From struggling to prospering

Managing distressed properties can be rewarding for a dedicated and professional real estate manager who seeks a challenge. No one-size-fits-all solution exists, so the manager’s role never becomes stale. Each asset is unique, and every aspect of that asset’s operations, including marketing, leasing, staffing, and financing, needs to be reviewed, analyzed, and coordinated with the owner.

One aspect that all distressed properties have in common is the planning process necessary to turn them around. A distressed property requires a comprehensive management plan that will address all the challenges inherent in transforming the property into a viable investment for its owners and a valued asset to the community.

What is a distressed property?

Distressed properties often result from a downturn in the real estate market or an economic recession. One example is the 2008-2009 financial crisis. “There was an oversupply of product,” Richard Forsyth, CPM, CCIM, explains. “Leasing activity declined. Developers and investors couldn’t meet their debt obligations, which led to lender foreclosures—and receivership business for property management professionals.”

Even when the economy is thriving, there are other reasons that a property can be classified as distressed. Overbuilding can still prevent some properties from achieving lease-up projections, and they may become nonconforming with the parameters of their financing agreements. This could result in the buildings becoming distressed properties, with a risk of takeover by their lenders.

Properties also become distressed when they are developed in neighborhoods with insufficient demand, the wrong demographics to support them, or when the property’s design does not meet the needs of the intended users. Developers will often use the land they own to develop buildings because of easy access to financing, rather than because of validated demand for the proposed improvements and diligent rental surveys.

Some distressed properties have inherent flaws in their original product concepts or designs. For example, an office building in an up-and-coming neighborhood may have the wrong size floor plates, a shopping center may be in a location with poor visibility, or a multifamily property may have only studio and one-bedroom units in a multigenerational neighborhood. An asset that was properly designed for the market when developed can become obsolete as users’ needs and preferences change and new trends and amenities are introduced.

Properties that are neglected and poorly maintained, with excessive deferred maintenance, or those where customer service to their tenants/residents is considered a low priority, will lose their ability to compete in the market. “Sometimes owners get in a situation where deferred maintenance was much more than anticipated,” Forsyth says, “causing the property to become distressed.”

Assets can also become distressed when the property has a large debt service and experiences difficulty in making loan payments, with the NOI declining due to drops in rental rates and/or unexpected vacancies. “Properties can become distressed by being either over- or under-leveraged,” Forsyth adds.

Potential indicators of difficulties that may signal an asset’s decline include job layoffs, plant closings, retail store closings, and a slowdown in the sales of single-family homes. From a real estate management viewpoint, indicators may include higher vacancy rates, a slowdown in rent collections, and unexpected move-outs and/or evictions. Construction of new properties may be put on hold or cancelled.

Managing distressed properties

Regardless of the various reasons that lead to properties becoming distressed, qualified real estate managers can be assigned the responsibility of developing a plan to restore these assets to financial stability.

There is opportunity in managing distressed properties. Owners are looking for seasoned real estate management professionals to offer solutions and provide value in the midst of challenging circumstances. The professionalism, attitude, and education that these property managers display may end up being the deciding factors that position them for success in managing distressed properties.

Experts in managing distressed properties have a large network for sources of business opportunities. This network to source management opportunities for distressed properties may include

• Local real estate attorneys
• Commercial loan officers
• Accountants
• Appraisers
• Brokers
• Vendors
• Local government officials (economic development offices and real estate tax authorities)
• Local judges
• Developers

“If a real estate manager or management firm wants to get involved in managing distressed properties, I’d recommend getting in touch with financial institutions, banks, and mortgage lenders,” John Hatton, CPM says. “I’d also consider attorneys who specialize in distressed real estate.”

Owners of distressed properties

Distressed properties can have several types of owners. They could include the existing owner of the asset, the existing owner and a representative of the owner’s lender, just the lender (in the case of either a deed in lieu of foreclosure or an uncontested foreclosure), court-appointed receiverships, or investors seeking to buy distressed properties and turn them around for a profit.

Effective and open communication is critical for owners of distressed properties, who can be challenging clients. “Highly leveraged properties in a down market are particularly difficult,” Forsyth says. “Owners want to reduce operating expenses, including property management fees, and defer needed maintenance in order to preserve some cash flow.”

Creating a plan and identifying the problem

First, you need a multidisciplinary team to address various elements of a property’s construction, operation, marketing, and overall market conditions. This group will also help define what actions are needed to achieve the owner’s goals. The team could involve an internal operations squad of architects, contractors, consultants, leasing brokers, and mortgage brokers.

A real estate manager will begin the planning process for the distressed property by defining the problem. There may be more than one challenge. It could be that inadequate cash flow might be the result of low occupancy. Upon further investigation, the low occupancy could be due to deferred maintenance that has resulted in poor curb appeal or even poor visibility of the property.

Are the challenges related to physical issues? Are they structural or design issues? Environmental issues such as asbestos or mold can cause major challenges. Is a poor tenant mix creating some challenges? How are the amenities and parking at the property? Are operational policies and procedures in place and being followed? Is the staffing adequate—too many or too few? Does the property have a leasing plan in place?

Once these questions have been answered, it’s time to tackle the ownership and financial issues. These can include

• Lack of operating capital
• Diversion of cash flow
• Lack of clear directions
• High tenant delinquencies
• Below-market rent
• High operating expenses
• Inadequate cash flow
• Reduced market value of property
• Overpayment for existing asset
• High interest rate on debt

Once the issues have been identified, prioritization becomes key to beginning a path back toward meeting the owner’s goals. It doesn’t make sense to prioritize addressing an issue that will have little or no impact on achieving financial stability.

The seasoned professional will concentrate resources—money, effort, and time—on those issues that will make the biggest impact on the distressed property. Physical and operational problems may be the quickest and easiest issues to resolve, provided cash is available for the action items. However, money must be spent wisely to achieve the greatest return on the investment. Management and leasing issues can involve an assessment of the effectiveness of the staffing in place, marketing programs, and other areas.

Ownership questions are best discussed in one-on-one meetings, which can in turn become an opportunity for the manager to discover previously unknown issues. Financial issues may involve negotiating with the lender to seek mortgage forbearance or a temporary loan adjustment. This could allow time for filling vacancies or increasing property cash flow so that the property can meet debt service coverage or any other requirements of the lender.

Making the case

The following is an example of a distressed property with an action plan outlined and the results that can be achieved with such a plan. A 19-story office building built in 1974 was acquired by a large institutional company in 2016.

The occupancy was 52% with seven tenants. Very few upgrades had been completed. The property had a 550-space garage attached to the building with elevator transportation to all levels. Windows were the original single-pane glass installed during construction, which affected the energy efficiency of the property. The roof was 22 years old, and none of the restrooms had been renovated. The property had enough cash flow to pay all operating expenses with some money for distribution to ownership.

An action plan was created, and implementation began in earnest in 2017. The garage was updated with paint, signage, new elevator lobbies, new insulation, and asbestos abatement. In addition, a new pathway was created to enhance the route into the building.

At the same time, the second entry from a plaza at the fifth-floor entry was created with pavers, landscaping, and outdoor furniture. The following year, the fifth-floor elevator lobby was renovated with glass, stone, and marble flooring. This renovation eliminated an awkward entry that included stairs and one broken door. There is now a revolving door with two side entry doors for handicap entry.

Window replacement was of the utmost concern. Ownership did not want to inconvenience existing tenants with long-term moves. A new product was located that could be installed on the interior without utilizing scaffolding on the exterior and without removal of the original windows. Average replacement time per window was 30 minutes. By utilizing this method versus the traditional window replacement method, a savings of $5 million was achieved. Since making the upgrade, energy costs have been reduced by $0.60 per square foot.

Restroom and floor elevator lobbies were the next issue to tackle. The action plan outlined the completion of four floors per year. The number of restrooms and lobbies renovated increased during the COVID-19 pandemic, as most tenants were working remotely. The fitness center and its equipment have been upgraded. A conference center has been added, along with a tenant socializing area. The roof was also replaced, as major leaks were developing. Even all the elevator cabs have been renovated.

Initial asking rents were $36/sf, while the market rents were $42/sf. After all the improvements, current asking rents are $44/sf. Although the COVID-19 pandemic slowed some of the leasing progress, current occupancy is expected to be at 83% by the end of 2021. Turnaround of the distressed property is well underway.

With a forward-thinking owner and a team of professionals, much can be accomplished, and a distressed property can be turned into a viable, stabilized investment. It takes time, money, patience, and a group of visionaries.

If you’re up for the challenge, there will always be opportunities to manage distressed properties. Those opportunities will only grow amidst the long-term recovery from the impacts of the COVID-19 pandemic. “The next few years will be huge,” Hatton says. “Landlords haven’t been collecting rents, so there will be mortgage defaults.”

While the economic circumstances accompanying this category of opportunity are unfortunate, real estate managers who excel at communication, work well with a diversified team, possess the ability to analyze a problem, and make a game plan are in a position to benefit from taking on the challenge.