December 12, 2021
Best Ever CRE Team

Investing in Distressed Debt

Distressed debt investments hold tremendous potential, but these investments are riddled with challenges and pitfalls. Because of this, they are not usually recommended for novice investors. Recently Joe Fairless sat down with Joshua Jaouli to discuss these commercial real estate investment opportunities in greater detail. Joshua focuses on value-add apartment investments and other debt-based opportunities.

These multifamily debt investments are generally lucrative, but Joshua Jaouli has run into challenges with them in recent years. Specifically, he has noticed that large investors are snatching up these notes for what Joshua has perceived to be obscene amounts of money. At the same time, market conditions have created a situation where many property owners are able to retain ownership of their distressed properties through refinancing and other options rather than being forced to sell. These factors have combined to make it much more challenging for debt investors to find great investment opportunities.

According to the FDIC, the current default rate on commercial real estate debt in the United States is below 1.5%. Candidly speaking, this is one of the reasons why Joshua Jaouli has not purchased these investments since the last time he spoke with Joe Fairless three years ago, but that has not been for a lack of trying. The reason for the low current default rate is that the real estate market is cyclical. This creates a feast or famine mode, and it requires investors to monitor the market and to carefully time their purchases.

Generally, an investor can purchase an individual note or a portfolio of notes when investing in distressed debts. Larger banks may sell portfolios and smaller or regional banks will sell individual notes. To find deals, Joshua relies on various published reports. Specifically, FDIC reports list which banks have owner-occupied commercial real estate notes in default, non-owner-occupied projects, small multifamily properties, single-family investment loans, and more. After you identify an opportunity that you want to know more about, you must reach out to the bank. The bank will ask you to sign a non-disclosure agreement. Then, you will be provided with data tape on the project that you are interested in. This includes the borrower, the origination date, the borrower’s credit score, the property address, and more.

According to Joshua Jaouli, opportunities may be easier to assume if they are on recourse debt. Recourse debt means that the borrower is personally responsible for the debt. It is opposed to non-recourse debt, which is when the borrower is not personally liable for the debt. Because the borrower is on the hook for recourse debt, the individual may be much more willing to negotiate a deal with you.

Another factor that may impact the borrower’s willingness to accept an offer is where the state is located. There are significant differences between judicial states, like Florida and others, versus non-judicial states, like Alabama. In a judicial state, a foreclosure must go through the courts to be finalized. This is more red tape, and it requires more time to complete.

In some cases, investors will make a flat offer, such as 65% of the outstanding balance. In other cases, the investor may need to take out a loan to finalize the purchase. There may be extended negotiations with the borrower as well. With these factors, there must be a discount applied to the deal. These are some of the many factors that can make these deals far more interesting than buying a standard multifamily property outright.

There are two primary exit strategies that are used with distressed debt. One of these is loan-to-own, which is the exit strategy that is most commonly used. It involves buying the note, foreclosing on the property, and operating it as planned to profit from cash flow. Another loan-to-own scenario involves recasting or restructuring the note. For example, you may offer to forgive a portion of the loan and to become the first lienholder. While this option has tax liability considerations, it also provides stable cash flow for the life of the loan. The other exit strategy that you could use if you purchase a portfolio of notes is to sell those notes to a hedge fund. In some cases, you can buy a large portfolio at wholesale, break it into smaller portfolios, and sell the portfolios at retail price.

To invest in distressed debt successfully, you need a deep understanding of the market and of valuation. You also need more capital than is required to simply invest in a multifamily property. With these commercial real estate deals, you may be exposed to greater risk, and you need to complete more due diligence upfront to ensure that you can actually foreclose on the loan. Likewise, you should get your attorney involved as soon as possible while completing the due diligence. On the other hand, the greater difficulty can yield greater profits. As an example of these factors in action, Joshua Jaouli had the opportunity to buy an apartment property that was worth $150,000 per unit for only $75,000 per unit. He failed to see the value in the deal at the time. The investors who seized that opportunity ended up pocketing more than $1 million from their investment within a few months.

Investing in distressed debt has extensive benefits, but it also comes with numerous challenges that you should be aware of and prepared for. Now that you have a better idea about what these investments entail, you may be able to proceed more confidently and make more lucrative investment decisions.

Disclaimer The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.

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