Distressed Real Estate Investing

It is the late 1800s and you are a farmer pulling an empty cart back from selling the last of your grain at the market before the winter. You’re happy to have made just enough to get through the winter months, but as you walk, you start daydreaming about how nice it would be if you could find a way to grow and sell more so you can have savings to pass down to your family.

“BOOM!!!” You look up suddenly to see a herd of wild oxen play fighting as they charge their horns together. You marvel at their beauty for a second before you go back to daydreaming. Panicked shrieking fills the air and dust kicks up as the herd of oxen begin to run. Then you see what they fear: snarling, growling, gnashing teeth and howls of the hunt join the cry as a pack of wolves have ambushed them through the trees! The herd looks to be able to outrun them as they run by you…except for a baby ox calf that is running its hardest, but just can’t keep up. It shrieks again for help, but you have no tools to fend them off. In less than a minute, it’s too late…the wolves catch it, bite it, tear at it, and it’s all over. The wolves eat, the herd can do nothing and go about their lives.

150 years later, scenes like this sound like they belong in National Geographic, but this primal practice is alive and well: welcome to the world of distressed real estate investing.

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What is distressed real estate investing?

In your everyday life, you probably think of distress as being when someone is highly stressed out, unable to think clearly, and more likely to make bad choices in the long run. It can be caused by many things, including relationships, family, mental or physical illness, financial difficulties, and other big life transitions.

In the real estate world, distress leads to similar outcomes, but they can be caused by different triggers. Distressed property investing triggers typically come from a few high level causes. One cause can be rooted in the physical world in the property itself that is very costly to repair, like a major pipe burst or significant roof leak after a natural disaster. Another theme can be rooted in the financial/capital markets world, where something like high interest rates might mean that what was a perfectly great deal seeking a refinance cannot get the amount of refinancing they need to operate the property and they do not have enough equity to fill the gap. The final cause can be due to the more personal world of the landlords lives’ that affect all of us, like needing to pay large medical bills, divorce, funeral, college tuition, and other large life expenses.

Distressed investors (the wolves), are those who understand that the owner of a property is in dire straits and use that to their advantage when negotiating terms in their favor since the owner (the calf) often does not have any other options. They know that the property itself has value and will return to being at least as profitable as it was, so they negotiate the price down significantly from the owner in distress. The owner knows that they have a great property, so they look for other options for help, but only find other wolves circling and eventually they get taken down and forced to sell below the value they once had.

Now that you have the concept of distressed investing principles and techniques, there are broadly two ways distressed real estate investors use to ultimately have this desired result. One is through buying the entire property outright for a significantly discounted price, whether in a private transaction or at a foreclosure auction by the bank. The other is distressed mortgage investing, or buying property’s mortgage for a cheaper amount, knowing that the owner/equity holder will be unable to pay and then foreclose on the owner as part of their business plan.

While distressed investing can be lucrative for those with cash on hand, it can leave many people stripped of their assets and unable to recoup their losses. To make matters worse, professional private equity firms that specialize in this kind of investment and make up the vast majority of dollars spent in distressed real estate investing often charge excessive fees to their investors, further raising costs for consumers. Overall, distressed real estate investing has the potential to benefit a select few at the expense of those who can least afford it.

When do people do distressed investing?

Although the issues that cause distressed investing can occur at any given time - particularly regarding personal drivers with the owners - distressed opportunities typically spike to extremes due to the financial markets, when market conditions experience sudden economic shocks that cause financial markets to become afraid, and lead to a change in government or financial policy. The most clear example in most people’s minds was in the Great Financial Crisis of 2008 and 2009 caused by mortgage backed securities. However, we are currently undergoing a similar huge shift with historically fast rate hikes by the Fed trying to tackle record inflation in March 2023.  And, sure as ever, Sponsors are having trouble refinancing assets  without putting additional money in and have nowhere else to go. 

In the physical world, distress investing typically piques in times of natural disasters or other unforeseeable circumstances like the COVID pandemic, distressed private equity funds raise record amounts of money to take advantage of worldwide turmoil as they only see profits when others are in literal physical and emotional distress. 

In contrast, Kopa will provide everyday investors with the opportunity to invest in distressed assets by working alongside those in need and reward both the property owner and the investor by providing owners with the necessary capital to overcome distressed situations and return the building to being profitable, and gives investors the benefit from the potential returns of providing capital when it was needed and seeing their values increase as the building regains its position.

Who does distressed investing?

Distressed real estate investing is not limited to a particular group of people. Private equity (PE) firms, while the most common, are not the only wolves. Servicers, distress lenders, private money groups and individuals will also try to feast. Distressed groups have a track record of raising significant amounts of money during times of dislocation in the market. In the wake of the 2008 recession, many distressed funds raised large sums of money as investors sought to take advantage of the market conditions. 

And once again, in 2020, amid the COVID-19 pandemic and resulting economic downturn, distressed funds once again saw the potential agony as Reuters reports they raised $45 billion in 2020 and $40 billion in 2021. Moreover, these types of investors can lead to gentrification and displacement, as these groups may take advantage of the situation to acquire properties and increase rents beyond what the community can afford without having to face any repercussions.

Conclusion

With the market in the midst of a big financial shock, the wolves are poised and ready to strike as usual in distressed real estate. But this time, imagine that instead of having to witness the wolves catch the calf yet again, you had a pitchfork or spearthat could protect the calf and yourself and help nurse the calf back to health over the winter. By spring, the calf has grown strong, helps you plough your fields, and triples what you can sell at market next year. If that sounds appealing, keep reading to learn more!