Back In the dynamic landscape of real estate investment, investors are constantly seeking innovative strategies that yield favorable returns. One such strategy that has gained significant traction, particularly in the wake of the COVID-19 pandemic, is investing in distressed debt collateralized by real estate assets. The pandemic-induced economic downturn led to a surge in distressed assets as businesses faced disrupted work environments and forced closures, prompting investors to explore alternative avenues for value creation.
According to data from PitchBook, the value of capital raised by investment funds created specifically to buy distressed debt soared from $17.5 billion raised in 2019 to $33.4 billion in 2020, followed by $36.6 billion in 2021 and $32.2 billion in 2022. Highlighting the sentiment that in times of economic hardship and market fluctuations, distressed debt presents unique opportunities for investors. By acquiring discounted debt instruments secured by desirable real estate assets such as multifamily properties, hospitality establishments, and office buildings, investors have the opportunity to navigate market disruptions and achieve significant financial gains. In this article, we delve into the realm of distressed debt, uncovering why real estate investors are drawn to this strategy and how they mitigate risks and maximize returns within the sometimes-overlooked sector.
Understanding Types of Distressed Loans
Before examining the reasons behind real estate companies’ interest in distressed debt, let’s first clarify the terminology. Non-performing loans (NPLs) refer to loans on which borrowers have ceased making payments altogether and have become contractually in default. Alternatively, sub-performing loans (SPLs) represent loans where borrowers are either consistently making partial payments but fail to meet their total monthly loan obligations, or those where certain loan covenants, such as a set debt service coverage ratio, are not being met, resulting in technical default regardless of if payments are being made.
Real estate investors have become attracted to this space due to the potential for acquiring distressed assets at a meaningful discount to their fair market value. When borrowers encounter financial difficulties, lenders can opt to transfer these NPLs or SPLs to investors at a discount to their outstanding principal balance. More recently, the market has started to see banks also offloading fully performing loans at reduced rates in efforts to minimize their exposure to certain asset classes or locations. This presents a unique opportunity for investors to step in and acquire these loans at a discount, while also securing the rights to pursue the underlying collateral in the instance the loan fully defaults.
Why Invest in Distressed Debt?
Upon acquisition, investors are presented with two primary avenues for potential value realization. The first avenue entails collaborating with the borrower to craft a loan payoff agreement, or forbearance agreement. This approach falls under the umbrella of traditional loan servicing, and it allows the investor to negotiate favorable terms to the borrower due to the investor’s purchase of the loan at a discount. By opting for this path, investors benefit from additional monthly cash flow from loan payments and also anticipate the eventual payoff of the loan and return of the asset to a non-distressed status.
Alternatively, the second path involves proceeding with foreclosure on the loan, thereby securing ownership of the underlying collateral. This scenario grants real estate investors a significant advantage over traditional lenders. Leveraging their knowledge of property management, market dynamics, and value enhancement, investors can execute value-add business plans, attract new tenants or buyers, and enhance the overall appeal of the asset. Not only does this approach align with a value-driven investment philosophy, but it also contributes positively to local communities by repositioning properties that might otherwise remain neglected.
The current climate of escalating interest rates has only heightened investor’s ability to create alpha with this strategy, as the rising expense of borrowing places greater financial burden on borrowers. These pressures ultimately result in a proliferation of distressed debt opportunities available for investment. Real estate firms, leveraging their expertise and resources, can transform these underperforming assets into profitable ventures in ways traditional lenders do not have the capacity or experience to do.
Mitigating Risks and Maximizing Returns
While the potential upsides of distressed debt investing can be enticing, it’s essential to acknowledge the inherent risks and adopt a strategic approach to mitigate them effectively. Thorough due diligence is paramount, encompassing detailed property assessments, borrower analysis, and legal considerations. A well-structured exit strategy is equally crucial, allowing investors to navigate potential hurdles and capitalize on repositioned assets. Additionally, successful distressed debt investing necessitates a nuanced understanding of real estate dynamics and a robust network of industry professionals. Partnering with experienced loan servicers, legal experts, and property management teams can significantly enhance the likelihood of a successful turnaround. Navigating the unpredictable terrain of distressed debt investing demands a flexible mindset and an ability to adapt to changing circumstances. Investors must be prepared to adjust their strategies and tactics based on evolving market conditions and borrower dynamics.
Investors must approach distressed debt investment with a comprehensive risk management framework. This involves analyzing the collateral’s fair market value, understanding the borrower’s financial situation, and assessing the potential for successful loan workouts. Rigorous due diligence helps investors identify properties with the greatest potential for transformation, ensuring that resources are allocated strategically to assets with a high probability of generating positive returns. Crafting a well-defined strategy for managing and improving distressed properties is pivotal, as it provides a roadmap for navigating challenges and optimizing the potential for value creation. By proactively identifying and addressing risks, investors can position themselves to weather uncertainties and maximize returns over the investment lifecycle.
In summary, the realm of non-performing loans backed by real estate assets presents an intriguing and potentially rewarding avenue for investors with a sense of opportunism and strategic foresight. Reflecting on past market downturns, such as the significant distress witnessed in 2010, underscores the value of early action in accessing distressed debt. By actively participating in distressed debt transactions, investors facilitate the orderly removal of these assets from banks’ balance sheets, thereby mitigating further decline. This proactive involvement not only safeguards the value of performing assets but also contributes to the overall health of the real estate market. Rather than waiting until banks are fully overwhelmed, Halstatt and others are adopting a proactive stance, recognizing the potential benefits of engaging with distressed assets before the market becomes oversaturated.
Halstatt’s Involvement
Since entering the sector in 2021, Halstatt Real Estate Partners (HREP) has acquired six non- and sub-performing loans, one performing loan, and one real-estate owned asset, with three deals successfully realized to date. These investments span across asset classes, such as office, retail, multifamily, industrial, and mixed-use properties, showcasing HREP’s agility and expertise in navigating various sectors of the real estate market.
