Considering Investing in Distressed Assets? Consider the Challenges First.
A common misconception is that many distressed properties can be profitable investments. However, when we analyze the value of these properties, we often find various complexities that come with them. These intricacies can overshadow any potential benefits, making it risky to pursue such deals.
Let’s start by understanding how a property becomes distressed. Usually, it happens when the owner falls behind on mortgage or tax payments. Distress can also arise from factors like geographical, environmental or government events. Sometimes, a property becomes distressed due to circumstances like divorce, bankruptcy or estate settlements. Advantages of distressed property purchases can include financial gain and time saved to gain approvals if purchasing land. Disadvantages may include a longer sale period and the need to forgo property inspection.
There are generally three types of distressed properties. In foreclosure or pre-foreclosure, the mortgage holder takes possession of the property and often sells it “as is” to the highest bidder. They may also choose to sell the property at a discounted price on the open market. If the property owner owes more on the mortgage than the property is worth, the lender might opt for a “short sale” to recover some of their investment.
In these situations, there can be a lot of competition for the distressed property, which ironically can drive up the price. Banks, in response to economic instability, usually prefer to avoid default and instead work with borrowers to find solutions. They aim to maintain a good relationship with borrowers they’ve profited from in the past, ensuring continued yield. Hence, we are not seeing as many notes being sold as some might think.
However, buying distressed properties has become challenging. Interest rates have significantly increased in the last year, making it difficult to access a mortgage with favorable rates and loan-to-value terms. Cash purchases are now considered the most attractive option. With a full cash purchase, borrowers can refinance later on and get their money back. Provided it is a good deal, there is less risk assumed.
When making an offer on a distressed property, investors must consider various factors. Many distressed properties have been poorly managed and were not prepared for economic downturns. Government restrictions favoring tenants over landlords can also impact property value. Liens, violations, and emerging environmental compliance costs can further diminish value. In addition, new government policies regarding housing for the homeless and asylum seekers can affect real estate, though the full economic impact is yet to be determined.
It’s important to note that the anticipated pent-up demand in rental and leasing activity along with increased occupancy after the pandemic has not materialized as expected. The government’s aggressive approach to acquiring and leasing properties for housing purposes adds another variable to the equation. In the office space, distress is evident in big cities such as New York and Los Angeles. Office vacancy reached an all-time high and, according to CoStar Group, only about one in three buildings is appropriate for housing developments. We have yet to see the impact of pricing and cost of conversions of office space to multifamily.
Overall, the complexities and risks associated with distressed properties make it crucial for investors to carefully evaluate various factors before making an offer, in any market. According to the late Sam Zell, buyers and sellers cannot come to a pricing agreement since no one knows how to assess the current property value. Buyers in today’s relatively unstable market ought to be very calculated, disciplined, and not get caught up in the supposed opportunities of distressed properties.
Esther Reizes-Lowenbein is the founder of Esther Reizes & Co.