Profiting from Distressed Properties
Market Analysis and Tenanting Strategies Help Turn Around an Industrial Investment.
Editor's note: Turning around a distressed property can be a lucrative, albeit risky, investment for commercial real estate professionals. This case study examines how one CCIM used in-depth market analysis and skilled asset management to turn a struggling industrial property into a high-performing investment in Austin, Texas.
In 1993, Austin's commercial real estate market was in full recovery from the economic dip of the late 1980s. The region's high-technology industry flourished, attracting new companies to the area. Absorption rates quickly accelerated, and demand for industrial space was high.
Significant multitenant flex and industrial construction already was underway, and more was planned. However, most new construction was delivering space of 10,000 square feet or more, with the smallest averaging 5,000 sf. A need for smaller space existed, but it wasn't being built.
As a fledgling broker, I was approached by a local savings and loan to list a lackluster, class C, 18,000-square-foot industrial property. I recently had leased up another multitenant industrial property south of Austin, and I was confident about the market for this product type.
Assessing the Property
The property was zoned light industrial -- a highly sought-after zoning code in Austin. It was located one mile from Motorola's major facility and five minutes from downtown. Close to a major highway, it had excellent access to existing and proposed airports.
However, I was less enthusiastic after my first inspection of the property. Two 9,000-sf buildings were each split into six 1,500-sf bays. The buildings were mostly metal with some tilt-wall construction.
The tenants caused even more dismay. Building 1, which was closest to the property's street entrance, had the most problems. After the bank foreclosed on the property, it aggressively leased space to any tenant that could meet the minimum qualifications. Consequently, quasi-professional auto mechanics occupied all of building 1. These tenants created a number of problems: Immobilized cars filled the parking lot, and car parts and junk were stacked 9 feet high on the loading dock between buildings. Graffiti frequently covered the building's back wall.
Building 2 was in much better shape -- its main problem was the spillover parking from building 1. The remaining fairly healthy tenant mix included the city of Austin's rodent control division, a contractor, and a University of Texas private-dormitory storage.
The bank was under pressure and anxious to sell, listing the property close to its $350,000 appraised value and offering favorable financing with an 8 percent interest rate on a 15 percent down payment, including a $5,000 selling bonus. The bank planned to renew expired leases at the previous terms of 25 cents per square foot gross per month.
Analyzing the Market
I thoroughly analyzed the local market with hopes of getting the listing. First, I studied market comparables between 10,000 sf and 50,000 sf within the city's south core area, eliminating all single-tenant projects and those with minimum tenant sizes larger than 5,000 sf. A surprising picture emerged: All small-tenant projects in the market were above 95 percent occupancy, 5 points to 8 points higher than their larger counterparts. The comparables within the specific market area were 100 percent occupied.
This data coupled with the property's close proximity to airports and highways made its location arguably stronger than any of the comparable properties.
With growing demand and increasing rental rates for all industrial types, many tenants had relocated to smaller, less-attractive spaces. As Austin's economy expanded, start-up businesses flourished and cheap space became hard to find. Comparable space was priced from 27 cents psf to 30 cents psf triple net -- essentially a 10 percent to 15 percent premium over larger space.
The market data and numbers told the story: This property offered an opportunity that was too good to pass up. Working with my company and other partners, I established the CTX Industrial Partnership No. 1 to purchase, manage, and, we hoped, receive high returns on the property.
The Asset Management Plan
The syndication negotiated a five-year balloon mortgage with staggered interest rates of 6 percent to 9 percent and 25-year amortization. The expired leases were renewed at 25 cents psf triple net per month, with annual increases of 5 cents psf per month on multiyear leases. CTX requested one-year lease terms for the auto mechanic tenants, with the exception of mechanic B and the contractor, who we suggested vacate immediately. CTX's attorney also drafted lease modifications allowing the owners to assign parking and to pass through taxes, insurance, and common area maintenance charges.
After assessing its options, CTX decided to focus on stabilizing building 2 during the first year and building 1 the next year. However, our strategy proved akin to the best-laid plans of mice and men.
The dormitory agreed to a three-year triple-net lease with 5-cent psf per month annual increases, knowing that our price was the best in town on a per-cubic-foot basis. During our feasibility study another contractor approached the bank and leased 1,500 sf vacated through eviction. The rodent control division would not renegotiate for a longer term or a triple-net lease due to the parking lot problems.
Immediately after closing the deal, CTX advised tenants that all parking, common areas, and driveways were to be vacated the following month for parking lot maintenance. We then repaired, resurfaced, and striped the lot. During the first 90 days, we implemented policies for designated tenant parking and inoperable vehicles. The rodent control tenant was pleased with our improvements and voiced interest in renewing its lease under the new terms and conditions.
Unfortunately, nothing went as planned. Mechanics continued to park wherever they chose; all but one mechanic succumbed to erratic rent payment; the original mechanic in bays 4 and 5 illegally subleased space to another mechanic; and the recurring graffiti made leasing bay 2 impossible.
Two events occurred shortly thereafter that turned the tide for CTX's investment. First, during a Federal Bureau of Investigation and Drug Enforcement Agency raid, the illegal sublessee in bays 4 and 5 was arrested and immediately defaulted. Second, the rodent control tenant reneged on its verbal agreement to renew its lease and gave notice of its intention to vacate. Losing the only credit tenant was a challenging blow, but it made CTX realize that we had no choice but to evict the offending tenants.
The partnership quickly resumed control of the property, creating a budget for landscaping, repair, rehabilitation, and eviction costs. It aggressively monitored the parking lot and towed violators. And it filed legal eviction notices against each of the mechanics, which forced them to quickly seek new space.
Upon gaining control of building 1, CTX began a six-week cleanup and rehabilitation. We repainted vacant units, demolished illegal tenant “improvements,” and planted vines in back of the property to prevent graffiti.
Once the auto mechanic tenants were evicted, the property turned around rapidly. The contractor in bay 10 decided to also lease bay 9, which previously belonged to the rodent control. During the first week of renovation a regional carpet wholesaler leased bays 7 and 8. While proceeding to evict tenants in bays 1, 2, 4, and 6, CTX completed repairs and leased bay 3 during the first week of construction. Bays 1, 4, and 5 became vacant the second week and were leased by the third week. To speed up the process, CTX hired additional contractors to cut construction time to four weeks.
Within 30 days, the property stabilized at 100 percent occupancy. During CTX's five-year ownership, the property generated the following returns:
- year one, 27.82 percent;
- year two, 2.82 percent;
- year three, 48.95 percent;
- year four, 44.80 percent; and
- year five, 43.15 percent.
CTX evicted the tenants and rehabbed the property during year two, which affected the property's performance. However, prior to year five the property sold for 35 percent above the original purchase price. In addition, CTX generated a 37.8 percent annualized internal rate of return during its ownership of the property.
When investing in distressed properties, it's important to approach your analysis with as few preconceptions as possible. Being a relatively new broker at the project's inception, I approached the property with an open mind. As a result, I was able to discern the market trends that were so critical to the eventual success of the property.