How to Invest in Commercial Real Estate

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Episode 115 - Investing in Distressed Properties: Strategies for Success in Today's Market

by Criterion, Braden Cheek, Brian Duck
August 21st 2023

Today hosts Braden Cheek, Brian Duck and Joel Thompson discuss the potential upside and value of investing in distressed commercial properties.

Time Stamps: 0:00 - Introduction and show over... More

All right. What is up and welcome back to how to invest in commercial real estate. Another super awesome, exciting, amazing, very interesting. Best, how to invest in commercial real estate show in, in Tulsa. Best one. I mean, show me another, nothing like having our own show, but it's the only one as far as I know, but that makes it the best. That makes it the worst. That it's very true. Unfortunately, anyway, um getting back to the show here, we announced on last week's show that we were launching a new investment offering in was we've been doing a lot of deals on. This is our third development deal. It is a ground lease with Bojangles and then a two tenant strip center that has five guys and uh Blaze Blaze Pizza. If you knew how many, if you knew it's, it's hard, right? There's a lot of sites, there's a lot of freaking tenants, but like we're, we're developing shit all over the place. So II I know it just, you know, it takes, takes a minute to register. So we launched that last week, right?

Yeah, we can we stay on topic, launched it and we filled it in 24 hours. What was the equity raise? Braden? Uh It was like 99 40 nine, it was 9 50 9 50 sold out in, in 24 hours. So we, we appreciate all the investors jumping on so quickly and making their commitments. We think it's gonna be a really great development. We have great national tenants. Let's see. We are closing tomorrow on another deal. Yeah, so we just closed on uh the Grand Prairie learning experience. Um We just signed the contract on that with commercial builders. This will be our third or fourth project with them, with them. So we're super excited to get that mobilized here in the next few months. Um Again, that's down in, in Grand Prairie, Texas just closed on, on that piece of land and we have several more of those. I know I keep mentioning and I always forget to write the names of the cities down, but generally speaking, they're in Dallas. Ok? And there's several. So if you like the investment profile, there's a lot. Yeah, it'll be a lot like the kitty academies.

We've done very similar single tenant deals. Yes, early childhood development. Yep. All right. What is our show about today? Today? We're gonna talk about uh considering distressed uh properties and, and so a lot of the deals we talk about are cash flowing properties or even some of these brand new developments. But there's another very profitable part of commercial real estate. And it's the distressed property. So it could be, uh, apartments that are being mismanaged. They may be bank owned, uh, you know, foreclosed. It could be a retail center that's got a bunch of vacancy and, you know, maybe it's got an outdated facade or something. It just doesn't look that great anymore. It's outdated. So let's dig into that because it's not always just a piece of shit, right? Like sometimes it's a nice looking center in a nice area. It's, it's distressed in the sense that maybe it lost several tenants, coincidentally or, or the seller couldn't figure out their financing or it's, or it's bank owned. So a lot of the times it's a piece of shit, I mean, which is fine. It's, it's fine but it's not always that way.

Yeah. And so what we want to encourage you guys today is to always be looking for ways to creatively add value and a lot of the, the properties that are distressed that are, that are bank owned that are foreclosed, you know, uh maybe apartments in, in tougher areas or retail without a lot of occupancy is people say, oh, that's, that's headaches, that's problems. Uh And it, they are, there are problems that you're gonna have to go in and solve. But the key is is that the competition is limited in those because not everybody wants problems. A lot of people want to avoid problems and So you limit your competition and that increases your potential uh for getting a good deal or for making outsized profits when you can take on problems and you can see through them to the other side and you know how to remedy those problems and, and improve the property. So do you think uh in light of the current interest rates being high that this could be something that, that uh might be more prevalent uh in the coming months? I mean, Joel, you lived through 2008, 2009 when it was very similar, you lived through the eighties when we talk about all the decades Brian's lived through.

But yes, I did make it through, I've lived through lots of interest rate increases. Uh But uh so what kind of series of events could happen that could lead, you know, in this kind of climate that could lead to uh distressed properties? Is it that uh because of the interest rates, people might have um leverage problems right now, banks might be taking over, there might be some foreclosures. Is that, is that possible in this, in this um current um interest rate increase? Question? It took him a while to get it out but he got, he did it. Yeah. So I think the biggest thing we're, we're talking about here, right? Is like the cost of the debt, right? Because the the debt has term on it, right? It's typically 57 or a 10 year note to maybe 15, you know, whatever, eventually it's going to expire and it's not fully amateurs, meaning there's a massive balloon payment, right? Like your loan is due, you owe us $5 million tomorrow. So how do, how do people get out of that in a normal situation or a normal client? Is you would either sell or refinance that asset? So you would pay off the old loan with a new loan or you would pay off the old loan with a sale, right?

So what we're talking about now is let's just say you want to keep the property, well, we'll go for both scenarios, but you want to keep the property, you owe, you know, $5 million on it. Um You know, so it's maybe a seven or a $10 million asset and the cost of that $5 million is, is what, maybe two or $300,000 a year. So now that same $5 million may cost you four or $500,000 a year. So what does that do to the profitability of that um center for the investor? It substantially goes down to the point where it may not be able to afford it and then they're having it. It's creating a negative cash flow event where the cost of the capital and then you obviously wouldn't get that loan, right? The loan, the new company, the new bank wouldn't give you that loan because it wouldn't support it. So then you're forced to sell this asset at kind of whatever the market will take. So you're fire sailing this asset essentially again to pay off your original loan that expired because you won't be able to get a new one because somebody's going to say you can't afford this property, can't afford $5 million.

We can loan you, you know, $3 million because that's the, what will meet your debt service coverage ratio of, you know, 12 or 125 or whatever it is? That's kind of a long answer, but it's really just not being able to afford a refinance. So you're being pushed into a sale to pay off your balloon payment. Yeah. And your question, Brian is, is, it's true. We are because of the high interest rates. I'm expecting us to move into uh what I'll call kind of an opportunity for distressed assets type situation. If you think back about 2000 8, 2009, what we had was a really hot real estate market for several years leading up to that with, you know, relatively low interest rates. And, and so once we had that, that crash, uh you know, lending dried up and people couldn't refinance, they uh couldn't find renters and it was just a global catastrophe. This is gonna be a little different in that. I don't see that kind of a crash coming this time. But what we have seen is for the, you know, for the last, you know, 15 years from 08 to now, 2023 is we've had this super hot real estate market and in generationally low interest rates.

And so, and, and high uh increase in rents because of inflation, especially the last two or three years. And so purchasing, they're like, yeah, I'm getting a 3% 2.5 3% 3.5% interest rate. And so I can, I can afford a 4, 4.5 cap on my deal and I can barely make this work. But don't worry, I'm projecting a rent growth of 34 5% a year. So I'm gonna be fine. Ok? But what's gonna happen is as inflation slows and interest rates rose. Uh Now the uh the rent growth is gonna slow down and their, their 2.5 3% interest rate is gonna come due and then they're gonna say, well, now, like you just said, I, I can't debt cover with 7.5%. I can't debt cover with 7% 8%. And so that is going to create opportunities because those properties are going to be fire sold. If they need to be, they're going to get foreclosed on in certain circumstances. And now the bank's gonna take them back, the bank will not operate it as well as an owner. And so the they don't have to. Right, because they're, they're trying to sell it for 60 cents on the dollar to recuperate their loan.

They, they don't care about it. I mean, if you, if it's a savvy bank, they may try to, like, make a little profit off of it, but at the end of the day business plan and they can go after the, the, the borrower for any, usually not always but for any detriment on the, the loan, any debt that they're still owed, so they can get it on both sides there, both selling the asset and going after the borrower. Uh So I really feel like, uh if interest rates stay high for any longer period, if they come back really slow in the next couple of years, we're gonna see some distressed opportunities. This is why we don't have, uh this is why all personal, I mean, not all 99% of home loans are fully amateurs. And so the average consumer isn't kicked out of their house when interest rates gets high. So I'm gonna ask you guys a really tough question. Precision has a lot of existing uh loans, criteria has a lot of existing loans. What we got to make our investors. Uh We got to answer their question is what happens to uh to our existing loans you're in. I mean, we did a good job of, of securing for as long of, of a term as we could, but I'd like to hear what you guys have to say about that.

Yeah, I'll go first. Uh, you know, precision equity. We've got on our apartments, we have long term fixed. Fannie Freddie loans. Um, and so I would say, and those are fully amateur. No, no, they're usually 10 year fixed. Uh, so seven years sometimes. And so I think we have one small loan that no investors are on that may be coming due in the next 2 to 3 years. So I think we still have time for interest to come back down, but we had that loan for like 10, 12 years. So my balance is really low. So I won't have a problem even if I have to pay more interest in in uh refinancing that asset because the amount you have to refinance is gonna be so low pretty low after 12 years of paying a uh and and so, but yeah, we have been fixing for as long as possible on the retail side. I think the the least amount of years we have left on any of our properties is probably three. so still we have runway and that's why you always want to be considering fixing uh when the interest rates are really low, fixing interest rates for as long as you can in the event they go up, you can weather that storm. Yeah, if you don't have a prepay on your loan and you're in a good economic climate with good low interest rates, you need to be going to lenders and saying, hey, I wanna lock this in now for as long as I can.

What's that rate and a good climate? You're gonna pay a little bit more for that lock and you're paying for the surety of having that through the ups and downs of market conditions. Exactly. Exactly. Ok. So, II I think that's a good answer. Um, so let's get back to the distressed. Um, ok. So you said that, um, so let's say it does go to foreclosure, I'm gonna assume, or if there's a, or if there's an owner that really can't afford much, I'm gonna assume that because he's gonna let the property, um, he's not gonna spend as much in maintenance probably. Right. Because he needs to save money. He knows he needs to save money. Um, that a man only, only man own real he or she, uh, they, um, I'm just kidding. And then, uh, I assume if, if, if conditions go down then maybe occupancy might go down because, because, uh, if, if you're in a bad center, you're, and you across the street, they're, you know, giving you the same rate and it's a nicer center, you're gonna go over there. So, occupants see, I assume could possibly go down at the same time. Is that right? So, I think that's really well put because most people and I think that's why we haven't seen a lot of these opportunities lately is because it takes a little bit of time and, and you kind of describe that from the moment it gets taken over by the bank or the owner can't afford the, uh, the main, the maintenance on it or the upkeep or whatever it is or a tenant starts to leave.

So they have some slippage in the triple nets. Then it really maybe goes through a 12, I mean, 6, 12, 18 month process of getting run down over that period of time, you'll have some more tenants leave, putting more distress on the property and the value. So it's really, you know, within a couple of years of that asset going into trouble is, is where you find opportunity. And again, that's where I think a lot of things, a lot of things, you know, the tide hasn't completely gone out yet. It doesn't happen overnight. So, yeah, that's what you have to continue to monitor and, and a lot of these, um, deals, you can just do that with your eyes, right? Like a lot of us in real estate, enjoy looking at buildings when you're driving down the highway. Oh, what's that worth? What are they doing here? What's going in there? Oh, that'd be a perfect. I mean, I do, I kind of think about all that stuff and when I see a, uh, what I would consider a diamond in the rough, it's typically something that hasn't had their lawn mower. They've got this roof that's needed to be repaired forever or fences that need blown down or just a bunch of down units or burned down buildings or, you know, retail that you think should be leased, you would be mind blown at the amount of landlords who don't get leases because they have a leaky roof of the space and they just can't afford a new roof or they can't afford tenant improvement dollars or they don't pay leasing commissions to the leasing brokers.

So like nobody really tries to bring them stuff anymore. A lot of the times there's value to be had and kind of going back to your sentiment in the beginning about headaches when you're getting involved. A lot of people get involved through distressed properties through e even the the base layer of just a fix and flip uh rent house like you, it's very rare. You talk to beginning rental investors or in the residential home space and they're like, yeah, I bought this rental house and in five years I'm gonna refinance it and do it again. They never do that. They're like, yeah, I bought this piece of shit. I'm gonna go add some value and then I'm gonna sell it to somebody later. That's what we're doing here. So, headaches are your friend. Headaches are dollars right? Going and fixing this problem that a normal investor doesn't want to deal with. That's where you fit in this puzzle. That's why you made money. That's why you bought this deal and it's the easiest to do in distressed properties because there's so much value to be added and it's all, it's all perspective, right? Like what are you gonna do with it? How much money are you gonna spend? I could do the same value deal as you, but spend twice as much money because I think I'm gonna generate twice as much money.

So it made sense to me whereas you said now it doesn't need that. I'll just do a little bit and get a little bit more money. So the value is there for you to kind of play around with. But finding the gorgeous center and the gorgeous part of town that doesn't need any work, everyone wants to buy that because there's no headaches. It's too easy. It's like a, it's like a bond. Yeah. So how do people go about uh evaluating the numbers on a distressed property? Because, ok, they see a property that looks run down, maybe it's an apartment complex that's 60% occupied and it's got, you know, 30% of the units are down, they need carpet, they need paint, they need drywall, they need all these things. And so as an investor, you've got to be able to determine what is the price I should pay today. What am I gonna spend uh on all these down units and beautifying the property and getting a great management involved. And then what do I, what am I gonna be able to rent these units for when I get done with all my work? And then how does that translate and mark through market cap rate into a, a sale price that I can make money?

So that's the pieces that you're putting together. Ok, I'm gonna buy this apartment complex for $2 million and I think it needs $400,000 worth of work. And I think I can increase the uh the rent per unit by $100 a month, 1200 a year times, you know how many units and then I can back into a sale price and say, ok, is there a profit left over though? That's the kind of mental exercise that you're doing on retail? It's fairly similar. You want good traffic counts. You want reasonable part of town don't have to be the best part of town, but a retail is more important to get a, a decent part of town. And then you gotta say, ok, uh what kind of rent if, if I, they haven't been able to rent the space? So I'm gonna have to offer it at a lower rent than they've been asking. And how much T I am I gonna offer? And what's my leasing commission I'm gonna pay? And if I can get tenants in there, what does my noy go to and, and can I make money and that's the distressed uh thing that we're always asking ourselves and we're looking for distressed properties and we've purchased a bunch of them, both mainly multifamily, but also some retail where we've leased up vacant space and added value.

It's, it's anything on the balance sheet, guys like anything going on your balance sheet as far as capital expenditures or improvements into the property, whether it's a distressed value add deal or we're thinking about renovating a property, it's what is this investment on the balance sheet translate to on the P and L? That's it. And understanding those relationships. Yeah. So going into a distressed property, you need to be prepared to having excess funds going in, right? Like you can't just buy the property, you're adding value value is dollars, right? Like value costs money, it it costs an investment. So be prepared for that. You're typically going in with some sort of loan to cost loan from a bank, you know, where maybe you're getting loan dollars for your renovation as well because they believe in your stabilized performer and then maybe penciling in some sort of refinance after it's stabilized, right? And that allows you to extract your value while still keeping the property and not generating a taxable event. That sounds like a massive win. Yeah, and we've done that a few times. Just just fix it up, get a new appraisal ref pull out cash, pay off your existing note and, and take that new cash and go do it again, but you still have the asset.

Uh but we encourage everyone. Uh This is a little bit of a slow period buying properties now because interest rates have gone so fast, they've increased so quickly. Sellers haven't adjusted their price and people haven't really got to the distress point where they're getting foreclosed yet. That is going to happen if rates stay high for, let's say another year or so, there's gonna be those opportunities. So we need to keep our eyes and ears open for those because you're gonna wanna to, to try to pick those up. I mean, the best buying opportunity of our lifetime was in 0809. You know, money was, you know, printed by buying assets when the market is depressed, just like you want to buy stocks when the market goes down. Not when the market goes up. The same is with real estate if real estate ever takes a dip. And I think about 0809 when uh, properties in Vegas and in Phoenix and in L A were all 40 50% off. Well, now they're, they're twice, three times as much as they were. Uh, but nobody wanted to buy an 09. They thought the world was ending. Everyone always thinks the world's ending. When you're going through a crash, we're going through a market correction and smart people bet their money uh, during that time and buy assets other people, they keep their money in the bank or under their pillow and they're afraid to take action.

But I'm telling you when the market goes down, when the market corrects, that's where you have to buy. What's it saying? When everybody else is selling, that's when you need to buy. When everybody else is buying, that's when you need to maybe consider selling. What do you guys think about the, the guy that put that massive short on the entire market? The guy that did the 08 housing short. I, I did see that article. Interesting thoughts last minute. I mean, we're due for a correction. I, I don't know that it'll be a crash like we had, but the market is due for a correction. We've been on a real long bull run. I agree. All right. Well, that's good for me. Anyway, we will catch you guys next week on how to invest in commercial real estate. Thanks. All right, thanks.

Episode 115 - Investing in Distressed Properties: Strategies for Success in Today's Market
Episode 115 - Investing in Distressed Properties: Strategies for Success in Today's Market
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