Distressed Property Acquisitions

Five tips for prospective buyers.

Although disarray in the lending markets has inhibited commercial property acquisition nationally, opportunities to acquire distressed properties, especially in the multifamily sector, abound. However, before hurrying into a deal, prospective buyers should take protective measures to guard against the inherent pitfalls of purchasing distressed properties. Below are five steps buyers should consider before purchasing distressed properties.

1. Move Quickly but Carefully. An expedited deal timeline decreases the likelihood of complications arising from the current property owner’s neglect. For example, apartment properties that generate negative cash flow are likely to worsen with time, making rehabilitation all the more challenging. Continued property neglect can drive away existing tenants and repel potential lenders requiring minimum occupancy and cash flow levels. Moreover, an existing owner’s continued deferred maintenance could saddle a buyer with extensive property repairs.

2. Contact the Lender. The existing property owner’s lender is an essential party in distressed property acquisition. Lenders are not in the business of operating properties and may be willing to negotiate a pay-off, payable out of the purchase price, which is less than the outstanding debt to prevent a real estate-owned situation.

While negotiating the sale agreement with a troubled seller, it’s reasonable to ask that the lender not seek a court order to have a receiver substituted for the seller. Such assurances help guard against a situation in which a receiver determines critical deal points and timing.  

3. Consider Alternative Options. While many property owners own and manage properties through wholly owned subsidiaries, the changing economic climate necessitates considering alternate ownership arrangements. Since financing remains difficult and expensive to obtain, a joint venture with another interested purchaser can be a sensible solution. For example, a multifamily management client recently created a joint venture that acquired control of a distressed apartment complex portfolio. The joint-venture party was the defaulted owner’s mezzanine lender, who had converted its mezzanine loans on the portfolio into an equity interest in the borrower entities. The mezzanine lender sought the management and operations expertise of a seasoned multifamily professional.  

Since borrower failures often result in REOs, it’s natural for lenders to look for management and operations specialists to handle property operations and –- potentially –- share in the ownership. Alternatively, those reluctant to buy properties under the belief that the price is too high might consider buying the distressed debt itself to get an interest in a particular asset. Buying senior debt is an attractive option in situations where the property is burdened by junior liens that can be wiped out in a foreclosure proceeding.      

4. Be Thorough. The sale agreement should obligate the seller to deliver the title free of all liens. Often, distressed property owners’ failure to pay contractors and suppliers results in mechanics liens on their properties. When inspecting a distressed apartment complex during the contractual due diligence period, prospective buyers should identify all deferred maintenance and needed repairs.

If a significant amount of rehabilitation is needed, the prospective buyer should try to re-negotiate the purchase price and consider terminating the deal if the seller refuses a price reduction. Also, buyers should contact contractors prior to closing to ensure the adequacy of repair budgets.  

5. Protect Post-Closing Rights. Buyers should ensure that distressed sellers can pay damages for any breach of representations and warranties discovered post-closing. If a strapped seller is unable to hold back a portion of the sale proceeds or unwilling to covenant to remain in existence and maintain a certain net worth for the duration of its representations and warranties survival period, the buyer should consider asking for a guaranty from the seller’s healthy parent company or related entity as an alternative.

Overall, the steps taken in acquiring distressed properties or debt are fact-dependent and vary from deal to deal. Prospective buyers should not only look to their brokers, but seek guidance from attorneys, accountants, and engineers to maximize their success.

Andrew Maguire

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