Investing in distressed real estate is often characterized by the high returns it can offer on invested capital, as well as the many ways an investor can lose his invested capital. When investing in distressed real estate, either via equity or debt, it is inevitable that investors will come across “hair” that would normally deter more institutional investors. This “hair” may appear in the form of a property in desperate need of repairs, one that has significant environmental damage, or a property that does not have clean and marketable title. Investors must be able to accurately assess the risks associated with the project before they make nonrefundable deposits. After assessing the risks, the ability to adequately gauge the costs of mitigation is the key to a successful investment.
Mitigating Risks
The first key to mitigating risks is to comprehensively review the asset and all relevant information pertaining to it (municipal searches, bankruptcy searches, history of permits, outstanding liens and judgments, etc.). This process can take time and can be costly, depending on the size of the asset and the scope of the investment. While many states have free online portals to obtain real property information, each state and county is different, and some states require a local bar number or a credit card to access real property records. It is best to require the due diligence materials to be provided by the seller, with a representation that the information is true, accurate and complete.
Title risks also are common among REO and properties sold at auction. In some instances, a receiver or creditor might not have properly handled the auction process, which could result in an unenforceable or problematic judgment. For example, a foreclosure judgment could have errors in it that exclude important amounts, or it might not foreclose out all relevant parties to the lawsuit. A spouse or a maiden name might be omitted, which can be a complication if the foreclosure of the asset coincides with a divorce of the marriage. In addition, it is important that the homeowners are “served” on the premises of the property, a measure that is not always taken, especially if the divorce has been acrimonious. In addition, there could be outstanding liens and judgments that have not been paid in full; these can include the foreclosure judgment, outstanding taxes and mechanic’s liens. Title defects like these might pose difficulties in obtaining title insurance, or the insurance might include exceptions that can cause lenders to shy away because the title is not “clean.” In any event, it is important that prior to consummating a transaction a lender and/or equity investor thoroughly analyze the title report with legal counsel and rectify any issues prior to closing to affirm marketability of title.
Another example of an intolerable risk is the presence of perchloreoethylene (PCE) and other volatile organic compounds (VOCs), which are usually present at the site of a former dry cleaning location. A lender might mitigate the risks associated with these environmental conditions by requiring an environmental indemnification in addition to requiring Phase I and Phase II environmental tests (along with requiring any clean-up recommended by the environmental reports). The Phase I and Phase II tests will identify the exact environmental risks associated with the property to ensure that an environmental indemnification is written correctly to protect a lender in case of an environmental loss.
Lenders can also protect themselves during construction loans by requiring inspections by certified third-party inspectors to ensure that certain construction milestones are achieved within an agreed-upon period of time after closing. In addition, these “drawdown inspectors” can make recommendations as to the quality of the work, compare the borrower’s actual construction progress to what was agreed to prior to closing, and determine whether a drawdown of further funds by the borrower is warranted. If the construction progress is not up to par, a lender may have the ability to deny further disbursements. The borrower would have to find a way to make up for the shortfall, which is also problematic for a lender.
With Risk Comes Reward
This all may seem like gloom and doom for lenders, but there are significant upsides. The risks inherent in these hairy transactions naturally lend themselves to higher returns. Equity investors, specifically in the “fix and flip” space, can sometimes achieve risk-adjusted returns superior to debt investors if they have the necessary expertise and discipline, as well as a high amount of leverage. Borrowers can often fund a significant portion of the acquisition and construction proceeds with private financing, which, when coupled with a low acquisition price relative to the value of the asset, can lend itself to high risk-adjusted returns, provided that the asset’s rehabilitation and disposition are done in a timely manner to minimize interest payments and carrying costs (property taxes, insurance etc.). What is required for a successful acquisition and disposition is knowledge of the pitfalls, adequate investigation into the risks — and a little bit of luck.