Since the early days of the COVID-19 pandemic, investors have been on the sidelines to take advantage of distressed real estate in the hope that this event will trigger something similar to the deep discounts that occurred during the Global Financial Crisis (GFC). As a Wall Street Journal article put it, funds, high-net-worth investors and family offices are “stockpiling cash, which allows them to move quickly into discounted properties.” However, banks have learned their lesson from the GFC and are being more cautious this time around in liquidating their CRE loan balances. As a result, there are fewer distressed real estate opportunities in the current economic cycle.
So far, strong fundamentals have allowed some owners to avoid the massive price cuts that many expected. But that may be starting to change as investors finally begin to see new opportunities. The problem is that the line between a declining asset and a truly distressed one is blurry, so it's crucial for investors to understand the difference between the two.
Non-performing assets are below the market average
Distressed assets are assets whose owners are unable to meet their obligations as a result of below-market occupancy rates. The situation becomes even worse when tenants move out or exercise their termination rights as their leases approach expiration. From a lender's perspective, distressed assets are technically in default, which requires banks to maintain larger capital reserves to offset potential losses.
The decline in value of assets is the result of high interest rates
Discounted properties, on the other hand, are performing above market levels but are valued lower due to market conditions. These properties boast “relatively” stable occupancy rates, active leasing activity, and market-meeting rents. Despite healthy property-level performance, rising capital costs are holding back asset values and creating refinancing risk based on current interest rates and valuations. In March 2022, just before interest rates began to rise, many of the discounted properties were valued at at least 1.5-2x their current value.
A property that has declined in value may still have a current loan on it, but the bank may have placed the loan on a watch list, especially if the property is approaching debt maturities or meets debt service coverage ratio (DSCR) or minimum occupancy requirements. For investors, a property that has declined in value may require a capital infusion to meet tenant lease requirements or pass DSCR tests.
Choose the right strategy
Distressed properties and properties that have declined in value have different acquisition strategies. When targeting distressed properties, investors must be prepared for an upfront investment plan and a long recovery period. The time frame to restore cash flows to a justifiable return on investment is longer, so the starting base is lower compared to the expected exit valuation, which is difficult to value in today's office market. Distressed properties may also require the asset to be repurposed or demolished to be redeveloped into a better use. Investors with the right capital profile will find distressed properties trading at slim profits.
In the case of a depressed acquisition, the investor will benefit from the reduced basis but will have to wait what feels like an indefinite period until market valuations stabilize again and institutional investors return with core capital priced funds. Once that happens, the investor can sell or refinance on more favorable terms. In the meantime, the investor should have funds on hand, either saved from post-debt cash flow, funds front-loaded, or available through capital calls to cover a variety of operational needs, including amenity improvements, security upgrades, lease rollovers, renewals, downtime, and tenant improvement packages.
Chicago is seeing big price cuts, but capital is starting to flow in
In 2023, depreciated properties were perceived to have declined in value by 50% compared to their historical peak. Today, that percentage is coming true at a much higher figure. For example, in the Chicago market, three office buildings over 500,000 square feet (150 N Michigan Avenue, Oakbrook Terrace Tower, and 230 W Monroe Street) sold at discounts of over 50% with occupancy rates around 60%.
There are numerous other notable office properties reportedly in the market, including 333 W Wacker Drive, 70 W Madison Street, and 1 N LaSalle Street, though terms of the deals have not yet been made public. The whisper prices represent larger discounts than those listed above, and are much wider discounts from the previous all-time highs for the properties in question. The recent closings and current activity should signal that the market is out of the trough. More closings mean capital is flowing back into the market, which is long overdue and signals the tide is starting to turn back. More capital means more capital, which in turn creates competition and the early stages of value stabilization.
While both distressed and declining real estate represent an opportunity for investors to acquire assets at a discount, that is where the similarities end. Investors need to understand the key differences between the two in order to execute the right strategy for their capital and achieve successful investment results.