By James Nelson, Principal, Head of Tri-State Investment Sales, Avison Young
Amid rising interest rates and downward pressure on real estate pricing, investors will have tremendous opportunities in the upcoming year. Some of these deals could include purchasing distressed loans and assets. This will be especially acute in the office sector, where the return to the workplace remains lackluster compared to pre-Covid levels.
Out of the $270 billion of bank commercial loan real estate maturing in 2023, about 30% (or $80 billion) are backed by office properties, according to Trepp data. Furthermore, the number of corporate defaults in 2023 through the end of February sat at the highest level since 2009, per Retail Dive. In some cases, this has caused the largest institutional owners such as Brookfield to act. It lost Macy’s in Water Tower Place, the first indoor mall built in Chicago, as a tenant in 2021. About a year later, it handed over the keys to the mall to its lender.
If you’re thinking about approaching a distressed real estate deal, there are several methods, but here, we’ll focus on buying non-performing loans, or loans that are in default. If 90 days pass with no payments, the note is said to be non-performing.
Buying distressed loans can sound like a great opportunity. However, it’s essential to follow the right path to ensure success and avoid pitfalls. At Avison Young, we have been involved in a variety of distressed sales ranging from loan sales to real estate owned (REO).
From our experience, I’ve found a few guidelines our clients have found successful to evaluate distressed loans:
- Have the right team in place.
In my book, The Insider’s Edge to Real Estate Investing, I discuss that having A-level players on your side is essential for success. This is especially true when buying a non- performing loan from a bank. You’ll want to work with a real estate attorney who has experience in this space. Team members with knowledge about bankruptcies will be
useful in case the borrower files for bankruptcy. - Make sure the loan is “money good.”
For a non-performing loan, you’ll want to establish the collateral value first. Then subtract the legal and closing costs to find its true value.
During the process, you’ll need to estimate how long it will take to foreclose and resume possession. Then you can decide what type of return you are looking to make over this holding period to determine the Internal Rate of Return (IRR). Based on the risk profile and unknowns of this type of investments, most investors will look for a return in the “high teens” or more. - Understanding why a loan is in default.
Was there a monetary or technical default? A technical default refers to the failure to uphold an aspect of the loan terms outside of the payments. For instance, the borrower might not maintain the qualifying ratio they need, such as their total debt-to-income ratio. You’ll want to check if any issues related the loan payments and terms could be resolved.
- Know where the loan is in the capital stack.
Check what position you would maintain in the capital stack. This will help you evaluate the risks involved. Are you buying a secure senior first position? Is it a mezzanine debt? Are there other secured creditors who could have prioritized claims that would lessen your claim? - Check the foreclosure.
Consult your attorney to understand next steps in the legal process. Has the lender started a foreclosure process? If so, what step are they on?
You’ll also want to have a grasp of the foreclosure process in the state where you are buying. The arrangement can differ drastically in judicial and non-judicial states. For example, a foreclosure process in Texas might only take a matter of months, while New York could drag on for years to get to the collateral. - Determine the pay-off amount.
Besides the original loan balance and interest due, there may be additional default interest applicable. Most loan documents will provide for the lender to recoup legal costs. That said, some courts will waive this in additional settlements. - Get intel on the borrower.
You’ll need to understand the borrower of the loan. Are they looking to make an amicable resolution and move on? Are they litigious and stalling in hopes of receiving concessions?
If there’s a personal guarantee on the loan, check the borrower’s net worth. A bank would have required a net worth statement when the loan was made. However, remember things can drastically change over time(!). - Understand the unforeseen liabilities.
You likely won’t have perfect information on the property tied to the loan. You might not be able to see the exact state of the rents, arrears, and expenses. You’ll need to give yourself plenty of room in your offer to allow for these uncertainties. - Consider the alternatives.
There may be other options besides a foreclosure and taking the property back. In somecircumstances, receiving a discounted payoff or allowing for a discounted payoff might make more sense.
Remember, loan transactions are complicated in nature, and these are but a few of the myriad evaluations to consider. These guidelines are simply a starting point to help you know what questions to ask and which indicators to find.
Buying a non-performing loan is not for the inexperienced investor. Most lenders will look for quick, all-cash non-contingent deals. As such, making sure you’re buying at the right basis is crucial. There will be incredible opportunities as banks look to unload bad loans off their balance sheet. Use your time now to prepare or partner with someone experienced in this space, and you’ll be ready to act when you find the right deal.
