Distressed real estate can attract investors with the promise of buying below replacement cost, repositioning an underperforming asset and capturing strong returns. But the opportunity is only as good as the investor’s understanding of why the property is distressed in the first place.
Todd Laurie, a partner at Armanino, told GlobeSt.com that buyers often place too much weight on financial statements, rent rolls and the seller’s explanation for the property’s troubles. Those materials may show symptoms, but they do not always reveal the cause.
The real issues may sit below the surface. A property could be suffering from weakened access, changes in traffic flow, outdated zoning conditions, deferred repairs, poor operating history or shifting customer behavior. These factors can build over time and may not be obvious during a quick review of the numbers.
That is where experience matters. Institutional investors and sponsors with a long track record of reviewing distressed deals are often better positioned to spot problems that are not immediately visible. Smaller owners, individual investors or newer sponsors may be more exposed, especially if they have not managed assets through multiple market cycles.
The upside can be meaningful when a distressed asset is properly diagnosed and repaired. But a bad read can turn a discounted acquisition into an expensive mistake.
Laurie’s key distinction is between problems that are fixable and problems that are structural.
Fixable distress generally involves issues the buyer can control, budget for and execute against. A shopping center with vacancy because the prior owner lacked capital for improvements may be a workable opportunity if a new owner can fund tenant improvements, refresh the property and bring in stronger tenants. Deferred maintenance may also be manageable if the cost of repairs is known and reflected in the purchase price.
Structural distress is different. Some problems are outside an owner’s ability to correct. An investor usually cannot change regional traffic patterns, remove a median that limits access or reverse a broad consumer trend that is hurting a tenant category.
Even then, the answer may depend on the buyer. A challenge that is too complicated for one investor may be attractive to another with the right expertise. Environmental remediation, for example, could be a reason for an inexperienced buyer to walk away. But for a specialist who understands the process and acquires the asset at the right basis, that same issue may create opportunity.
The lesson is that distressed deals require a deeper level of due diligence than stabilized acquisitions. In a conventional deal, a buyer may be able to rely on the seller, broker, lender and standard property review. In a distressed situation, that is rarely enough.
Investors need to investigate the operational, physical, legal and market conditions that will determine whether the asset can realistically be stabilized. That may mean bringing in third-party specialists, reviewing local market conditions more closely, studying access and zoning issues, and stress-testing the capital plan.
For investors without that experience, Laurie suggested either working with qualified experts or partnering with investment managers who have a proven record in distressed real estate.
The discount is only the starting point. The real question is whether the distress can be solved — and whether the buyer is the right one to solve it.
Source: GlobeSt.