Distressed properties

Today’s challenging economy has faced many financial institutions, investors and owners with nonperforming or underperforming assets. The holders of these nonperforming assets are in immediate need of guidance that will address the workout, restructuring and recovery of distressed commercial real estate loans and assets.

“We have seen a shift in the real estate industry, where the primary stakeholders have moved from investors to creditors, debtors and trustees,” says Randy Buddemeyer, managing director, asset services group, CB Richard Ellis Florida. “The needs of these clients are more urgent and require greater in-depth knowledge of all aspects of commercial real estate and lending. Professional guidance is essential if anyone is to see a positive outcome from the situations they are faced with.”

Smart Business asked Buddemeyer to discuss how the influx of distressed assets is being dealt with by both property owners and their capital sources.

What defines a ‘distressed asset’?

There are three types of distressed assets: assets in distress due to fundamental deterioration (reduction in net operating income due to weakening tenancies and/or increasing operating expenses); assets in distress due to capital markets constraints (fundamentally sound assets that are in distress due to the inability to refinance an asset when a loan comes due); and assets with some combination of the first two, which are often assets that are overleveraged at initial underwriting and fall into default due to a covenant default or the unwillingness on behalf of the developer to fund future capital commitments because the asset is deemed to be far too underwater from an equity standpoint to justify further investment.

Due to the combination of excess utilization of leverage, overly ambitious cap rates based on proforma NOI (net operating income) growth and the difficulty of renegotiating securitized loans, we have seen a rise in distressed properties and properties under foreclosure order.

What property types are distressed and where are they mostly located?

Distressed properties have already appeared in almost every significant commercial property market in the United States. The West has the largest value of both distressed and potentially troubled assets, and the Southeast contains the largest number of individual distressed properties.

Construction financing was the first and the hardest hit. Retail assets have the largest exposure of potentially troubled properties. Apartments, including failed condo conversions, have the largest number of potential troubled assets, and hotels could see the most dramatic increase in the coming months. Total inventory of distressed assets exceeds $106 billion and is growing rapidly.

How are distressed assets affecting those who invest in commercial real estate?

With the rise in foreclosures comes a swift change in property owner interest. When a lender forecloses on an asset, it assumes the property’s debts. By contrast, when a court places a property in receivership, responsibility for the property’s debts remains with the borrower. A court-appointed receiver is charged with taking guardianship of the asset’s finances, property management and leasing. The receiver will either retain other specialists to handle these responsibilities or manage them on its own.

To effectively manage the role of receivership, several phases of the distressed asset’s life cycle need to be addressed. For instance, restructuring services from a professional should include consultative recapitalization strategies, realistic market analytics and timelines, and exit strategies. As court-appointed receiver, the restructuring services provider will gain control of the asset, its cash flow and all related accounts and will advise in asset stabilization, like project management and development services along with transaction management.

The goal is to reposition the property for the highest and best use and then strategically position the troubled asset or loan through all phases of disposition through either increased steady-state operations or speed-to-sale. Each transition plan needs to be carefully tailored to stabilize asset value and to elevate service benefits and operational efficiencies. Without professional guidance, managing a distressed property can leave property owners, lenders and occupants of the property in great turmoil.

How is this translating into opportunity for investors?

We are seeing investors change in their analytical approach and decision-making regarding sound investments. This distressed asset can be a profitable new opportunity to a new investor who might not have previously considered this investment. It is not always the case that the property itself is performing poorly but that the borrower entered into financial terms that it is unable to sustain or has little potential for restructuring. Due to the change in core economic fundamentals, we will continue to see a change in the investor’s approach to new opportunities and willingness to assume risk.

As stated by Anthony Buono, the executive managing director for CB Richard Ellis Retail Services: ‘In five years we will look back to this period as the ideal time to have acquired core retail.’ This is a statement that could most likely be applied to most property investment types.

Randy Buddemeyer is the managing director of the asset services group at CB Richard Ellis Florida. Reach him at (813) 273-8412 or [email protected].