What is distressed real estate?

Distressed real estate refers to an asset that is priced at a discount to market value, usually because the owner is insolvent or because the sale is the result of an enforcement action by the lender of a non-performing loan. For obvious reasons, such sales become more prevalent during an economic downturn.

Not only can investors acquire distressed assets at an undervalue, but the properties themselves are often neglected, with sellers unable to fund the necessary capital expenditure for maintenance or upgrade works, or simply of lower quality. This presents the possibility of making improvements to drive up value and resell at an even greater profit. New investors can either acquire assets directly or pursue a longer term “loan-to-own” play of taking control of the distressed borrower by buying up debt and exchanging it for equity through a restructuring process.

Such strategies are far from risk-free, however. With a delinquent or insolvent seller, it may not be possible to carry out normal due diligence of title and letting documents and management information might be incomplete or inaccurate. Acquisitions may have to be completed rapidly on a fire-sale basis. Assets may not be immediately lettable or income generating without significant investment of time and capital.

Distress in the current market

The era of low interest rates, which began with the GFC and ended with rising inflation in 2021, is one of the key drivers behind distress. Borrowers looking to refinance property debts suddenly find they are not only facing potentially higher interest payments on their existing debt, but new debt is either unaffordably expensive or simply unavailable. At the same time, occupier demand for secondary office space in particular has weakened, putting further pressure on interest cover ratios. Many real estate investments no longer make financial sense, which in turn has led to a fall in investor demand and reduction in values.

The result is a so-called “funding gap”, which refers to the shortfall where the amount of debt now available to finance real estate is less than the amount originally borrowed. Some have reported that this funding gap amounts to tens of billions of pounds in the UK alone, mainly in the offices sector but also affecting residential, retail and other asset classes. Within that context, 2024 is a key year for loan maturities, forcing borrowers to sell assets, find new sources of debt or seek to negotiate extensions with their lenders.

The willingness of lenders to extend existing loans is one of the reasons why the predicted uptick in distressed real estate deals has yet to fully emerge, another being the replacement of banks by debt funds and other private lenders as alternative sources of debt to help plug the funding gap. But for how long will lenders “extend and pretend”?

So far, lenders have been relatively slow to enforce non-performing loans, protected in part by much more cautious loan-to-value ratios used following the less prudent days of the noughties. It may also be the case that some lenders lack the internal resource and expertise to deal with large-scale work-outs of the type we saw in the GFC, especially given the more diverse pool of lenders now in the market. However, there is some evidence of lenders becoming more proactive, particularly where the capital value of assets – such as secondary offices facing structural issues like working from home and energy efficiency requirements – is not expected to recover as the market improves. For less challenged assets, where the source of stress is the cost of leverage rather than structural issues, some are already calling the “bottom of the market” in 2024. If this is the case, the gap between buyer and seller expectations in terms of pricing may be about to narrow.

Navigating the pitfalls

Acquiring distressed real estate presents a significant opportunity for the right investors to acquire undervalue properties. With the right strategy, the increased risk will, hopefully, be offset by more generous returns that may be unavailable to other (particularly institutional) investors who are more risk-averse.

These risks can include lack of information or opportunity to carry out proper due diligence, particularly where the property or seller is subject to an insolvency process. The insolvency practitioner will be unable to provide the usual package of information, or reply to sensible enquiries. The investor will, therefore, acquire a property with limited information. It could turn out fine, but in many cases there will be issues to resolve. This will, at the very least, be a management hassle and it may be expensive, potentially undermining the investment. Successful investors in distressed real estate accept these risks but have strategies for managing them.

Firstly, they use their experience and take advice to form a commercial view about the size of any supposed risks. Lawyers are often seen as quick to point out problems but those experienced in dealing with distressed real estate can help clients assess the problems and suggest strategies for solving these.

Secondly, private capital investors often have access to greater resources (or more easily available capital) to resolve issues. This can be difficult for other investors, particularly if they are already highly leveraged, which may be the reason the property is being sold in the first place (eg if a seller does not have the cash to make energy efficiency improvements to make a property marketable).

Thirdly, distressed real estate can sometimes be acquired on a portfolio basis, either directly or by acquiring debt with a loan-to-own strategy. The underlying risks facing each property may be the same, but the good assets will, hopefully, offset the bad ones.

Opportunities for private equity

This backdrop of distress in the commercial real estate market continues to attract private equity investors. After the start of the Covid-19 pandemic, there were large distressed funds raised by experienced private equity real estate investors but, as mentioned above, the anticipated level of distressed deals did not materialise. Distressed real estate funds have, however, continued to be raised, although not at the same levels as the Covid peak. With capital waiting to be deployed, real estate having been meaningfully repriced and debt funding costs for deals likely to be on a downward trend, now may be the time that private equity investors are able to take advantage of still attractive entry valuations for distressed investments.

Private equity investors think about market opportunities in terms of the risk-return dynamic of any particular prospective investment. If a private equity investor can identify a situation where it believes the relationship between risk and return is asymmetric, and that it has sufficient knowledge of the asset to enable it to execute its investment strategy, then it will be willing to take the risk. Private equity investors in distressed commercial real estate tend to be market and sector-agnostic, their focus is much more on the investment return potential of a particular situation.

A private equity investor will have the skill set to assess the best point in the capital structure of the distressed asset to invest. That may be an equity investment or a debt investment, including a purchase of debt in a loan-to-own strategy. The key point for the private equity investor is whether the investment has the potential to meet its target returns. For distressed real estate funds, target returns are high in internal rate of return terms, reflecting the level of risk.

Private equity funds will also need to be able to access the real estate asset management skills necessary to deal with the distressed situation and its proposed investment strategy.

If the increasing pressure on commercial real estate owners to de-leverage in the near-to-medium term begins to generate a wave of distressed opportunities, then private equity investors will be standing by.

Authored by Mathew Ditchburn, John Livesey, Graham Nicholson, and David Horan.

An earlier version of this article appeared in EGi on 11 September 2024.