Can’t Be Too Careful: Purchasing Distressed Real Estate Requires Considerable Experience and Thorough Due Diligence

Date: 04/08/2013

Loan delinquencies are on the decline, but there are still ample opportunities for investors to purchase distressed commercial properties. Before forking over money for those troubled assets, however, investors should make sure they have suitable real estate experience.

Those were some of the observations and tips provided by a panel of experts in distressed real estate on a recent episode of my “Commercial Real Estate Show” radio program. The show provided an enlightening look at the issues surrounding the acquisition of troubled commercial properties. Topics included CMBS delinquency rates, selling notes and due diligence.

Delinquencies Dropping

The delinquency rate for U.S. commercial real estate loans in commercial mortgage-backed securities (CMBS) fell to 9.42 percent in February, its lowest level in a year, according to Tom Fink, a senior vice president with the analytics firm Trepp LLC. “It’s come down significantly, and we expect to see that number continue to decline,” he added.

Investors who acquire those commercial properties still experiencing distress should have plenty of real estate experience, Fink cautioned.

“If you’re looking at a distressed property, you’re looking at something that from a real estate point of view is broken, and so you have to be able to say, ‘I will address the real estate issues relating to this property,’” Fink said. “I would not try and do it on your own if you don’t understand real estate.”

When asked to identify a specific sector that represents a good opportunity for investors, Fink pinpointed the industrial segment. Noting that loan default rates are still relatively high in the sector, he added, “If you can get your hands on a good, well-located industrial property that’s got high ceilings and the ability to bring in big trailers, I think you’ve got something that’s going to be profitable, particularly if you’re near a knowledge center like Denver, Houston or Pittsburgh.”

Careful Planning

Ann Hambly, CEO of 1st Service Solutions, noted that an owner of a distressed CMBS-financed property can simultaneously list its troubled asset for sale while negotiating a discounted pay-off with the servicer. However, in these instances, the servicer “is not agreeing to just accept whatever the [sales] price is [as the pay off],” she added. “So these are two parallel paths that have to be obviously very, very coordinated.”

Lenders selling distressed properties typically want to sell the assets as is and make no reps and warranties, noted Duncan Miller, a partner with Morris, Manning & Martin. However, thorough due diligence on the part of a prospective buyer can make some lenders consider otherwise.

“Knowledge is everything, so if you go to the lenders and ask them to make specific representations and warranties and give them specific reasons why you need [them], then they’ll listen because it’s a good request,” Miller said.

Too often, potential buyers simply look at the differences between the loan values and the asking prices of distressed assets before concluding they’re getting good deals, according to Duncan. “If the loan was originally $5 million, and they’re picking it up for $2.5 million, they say, ‘What can go wrong?’” Duncan said. “From my perspective, that isn’t the right way to look at it… Buy it like you’re buying regular commercial real estate, and do all the due diligence you can.”

Investors looking to buy a troubled note should also carefully weigh the pros and cons, Duncan advised. “It’s a negative because you have foreclosure risk, you have lender liability risk,” he said. “It’s a positive because you have different options in dealing with the asset … Knowing your plan, what you envision happening, will dictate your underwriting.”