By Ralph Serrano
According to the St. Louis Fed, the delinquency rate on all commercial real estate loans (excluding farmland) was 0.72% in October 2018. That’s down dramatically from a peak of 8.75% or so in 2010, in the aftermath of the global financial crisis (and far lower than the 30-year peak of about 12% during the savings and loan crisis of the late 1980s and early 1990s).
Meanwhile, office construction is decelerating as vacancy rates remain flat. In other words, while the market for commercial real estate does not presently appear to be distressed, it’s not showing any real signs of frothiness.
This isn’t to say that commercial real estate investors can’t or won’t find distressed assets that meet their investment criteria.
“Distressed commercial assets are always present: in every market, in any business cycle. Opportunity abounds, if you know where to look.” —Ralph Serrano
Let’s take a closer look at some of the basic concepts commercial real estate investors need to know before purchasing distressed assets directly or buying into a professionally managed commercial fund.
1. Institutional Investors Tend To Ignore Smaller Assets
Institutional investors with hundreds of millions or billions in investable capital usually overlook opportunities that come in under strict principal thresholds — generally, $10 million to $20 million, depending on the institution. That Class B medical office building in an up-and-coming suburban submarket might look great on paper, but if it’s only worth $5 million, your typical blue-chip life insurer isn’t going to bother — unless it’s part of a larger basket of similar properties in the same market.
Institutional players’ lack of interest in smaller commercial assets means more opportunity for independent investors and boutique funds that specifically target opportunities at the lower end of the market.
2. Loan Position Matters
Many distressed debt investors exclude all loans that fail to meet first lien criteria. A first lien mortgage holder has priority over all other debt holders, meaning they’re first in line to be repaid should the borrower default. Investing in first lien loans only is a crucial principal protection strategy.
3. Occupancy Isn’t Everything
It’s tempting for novice real estate investors to focus on occupancy rates above all else, but that may be shortsighted. Occupancy is of course a crucial indicator of near-term cash flow, and an important factor in determining the asset’s value.
That said, it’s not immutable: This month’s occupancy rate is merely a snapshot in time, one that may change with effective marketing and shifts in market conditions. Even if the asset’s near-term cash flow isn’t where you’d like it to be, lower occupancy means it’s likely to be offered at a discount, with long-term benefits — e.g., appreciating value — should occupancy increase.
4. Opportunity Is Always Market-Dependent
National delinquency and vacancy rates are instructive indicators of overall market health, but they don’t say much about what’s happening on the ground in individual metropolitan markets.
Indeed, every commercial real estate market has its own quirks and patterns. Some consistently present delinquency rates well above the national average, while others are counter-cyclical — exhibiting elevated delinquency and vacancy rates in defiance of national or neighboring market trends. Whether you plan to purchase distressed real estate assets directly or invest in a private equity fund that does the same, it’s important to look beyond the headlines.
5. Diverse Portfolios Tend To Perform Better Over Time
Diversification is the lifeblood of any sound real estate investing strategy. Prudent commercial real estate investors target a range of collateral types to ensure they’re not overly exposed to sector-specific weakness.
That said, every diversification strategy is different. A fund raised specifically to invest in office debt by nature excludes retail and multifamily — but it’s not likely to focus wholly on, say, medical office or flex space in a single submarket.
6. Every Submarket Is Different
Every market is different, as they say. In South Florida (Palm Beach, Broward, and Miami-Dade) for instance, the residential mortgage delinquency rate is significantly higher than the national average: over 12% in October 2017, compared with just over 5% nationally during the same timeframe. (Commercial delinquency rates were lower.) Both trend lines were rising, but South Florida’s from a far higher baseline.
But if looking at the national picture tells you little about the state of play on the ground, gazing through a wide-angle lens at a region of 6 or 7 million people isn’t much better.
Examining what’s going on in individual submarkets is far more instructive. In fact, it’s essential for anyone who’s serious about investing in distressed commercial real estate assets. Knowing whether an area where real estate assets are broadly undervalued is due for a rebound, or where they’re likely to depreciate further.
And that leads to our next point.
7. Local Expertise Matters
There is no substitute for on-the-ground expertise. There’s a reason why major institutional investors maintain dozens of branch offices across the United States: Local market knowledge is extremely difficult to replicate from one’s perch in New York or Los Angeles, no matter how sophisticated your risk models or thorough your due diligence.
If you’re just getting your feet wet in the world of commercial real estate investing, you’d do well to stick with the market or markets you know best. Bear in mind that you’ll find more opportunity in a market with above-average delinquency and foreclosure rates, like South Florida, than a market with below-average delinquencies — but distressed assets exist everywhere. You can always partner with local market experts to achieve geographic diversification, though you’ll of course need to apply your own risk models and due diligence processes to any opportunities in less familiar markets.
8. Your Network Is Your Net Worth
The most attractive distressed debt opportunities very often aren’t advertised publicly. For this reason, it’s crucial for serious investors to develop relationships with financial institutions and property owners, who have far more insight into the local market — and knowledge of off-market opportunities — than publicly available sources of information.
Are you interested in real estate investing? What would you most like to know about distressed commercial real estate assets and debt instruments?
Ralph Serrano of Miami-based Safe Harbor Equity, is the founder and managing partner.