Distressed assets

Dealing With Distress

CCIMs transform liabilities into profitable investments.

By Matt Hudgins |

Daniel Latshaw, CCIM, played an artful balancing act in marketing a failed mixed-use development last summer in midtown Atlanta. A partner at Bull Realty, Latshaw represented the property owner, who had defaulted on loans for the 2.5-acre site covering most of a city block at 131 Ponce de Leon Ave. Rather than foreclose, however, lenders United Bank and Synovus Bank agreed to hold off while Latshaw collected offers and conducted a short sale.

The arrangement enabled Latshaw to attract potential buyers eager for a bargain on a distressed asset, but showed that the seller had enough breathing room from lenders to hold out for a fair price. “Because the banks hung in there with us, we were able to retail it,” Latshaw says. “There wasn’t a foreclosure so there wasn’t a sense of as much blood in the water.”

The sale drew 10 competitive bids and sold for $6.5 million to Sereo Group and Faison Enterprises. The joint venture has since submitted plans to redevelop the site into 321 luxury apartments and 8,600 square feet of retail space. Latshaw credits the lenders’ willingness to forego a note sale or foreclosure with enabling him to secure a higher selling price. “We were able to get a significantly higher (recovery) amount than what the banks’ internal valuation was for the property,” Latshaw says.

The Big Picture

Across the nation, CCIMs like Latshaw have tested and refined strategies for buying, selling, or repositioning distressed real estate. And with economic recovery gaining traction in secondary and even tertiary markets, there is a growing consensus that investors who acquire and rejuvenate the right assets today will be able to market those properties to tenants in a climate of accelerating demand and strengthening fundamentals.

Indeed, the window of opportunity for distressed-asset investors is already beginning to close as the volume of property loans in default or referred to special servicing declines. Roughly $5.8 billion in loans fell into default or were transferred to special servicers in the third quarter of 2012 — half the volume of the prior quarter — while lenders and special servicers worked out $10.9 billion in troubled debt, according to Real Capital Analytics, which tracks distressed properties valued at $2.5 million or more nationwide. Of $387 billion in properties to enter distress since the crisis began, 57 percent have been resolved, the company found.

“The pool of assets in distress is falling rather quickly,” says Dan Fasulo, RCA managing director. “It’s a result of surging property transactions in the fourth quarter, and the desire of banks to finally take care of some of these loans, either liquidating them or taking back the assets. We’re moving into the later innings of the distress cycle.”

Resolutions to distress situations in 2012 were concentrated in the top secondary markets including Seattle, Denver, South Florida, Phoenix, Texas, and Las Vegas, Fasulo says. Las Vegas continues to hold the top spot for the most distressed commercial real estate as a percentage of local market inventory, followed by Detroit at a close second. Pittsburgh, Phoenix, Palm Beach, and Miami round out the top six distressed markets, RCA found. And in those secondary markets, CCIMs are leading the charge to capitalize on distress opportunities.

Deals and Steals

A cardinal rule for distress investors is to choose locations carefully, says Tom Dermody, CCIM, owner of Tom Dermody LLC in Colorado Springs, Colo.“You can never fix the location, but if you have a good location, then you have something to work with,” he says. “Then there needs to be enough vacancy for me to create some upside as an investor.” Dermody’s third rule is to avoid buying properties with problems beyond his ability to fix.

Last July, Dermody used those criteria to buy Parker Plaza, a 34,000-sf shopping center in the affluent Denver suburb of Parker, Colo. Due in part to a low occupancy rate of 64 percent, Dermody paid a little more than $2 million, or $59 psf, in a seller-carry transaction in which the seller provided an undisclosed amount of financing. The purchase price equates to about 40 percent of replacement cost, Dermody estimates.

Less than a year later, Dermody has given the property a facelift, inked four new leases, and renewed other leases to bring occupancy to 82 percent. In the process, he has converted the entire center to triple-net leases, in which tenants assume responsibility for their own maintenance and operating expense, thereby boosting the owner’s cash flow.

Despite the shift to higher rental rates and the expense of a new roof, parking lot, and landscaping, Dermody’s low acquisition cost has enabled him to offer rents below those at nearby properties. “That puts me at a pretty good competitive advantage,” he says.

Like Latshaw in Atlanta, Dermody was able to build upon recovering fundamentals in a resilient secondary market. Yet savvy investment managers are also discovering opportunities in smaller communities.

Neyer Properties is a development company in Cincinnati, Ohio, that is buying up properties for redevelopment. The company avoids larger markets where it would be competing with institutional investors for acquisitions, says Chris Dobrozsi, CCIM, who is vice president of real estate development at the firm. Neyer prefers to work in smaller markets, where competitive bidding hasn’t driven up prices and reduced available returns, he says.

Neyer made one of its most recent acquisitions, the 250,000-sf Centennial I and II office buildings in Cincinnati, through Auction.com, an online venue that requires top bidders to close within 30 days. As a developer with a reputation for closing acquisitions quickly, Neyer hears regularly from brokers listing banks’ real estate-owned properties for sale, Dobrozsi says.

In choosing which assets to pursue, the company looks for semi-vacant properties with enough in-place leasing to cover debt and operating costs. That means that any additional leasing or rate increases the company can put into place will boost cash flow. “That’s the value-add for us,” Dobrozsi says.

In November, Jeremy Malensky, CCIM, president of Dutchman Realty in O’Fallon, Mo., helped his client FS Investments complete a 30-day due diligence and closing to purchase the 36,500-sf 4 Seasons Center in that market for approximately $1.3 million. To help the buyer meet its objectives for the shopping center before the onset of winter weather, the seller, Reliance Bank, allowed painting and exterior renovations to begin while the asset was still under contract. The speedy turnaround paid off; within 60 days of the purchase date, Malensky’s team had negotiated 14,000 sf in additional leases to bring occupancy up to 75 percent, doubling the property’s cash flow and meeting the buyer’s 12-month leasing goal.

“I like to get in there very quickly,” says Malensky, who has repositioned several distressed properties in the region. “I always go in and give them unique curb appeal, and I also want to be the most competitive lease rate in that market area,” he says. “If you’re the best price and you look the best, it’s hard to lose a tenant.”

U.S. Cumulative Distress, January 2013

Distress Strategies

The appeal of distressed assets typically revolves around the opportunity to reset the basis, or owner’s cost position. A basis reset enables brokers like Ronnie L. Miranda, CCIM, SIOR, to help clients acquire and improve properties that the previous owners were unable to cost-effectively maintain or repair, due to the distressed owners’ greater cost in the asset. “It’s not always about fixing something physical,” says Miranda, who is a senior vice president for asset management at Thompson National Properties in Houston. “It’s also about lease rates — Can I sell a gallon of milk for $1 instead of $3.”

Miranda recently helped a publicly registered, non-traded real estate investment trust to acquire Constitution Trail, a 198,000-sf, grocery-anchored shopping center in Normal, Ill., that originally opened at the beginning of the recession. When rents in the area declined, the property’s cash flow couldn’t support its debt.

The previous owner had $60 million invested in the asset, but defaulted on the property’s $42.2 million loan. Miranda’s client purchased the note for the amount of the remaining balance, $19 million, and obtained a deed in lieu of foreclosure to take possession of the property. At $19 million, the new owner’s basis was 68 percent below the previous owner’s. “This reset in basis allowed us to meet the market and begin driving new leasing activity, improving net operating income and by derivation, asset value,” Miranda says. “Instead of renting space out for $28 psf triple net, we’ll rent at $12 psf triple net and escalate from there to achieve our investment objectives. It’s a very compelling strategy.”

Another skill set with lucrative potential for CCIMs is to work with the court as a receiver, managing properties while borrowers and lenders work out their differences and perhaps marketing notes for sale as part of lender workouts. Mark B. Weiss, CCIM, president of Mark B. Weiss Real Estate in Chicago, has served as a court-appointed receiver and sales broker off and on since he started his firm in 1988.

As in acquisitions, the ability to analyze proposals quickly is an asset in bank workouts, Weiss has found. The financial resources of a borrower who has fallen into default will typically deteriorate with time, so lenders who negotiate a deal early in the process stand to recover more on the debt than those that hold out for a larger amount, he explains. “The smart strategy is to absorb some of the loss, and the first loss is often the best loss,” Weiss says.

With their analytical skills and local market knowledge, CCIMs are in a good position to leverage distressed assets into profitable deals. “There are opportunities out there,” Malensky says. “You just have to be at the right spot at the right time, and know how to analyze the profitability of a project quickly.”

Matt Hudgins is a business writer based in Austin, Texas.

Brokers Provide Boots on the Ground for REO Sellers

Some real estate professionals are turning their CCIM analysis training to good use by helping lenders evaluate and dispose of real estate owned, or REO.

In the San Diego office of Newmark Grubb Knight Frank, Bob Teglia, CCIM, associate director, and his partner Brent Bohlken, a senior managing director, have completed 25 REO sales for 20 different lenders over the past year-and-a-half. Teglia says lenders are often out of state and rely on his local market knowledge and firsthand assessment of the physical condition of the property to maximize sale proceeds.

As a lender’s representative, Teglia has done everything from securing a property and coordinating cleanup to walking the roof and checking for structural damage, all of which helps him better assess acquisition offers. “We really incorporate those property management type services into our brokerage relationship,” he says. “A lot of the lenders are really struggling through a massive volume of deals, and they need boots on the ground.”

Teglia has found that selling to business owners who plan to occupy the space often maximizes value for his lender clients. “When business owners can acquire their own real estate, they capture both the investment value and the value in use for their business.”

Frank Szelest, CCIM, is general manager and commercial manager of the Re/Max Realty Group in Fort Myers, Fla., and estimates that he has sold more than $500 million in REO over his lifetime. He says lenders and their real estate representatives have several advantages in selling REO today, including historically low interest rates that enable investors to pay higher prices. In the 1990s, he recalls, interest rates were 20 percent or more and limited sellers’ ability to command higher prices.

Based on his experience in previous cycles, Szelest believes Florida will take another six to 12 months to work through the majority of its commercial REO before pricing increases to a point that will make development cost-effective again. “In the second half of this year, I’m looking forward to getting closer to that equilibrium so that commercial builders can start new construction again,” he says. “There will be pent-up demand for commercial real estate, too, because no one has built anything for a few years.”