How to Navigate Risk and Maximize Returns When Investing in Distressed Real Estate

Savvy moves require homework to profit in a challenging environment.

As interest rates continue to rise, the market will see more distressed real estate deals. Investors who know how to navigate the risk associated with these transactions should be able to capitalize on these opportunities.

A quick refresher: Distressed real estate is property that is not performing to its full potential. Distress occurs for many reasons. In some cases, the property is in physical disrepair. This often happens because of deferred maintenance and lack of capital improvements. In other cases, the property’s capital stack is distressed. The asset may be physically fine, but the owner took on too much debt or otherwise cannot repay their lenders. In situations like these, the owner may have to sell at a discount or turn the keys over to the bank if they cannot repay the loan.

Distressed real estate can offer great opportunities. The office market, for example, has collapsed in many areas of the country, and some buildings are trading for 20 cents on the dollar. For an investor with long-term, patient capital, some of these deals are going to be attractive. These buyers must be well capitalized because few banks are going to make a loan on an office building in today’s market — but this is an example of where opportunity exists.

One of the best ways to land distressed deals is by providing the seller with surety of close. This means having capital lined up and ready to invest when deals come to market. In some cases, there might not be time to get a traditional loan. Buy it with cash if possible and put a loan on the property later.

Passive investors, such as those putting money into a real estate fund or syndication, should spend this time doing their homework about different sponsors. Those who do extensive research now will be prepared to move as soon as their preferred sponsor has a deal in hand.

How Cap Rates Impact Property Value

One way to calculate the value of commercial real estate is by its capitalization rate, or cap rate for short. It’s calculated by dividing a property’s net operating income (NOI) by its market value.

For many years, properties were trading at 3% to 5% cap rates, depending on the asset class, its condition and market location. The low-interest-rate environment allowed investors to buy properties at arguably inflated values, which pushed cap rates to all-time lows. However, all things being equal (e.g., assuming NOIs remain the same), as interest rates have risen, properties have become less affordable. To make comparable returns, investors must pay less for properties. That’s because more of the NOI must be used to make debt payments, which are now higher since interest rates are higher (even if total debt remains the same).

In short: as interest rates go up, cap rates go up, and values correspondingly come down.

Assumable Debt is Keeping Cap Rates Artificially Low

Whenever there’s turmoil in the capital markets, as there is now, cap rates should rise — as noted above. However, in some cases, cap rates haven’t climbed, at least not as fast as might be expected.

This is apparent in the multifamily sector. As it turns out, multifamily cap rates are not telling the whole story because people are selling deals with assumable debt. This allows them to sell at inflated values which, in turn, keeps some cap rates low.

Here’s an example of how that might work. Consider a hypothetical business environment with 7% interest rates. Someone may only be willing to spend $10 million on a property given the cost of their anticipated debt service payments. Now, consider an owner who is willing to sell with “assumable debt,” meaning they work with their bank to have the buyer assume the existing mortgage, which is presumably locked in at a lower rate. Someone who was only willing to spend $10 million in a 7% interest rate environment might now be willing to spend $12.5 million on that same property since they’ll only be paying perhaps 3.5% on their loan. This keeps the property value artificially high when the expectation would be for values to come down. Similarly, it keeps the cap rate lower than the market would otherwise bear. Deals with assumable debt are artificially propping up values and also keeping cap rates low. (CBRE noted that this trend might be happening across all asset classes in its 2022 Cap Rate Survey.)

How to Navigate Risk in Today’s Market

It is important for investors to understand the market dynamics at play. For instance, lack of knowledge about the number of deals trading with assumable debt could cause some buyers to purchase a comparable property for the same price, except the interest rate might not be as low. In the case of two otherwise similar properties, one would be worth less because more must be spent on debt payments. To achieve the same returns as the other investor, the property would have to sell at a discount.

Here are some other steps to consider when trying to navigate risk and maximize returns:

Understand the current bid-ask spread. The “bid-ask” spread is the difference between what sellers want to sell for (the “ask”) and the bids they’re actually receiving from potential buyers. There is still a lot of bid-ask spread in today’s market. Owners are not in enough distress to be willing to sell at a discount — yet. Savvy investors should consider putting in conservative offers based on their own sophisticated underwriting (more on this below). Some sellers will reject the offer. Others may wait to see what other offers they get before coming back to negotiate closer to the desired asking price. In some cases, sellers will pull the deal from the market entirely. It’s risky, but it also ensures properties aren’t purchased at over-inflated prices. As the bid-ask spread narrows, more deals will begin to happen.

Play defense. One way to navigate risk in today’s market is by playing defense with existing assets. This can be accomplished through aggressive asset management, such as improving rent collection efforts, getting three bids on every contract, or renovating units to get a pop in value. Focusing on these things now will increase the property’s value as the market recovers.

Be sophisticated with underwriting. Properties became financially distressed in recent years because some owners were too optimistic with their underwriting. They assumed rents would continue increasing by double digits. Instead, it’s important to be conservative with underwriting. Look at historical averages, which are closer to 4% to 6% vs. the 7% to 12% that people were underwriting. By underwriting more substantial rent increases, owners were able to juice their projected returns, leading to inflated property values. This strategy ends up backfiring as double-digit rent growth can’t be sustained.

Here are some important considerations for underwriting:

Conduct sensitivity analyses. This is a technique that considers various elements that could influence the return on an investment property and helps determine how adjustments to each element could affect profitability. Consider the best, worst and most likely scenarios. Stress-test for things like inflation, rising interest rates, higher insurance premiums and higher taxes. Taxes can be particularly challenging to predict in markets where there is no cap on how much a municipality can raise them in a given year. This is why it is important to be conservative.

Don’t forget about insurance. Expect premiums to rise as properties get older and deferred-maintenance costs increase.

Consider local job growth, future supply and construction costs. These will all affect property values in the local marketplace.

Of course, being too conservative with every number will effectively kill each deal. Nevertheless, it is important to have confidence in underwriting. Sensitivity analyses should help prepare for worst-case scenarios. Those who were too lackadaisical with their underwriting in the recent past are in distressed deals today.

Bridge Lenders

During the most recent market run-up, some investors used excessive leverage to bolster their returns. Whereas most traditional lenders will only make loans worth 60% to 65% of the property’s value (the “loan to value”), bridge lenders are usually willing to take on a riskier second position. However, these loans come at higher rates.

Some borrowers, particularly those with less equity to invest, take out a bridge loan to secure a deal. Many of these loans are starting to come due, and borrowers face a deadly combination: they either can’t refinance into a new loan because values have come down, or they’re forced to refinance at a higher rate. In either case, the borrower might be forced to sell in a distressed situation because they cannot afford to make their debt payments.

Bridge lenders, unlike traditional banks, tend to be more comfortable taking over and managing commercial properties. They are less likely to work out an alternative arrangement with the borrower. This is poised to cause more distressed deals to hit the market as borrowers have no choice but to sell at a discount.

Bringing it All Together

The market is experiencing a correction, and the worst is yet to come. Short-term loans are starting to expire; leases are starting to roll. More investors will find themselves in distressed situations over the next 12 months, creating opportunities for diligent sponsors to invest at a discount. There will always be some risk associated with buying distressed property, but those who know how to navigate it will be well positioned to realize tremendous returns.

Adam Gower, Ph.D., builds digital marketing systems for real estate professionals who want to raise equity capital online (also known as crowdfunding). His latest book is “The Reality of Distressed Real Estate.” Learn more about Gower at GowerCrowd.com.