Distressed Assets

In this article we will discuss distressed assets.

What is a distressed asset in commercial real estate? A distressed asset is an asset that is not stabilized, meaning not over 90% occupied.  There are a few other factors as well, not just stabilization, that define a distressed asset.  An asset can become distressed due to property management and or investment management inefficiency. An asset can be distressed due to the lack of capital for project.  There may not have been enough capital for renovation or working capital and capital expenditures. Another form of distress is on the financing side.  The mortgage payment or debt service may not be covered if the asset is not stabilized, and the occupancy is low.  Additionally, an asset can be distressed due to some type of physical event to the property such as a fire, wind, hail, hurricane, or flood. There could be many reasons an asset is distressed.

Currently, in 2023, assets are becoming distressed because of leverage and interest rate increases. In the last three years, during the market run up, the values on assets were so high that investors and companies were over leveraging deals. They used “floating” rate debt.  Interest rates are significantly higher, almost double what they were over a year ago. This causes debt service payments to increase significantly, eating into cash flow.  Given higher interest rates, these assets are worth 30 percent less than they were before because the cost to borrow capital to purchase investment properties is so much higher. Some of the owners are having to pay out of pocket to cover debt service and other expenses. Because of this, they are distressed, even if the property is stabilized and performing well.

Why do investors like distressed assets? Investors like distressed assets because they can acquire properties that were once valued high for a much lower value. This means 50 cents, 60 cents, 70 cents on the dollar in some cases. If they hold that asset for two to three to five years, they are betting on the market turning around.  They know where the values used to be at the height of the market and hope to profit once the market stabilizes. Investors know that if they are buying at a discount to market, it will be hard to lose money.

The investment thesis or style of pursuing distressed assets is call being opportunistic.  

Opportunistic investments (distressed deals) are for capital growth minded investors.  Most opportunistic assets do not cash flow and require intense capital injection and operational management.  The risk is high, and the reward is high.

At APTVEST, we’ve purchased properties that were distressed.  For instance, one project was 60 percent occupied, and we took the property to 0 percent occupancy and through capital injection and aggressive management, turned the project around and had it reach stabilization at 90+ percent occupancy.  This can be viewed in the case study section within our library.

Valuing a distressed asset to determine what price to pay for the project is not as straight forward as using a Cap Rate like a stabilized deal.  These types of deals do not trade on a cap rate basis. They trade on what’s called a price per pound, or a price per unit basis. That can be determined relative to current marketplace conditions.  Distressed assets can be financed.  Lending providers will review the investor or ownership groups experience given the risk of the project.  Proforma income via rents and expenses will be used to determine pricing and financing leverage.

Distressed deals usually have some type of “bad” operator.  This means, an inexperience operator or firm acquired the asset and poorly managed the investment operations.  For instance, maybe the operator didn't know how to operate a rental real estate business.  The owner/operator could also live out of state from the location of the project.  This causes distress due to the lack of physical oversight. In Texas, we see a lot of California and northeastern owners that are trying to operate from a distance with just an onsite manager. They trust what the manager is telling them and rarely visit the property.  This can cause a lack of regular oversight.  There is nothing wrong with not having a local presence where an investment project is located, but more oversight in this scenario is recommended.

An asset can also become physically distressed because of poor renovation management.  Maybe there was an unscrupulous contractor that underperformed or didn’t complete their work. In this case the operator is unable to renovate the property and finish the business plan.  “An act of God” such as a fire, tornado etc. can cause distress.  If the project is under insured, there may not be enough insurance proceeds to repair the damage to the property. This causes your deals to be distressed.

There could be many variations of distressed - it’s not just physical, it can be operational. It’s also not just operational and physical, it could also be financial, and the way that the capital stack is structured for the project.  Distress asset investment requires vast experience and understanding of marketplace conditions.  Make sure the risk is worth the reward and the project aligns with your investment thesis.

If you are looking for distressed deals, make sure that you're with an experienced operator that has worked with distressed assets before. At APTVEST we have significant experience. We've completed several distressed asset projects.  

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