How Smart Investors Discover the Hidden Value of Distressed Properties

How Smart Investors Discover the Hidden Value of Distressed Properties

6 min read
Paul Moore

Paul Moore is the managing partner of Wellings Capital, a private equity real estate firm.

Experience

After college, Paul entered the management development track at Ford Motor Company in Detroit. After five years, he departed to start a staffing company with a partner. They scaled and sold the company to a publicly traded firm five years later.

After reaching financial independence at the age of 33 and a brief “retirement,” Paul began investing in real estate in 2000 to protect and grow his own wealth. He completed over 85 real estate investments and exits, appeared on HGTV’s House Hunters, rehabbed and managed dozens of rental properties, built a number of new homes, developed a subdivision, and started two successful online real estate marketing firms.

Three successful commercial developments, including assisting with the development of a Hyatt hotel and a very successful multifamily project in 2010, convinced him of the power of commercial real estate.

Press

Paul was a finalist for Ernst & Young’s Michigan Entrepreneur of the Year two years straight (1996 & 1997). Paul is the author of The Perfect Investment – Create Enduring Wealth from the Historic Shift to Multifamily Housing (2016) and has a forthcoming book on self-storage investing. Paul also co-hosts a wealth-building podcast called How to Lose Money and he’s been a featured guest on 150+ podcasts, including episode #285 of the BiggerPockets Podcast.

Education

Paul earned a B.S. in Petroleum Engineering from Marietta College (Magna Cum Laude 1986) and an M.B.A. from The Ohio State University (Magna Cum Laude 1988). Paul is a licensed real estate broker in the state of Virginia.

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Email [email protected]
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Twitter @PaulMooreInvest
How to Lose Money podcast

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Are you sick and tired of being outbid for investment real estate in this overheated market? Or even worse, are you overpaying for real estate just to deploy capital and get in the game?

If you’re on the first path, you may be settling for dismal returns and missing out on real estate’s amazing tax benefits and appreciation. And you may be subjecting yourself to the whipsawing stock market or dismal yields in bonds. Or enjoying a lumpy mattress stuffed with cash.

If you’re on the second path, you might be on the tracks of an oncoming freight train. It may work out. I hope it does. But hope isn’t a sustainable business strategy for most of us, at least in my experience.

I’m writing today to propose a better path. A powerful path that could…

  • give you access to deals others miss.
  • protect you from downside risk.
  • provide income and growth others only dream of.
  • pave a path forward for your success in any market or economy.

Notice I didn’t say it was easy. Nothing good is easy. At least that’s what the old-timers say.

Also, notice I didn’t say it would work in every asset class. I believe the principles apply to every asset class, but certain types of real estate lend themselves to this type of thinking and action. Others, not so much.


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Intrinsic vs. extrinsic value

Warren Buffett told us that price is what we pay, but value is what we get. Discerning the difference is the key to what I’m about to lay out.

The price of an asset reflects its extrinsic value. The intrinsic value is the often overlooked and typically unknown value locked within the asset. It takes a skilled eye to spot the latent potential in that asset and a skilled hand to extract that value.

Thousands of real estate assets are performing “fine.” They are operating exactly as designed, and their owners are quite satisfied with them. And these owners are elated that the rising tide of an overheated market can fetch them top dollar when they sell.

Now, if you are a savvy buyer with an eye for intrinsic value, you may be able to see the potential of the asset that is being completely overlooked by the seller who’s done things his way for decades.

This is your opportunity!

You can’t change the cap rate, and you probably won’t talk this owner down to a lower price. And you can’t get this property from a bank that repossessed it.

In this overheated market, you will probably pay full price. But if you can see the hidden value and know how to extract it, you can make a fortune for yourself and your investors. Yes, even after paying full price.

An ancient Rabbi told the story of a valuable treasure hidden in a field. A man discovered this treasure and buried it again. Then he went and sold everything he had and bought that field. This is what I’m talking about in this post.

Let’s go through a few examples.

Case study #1: Residential rental property

My friend Eric Eickhof is an extraordinary Minneapolis real estate broker and investor. He helps investors spot homes that can be acquired and rented by the bed to college students. A $400,000 home near campus may be acquired at full price. You and I may think it is overpriced, and the seller may be smiling all the way to the bank. Other investors passed because they could only rent it for $1,500 per month.

But Eric knows more than the home values in that neighborhood. He knows the zoning rules, the walk time to important parts of campus, and the student preferences for rentals. And he knows great property managers who rent by the bed. He helps investors buy the home, and then he sets them up for a much higher income stream. Say seven beds at $600 per month—that’s $4,200.

As I said, Eric understands the intrinsic value of residential Minneapolis real estate.

Case study #2: Texas self-storage facility

My firm invests in self-storage facilities with some of the nation’s experts in intrinsic value extraction. One of our operating partners, Matt, connected with five angry siblings in Texas. Their parents had passed away, leaving them a self-storage facility they weren’t equipped to manage.

They weren’t getting along, and they were ready to sell their 600-unit asset ASAP. Matt was on a plane within days. Matt could see the asset’s potential, and he made a $2.4 million cash offer. They closed quickly.

Matt’s team went to work. They built a website and implemented a marketing program. They evicted deadbeat tenants and raised rates to market levels. They hired a great manager and slashed bloated expenses. The vacancy was cut in half, from 20% to 10%. And they implemented U-Haul truck rental.

Three months later, in June 2019, the property appraised for $4.6 million. Matt then acquired $2 million in debt, a 43% LTV ratio. Matt sold the property in September 2019 for $4.6 million, and the ~$400,000 in equity investors took home $2.6 million. Not a bad payday.

Case study #3: Midwestern mobile home park

The owner passed away in 2015. His wife lived three states away, and she never visited the 300+ lot park. The manager was quite capable, but she didn’t have the skills, resources, or desire to increase park income and maximize value.

This was a typical mom-and-pop operation. The manufactured housing world is full of them, to the tune of 85% to 90% of the nation’s 44,000 mobile home parks.

Our operating partner acquired the park for about $7 million in early 2020. The operator cut expenses by over $60,000 and improved the community for tenants.

The previous park owner paid the utilities, which was quite unusual for a park this size. The operator passed utilities back to tenants, saving over $100,000 annually.

The park had 50 or so empty lots as well, and our partner started a plan to fill these vacancies. This is a massive undertaking, one few mom-and-pop operators would attempt. As the team started down this path, they got an offer they couldn’t refuse.

The operator sold the property for over $14 million. The asset doubled in value, but the equity investors got a return of 3.4x, a 240% profit in about 10 months.

Did the value really change? Yes and no.

The extrinsic value changed dramatically. But the intrinsic value remained the same. It took our operating partner to see this value and extract it on behalf of investors.

Who are the winners in this strategy?

Who won in this deal? The same parties who win in most of these types of deals.

  1. The original seller. Compressed cap rates turned a mediocre asset into a $7 million retirement plan for this lady.
  2. The final buyer. He acquired a park that still had quite a bit of upside by filling 50 vacant lots.
  3. The tenants. They got a much nicer park with professional management, and their rates remained well below market levels.
  4. The environment. Studies show water usage drops by over 30% when tenants pay their own utility bills.
  5. The bank. You may not care about banks, but they’re made up of investors, and it’s good that they made a fair profit.
  6. The syndicator. He made well over a million dollars.
  7. The passive investors. They made several million dollars in under a year. And they never visited the park or even lifted a finger.

What types of properties work best for this strategy?

I believe this strategy can work well for all types of real estate. But after being involved in many asset classes over 20+ years, I see a few issues that stand out.

First, I believe this works especially well for commercial real estate assets. Why? Because appreciation can be forced. The value is based on a math formula. The value can be raised by increasing the numerator and compressing the denominator (when possible). Often dramatically, as we’ve seen.

The commercial real estate value formula: Value = net operating income / cap rate.

Secondly, I recommend you choose an asset class with a fragmented ownership base. One that has a large percentage of unsophisticated owners and operators who don’t have the knowledge, resources, or desire to increase income and maximize revenue.

These owners have greatly profited from the rising tide that raised all boats in the past decade and never dreamed of the price they could now receive for their run-of-the-mill asset. This is the case for both commercial assets in case studies #2 and #3 above.

Third, I recommend you seek off-market deals. This certainly isn’t necessary for the strategy to work, as we see in case study #1 above, but it sure helps. And finding off-market deals is a game for the obsessively passionate, full-time real estate strategist, for the most part.

So, what if you’re not full-time in real estate? Can you still get these benefits? Certainly. I have never run a self-storage facility and never managed a mobile home park. As a professional passive investor, I make good money from passively investing in these assets through professional syndicators.

This may be the era of overheated real estate. But if you know how to find deals like this or know someone who does, it’s a fabulous time to invest. As it always is.

Read more about distressed properties

Are you overpaying for real estate just to deploy capital and get in the game? You may be settling for dismal returns and missing out on real estate’s amazing tax benefits and appreciation. Here's a better path.