When people think of distress, they typically think of run-down properties as you’d see on home flipping shows on TV. In general, distressed assets are situations where the property is nearing a foreclosure.
In this article, we will be talking about, ‘Where Distress Can be Found in Commercial Real Estate.”
Distress can look differently in every case, and can range from physical distress (value-add), to defaulted subordinate equity in a sky scraper in Manhattan.
Distress can be found in four main areas of a real estate deal.
60% of all distress in a real estate deal can be found within the debt side of the capital structure. We all know the term ‘over-leveraged’, this didn’t just occur during 2008, this happens more than you think, it just doesn’t always present itself negatively right away. Sometimes it can take several years for this to present itself. A few examples of distressed debt would be; Maturity Defaults, Term Defaults, or Bank Regulatory Stress.
We mention this a lot. The operator runs the show, hence 25% of distress in a real estate deal can be found within the operating team that manages the day to day operations. Typically distress from the operator is caused by one or more of these three causes; weak, inexperienced, or an absentee operating team.
10% of distress can be found within the asset itself. Most people would think that this would be closer to the top of the list, but it’s not. When distress is found within the asset itself, it usually lies within the key events not occurring, the property being unattractive, or not enough demand for the asset where it sits.
Lastly, is equity. Just 5% of distress in commercial real estate can be found within the equity portion of the capital structure. This usually occurs when the property is overleveraged, and a default occurs on subordinated equity. Or, in the case of issues with a weak operator, limited partners may look to get out of their position.
These are the four main categories where distress is found in commercial real estate. Although you could dig into further sub categories, looking at the macro picture can help investors understand where risk exists, and opportunities lie.
When is comes to where distress can be found, most people have it all wrong. The asset, where only 10% of distress is found is usually what many would consider to be where the most distress is found (value-add). The reason its only 10% is that with a properly formed capital structure, and a strong operator, bad real estate deals can actually go good. But on the other hand, with a weak operator with an overleveraged capital stack, good real estate deals can go bad.
We recently published our 9-Point Due Diligence Checklist that covers the nine essentials that should be reviewed, verified, and personally alight with in order to control the risk. Click here to access the checklist.