How To Buy Distressed Commercial Property

This article was updated on 6/05/2024

Interest rates remain high, and for many markets and asset classes, prices have yet to fall. However, there's at least one way real estate investors can buy a property at the right price in this cycle: Distressed sales.

"It's a main mechanism for price correction," said Matthew Scoville, a New York-based attorney and partner at Hunton Andrews Kurth who has represented both lenders and real estate developers. In many cases, distressed sales allow investors to acquire properties that would otherwise not be available. "Opportunities are the name of the game," he said.

While savvy, buying distressed properties requires a blend of strategic thinking, legal expertise, financial acumen and market awareness. Though the landscape may be complex, the potential for substantial returns exists for those who can navigate the challenges effectively. Engaging with professionals who understand the nuances of distressed property transactions is key to making informed decisions and capitalizing on distressed property.

What is a Distressed Property?

Distressed sales are driven by some type of financial or outside influence that coerces the owner to sell involuntarily, and/or for a price often well below market value.

Forms of distress include:

• Pending foreclosure.
• Bankruptcy sale (when a bankruptcy court approves the sale of a distressed asset).

There are many reasons a property can fall into distress. According to Brian Cohen, a New York-based attorney and partner at Goulston & Storrs, these can include:

• The property is not generating enough cash flow to pay its debt obligations or tax liability.
• The property doesn't generate enough cash flow to pay tenant improvement allowances or brokers' commissions.
• Death of a partner in the investment.

All of these are situations where the property owner is unable to meet mortgage payments, maintain the property, or even cover the expenses associated with its operation. A lender is entitled to pursue foreclosure on a property as soon as its mortgage is in default (from either missed payments or having an unpaid balance upon the loan's maturity date).

How Do You Acquire Distressed Property?

Besides searching for them online, find an experienced real estate broker, real estate lawyer, banker or other professional who will know about potential deals before they're publicized.

"Real estate is a pretty small community, particularly New York real estate," Scoville said. "A property might not necessarily be marketed as distressed yet, but it's on the radars of brokers, law firms and off-the-record brokers as well."

Traditional ways to acquire a distressed property are:

At a foreclosure auction held by the lender, or a bankruptcy auction held by a court. The lender will usually offer a credit bid (or the amount of the outstanding debt) and oftentimes will be the highest bidder at auction.

Acquiring a real-estate-owned (REO) property directly from the lender if it fails to sell at auction.

Pursuing a short sale, when a lender agrees to sell a property for less than its outstanding debt instead of pursuing foreclosure.

In some cases, distressed properties are auctioned off under the Uniform Commercial Code (UCC). This process involves selling assets secured by collateral, such as equipment or inventory.

The foreclosure process differs depending on whether a state is judicial or non-judicial. In judicial states like New York, foreclosures can be a more extended and complex process, involving court proceedings that can take years. In non-judicial states like Texas, foreclosures can occur more swiftly without court involvement.

Many investors will acquire a distressed and discounted commercial mortgage note from a lender, and then pursue foreclosure themselves. But this method is not for the faint of heart.

"If you're coming from a straight transactional background, you're going to be hopping right into a litigious and potentially highly confrontational situation right off the bat," Scoville said. "So I think you need to prepare yourself for the fact that there may not be any deals to be had in this. It's going to be blunt force – enforcing documents and seeing how it goes."

This approach also requires even more due diligence than usual.

"First, you want to understand, among other things, what kind of security does the lender have?" Cohen said. "I would say the key is to understand the priority of the lien you are going to be taking control of."

Collateral Types

Like all real estate sales, the endeavor to buy distressed properties is deal-specific. It involves navigating through a maze of jurisdictions, collateral types, and legal considerations. As a prospective buyer, you'll encounter a variety of scenarios, each with its own set of rules and challenges.

When pursuing distressed properties, you'll encounter terms like equity interest pledges, mezzanine loans and mortgage loans. Let's break down some of these terms to gain a better understanding:

• Mortgage Loans: Mortgage loans use the property itself as collateral, with the lender having the right to foreclose if the borrower defaults on payments.
• Equity Interest Pledge and Mezzanine Loans: An equity interest pledge involves using equity ownership in the property as collateral, while mezzanine loans are a hybrid of debt and equity financing. Investors providing mezzanine financing have a secondary claim to the primary lender on the property's assets. Mezzanine loans are used when the primary loan doesn't cover the full cost of the purchase or project.
• Guarantees and Recourse: Personal guarantees signed by borrowers or guarantors can complicate the investment process. In the event of defaults, investors may need to account for additional financial obligations owed by the borrower.

Due Diligence

Distressed property sales require cooperation among many different parties, often with competing interests. "It gets very complicated, very fast," Cohen said.

"The most important thing I would tell someone venturing into the distressed game is to be the smartest person in the room and to make sure to know everything there is to know about every single position in the capital stack," he continued.

Unfortunately, many times it's difficult to inspect a property before it is auctioned. But there are other forms of due diligence on these deals that are paramount. This involves a comprehensive assessment of the property's legal and financial aspects to mitigate risks and make informed decisions.

• Legal and Loan Document Diligence: Reviewing loan documents, guarantees, and communications between parties is crucial. Understanding the jurisdiction and the specific terms of the loan can impact the timing and success of the foreclosure process.
• Intercreditor Agreements: If you're acquiring the mezzanine position or subordinate debt on a property, understanding the inter-creditor agreements is essential. These agreements define the relationship between creditors and their priorities during a foreclosure or bankruptcy.
• Property Diligence: Examining the property itself, including its physical condition and potential for value enhancement, is essential.
• Value-Add Opportunities: Consider whether leases can be broken or renegotiated to attract more lucrative tenants.

Like any other real estate deal, leverage is everything in distressed sales - as in the leverage a lender has over a distressed borrower or the leverage different creditors have against each other in a more complicated deal.

As an example, Scoville presented a situation in which a subordinate lender may have a chance at recouping some money on a soured mezzanine deal, but the senior lender with priority does not.

"The [mezzanine] is probably going to want something, but the sponsor will be happy with getting off the guarantee liability. That's your baseline assumption," he said.

Where We're Headed

Scoville hasn't yet noticed huge discounts on distressed commercial loans, because, for the most part, lenders are secured by the collateral properties. But he does believe that, as of late, foreclosures are cleaner transitions than they were in the past.

"The economic assumptions were just so off on some of the [pre-pandemic] deals that were made that there's no realistic profit in some of [these properties]," he said. "That trend is going to continue as people understand interest rates aren't going to go down fast and office [space] is going to be challenged in society. It is just a reset. I think you're going to see that trend continue where developers and [loan] sponsors don't feel stigmatized as much by saying ‘Hey, the deal doesn't work. Let's transition it and you can sell it at your basis and we can be done with it.'"