options that can provide significant rewards. Alternatives could range from foreclosing on the property (assuming default) to renegotiating the loan.
The best solution for the distressed debt investor depends on many variables. They include the skillset of the investor, the relationship between the two parties, and the willingness to “work” through the situation as partners.
Options for Borrowers
The borrower also has options that aren’t always obvious. When people are in a distressed situation, they tend to get “tunnel vision” and are unable to see the options that may be available. There are often alternatives that may relieve the situation or drastically reduce the stress. There may be opportunities such as working with alternative lenders or executing a sale/leaseback strategy.
If you are interested in help identifying potential distressed asset debt investments or looking for options to work out a distressed asset you own, contact a Sterling CRE Advisor today.