What is Distressed CRE?

Distress is a subjective term and there is no single definition of what constitutes a distressed CRE property. For many, distressed opportunities might describe properties dealing with poor management, declining physical conditions, slowing market-level fundamentals or legal violations.

In the current economic context, distress is more often used to describe properties in financial distress as it relates to meeting debt obligations or managing negative cash flow. The Federal Reserve has increased interest rates substantially and rapidly since March 2022, leading some property owners to deal with stricter lending standards, higher debt service costs and lower property valuations. However, there is no clear threshold at which a property facing these issues becomes “distressed.” For many asset managers, capital market headwinds are simply another obstacle to which one must adapt or overcome entirely.

In some situations, the degree of distress may be too challenging to overcome, forcing property owners to sell assets in a down market. For investors, these assets could appear to be undervalued and therefore present the potential for higher returns either through a value-add strategy and/or market timing (i.e., selling the asset during the next economic upcycle).

CONTI Capital defines distress in relatively broad terms to include properties brought to market during periods when it would otherwise be prudent to hold, regardless of the reason for bringing the property to market.

A wave of distressed properties hitting the market has been long anticipated but has yet to fully materialize despite rising interest rates and slowing economic growth. Part of the reason for the lack of distressed properties on the market stems from strong underlying economic fundamentals, namely low unemployment. The strong labor market is mitigating the impact of higher borrowing costs through solid rental income gains.

In addition, strong investor demand for certain asset types is helping to support property values even in the face of higher interest rates. This is especially the case for multifamily properties in well-located nodes within high-growth metropolitan areas, which are often viewed as a hedge against economic uncertainty.

This is not to say that asset managers are not feeling the sting of higher interest rates. Some of these groups are bringing properties to market that they would have otherwise held absent rising rates. Well- publicized examples include major non-traded REITs being forced to sell properties to meet redemption requests from existing investors even as the investment vehicles remain financially sound.

However, in general, many property owners are still able to look past the short-term challenges facing the market and recognize the long-term growth potential of CRE as an asset class. These owners may recognize that there has not been a fundamental shift in the supply and demand profile of most CRE asset types, particularly multifamily . Using apartments as an example: although property values may have fallen in the short-term, the supply of housing remains insufficient to meet demand stemming from job and population growth as well as demographic shifts and changing tastes and preferences.

Even when distressed opportunities are available, the lure of higher returns should be counterbalanced by a sober assessment of the high risks involved in such investments. Higher returns are generally expected because distressed assets are typically acquired at a discount relative to their intrinsic value, which can generate additional profit when the assets are ultimately resold. If the distressed asset also presents a value-add opportunity, investors can enjoy additional upside after repositioning the property.
On the risk side, investors will have to assume all problematic financial obligations, which can add an additional wrinkle when it comes to financing the acquisition. Investors may acquire such assets believing the local market is soon to turn around when further declines in property income and values may be in store. On the operational side, distressed assets can be difficult to reposition and stabilize, particularly in a down market. Any such repositioning may require a considerable amount of patience and specific expertise in turning around troubled assets.

As a result, investors in distressed opportunities should rely on the experience and expertise of seasoned investment managers with a proven track record operating, repositioning and successfully exiting distressed assets.

Although the U.S. economy is facing a number of headwinds in 2023, certain investment sectors appear to be on a firmer ground relative to others. While CRE is generally exposed to rising interest rates, some asset types are more exposed than others. Multifamily, for instance, continues to benefit from a tight labor market, which has translated into steady rent growth and income returns . This is effectively mitigating the impact of rising interest rates on property values . As a result, we have yet to see a wave of distressed multifamily assets hitting the market. Nor do we anticipate any such wave to materialize in the near term. In times of economic uncertainty, it behooves CRE investment managers to remain laser-focused on the underlying drivers of investment performance, namely supply and demand.