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Best Practices in Distress Investing: No Single Strategy Fits All

When it Comes To Seizing Recessionary CRE Opportunities, Investors Don't See a Specific Market or Property Type Holding a Special Advantage
September 15, 2010
When it comes to commercial real estate investment, distress is all the buzz. It's the catchword that seems to always precede the word 'asset' and is currently the archetypical investment craze. There has been a downpour of money targeting distressed property, and according to CoStar Group data, almost one in every four commercial property sales done so far this year fits in some sort of distress category, whether it's an REO or foreclosure sale, delinquent or underwater loan, or a property with negative cash flow.

CoStar sampled a number of commercial real estate executives asking them what strategies they found to be the best in pursuing distressed deals. In general, investors almost universally agree that a distress opportunity must have clear value and make sense for the buyer's specific investment goal; the more uncertainty an opportunity presented, the less sense it made. Beyond that, there was only one consistent answer:

"There are as many strategies as there are investors," said David W. Popp, senior vice president, Transwestern in Bethesda, MD. "Just as each investor may have their own distressed asset strategy, each property or portfolio must be considered independently on their own merits."

"We don't approach any given assignment with a preconceived bias in terms of quick flip, stabilize and hold, discount rate to achieve occupancy, etc," Popp said. "Achieving the specific goals and objectives specified by our client is paramount and these may change based on the characteristics of the property, loan terms, strength of mortgagor, etc."

Jeffrey Rogers, president and chief operating officer of Integra Realty Resources in New York concurred, saying no clear-cut strategy has emerged as the best practice. It all depends on what type of investor you are.

"The type of investor you are largely depends on the type of investment capital you have to deploy," Rogers said. "For example, if you are running an investment fund raised with institutional money, which requires a certain return (typically in the double digits now) that needs to be achieved before the investor can share in the profits, you need to look for situations which offer adequate yields. In such a situation, the stronger markets like New York and Washington, DC, are not as attractive because of the relatively higher prices and lower yields."

"If you are a REIT paying a dividend of 4%-6%, the stronger markets appeal to you because you can afford to focus on quality and take less risk in a secondary market," Rogers continued. "The big REITs may earn a lower yield, but the return to investors is a lot lower. So, it really depends on where you get your investment capital and on your time horizon."

There was no specific market or property or asset either that jumped out as having any particular advantage either.

"If investors want stability and a relatively safe investment, they would tend to prefer multifamily in 24-hour markets such as New York City," Rogers said. "If the investors are willing to take on greater risk for a higher yield, they might prefer retail in this current market. The vacancy rate in retail is generally higher than the vacancy rate in multifamily in this market, but the upside is greater as well."

Or an investor may not even prefer property, Rogers added.

"Properties acquired between 2003 and 2007 with significant leverage are underwater and no longer have equity. Thus, the target is the debt not the property. The goal is to buy the debt at discount. Depending upon your ultimate strategy, once you own the note, you can negotiate with the owner or you can move to foreclose to gain control of the property."

The following summaries are examples of some of the many distressed investment strategies being deployed in the current commercial real estate environment:

Better To Buy at $100/SF in a Strong Market, Than $10/SF in a Weak Market
Gabriel Silverstein, SIOR, President, Angelic Real Estate, New York, NY
"I think the only markets that one can go into and buy distressed assets are those where there is some reasonable amount of clarity, at least for that asset, in the value-add and exit strategy. I'd rather pay $100 a square foot for an office building in a market with some leasing momentum and tenant activity than $10 a square foot for one in a market where I can't say if I'll ever get a tenant, (like I perceive to be the case in Las Vegas, among others). I think this is part of why the "value-add" or "core-plus" market segment was all but dead for most of the past 24 months.

"At some massive discount to replacement cost and intrinsic value there is a buyer for anything opportunistic (i.e. vacant or largely so). And there is no question that the "core" market has been very strong for top, stable properties. Where the most historic market activity lies is in the margins - the place where taking some chance has realistically achievable risk-adjusted returns, rather than all-or-nothing Boolean outcomes.

"As the leasing market (tenants, rental rates, and concessions) slowly becomes clearer, the meat and potatoes deals that drive the overall market will start to come back: value-add deals in more stable markets. That's where I believe the best risk-adjusted returns will be on average over the next several years. Going for the big discount in a bad market is a roll of the dice, and in Las Vegas they know those odds never favor the shooter.

"I often find myself in a moderately contrarian position, and while there have been a lot of funds raised to target the worst distress (REO or soon-to-be-REO property, etc.,) I think the risk-adjusted returns here favor those that focus on the less en vogue asset situations. There seems to be more money chasing the already-foreclosed-on product than the non-performing or soon-to-be non-performing loans that require more work, but have far less risk associated with them.

"Exit timing, especially on higher risk deals, is the single biggest swing factor: Get in and get out if you are going to take a big risk and want a big return. If you took a huge risk and it pans out, holding the asset to milk more equity multiple (but badly diluting IRR) seems contrary to the risk-adjusted return equation. The optimal blend allows for a cash-out refinancing after a big turnaround effort, taking equity risk off the table but still generating cash flow and growing the equity multiple.

"In most cases, timing drives IRR more than incremental rent increases: Waiting an extra three to six months for an extra 10% in net effective rent probably hurts the overall return model, with rare exceptions. Take advantage of a low-cost basis if you have one, and don't look back and second-guess yourself, especially in a market that isn't going gangbusters with more tenants lined up to take the space if you pass on the first deal.

"As a rule in the early stages of an economic recovery I like assets that are likely to not only have rents at or below market levels, but which have the ability to increase those rents quickly as the market starts to recover. Hotels have overnight tenancy and rent adjustment abilities, multifamily has shorter-term (usually 12 month) leases. These are not only able to quickly increase rents as the market strengthens, but are more likely to have already had their trailing/current numbers marked all the way down to today's market levels (or below).

"Office space more than any other takes a long time to adjust downward to market (making many office rents today above market). And once adjusted down, (office rents) take a longer time to catch-up as the economy expands. In the present environment I prefer homogenous space (i.e. industrial) vs. unique and more differentiated space (office, retail, special use) because of its ability to compete for a wider variety of tenants without excessive deal costs. For occupancy gains I like higher class space in the early years of a recovery as tenants "trade up" to better space that is at or below their current rent on lower class space."

It's Not the Market, but the Submarket and Partner that Matter
Arthur Nevid, Chief Investment Officer, Mountain Real Estate Group LLC, Charlotte, NC
"If we are purchasing a portfolio, then we obviously need to be prepared to purchase assets in almost any market, which is fine as our bulk pricing will appropriately reflect positive and negative market influences.

If we are targeting individual assets, then we are more market driven, but not broad markets such as Las Vegas or Phoenix, but "submarkets" such as Gilbert and Summerlin as examples within Phoenix and Las Vegas, and maybe even further down into smaller pockets within those submarkets. We perform intense research into submarkets, and interesting opportunities can be found in almost any broad market if you zero in.

"For example, two of our best recent investments are located, in of all places, Naples and Ft. Myers, FL, which are typically considered "ground zero" for Florida distress! But as important as the submarket is, the ability of the partners we choose to team up within those submarkets are even more important. We have teamed up with some great partners to successfully resurrect difficult projects in difficult markets.

"While we typically target non-performing assets in search of higher returns, we don't necessarily consider that decision to be any riskier than buying performing assets. That's because performing assets can easily be non-performing shortly and are subject to extended litigation risk that is often not present in non-performing assets, which have already gone through a legal exercise. In either case, we underwrite the real estate and not the security with the assumption that we will own the asset at some time and our exit strategy will be a development/sale strategy rather than a repayment strategy.

"If we are buying a portfolio that includes a C property in a tertiary location, we probably will not be able to justify a much higher exit price in 3-5 years than we see in 1-2 years, so we will assume a quicker sale and try to buy as cheaply as possible to maximize our IRR and multiple. If, on the other hand, we think that the asset and its market have hit bottom and may see some value bumps down the road, then we would probably want to go the rent-and-hold route, which we are successfully currently doing with a number of fractured condo projects in Florida and some distressed retail projects in the Midwest.

"We are waiting (and waiting, and waiting,) for distressed commercial assets to be available at attractive pricing, but we have just not seen much of that. Instead, the banks are doing what they can to hold on to those assets in hopes of recovering value over time. Where we have seen opportunities have been on the residential side, and particularly in land positions where we have purchased over $500 million of assets this year alone. This happens to be our group's specialty, so we are trying to buy as much as possible while the window is open over the next 1-3 years."

Distress Doesn't Always Equate to Great Deals
Navin Nagrani, Senior Vice President, Hilco Real Estate, Chicago and President of the Real Estate Investment Association
"As it relates to targeting, we've learned that distressed situations don't always equate to great deals on the real estate. We spend our time focusing on situations where we can acquire real estate assets at distressed pricing. In addition, Hilco has one of the largest machinery and equipment as well as inventory trading platforms, so sometimes we find opportunities where we can acquire an entire business, and then get at the real estate as part of a broader deal.

"There is a huge supply of distressed deals in the marketplace and many investors look at the same deals, which isn't really that exciting for us to pursue. We spend a great amount of our business development efforts focusing on the demand for that real estate. For example, Hilco has very strong relationships with retailers and restaurant chains. With a user partner in hand, we can look at the real estate market with more excitement because we have (and can bring) potential solutions to the vacancy issues."

Bargains Are Elusive
David C. Nilges, President, Managing Broker, Nilges Commercial Realtors Inc., Centennial, CO
"I personally look for loans, but real "bargains" are elusive. Until the regulators have the staff, the funds, and a clear mandate from Treasury, FDIC, and the White House, with support from a bi-partisan approach from Congress, "troubled assets" will continue to be held by weak, or near failing banks, or failed banks on the "watch list" or under federal supervision, the bargain assets will not hit any market.

"A deep discount approach works in a normal commercial real estate market. However, we are not in such a market, again. The demand, other than for apartments, is not in any market I am familiar with, i.e., retail, industrial, office sectors, and in my view, won't be had until, if, when we see unemployment at around 5.5%, and a consistent job growth gain across the U.S."

Best Deals Come from Best Relationships
Charles Cecil, CEO, Southwest Fund, Phoenix and New York
"In general, we find that our best opportunities are coming from direct relationships that we have had for years with owners, developers and lawyers. What we see from the major brokerages is rarely interesting. At the moment, we have approximately $600 million of off-market existing, cash flow positive office, retail, multifamily, industrial and raw land in our acquisition pipeline.

"We target major metros, with international airports. We look at buying in Las Vegas, Phoenix and Atlanta (although we are not thrilled about Atlanta, so it needs to be very special).

"We target properties, but consider loans where there is a clear and actionable strategy to take ownership of the property. Either could make sense, as long as value is understood and legal/political is understood.

"In general, we look to buy at a price that enables us to rent vacant space at market. We like office, retail, multifamily, industrial and raw land. It just depends on the deal and the submarket."

The Odds on Las Vegas
Ron Opfer, CCIM, Director of Commercial Real Estate | Special Asset Solutions, Coldwell Banker Premier Realty, Henderson, NV
"In Las Vegas, I see a tremendous interest in distressed loans, however, most of them have a big mess associated with them: multiple partners in first position fighting for who is first in the first position; several junior lenders from hard money loans to other banks; and liens from service providers that fell victim to an asset's failure. Often, a foreclosure is needed just to clean up the title and the past problems associated with the property.

"I have found mixed results from the loan workout departments of banks and the OREO department. In one case, I presented an offer to purchase a loan for $1.6 million. The bank countered at $1.8 million. My buyer backed out, and the property eventually foreclosed and came on the market for nearly $3 million. The better deal came from the loan work out department than the OREO department.

"In Las Vegas, performing properties are not being sold at much of a discount. The deals are in the distressed underperforming assets. Even there, it is extremely hard to make a deal pencil out. There has been a lot of lateral movement from existing businesses/investors taking advantage of some early deals and paying way too much for property. (When I say 'way too much', I mean the deals do not pencil under basic fundamental commercial real estate math.) Banks are hanging on to these deals and pricing their OREO properties higher than what the fundamentals dictate -- "pricing with a prayer" and hoping to duplicate a higher than market sale of the past.

"Deep discounts and a flip in two years was the founding principal of many distressed asset funds formed between 1.5 to 2 years ago. I don't believe they feel that way anymore. Their vision of a recovery in two years is definitely foggy. Distressed investment proformas are stretching out five years and much less optimistic than proformas of just one year ago.

"In Las Vegas, everybody wants a fully leased grocery anchored shopping center for a 10% CAP or higher or a Class A apartment complex for $30,000 a door. These properties are far and few between. There are distressed asset investors for every asset class. Banks just need to understand that the price these assets will sell for is a price that makes sense under commercial real estate fundamentals, and that the investor is going to build risk into their proforma. A sound distressed investment strategy is to purchase the asset at a price that insures the new investor will not fail. Nobody wants investors purchasing properties at a price where they fail."


Great Projects Offer Great Opportunities
Brad Hutensky, General Partner, Hutensky Capital Partners, Hartford, CT
"Our fund has had the most success providing capital to owner/borrowers who have quality retail properties with a capital structure that is inappropriate. Our recent investments may seem very different: a loan on a Phoenix center purchased at a discount; a loan payoff and purchase on an overleveraged retail mall near Washington, DC; and the purchase of a general partnership interest in a large ground-up mixed-used project under construction. However, in all cases the end result is the same: we have invested capital in a great project that is now capitalized in a way that allows it a chance to be properly redeveloped and the borrower stays involved with the property as our partner."


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