What is distressed opportunistic investing?
Distressed assets are the fixer-uppers of the commercial real estate world. They’re performing well below their potential—whether due to market factors, physical condition, or mismanagement—and are therefore available for a lower-than-average purchase price. The reasons an investment might fall into the distressed opportunistic category are pretty diverse, but the most common situation is financial distress, meaning the owner is very behind on debt payments. Sponsors leading an opportunistic deal with a financially distressed asset can either buy the subject property outright or purchase the debt that is secured by the financially distressed seller. Assets in distress are a specific subset of the opportunistic risk profile. Not all opportunistic projects start with a distressed asset, but all commercial real estate investments with a distressed asset fall into the opportunistic bucket. This puts distressed opportunistic investments at the top of the risk-reward structure: there’s potential for significant gains, but these assets usually have the most complex issues to resolve.
Things to know about distressed opportunistic investments
- Discounted purchase price: Whether the sponsor is buying the actual property or the debt, distressed assets trade below the market value of a comparable stabilized asset.
- Appreciation: Since the initial purchase price is discounted, the potential for appreciation is high. This provides investors with the possibility of a strong return even though cash flow can be low to nonexistent in the early stages.
- Due diligence: Distressed assets often need lots of work to attract the end-user, and sellers typically award distressed deals to buyers who can close quickly. Sponsors must act fast, often with shortened purchasing processes, meaning there could be less time to evaluate the merits of a project.
- Business plan: Stabilizing a distressed asset (meaning making it profitable) requires a strong business plan. Unaddressed issues, such as deferred maintenance and disgruntled tenants unwilling to occupy a distressed project, can impact the timeline for a project as well as the final cost.
- Legal costs: Purchasing debt to acquire a property through a foreclosure can come with borrower bankruptcy risk or substantial legal costs.
The number of unknowns and assumptions in distressed opportunistic projects makes for a very wide range of possible outcomes. The best-case scenario is very attractive, potentially earning large returns, while the worst-case could involve a significant loss of capital. The risks are often tied to the complexity of the proposed business plan. However, good execution and good market conditions can lead to favorable risk-adjusted returns through forced appreciation.
What to look for when considering a distressed opportunistic investment
Sponsor expertise and their ability to create and execute a business plan are critical to the success of a distressed project. With so many risks, you want to work with someone who knows what you expect and can navigate the potential pitfalls. Closely vetting the sponsor’s track record can help you assess the sponsor’s ability to pull off their plan. Have they done similar distressed opportunistic deals before? How did the outcomes of past opportunistic projects compare to their original plan? Are they experienced in the same asset class and geomarket of the proposed project? Of course, each deal is different, and all kinds of factors can impact a project’s outcome. But picking a project led by a sponsor who’s already shown they can handle the complexities of a distressed opportunistic deal can increase your chances of success.
Why we think now is a good time for distressed opportunistic investments
The COVID-19 pandemic has created a dynamic of over and underperformers in commercial real estate. This has resulted in a K-shaped recovery, creating opportunities for development projects such as build-to-rent homes as renters leave urban cores for more space, but it has also contributed to an increase in distress sales. Many of these distressed assets were performing well before the pandemic, especially those in hospitality, meaning there’s now an opportunity to buy/invest into these properties below their normal value, recapitalize the project, and be in a great position when the industry eventually recovers. This dynamic is unique to the moment, but we anticipate that many opportunities in this commercial real estate category will continue to emerge over the next couple of years, creating new short- and long-term investment opportunities with the potential for great returns.