Distressed Assets — What, Why, and When
A “distressed asset” refers to an investment in real property that is priced below market value—typically due to solvency or cash flow issues on the part of the asset’s current operator, manager, or owner. These investments can take many forms: equity positions, partial equity interests, structured notes in the middle of a capital stack, or even senior loans. In layman’s terms, a distressed asset is a bargain that can be seized upon by well-positioned real estate investors. Like any other bargain, these bargains would cease to exist if the market for distressed assets were perfectly competitive. Distressed asset opportunities arise at particular moments when the seller is encumbered and the market for such properties is relatively cool, creating a demand mismatch for capital. The ability to realize value from a distressed asset rests on a couple of things:
- Being able to identify and acquire the distressed asset at an optimal moment, given broader market and asset pricing dynamics.
- Having the resources, experience, and wherewithal to realize the untapped value of the distressed asset by managing through sale, repayment, or other resolution.
- Future return potential is dependent on future cash flows, and hence depends on unlocking asset value.
- Successful distressed asset investing requires experience, scale, and competitive advantage.
- Access to distressed asset funds was extremely limited during the years following the Great Recession. EquityMultiple is working to offer distressed asset investing, alongside quality sponsorship, to accredited individuals.
Distressed assets are considered by some to be counter-cyclical investment vehicles and attractive diversification options during moments of public market volatility. Most fundamentally, future returns are determined by the future cash flows of an asset weighed against the price paid for those cash flows. Distress allows professional investors to capitalize on a lower price while also optimizing those cashflows through expert management.
Distressed Assets During Economic Downturns
Distressed asset opportunities arise far more commonly during economic downturns for reasons one might expect:
- An operator or asset manager (the current owner of the distressed asset) faces decreased demand for space or units at their property, whether the asset is an office building, a multifamily property, retail, or mixed use. Hence the operator may face increased vacancy, be forced to lower rents in order to retain tenants, or both.
- The current owner of the distressed asset faces other business challenges, such as an inability to retain a property management firm, that make it difficult to maximize value of the asset.
- The current asset owner expedited to exit the asset but, as a result of unexpected adverse economic conditions, is now forced to sell the asset at a lower price.
- Lower valuations across markets can push real estate lenders to “mark to market” their loans due to pressure from their auditors, in turn causing pressure on regulated reserves. During the last downturn, this created opportunity in the purchase and sale of debt securities.
- Some lenders are not equipped to own real estate. When underlying distress affects an asset to the point that a lien holder no longer wishes to invest in it, lenders may want to sell their position to avoid the difficulty of working out the problems.
During the Great Recession, several large, national investment firms – such as Lone Star Funds – established successful funds predicated on the acquisition of distressed real estate assets. The scale, expertise, and capitalization of these firms allowed for opportunistic acquisition of distressed assets across markets and throughout the recovery period. These funds focused on distressed real estate assets during this time purchased distressed debt, portfolios of distressed loans, equity, CMBS, or some combination thereof.
Success in distressed asset investing requires experience; the ability to accurately assess distress and opportunity; and sound strategies for realizing value and managing through uncertain times.
The following strategies may come into play as an experienced investor targets a distressed asset:
- Purchasing distressed debt at a discount to the value of its underlying asset collateral;
- Restructuring non-performing loans, or a multitude of loans sold in a portfolio.
- Installing “asset turnaround” strategies – borrowers in distressed debt situations often expect to ultimately lose the asset to foreclosure, and hence have ceased to practice quality asset management. Distressed debt investors may realize value by implementing better asset management strategies, including the creation of a dedicated entity to manage the property. They can also provide additional capital at far higher rates, given their priority position.
- Engaging in complex transactions that increase barriers to entry and lower competition.
- Leveraging a trusted industry name to engage in off-market transactions, further reducing competition and improving basis.
The rehabilitation of distressed assets entails significant legal knowledge, investment agility, and asset management acumen. Distressed asset investors may take advantage of a low-interest rate environment to achieve enhanced returns through leveraged acquisitions, particularly important given the increased likelihood of prolonged low-interest rates following the outbreak of COVID-19.
Reporting from Bloomberg on the current outlook of distressed real estate fund managers.
Access to Distressed Assets
While large investment firms were able to achieve sustained success during the Great Recession, individual accredited investors enjoyed little access to quality, private distressed asset fund structures.
Our goal is to present distressed asset investment opportunities, alongside quality fund sponsorship, at relatively low minimums. If you would like to discuss distressed asset investing with our Investor Relations Team, please feel free to reach out at email@example.com or schedule a call.
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