Investing in distressed real estate is not new by any means. In fact, investments in distressed real estate is one of the 4 main categories of investment strategies in real estate (including developments, value add and turn key properties). There has been a lot of attention on potential future distress in real estate and many funds are popping up to take advantage of this forecasted future windfall. Is it worth jumping in the mix?
What Is a Real Estate Fund?
We have previously spoken about real estate funds and the comparison of investing in funds versus investing in a single entity syndication. You can find more details here. For the purpose of this article, we will focus more on the niche of funds specifically created for investment in expected future distress in real estate markets.
What Is A Distressed Real Estate Investment Fund?
A distressed real estate investment fund is a fund that focuses specifically on investing in distressed real estate assets. This is particularly common in the commercial real estate space. These investors may invest directly in the property by buying it outright or invest in the debt (by purchasing a part or all of the debt).
Additionally, the fund may invest in the equity by providing a portion or all funds needed to cover capital shortfalls. The term “rescue capital” is often used to describe these kinds of investors. While these types of investments may be mutually beneficial for the distressed real estate investment fund and the investor in distress this is not always the case. Some distressed real estate funds don’t have the best intentions.
What Is A Real Estate Vulture Fund?
Vulture Fund is another name that may be used for distressed real estate investment funds. As the name “vulture” may imply, these funds look to profit off of dead or dying real estate assets/investors similar to vultures that prey primarily on dead animals. The term vulture fund draws even more ire as it speaks particularly to funds who may not be seen as the most ethical.
Vulture funds are very common in debt markets and equities markets. The controversy around these funds is that they may “loan to own” meaning that they will provide funding to a failing investor not with the intention to help but to rather take advantage of the failing investors eventual down fall. The fund may use rigid terms, litigation, or other means to get as much money out of the failing investors and eventually get the asset at a rock bottom price once the failing investor defaults and can no longer keep the asset. Other invested parties may also feel the brunt of vulture funds force as they may end up not being able to recoup any losses due to the actions of the vulture fund.
How Does Real Estate Become Distressed? What Is An Example Of a Distressed Investment?
Real estate investments can become distressed for many reasons. One of the most visible reasons would be that the operator of the investment group was not competent to manage the investment. The deal sponsor may have not had sufficient experience or made inappropriate decisions about the investment property which ultimately led to a decline in it’s performance. This decline would have to be sustained over a period of time before the asset would be considered distressed. A distressed real estate asset is likely already in issues with their current lenders and on the verge of missing debt payments if they have not already begun to miss payments. The bank may even already be in process of starting to foreclose on the asset.
Not all distress arises directly from a poor operator. Even good Deal Sponsors may fall into a situation where they are dealing with a distressed asset. This may be due to macro-economic shifts (like rapid rise in interest rates and costs of rate caps), inopportune timing for a needed capital event (such as a refinance or loan maturity), local market changes (such as the departure of major employers), weather related damages, geo-political turbulence, poor capital structures or distress in other assets in the Deal Sponsors portfolio that cause a domino effect. All of these reasons could leave an investor in dire need for capital to help stabilize an otherwise good investment.
How Do Distressed Investors Make Money?
Distressed funds fill a hole where banks and other investors may not feel safe or comfortable to fill; they provide capital to risky investments that need money to stay afloat. Most banks are usually more conservative and would not lend money on an asset that is not performing.
Distressed funds seek to identify opportunities where they see the price of acquisition is significantly lower than the future expected return. Due to the nature of the situation where they are providing rescue capital and the associated risks, they are able to command a higher percent return from the investment group that is being helped. The distressed fund will also gain their return on their investment once the asset is stabilized and returned back to healthy condition. At this point the fund could sell their interest for a quick gain or invest with a longer term horizon to exit once the asset has reached desired goal metrics.