Buying Distressed Assets: Should You Acquire the Property or Its Debt?

Manuel Fishman's phone has been ringing a lot lately.

Fishman, a shareholder at the Los Angeles-based law firm Buchalter, has represented real estate developers and owners in the acquisition, sale and financing of commercial properties for more than 35 years.

Now he's getting calls from people with money and one specific interest — distressed real estate. “It's the more speculative or higher-risk kind of people that are coming to me," Fishman says. “The institutional or the safe money has been looking at distressed real estate for the last few years because we all thought that we were in a bubble, even pre-[pandemic]."

With the stay-at-home orders making it difficult for tenants to pay rents, Fishman's callers sense that many commercial properties could fall into distressed situations where the owners are unable to meet their loan obligations.

In past cycles when that has happened, vulture investors made a lot of money — usually buying the asset after it has been given back to the bank. In fact, some of the biggest names in commercial real estate, such as Colony Capital's Tom Barrack and Equity Residential's Sam Zell, built their empires from assets that they accumulated from The Resolution Trust Corp. (RTC), which was established to disperse the assets of failed Savings and Loans (S&Ls) in the 90s.

“These banks were failing and we'd go out to Kansas City," recalls Brad Salzer, an RTC veteran and president of Redstone Funding, a Tampa, Florida-based firm created to acquire performing and non-performing real estate debt. “We'd sit in the ballroom in the Kansas City Convention Center and stay up all night looking at hard [loan] documents. Anyone acquiring assets back then would joke if we bought $50 million [in assets], while we wish we had bought $100 million. If you bought $100 million, you wish you had bought $200 million. It was easy money."

A lot of investors expected a repeat with the great financial crisis of 2008, but many lenders worked with their borrowers to make it through, a practice skeptics derided as “extend and pretend." Still, many others made a lot of money, securing returns as high as 30% off of assets that had been taken over by the banks or special servicers.

Given that history, it's little wonder that opportunistic investors are calling the Fishmans of the world for advice. On the surface, it seems like there's little to lose — if you buy something cheap enough, it shouldn't be hard to make a few upgrades and sell it for a tidy profit.

But it's not so simple. To play in the distressed game, you need to know whether to buy the property itself or the asset's bank note, and the pros and cons of each route. Then you have to figure out how to secure those assets and determine which sectors will have the most troubled assets.

The Loan or the Property?

It might be aspirational to drive by a blighted strip mall with an empty, cavernous Big Lots, a well-fortified payday lender and a beat-up bodega and dream about knocking everything down and building a warehouse facility to serve the same-day shopping needs of the surrounding area. You may even want to dig into tax records, find that property's owner and make them an offer.

But think twice before you pick up the phone or hit send on that email.

Property owners, especially those in trouble, can be emotional. In many cases, they've poured blood, sweat, tears and yes, lots of money, into upgrading their asset.

“Everybody thinks their home or their building is worth X," Salzer says. “They take a great level of personal offense to having to take less [than X] for it."

If you secure the property without enough cushion to make upgrades, you might suddenly inherit that owner's problems and also have to deal with the management.

“If you're buying a property that lost all of its tenants and its income, it's challenging if you can't kick out that existing debt," says Noah Shaffer, senior director of asset management for Confidant Asset Management, a Tampa, Florida-based manager of net lease properties. “Then you've got to lease it up pretty quickly, or you're going to get foreclosed on."

If you can extricate yourself from that existing debt, you'll have a chance. But generally, it can be easier to gain access to real estate by acquiring the loan as a first step and have the option of taking possession of the property later through foreclosure. Unshackled of emotion, banks and servicers are solely focused on achieving a dollar value for a piece of paper.

Still, if the loan is in enough trouble, you'll ultimately contend with the owner, possibly through litigation that can potentially stretch over multiple years, especially with an expensive property.

“Typically, the bigger the amount of money involved, the more sophisticated the opposing party in that litigation is going to be," says Rafael Serrano, managing director of Safe Harbor Equity, a Miami-based private equity firm. “That typically means much more protracted and involved litigation, specifically in commercial real estate."

The experts agree that if you end up with the property as the note holder, it can be worth the time even if you have to deal with management duties. Suddenly, you're no longer just collecting the debt service payments. You enjoy the rewards of monthly cash flow and the profits of eventual sale, having solved the issue causing the default in the first place.

“You make more money ending up with the real estate, but it takes more time," Salzer says. “It's the fundamental risk/reward analysis."

How Do You Get the Debt?

First, you need to have cash lined up because using leverage to buy a loan isn't an option. Then, you need to be realistic. Big money-backed groups or individuals were mobilizing for distressed opportunities long before anyone knew what COVID-19 was. So, the loans for downtown office buildings or large shopping centers probably won't be available.

Those commercial mortgage-backed securities (CMBS) loans, which are sold as bonds on the secondary market, might seem appealing, but the structure is extremely complex. That limits access to bigger players if the properties even make it to the market.

“Even if one very large investment [property] goes into special servicing, the likelihood is that there will be some sort of workout," says Gayle R. Klein, a principal in McKool Smith's New York office who specializes in representing hedge funds, private equity firms and public companies. “So there is going to be some sort of payment that comes in rather than a foreclosure."

Bill Bymel, managing director of Florida Asset Management for Spurs Capital, a fund manager and direct investor of residential whole loans and distressed mortgages, compares the hunt for distressed debt to gaining admittance to 'an old boy's network.'"

“A lot of deals are made not even on a handshake, but on a zoom call," Bymel says.

Still, there are many avenues for small investors to get started. Bymel recommends starting at your local bank. “There are special asset divisions at most community banks," he says. “There's a possibility that some loans go into those special servicing divisions or special asset groups."

Fishman suggests that prospective debt buyers reach out to commercial loan brokers or read the legal notices on scheduled foreclosure sales. “Where a lender is foreclosing on one loan there is a good chance it is holding a portfolio of other bad loans," he says. “Talk to their loan workout officer."

Getting the Property

For those looking to purchase the property itself, you'll want to look for a motivated, rational seller and make sure you can work with the lender.

Fishman recommends talking to general contractors. “They know which projects are stalled, have run into money issues [such as mechanics' liens] and where work has stopped," he says.

Brokers can also provide valuable input. “They are getting the 'off market' calls from distressed owners seeking to get out of over-leveraged deals that were dependent on pre-COVID-19 rent pro formas," Fishman says.

And just who are those owners having trouble with their pro formas? They own in the sectors getting hit hardest by COVID-19.

“It's going to be hospitality," Salzer says. “It's going to be retail. We're going to have some systemic change in our behavior, including how we use offices and shop [which could lead to distressed situations]."

Most observers think industrial, which has been buoyed by the online shopping boom, will be a clear winner.

While multifamily should hold up relatively well, investors could have trouble meeting return expectations if rent payments lag into the back half of 2021 and into 2022.

However, even the most difficult situations can offer opportunity. Fishman thinks that investors with a vision and a long-term time horizon can do well with those troubled strip malls, even the ones with the cavernous Big Lots.

“The area where I see a real opportunity for people is in the strip center retail," Fishman says. “Those are really going to change and most local municipalities are going to want to convert that underutilized property to multifamily housing to resolve the housing crisis."