Financing Focus

Distressed Decisions

Can you spot a diamond in the rough?

With the real estate collapse several years behind us, the industry has been riding a wave of available distressed commercial properties. But this groundswell of opportunity also brings a groundswell of risk. Knowing what to look for can ensure that a bargain doesn’t become a burden.

While some analysts believe we may have hit the peak, there are still good deals to be had for savvy investors. Many lenders are still dealing with troubled loans, and while some of them will be worked out with the borrowers, others will make their way to the market.

The key is to understand the intricacies involved in purchasing a distressed property and do a proper investigation so you — or your clients — don’t end up losing money.

Complete Due Diligence

What makes a distressed property attractive is also what makes it a risky opportunity. A property priced below market value means it has issues — delinquent taxes, possible liens, potential tenant issues, and more. You need to identify all the property’s warts before investing. Often the lender may not know or care to know those details, but the buyer doesn’t have that luxury.

When a property is distressed financially, there’s a good chance that the previous owner has allowed it to fall into disrepair physically. A thorough inspection from the foundation to the roof is imperative in order to understand the actual cost to improve the facility.

If you’re not familiar with the area, get on the ground and learn the market. Looking at pictures and numbers won’t give you an accurate understanding of what’s going on in the surrounding neighborhood. Identify the demographics and the socioeconomic makeup of the property’s community. Some investors miss out on opportunities to purchase distressed properties in smaller markets because they view them as having less value. But this often is the home of the hidden gem.

Additionally, find out if the area needs office, retail, or housing. If it is suffering from an overcapacity of active medical offices, strip malls, or industrial parks, then adding similar space with a depressed market value is going to be an uphill battle.

Use Local Expertise

Real estate always has been a local product in a local market. Many times out-of-town investors zealously jump into deals with great expectations but shortchange their reconnaissance of the local market. The result is they overpay for a property, then they have to backtrack and bring in a local service provider to make the property profitable or help develop an exit strategy.

To avoid this trap, identify professional, experienced local service providers upfront. They can help you avoid overpaying as well as identify potential complications, including financial and structural problems — things you’re never going to see in a picture or on a spreadsheet. Local market experts can work to preserve and protect your investment while creating value and cash flow.

Here are three ways to qualify your provider:

• Check for professional accreditations, such as the CCIM designation.

• Ask the tough questions. Determine the firm’s experience in that particular market, ask about their recent successes and failures, find out how they measure results, and look for proof that they pay attention to details.

• Talk to enough providers to understand the market and average costs for services to avoid overpaying.

Determine the Price

There’s as much art as science to determining the appropriate price for a distressed property, especially when there are no recent comparable sales. A conventional model for pricing distressed properties does not exist. It is important that you clearly understand your costs to bring the property back into service and factor that into your calculations when deciding what you are willing to pay. Keep in mind your end goal is to charge the rent you ultimately need to be profitable. If the seller is motivated to get out, you might be able to pay even less for the property.

In one case where Broder & Sachse recently stepped in, the lender got into a protracted fight with the borrower over a 25-unit overleveraged property in a solid apartment market. The property deteriorated and Broder & Sachse became the receiver. Even though we stabilized the property, the lender wasn’t willing to spend the necessary capital for improvements in order to lease the units. Eventually, a local buyer bought the property for pennies on the dollar and immediately began renovating it. The property now is at full occupancy.

That’s what can happen when a buyer and lender don’t do their homework on the property. The borrower paid too much and the lender lent too much. The next buyer knew what he was getting — good bones in a good location at a bargain price. He knew exactly what he could do with the property and what it would cost to make it profitable.

Dealing with troubled or challenged properties is not for the faint of heart or passive investors. Inexperienced investors can often overpay, and in the end, get hurt when they can’t manage the investment. Distressed properties can provide opportunities for new players to enter a market in substantial ways, but the more you know about the property, the better. If you don’t have experience in the arena, be sure to talk to someone who does.

Richard Broder, CPM, is CEO of Broder & Sachse Real Estate Services, a full-service company in Birmingham, Mich. Contact him at rbroder@brodersachse.com.

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