The COVID Proposition

Without a doubt, the COVID Pandemic has upended many property owners as many tenants have ceased or deferred rental payments due to stoppages of operations during lockdowns. While governments around the world have provided stimulus packages to support businesses, landlords are expected to remain under severe strain even after lockdowns ease and people begin to return to work. Crowds are unlikely to return to malls or travellers to hotels until the COVID-19 pandemic is somewhat controlled. Residential landlords in some countries are facing rent strikes due to heightened unemployment. Demand for office space could tumble if workers continue to work from home.

This unprecedented economic slowdown will inevitably create market dislocations. With declines in rental rates, occupancy levels, other deteriorating property fundamentals and increases in capitalisation rates, property values will inevitably fall. Asset owners who are unable to withstand the economic fallouts will be under extreme pressure to divest their assets at discounted prices.  Distressed assets may look like a fantastic opportunity for investors with cash reserves; however, there are also considerable risks and legal intricacies which an investor should be aware of. Those who are able to mitigate the risks will be richly rewarded. This article examines the value propositions and risks involved in distressed real estate investing.

What is Distressed Real Estate?

It is important to understand what is considered distressed real estate. The term “distressed” has been used loosely to make an acquisition case. Generally, a distressed property has the following characteristics or a combination of these characteristics:

  • Properties with Non-Performing Loan (“NPL”) - These are assets that are not able to meet outstanding loan payments and have been foreclosed by the mortgage lender or bank.  The banks have taken control of these properties and are seeking to dispose them, usually at a discount to the prevailing value, to recover the principal loan sum.
  • Decaying or sub-performing properties - This could be a property in need of substantial capital expenditure to upgrade or to reduce obsolescence. Certain assets could also be poorly managed with high level of vacancies causing capital values to be depressed.
  • Incomplete Development Projects - These projects are at various stages of construction due to the lack of cashflow or failure to meet hurdles to secure construction financing.
  • Property owners seeking quick exit - These are distressed sellers who are in financial difficulties and are seeking to dispose their assets quickly to meet urgent financial commitments.
  • Sale of tightly held assets – these are usually prime assets that are very seldom traded and becomes available for sale only in times of financial distress.

Sniffing out the Value

In distressed real estate investing, it is critical to identify the value in the investment and how the value can be created or harnessed. Distressed assets which are in derelict conditions or in certain stages of construction present a straight forward value creation strategy. Such distressed assets are usually listed at comparatively lower prices due to the additional capital and work involved. However, these assets are not easy to deal with and require a lot of time and effort to turnaround. Therefore, having a solid asset enhancement strategy is vital. This includes knowing what and how to upgrade the asset that will meet future demand, correct estimation of the construction/upgrading cost, engaging good and reliable project consultants/builders and forming a realistic timeframe to get the job done.

For assets that are in decent condition and offered at seemingly below prevailing market value, it is important to identify the genuine reason for the “discount” offered. Do not assume one is getting a bargain just based on the price offered. There could be latent issues regarding the property, the surrounding neighbourhood, government regulations (e.g. compulsory acquisition) that could materially affect the value in future. Thus, it is critical to carry out a comprehensive due diligence covering legal, technical, environmental, regulatory and financial aspects.

If it is obvious that the property owner is in financial distress and seeking a quick disposal, the key consideration is to ascertain the right price to go into. Buying at a discounted price today might not be the right price in a couple of months. Therefore, an investor has to be cognisant of the market conditions - the demand and supply dynamics, the price cycles, rental trends, etc, to make a calculated decision that future price of the asset will eventually surpass his acquisition price within the envisioned timeframe.

Beware of the Risk Involved

Distressed assets are laden with risks and investors should be aware of them and seek viable mitigants. For sub-performing assets that require additional capital expenditures for renovations or upgrades, the risks of cost over-runs and project delays are real. This is particularly so for assets that have been neglected for some time or construction halted projects. We have to ensure sufficient contingencies are being built into the financial projections, both in timing and cost.

Secondly distressed assets that involves banks or several creditors may have legal implications that could derail the investment. The asset could have been pledged to creditors that were undisclosed to the purchaser. Therefore, an investor should ensure that a thorough legal due diligence is being conducted to find out if any liens, charges, encumbrances or securities have been imposed on the property.  In certain cases, there is a need to re-negotiate terms or restructure the deal with the various stakeholders to achieve a positive outcome.

It is also imperative for the investor to underwrite a distressed asset conservatively. This includes taking on lower leverage, moderating growth assumptions and exit cap rates. Having a prudent capital structure (i.e. a moderate loan-to-value ratio) would help mitigate against adverse market conditions where occupancy levels or rental rates do not perform as anticipated. You would not want your investment to turn into another distressed case.

Where are the Opportunities

The hospitality and retail sector, which are undergoing structural issues are going to have an especially difficult time weathering this storm and are likely to present distressed opportunities. The US hotel industry is bracing for more foreclosures or bankruptcies as owners increasingly fail to repay maturing loans. Hotel occupancy rates dipped to 39% in March, a 42% decline compared to the same period last year. An Oxford Economics study predicted 2.8 to 3.4 million jobs in the hotel industry will be lost, compared to the 400,000 lost from the recession in 2001 and 9/11 and the 470,000 lost in the recession of 2007 to 2009.  Therefore, hotel owners who are holding on to these mortgages will be under pressure to reduce their debts through asset disposal.

The retail sector has been undergoing structural changes even before the pandemic as shoppers change their spending habits with the growth of e-commerce. Apart from demand changes, the sector in general is also facing an oversupply situation in certain countries. Over the past 50 years, the number of American malls grew almost twice as fast as the population, to the point that in 2015, the US had 10 times more shopping space per capita than Germany. Over-leveraged, overbuilt, and over-sprawled, American retailers had a long way to fall as the country moved towards online shopping. In 2017, and again in 2019, physical-store closures reached an all-time high according to a WSJ article. The COVID-19 pandemic will certainly exacerbate this structural overhaul with further decline in consumer spending. Therefore, many retail properties are just not going to come back as successful retail assets. While some property prices have been reduced to mere land value, many are well below replacement cost and are in good locations for exploring conversion to alternative usage.

The Bottomline

A growing number of property investors are preparing for what they believe could be a once-in-a generation opportunity to buy distressed real-estate assets at bargain prices. Large real estate firms such as KKR, Blackstone, and Terra Capital Partners have closed or are raising funds in the billions of dollars from wealthy families, sovereign-wealth funds and others aiming to channel the funds into distressed real estate. (source https://www.wsj.com/articles/cash-pours-into-distressed-real-estate-funds-as-investors-aim-to-play-offense-11587470400)

At RealVantage, we are well positioned to take advantage of this opportunity since its principals are well experienced investing in downcycles. We believe the current economic volatility will present distressed assets but this will likely manifest in the next 6 to 12 months when real estate values start to decline.

For more real estate insights:

RealVantage’s COVID-19 Viewpoints and Strategies
Blockchain in Real Estate Investment: Hope or Hype?
Deal Sourcing with AI
How Machine Learning Can Help Looking After Your Property
Australian Residential Market Correction Nearing an End
Macro Overview of Brisbane
The Real Estate Risk/Reward Spectrum & Investment Strategies
Knowing Your Capital Stack
Understanding IRR, Cash Yield, and Equity Multiple
What is Cap Rate?
What is Sources and Uses of Funds?


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