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Distressed Assets Are Hitting the Market. How Can Investors Buy Wisely?

June 18, 2020Publications / Mentions
Bisnow

As the U.S. heads into another major economic downturn, one type of property has bubbled to the top of every real estate investor’s mind: distressed assets. During the last recession, U.S. commercial property prices fell by 35%, only to more than double over the course of the next decade, powering substantial gains for investors who were willing to take the chance on purchasing them.  Now, it is time for investors to decide if they want to take that risk once again.   “Investors need to look beyond pricing,” said Trevor Hoffmann, a director at law firm Goulston & Storrs. “Some investors are looking for short-term gain while others have long-term strategic interests. They need to choose a property that can help them meet their specific goals.” A recent poll from fund service firm Intertrust Group showed that 92% of private equity professionals across North America, Europe and Asia believe distressed fund activity will increase following the pandemic and 83% indicated there would be more investor demand for strategies that target distressed assets. Bisnow recently spoke with Hoffmann and two of his colleagues from Goulston & Storrs, Director Jonathan Stein and Counsel Eric Seltzer, to discuss a range of strong distressed asset investment strategies.  

Bisnow: What is your view of the current distressed asset market?

Hoffmann: While we are seeing deals get done, it appears that many investors are still waiting on the sidelines. Similarly, owners and borrowers are trying to avoid fire sales in the hopes of a strong economic recovery. We don’t yet know how the pandemic will impact medium and long-term retail preferences, commercial real estate needs or even residential housing markets. Additionally, lenders and landlords have granted forbearances, deferrals and other accommodations to distressed borrowers and tenants. Government aid has also helped stem the tide. Until we have greater clarity regarding the contours of the recovery, it may be difficult to price deals.    

Bisnow: What should buyers look for in a distressed asset acquisition?  

Seltzer: While there are many considerations, when it comes to distressed assets, the first question a buyer needs to answer is: Why is this property distressed? Is it poor management, a tenant rollover, issues with the existing financing, overpriced condo units in a soft luxury condo market or simply a consequence of the pandemic? After you answer that question, you can go about carefully determining what it will take to create value and maximize returns, and whether it is worth your time and capital to do so. Distressed assets often come with various financial, tax and legal issues, so you can’t just jump at a below-market opportunity because you have some capital to deploy. That said, distressed deals generally happen on a compressed time frame, given that there may be numerous other interested investors and the property owner or lender may be pushing for a quick closing to stop the bleeding.

Bisnow: What does a strong negotiation strategy look like for purchasing a distressed asset?  

Seltzer: Unlike traditional deals, the seller may not be a voluntary participant in the negotiation. I think the key to smooth negotiations is for both parties to recognize that although they may have competing interests, it is best to try to reconcile them in a non-adversarial and mutually productive way.  In terms of strategy, you need to be creative structurally. Don’t go into a deal with a preconceived notion that it will have to be structured in a certain way. Being nimble and flexible is essential to getting deals done in distressed situations and could differentiate you from a competing purchaser who is more rigid in its approach. For example, maybe you find a way to let the existing equity holders continue to have a slice of the deal when other prospective purchasers are looking to wipe them out entirely. 

Hoffmann: Another strategy is to buy up the debt at a discount, either at the mezzanine or mortgage level, depending on who holds the fulcrum position. The debt may then be used as leverage to restructure the loan, or to acquire the property via a credit bid at foreclosure or bankruptcy.    

Bisnow: What are some of the tax issues buyers should keep in mind?  

Stein: Buyers need to realize that in workouts, they need to proactively look out for the seller’s tax problems to get the deal done. They need to avoid pitfalls like triggering cancellation of debt income by becoming related to the debtor, or triggering guaranties that could cause otherwise nonrecourse debt to be treated as recourse for tax purposes. Buyers should be open to restructuring debt and even the whole capital stack to get to a favorable tax position for all of the parties.  Sometimes, a buyer who is coming to ‘rescue’ a property where the borrower has defaulted is doing so because they have 1031 exchange proceeds that they need to invest. In those cases, we can restructure the capital stack to meet both the seller’s tax needs when it comes to avoiding income recognition and the buyer’s needs to qualify for 1031. And of course, watch out for transfer taxes and mortgage recording taxes. These could be a significant closing cost and need to be minimized and priced into the deal. 

Hoffmann: I would add that one of the unique benefits of bankruptcy is that if the property is being sold via a Chapter 11 plan of reorganization, as opposed to under a Bankruptcy Code section 363 sale, it can actually be exempt from transfer taxes and similar taxes. This can be an important consideration in larger deals.   

Bisnow: What do you do to help maximize tax losses in a workout? 

Stein: While avoiding cancellation of debt income is the first order of business, careful tax planning can help preserve losses as well. Occasionally, writing down the debt or declaring an entity worthless can generate an ordinary loss. Often, however, the seller will end up with a capital loss, so they need to see if they have capital gains which they can use to offset losses.