The Ups and Downs of Investing in Distressed Assets

Having an Investment Strategy means having a business plan that describes “what” we plan to invest in, “where” we plan to invest, and “how” we plan to manage the investment. In multifamily real estate, our Investment Strategy will usually focus on one of three primary categories of investment assets:

1. Distressed Assets
2. Value-Add Assets
3. Turnkey Assets

While no one strategy is necessarily right or wrong, each does require its own set of expertise to be fully successful. This article will focus on the Distressed Assets Investment Strategy.

Distressed Assets are essentially just that, properties that are very distressed.

These properties are tired, worn down, and fatigued in various aspects including physically, operationally, and occupationally. They are usually distressed physically with outdated exteriors, interiors, and at least a few major deferred maintenance issues. They can suffer from poor management, lack of maintenance, and lack of amenities. Based on all these problems, no one really wants to live in these apartments, and therefore the rate of paying Tenants, known as economic occupancy, is considerably low in these properties.

Thus, we refer to the asset as non-stabilized. That is, the economic occupancy is less than 85%, and often down into the 60-70% range or even lower.

So why would anyone invest in such a property?

Well, the Investment Strategy for Distressed Assets can vary, but generally the strategy is to purchase the property, fix the physical and maintenance issues, improve operations, and replace the management so that it’s a more favorable place to live and therefore attracts new Tenants.

The goal here is to stabilize the asset, increasing its economic occupancy to at least 85%, and ideally over 90%. Once this is done, the Investor generally has two choices, hold it for a period and collect the Cash Flow or sell the property to the next investor for a higher price now that its value has increased.

Wow, sort of sounds like an episode of “fix-n-flip” TV, right? Well, it can be just that, but on a much larger, more complex scale and longer time-frame because we’re talking about an entire apartment community rather than just a single-family house.

The benefits of the Distressed Asset Investment Strategy are that these properties are generally purchased at a price well below market value, and therefore when things are fixed and improved and quality Tenants are paying higher rents, then the asset can yield substantial equity for the Investors. A potentially very high upside potential if purchased at the right price.

However, its an investment, so higher upside also means more risks.

The major risks involved include the myriad of issues, both physical and operational, that need to be addressed. More issues always equal more risk. Additionally, due to the low economic occupancy rates, the Distressed Asset is likely to not provide any Cash Flow at first, and maybe for several years depending on how quickly the upgrades can be made and Tenant occupancy can be improved. This can mean money out, but no money in for a while until the asset can be stabilized.

Conclusion

Investors who are looking for significant upside potential, are not concerned with immediate Cash Flow income, and willing to take on greater risk may lean toward Distressed Assets as their strategy. However, due to the risks involved, this Investment Strategy should be approached with careful consideration and a very experienced team.