Distressed Properties Can be Profitable, But Pose Booby Traps for Unwary

David Tesler

Dees Stribling, Contributing Editor

Recently, David Tesler, founder and CEO of Real Diligence LLC, participated in a seminar in New York City about buying distressed commercial real estate — a topic of considerable interest these days. In fact, something of a gold rush mentality seems to be afoot in the industry, which might lead even experienced real estate players to believe that distressed properties represent easy money.

Tesler warns that it isn’t so. Distressed properties can be quite profitable, of course, but also pose booby traps for the unwary. After the conference, MHN asked Tesler to expand on that theme, especially in the multifamily context.

MHN: What’s different about acquiring distressed assets, compared with other kinds of deals?

Tesler: The difference is more of a matter of degree than anything else. There are basic things you should do when buying any commercial real estate, though during the last cycle, buyers were sometimes moving too fast to even do the basics. I knew of buyers that acquired assets north of $60 million without any kind of financial analysis.

Distressed means being exceptionally careful about verifying and validating every single number associated with the property. There are no shortcuts. If you want to wrap your head around an asset, you have to understand the property’s income as well as all the expenses.

But it goes even deeper than that. Line up your experts. They can be in-house, or third party, but you need them: legal experts, physical structure experts, due diligence experts. You have to make sure that there isn’t any aspect of the property that you don’t fully understand.

MHN: Presumably the same would be true when acquiring a note on a distressed asset?

Tesler: Absolutely. When you buy a note from the lender, you’re stepping into the shoes of that lender, essentially becoming the lender, and it adds an additional layer of due diligence. You as a lender will take over the property after the foreclosure, which is usually the point of the purchase, but until that point, you have to look at the mortgage and understand everyone’s rights and obligations under it. If there’s a defect in the note, not only are you never going to take possession of the property, you’re not going to get any of the benefits from the note, either. You have to go over it with better than a fine-tooth comb.

There’s now a cottage industry of experts in loan documentation who are taking on clients for the sole purpose of finding defects in loan documents. If defects are found, as well as a judge who is borrower-friendly — and those aren’t too hard to find — you might be stuck with a note that’s invalid, or partially invalid.

MHN: What are some special considerations for distressed multifamily properties?

Tesler: Every asset class has its own challenges, and for multifamily one of them is understanding what the financial troubles might mean for the vacancy rate, and whether people are going to be interested in renting an apartment in a building under those conditions. Are potential tenants going to shy away from a property that’s, say, 60 percent occupied? You have to understand what you have to do to get that occupancy up to, say, 80 percent or 90 percent.

It’s also critically important to understand the demographics of the area, and why the building is distressed in the first place. Is it a function of the economy, with other buildings in the area in a similar situation? Or is something else at work? Sometimes management has run a property into the ground in an otherwise healthy market, so that’s what you have to deal with first and foremost.