Investing in Distressed Assets? Prioritize Due Diligence

The commercial real estate market is witnessing a significant uptick in distressed assets, presenting both challenges and opportunities for industry professionals. Recent distressed data from CRED iQ’s evaluating payment statuses and special servicing status for CMBS-financed loans, revealed a record-breaking 9.1% overall distress rate as of August 2024.

Furthermore, the data reveals that distress is unevenly distributed across CRE sectors

Office properties top the list at 13% distress
Multifamily saw a steep rise from 2.6% to 11% since January
Industrial assets climbed from 0.8% to 4.6% in one month

These statistics reflect a market undergoing significant transformation, with implications for investors, lenders, and property owners alike.

Several key factors driving this surge in distressed assets include:

Evolving work and living patterns post-pandemic
Interest rate fluctuations affecting financing structures
Shifts in consumer behavior impacting property sectors
Regulatory changes exerting pressure on property owners

However, it’s crucial to note that not all distressed assets are equal. The ability to differentiate between temporarily stressed properties and those with fundamental issues often determines investment success.

Whether you’re an experienced investor seeking to optimize your portfolio or a property owner navigating market uncertainties, success in the distressed asset arena hinges on one critical factor: due diligence. The ability to thoroughly assess a property’s potential risks and hidden value can make the difference between a costly mistake and a lucrative investment.

But what does effective due diligence look like for distressed properties? Keep reading to find out.

What is a Distressed Asset?

Before we delve into the intricacies of due diligence, it’s essential to establish a clear understanding of what a distressed asset is.

In commercial real estate, a distressed asset is a property facing significant challenges that threaten its financial viability and market value. These assets often present unique opportunities for investors who can navigate their complexities, but they also carry substantial risks.

Types of Distress Include:

To better understand the landscape, it’s important to consider the various types of distress:

Financial Distress: Properties struggling with debt service, cash flow problems, or impending loan defaults. For instance, the $247.2 million Stamford Plaza Portfolio loan failed to pay off at its August maturity date, with two of the three loan pieces changing status from current to nonperforming matured balloon. The property’s Debt Service Coverage Ratio has been below 1.0x from 2018 through 2023, indicating ongoing cash flow issues.
Physical Distress: Buildings suffering from deferred maintenance, outdated systems, or structural issues. This could include aging office buildings with outdated HVAC systems or properties requiring significant renovations to meet current market standards.
Operational Distress: Properties facing management inefficiencies, high vacancy rates, or inability to attract quality tenants. Consider downtown office buildings in major cities post-pandemic: high vacancy rates make it difficult to generate sufficient income to cover operational costs and debt service, creating a cycle of declining property value and increasing financial strain.

Root Causes of Distress:

While understanding types of distress is crucial, it’s equally important to recognize the underlying causes.

Economic Volatility: Market downturns or shifts in local economies can dramatically impact property performance. The COVID-19 pandemic’s impact on retail and hospitality sectors is a prime example, with sudden changes in consumer behavior leading to widespread distress in these property types.
Debt Overload: Overleveraging or poorly structured financing can lead to unsustainable debt burdens. Take for example a property that refinanced at the peak of the market with a high loan-to-value ratio, leaving little room for error if market conditions or property performance decline.
Mismanagement: Inefficient operations or neglectful property management practices erode asset value. For instance, a property manager’s failure to conduct regular maintenance on a building’s roof could lead to leaks, causing significant water damage and mold growth. This neglect not only results in costly repairs but also potentially drives away tenants, leading to decreased occupancy and income.
Market Shifts: Changes in local demographics or business landscapes can render properties less desirable. The shift to remote work following the COVID-19 pandemic has significantly impacted office properties, particularly in central business districts. For instance, many tech companies in San Francisco have downsized their office footprint or moved to a hybrid work model, leading to increased vacancy rates and decreased demand for large office spaces in the city center. Office vacancy rates in major markets like San Francisco reached 7% in Q2 2024, compared to 17% for suburban offices, indicating potential distress in urban centers.
Regulatory Changes: New zoning laws or building codes may affect property use or increase compliance costs. For example, new energy efficiency requirements in cities like New York can necessitate significant capital expenditures for older buildings to remain compliant.

What is the Difference Between Stressed and Distressed Assets?

The line between stressed and distressed assets is crucial yet often blurred. While both categories represent properties facing challenges, they differ significantly in the severity of their issues and the strategies required for resolution. Understanding this distinction is key for investors, lenders, and property owners to make timely and effective decisions.

Key differences include:

Characteristic	Stressed Asset	Distressed Asset
Financial Health	Early signs of financial strain	Severe financial difficulties
Cash Flow	Reduced but still positive	Negative or severely compromised
Debt Service	Struggling to meet obligations	Default or imminent default
Asset Value	Moderate decline	Significant depreciation
Occupancy (Real Estate)	Slightly below market average	Substantially below market average
Management Approach	Proactive measures may stabilize	Requires significant intervention
Investment Risk	Elevated, with turnaround potential	High, with substantial uncertainty
Opportunity	Value preservation and enhancement	Major restructuring or repositioning
Time Sensitivity	Action beneficial but not critical	Immediate action often necessary
Pricing	Slight discount to market value	Substantial discount to perceived value

The Importance of Early Intervention:

Given these distinctions, it’s clear that early intervention can play a pivotal role. Early intervention can:

Preserve value and prevent further decline
Maintain more options for refinancing or restructuring
Avoid costly legal proceedings and potential reputational damage
Create opportunities for value-add investors to acquire properties at attractive prices before they hit the distressed market

By understanding the nuances between stressed and distressed assets, stakeholders can make more informed decisions, potentially turning challenging situations into profitable opportunities.

What Does Due Diligence Look Like For Distressed Assets?

With a clear understanding of distressed assets, let’s now turn our attention to the critical process of due diligence. Due diligence is the cornerstone of successful distressed asset investments. It’s the process that separates calculated risks from costly mistakes. For AEI, due diligence is more than a checklist—it’s a comprehensive approach to understanding and evaluating distressed properties.

With our national presence and local market knowledge, we offer a unique advantage in due diligence. As a one-stop shop for due diligence and risk management, our cohesive divisions work seamlessly together, providing you with a full view of your potential investment. This integrated approach not only streamlines the process but also reduces the likelihood of overlooking critical issues.

Here’s an overview of AEI’s due diligence process:

Property Condition Assessments:

Our Building Consultants arm property stakeholders with critical insights that can unveil the true potential of challenging assets, enabling you to make decisions confidently and precisely. Here’s how you can use our PCAs for distressed asset due diligence:

Risk Mitigation

Distressed properties often hide a multitude of issues beneath the surface. Our Building Consultants conduct thorough evaluations of structural systems, building envelopes, and MEP components. By identifying and quantifying deferred maintenance, we help you avoid costly post-acquisition surprises and develop strategic plans.

Value Discovery

Where others see challenges, we uncover potential. Our assessments go beyond identifying problems – we pinpoint value-add opportunities that can significantly boost NOI. From energy efficiency upgrades to modernization of outdated systems, we help you see the diamond in the rough.

Negotiation Leverage

Knowledge is power in transactions. Our detailed PCA reports arm you with concrete data on property conditions, necessary repairs, and potential improvements. This information becomes critical during price negotiations or loan workouts, ensuring you’re always in a position of strength.

Compliance Assurance

With an evolving regulatory landscape staying compliant is more crucial than ever. We meticulously review life safety systems, ADA compliance, and adherence to local building codes. Our forward-looking approach helps you anticipate and budget for upcoming regulatory changes, avoiding costly surprises down the road.

Gain a Competitive Edge with Our Comprehensive PCAs

Remember, in the world of distressed assets, what you don’t know can hurt you. A thorough PCA isn’t just a due diligence step – it’s your competitive edge in a complex market. Our PCAs allow you to:

Prioritize investments strategically, balancing immediate needs with long-term value creation.
Develop phased improvement strategies aligned with projected cash flows.
Integrate PCA findings with market analysis for a robust asset evaluation.
Leverage our Capital Reserves Schedule for precise financial planning throughout your hold period.

Environmental Consulting:

The environmental profile of a distressed asset can significantly impact its value and viability. As environmental regulations become increasingly stringent and new concerns like PFAS contamination come to the forefront, the role of Environmental Assessments in risk mitigation has never been more vital. Our Environmental Assessments can uncover:

Emerging Contaminants

The recent inclusion of PFAS (Per- and Polyfluoroalkyl Substances) as a Recognized Environmental Condition (REC) in the ASTM E-1527-21 standard has significantly expanded the scope of environmental due diligence. PFAS, once considered “emerging contaminants,” now requires evaluation in Phase I ESAs. This change highlights the dynamic nature of environmental regulations and the need for up-to-date assessments.

Potential Liabilities

ESAs provide a comprehensive understanding of environmental risks, allowing investors to accurately price these factors into their investment decisions. From historical contamination to current operational practices, a thorough ESA reveals potential liabilities that could significantly impact property value and future use.

Compliance Issues

A properly conducted ESA offers more than just information – it provides legal protection. By satisfying the “innocent landowner defense” under CERCLA, investors can shield themselves from potential future environmental liability claims, a crucial consideration in distressed asset acquisitions.

Cost-Effective Remediation Strategies

Environmental assessments can uncover opportunities for value creation. Identifying and addressing environmental issues early can lead to cost-effective remediation strategies, potentially increasing property value and attracting a wider pool of future buyers or tenants.

Leverage Our Environmental Findings Into Your Decision-making By:

Integrating environmental and financial due diligence, using ESA findings to adjust valuation models.
Look beyond obvious risks, considering historical uses of adjacent properties and regional contamination issues.
Plan for long-term implications, considering how current environmental conditions might affect future property use or exit strategies.
Use ESA information as a negotiation tool to justify price adjustments or specialized deal structures.
Stay ahead of regulatory changes to ensure your investment remains compliant and valuable in an evolving landscape.

Land Surveying and Mapping:

Precise land surveying is more than a formality—it’s a powerful tool for risk management and value optimization. From identifying encroachments to uncovering development opportunities, accurate surveying provides the foundation for informed decision-making. Here’s how:

Boundary Certainty and Encroachment Identification

Our ALTA/NSPS surveys provide definitive property line delineations, uncovering potential encroachments that could impact value or lead to post-acquisition disputes.

Easement Analysis and Title Discrepancy Resolution

We thoroughly review and map all recorded easements, reconciling discrepancies between legal descriptions and actual property conditions. This clarity reduces title insurance exceptions and informs strategic planning.

Development Potential Assessment

Using advanced mapping technologies, including 3D LiDAR and drone surveys, we provide detailed insights into site characteristics and topography. This information is crucial for evaluating highest and best-use scenarios and informing redevelopment strategies.

Zoning and Land Use:

With extensive experience navigating the regulatory landscape, our team anticipates potential hurdles and addresses them proactively, helping clients avoid unforeseen complications. Through our Zoning Analysis Report (ZAR), we deliver a comprehensive breakdown of zoning and land-use factors that are critical for assessing the viability and future potential of distressed properties. Here’s how:

Uncovering Hidden Constraints

Distressed assets often carry zoning issues that could obstruct future development or usage. Our ZAR provides a detailed evaluation of property use, setbacks, height restrictions, and parking requirements, ensuring you’re aware of any limitations upfront. By scrutinizing aspects such as bulk density and floor area ratio (FAR) restrictions, we help you avoid surprises that could impact your investment’s long-term potential.

Identifying New Opportunities

While distressed assets may present challenges, they also open the door for innovative redevelopment. By thoroughly reviewing the zoning ordinances, we uncover opportunities for you to make the most of the property, whether through redevelopment, alternative uses, or potential expansion. We identify pathways for variances or conditional use permits, allowing you to explore strategies to optimize the asset’s usability within zoning laws.

Strengthening Your Position

Armed with our precise zoning analysis, you’ll be well-positioned to engage in negotiations with clarity. Our findings on zoning conformity, parking allocations, and potential violations provide you with the leverage needed to negotiate favorable terms. These detailed insights can help you gauge necessary zoning adjustments or improvements, enabling you to plan effectively for the property’s future.

Ensuring Long-Term Compliance

Staying compliant is essential to avoid costly setbacks. Our zoning team retrieves key municipal documents, including zoning verification letters, certificates of occupancy, and site plans, ensuring the asset meets all necessary legal standards. Additionally, we anticipate zoning or land-use changes that could affect the property’s future, allowing you to plan ahead and safeguard your investment against unforeseen regulatory shifts.

Energy and Sustainability Consulting:

In distressed markets, where margins can be tight and competition fierce, a strategic approach to sustainability can be the differentiator that turns a challenged asset into a market winner. It’s not just about being green—it’s about being smart, forward-thinking, and positioned for long-term success in an evolving real estate landscape. Some sustainability strategies for distressed assets include:

Quick-Win Energy Upgrades

Distressed assets often come with outdated systems that drain resources and drive up operational costs. We conduct energy assessments, identifying opportunities to improve efficiency through targeted upgrades. From modernizing HVAC systems to implementing renewable energy solutions, we help you streamline operations and reduce overhead, making your asset more attractive to potential buyers or lenders.

Resilience Planning

With climate risks becoming a greater concern for investors, sustainability is critical in protecting property value. Our Climate-Informed Due Diligence Assessments evaluate your property’s resilience to extreme weather events and regulatory changes. By identifying vulnerabilities early, we help you develop action plans that mitigate risk and increase the property’s long-term appeal.

ESG Reporting and Green Building Certifications

Sustainability goals are increasingly tied to compliance with regulations and corporate reporting standards. Our team ensures that distressed assets not only meet current standards but are also prepared for future regulatory shifts. This not only reduces compliance risk but also positions the asset as a forward-thinking investment, appealing to ESG-conscious stakeholders.

Valuation

While all previously mentioned factors contribute to an asset’s worth, a comprehensive valuation ties these elements together. For distressed assets, valuation is a cornerstone of due diligence that influences every aspect of decision-making—from financing options to repositioning strategies.

Our valuation services provide a clear, comprehensive understanding of a property’s current market value, enabling stakeholders to make confident and strategic decisions. We go beyond a simple market assessment, offering deep insights into the property’s financial performance, future cash flow potential, and its position within a broader market context.

Here’s how our appraisals can help you make informed decisions when it comes to distressed assets:

Uncovering True Market Value

Distressed assets often present unique challenges that obscure their true market value. Our appraisers conduct detailed evaluations, taking into account not only the land and structural improvements but also the property’s income potential and market conditions. This multi-faceted approach ensures that all elements influencing value—location, current market demand, and asset quality—are thoroughly assessed.

Identifying Financial Liabilities

Beyond determining the property’s value, AEI’s valuations help identify hidden financial liabilities that could impact a deal. We assess potential risks, such as environmental issues, deferred maintenance, or zoning non-compliance, which might affect the asset’s profitability or encumber future income generation. By pinpointing these liabilities, we enable clients to mitigate risks before acquisition, reducing the likelihood of unexpected costs or financial burdens down the line.

Projecting Cash Flow Potential

For distressed assets, understanding future income potential is vital. AEI’s valuation process includes a thorough analysis of projected cash flows, factoring in market trends, vacancy rates, and potential rent escalations. This forward-looking perspective allows clients to assess how the asset could perform under different scenarios and how to structure deals accordingly. Whether repositioning the property or holding it for long-term gain, our valuations offer clarity on the asset’s financial outlook.

Strategic Decision-Making for Distressed Assets

Having gathered all due diligence assessments the next step is to apply it to strategic decision making. Success in distressed asset investments requires tailored strategies for different stakeholders. Here’s a breakdown of approaches for various groups:

For Lenders and Financial Institutions:

Use assessments to identify early warning signs of distress in loan portfolios
Inform workout strategies and foreclosure decisions with comprehensive property data
Optimize recovery through data-driven disposition strategies

For Property Owners and Sellers:

Leverage professional reports to support refinancing or recapitalization efforts
Use comprehensive assessments to demonstrate proactive management to lenders
Prepare properties for sale with strategic improvements based on expert recommendations

For Buyers and Investors:

Structure deals using insights from detailed property and market analyses
Create effective asset management plans based on professional assessments and recommendations

By tailoring your approach based on your role and objectives, you can navigate the complexities of distressed assets more effectively. Professional assessments and expert recommendations serve as invaluable tools in this process, providing the data and insights needed to make informed decisions in challenging market conditions.

Why Buy Distressed Assets?

Distressed assets often represent diamonds in the rough – properties that, despite their current challenges, hold significant potential for sophisticated investors. While these investments come with their share of risks, they also offer unique opportunities for those with the expertise and resources to navigate their complexities.

Despite the challenges there are compelling reasons why investors are drawn to distressed assets such as:

Potential for Above-Market Returns:

Distressed properties are typically acquired at substantial discounts to their intrinsic value. This pricing disparity creates an opportunity for investors to generate outsized returns as they stabilize and reposition the asset. By addressing the property’s issues and improving its performance, investors can capitalize on the spread between the discounted purchase price and the asset’s true market value.

Value Creation Opportunities:

Distressed assets often suffer from deferred maintenance, poor management, or outdated features. For investors with the right skills and resources, these challenges represent opportunities to add significant value. Through strategic renovations, operational improvements, and repositioning efforts, investors can transform underperforming properties into high-quality assets that command premium rents and attract stable tenants.

Portfolio Diversification

Distressed assets can serve as an effective tool for diversifying real estate portfolios. These properties often behave differently from traditional, stabilized assets, potentially offering a hedge against market fluctuations. By including distressed assets in a broader investment strategy, investors can balance risk and potentially enhance overall portfolio performance.

Competitive Advantages in Niche Markets

The complexities of distressed assets can deter less experienced or risk-averse investors, creating opportunities for those with specialized knowledge or capabilities. Investors who develop expertise in specific types of distressed properties or particular geographic markets can gain a competitive edge, accessing deals with less competition and potentially more favorable terms.

Potential for Long-Term Cash Flow

Once stabilized, former distressed assets can become reliable sources of long-term cash flow. By acquiring these properties at a discount and implementing effective turnaround strategies, investors can create assets with attractive yields relative to their initial investment. This can result in strong, sustainable cash flows over the long term, especially in markets with solid fundamentals and growth potential.

Remember:

While the potential rewards of investing in distressed assets are significant, it’s crucial to approach these opportunities with caution and thorough due diligence. Success in this arena requires a deep understanding of real estate markets, strong operational capabilities, and the financial resources to weather potential challenges during the turnaround process.

When is the Best Time to Buy Distressed Assets?

Understanding the potential benefits of distressed assets naturally leads to the question of timing. Timing plays a crucial role in distressed asset investments. While opportunities can arise at any point in the economic cycle, certain conditions tend to create more favorable environments for distressed asset acquisitions.

Economic Downturns:

During the 2008 financial crisis, commercial real estate values declined by approximately 15% nationwide. Well-capitalized investors acquired billions in distressed assets, positioning themselves for substantial returns as the market recovered.

Sector-Specific Disruptions

Industry shifts or technological changes can create pockets of distress in specific real estate sectors, offering targeted opportunities for investors with sector expertise.

A prime example is the ongoing transformation in the retail sector due to the rise of e-commerce. Traditional shopping malls and big-box stores have faced significant challenges, with many becoming distressed assets. For instance, the Northgate Mall in Seattle, once a thriving shopping center, faced declining foot traffic and retailer bankruptcies. However, investors with vision saw an opportunity in this distress.

The property was acquired and is being redeveloped into a mixed-use complex that includes office space for tech companies, residential units, and an NHL practice facility. This transformation not only revitalizes a distressed asset but also aligns with changing urban living preferences and the growth of the tech industry in the area, demonstrating how sector expertise can turn industry disruption into investment opportunities.

Early Stages of Market Recovery

The period just as markets begin to recover can be ideal for distressed investments, as risks start to decrease but prices haven’t yet fully rebounded. For instance, consider the current market dynamics following the Federal Reserve’s recent announcement of its first of many rate cuts (September 2024 rate cut of .50bps) after 11 consecutive hikes since 2022. The recent shift has sparked optimism in the commercial real estate sector, with projections of increased transaction volume as previously sidelined investors re-enter the market. Such a scenario presents a prime opportunity for savvy investors to acquire distressed assets at still-attractive prices before the market fully prices in the improved outlook.

Balancing Risk and Reward:

Timing distressed asset investments requires a delicate balance between risk and potential returns:

In severe downturns, prices may be lowest, but risks are highest
During recovery phases, risks may be lower, but competition for assets often increases
Consider your risk tolerance, expertise, and capital resources when timing your investments

The key to successful timing in distressed asset investments lies in thorough market analysis, a deep understanding of economic cycles, and the flexibility to act when opportunities arise. Investors must be prepared to move quickly when conditions align, balancing the potential for higher returns against the increased risks inherent in distressed properties.

Final Thoughts

The landscape of distressed asset investment is as challenging as it is rewarding. Success in this arena hinges on the depth and quality of due diligence performed. A comprehensive, multi-faceted approach to assessing distressed properties not only mitigates risks but also uncovers hidden value and opportunities that less thorough evaluations might miss.

In today’s dynamic real estate market, where economic uncertainties can rapidly shift property values and market conditions, the importance of robust due diligence cannot be overstated. For lenders, owners, and investors alike, partnering with experienced professionals like AEI is the critical difference between a calculated risk and a costly mistake. From property condition assessments to environmental considerations, from zoning intricacies to energy efficiency opportunities, each facet of due diligence contributes to a fuller understanding of an asset’s potential and pitfalls.

As you navigate the complex world of distressed asset investments, don’t leave your investment decisions to chance or incomplete information. Arm yourself with the comprehensive due diligence insights that AEI provides. Our national presence and local market knowledge can give you the in-depth, multi-disciplinary due diligence you need to make informed decisions and maximize your returns. Ready to turn distressed assets into successful investments? Contact us.

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