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Assessing Distressed Debt Opportunities

Matt Pitcher
4 min read

We all understand the fundamental philosophy that  generally drives winning investing (or at least I hope we all do): “buy low,  sell high”. Well, real estate is getting  pretty “low” across the  board these days. The billion dollar question, of course, is: is THIS “low” THE “low”? We’ll have to leave that question for another blog  since I have no idea nor does anyone else. But,  given that real estate operates in an imperfect marketplace (therein lies the  opportunity), chances are that all current “low real estate” has some  kind of distress associated with it (either personal and/or debt driven  distress). This blog will focus on assessing the distressed debt  opportunity.

As due diligence consultants, we’re asked all the  time to assess deals with some sort of distressed debt association. There are  those, such as Matthew Landau who spoke recently at iGlobal Forum’s real estate private equity summit in New York, who believe that the government’s  plan to repurchase troubled real estate-related assets from financial institutions is likely “to make for price discovery in the market and  provide a minimum price, or floor, for the asset prices”. Landau noted that  Lehman Brothers, for example, “made a good call in not selling its real  estate-based assets at very steep discounts, considering that the government  could pay more for the assets”.

Ok, I’m following you. That makes sense. But what about the following?
From National Real Estate Investor Online

In fact, the troubled asset  relief program (TARP) could even contribute to an upward pressure on prices,  Landau believes. As for the possible risk of buying too early in the cycle and  missing out on good deals, he noted that it is always difficult to time the market perfectly and investors need to buy whenever they feel comfortable and  leave room in case things don’t go right.

Wow, that’s not very helpful is it. That’s like  saying: “hey, do your due diligence”. Yes, I know that, thank you very much.  But, HOW?!? What specific things do I need to know about, watch out for when  dealing with a distressed debt opportunity? I’ll get to that in a minute, but  here’s more on the current state of the  distressed debt opportunity …

Jeff Gronning, a managing  principal with Normandy Real Estate Partners, agrees that the government  program makes for price discovery and could provide some direction to a  cautious market in which everyone is waiting for a bottom. Even then, he says,  “The problem is so much greater than what TARP is designed to handle,” which  means that until there is some kind of catalyst, people will not buy.

Thomas Deane, head of structured transactions and special assets at Wachovia Securities, noted that considering the problem is based on billions  of dollars in assets, there won’t be a bottoming out until the first or second  quarter of 2010. “Too much stuff needs to go out the door,” according to  Deane. Deane has seen a lot of buyers pull back since they don’t want to buy  at the wrong price. “Nobody is going to call the bottom. Do sensitivity  analysis and have confidence in your abilities,” is his advice.

From the buyer’s perspective, Lawrence Ellman, North America head of  investments for Citi Property Investors, expects that prices will come down  and become more attractive. “So far, we haven’t seen prices to our liking,” he  said. “We need more deal flow and sense of urgency on the part of sellers.”  However, lenders that are working with developers on assets in transition are  beginning to see reality — such as a possible need for a haircut on the loan —  and the borrowers are following along.

Ok, that’s a bit more helpful, but that still doesn’t help me figure out  how I can take advantage of this historical opportunity.

All of these experts seem to be saying the same thing: there’s a huge  buying opportunity out there right now in distressed debt. We don’t really  know when it will bottom and we don’t really know how you can profit from this  opportunity, but it exists.

Well, I can tell you how to profit. What will determine whether you will  either make money or get swallowed up is one thing and one thing only: due  diligence! There are “deals of the century” out there in waiting right now,  but you have to know how to make sure they don’t blow up in your face. Here’s  a high level review of a starting due diligence checklist when evaluating a  distressed debt opportunity:

1 – Remember that you really have two major due diligence projects: (1) the  property and (2) the debt.

2 – Understand the lender’s business rules: the visible (organization  charts, documents, forms, processing guidelines, etc) and the invisible  (office politics, relationship between who originated the loan and who’s servicing it, history of bank and the players involved, etc).

3 – You have to work with whatever the lender gives you, which won’t be  everything you need. You’ll need to review the documents with one eye on the  documents they give you and one eye on what’s missing. So, you’ll need  your detective hat on and be able to read between the lines and fill in the  blanks.

4 – You will have to really understand all the security documents, so  don’t skimp on legal/advisory help.

5 – You’ll need to understand who has recourse. What other liens are  attached or, better yet, could get attached?

6 – You’ll need to do all your normal due diligence on the property  itself. Environmental, title, appraisal, management, lease analysis, financial  solvency of leasebackers, local political environment review, use analysis,  market supply/demand dynamics, trade areas, employment trends, absorption  rates, etc. Don’t forget about that while focusing on the distressed debt due diligence.

So, there you have it. There is a great distressed debt opportunity out  there right now and it’s only going to continue to get better and more  prevalent in the months and years to come. If you become an expert at  assessing those opportunities, you will thrive during these turbulent economic  times and be in a great position when the market comes back and make fortunes for  you, your family, your contractors, your investors, and your community.

After all, remember that – although I do not believe we are heading into a  depression – more fortunes are made during depressions than at any other  time in economic history. Make yours now!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.