How to Pinpoint Distressed Properties to Target

Distressed properties, including multifamily buildings, are about to become big items on the commercial real estate landscape. More than a hunch, it comes down to warning signs in data.

Trepp reports the following: $52 billion worth of loans representing just over 3,000 properties that will mature over the next 24 months and for which the current debt service coverage ratio (DSCR) at the property level is 1.25 or less.

Of that group, 1,450—almost half—are multifamily. And of the total $52 billion, about a third has occupancy below 80%. (Given that even an 80% occupancy would seem bizarrely low in the current housing market, we’re assuming that it applies to other commercial property types, probably office.)

“Some see this as a leading indicator of broader distress finally playing out in the marketplace, while others would argue this volume of loans barely scratches the surface,” Trepp wrote.

Even if not barely scratching the surface, that’s a lot of properties. A DSCR of 1.25 is the typical target that prudent commercial banks—in today’s economic atmosphere, that’s more and more of them—require. Loans maturing over the next 24 months likely were made at the more favorable rates available until the Federal Reserve started tightening the money supply to battle inflation.

Let’s run the numbers for a moment. A property purchased with, say, a 4% loan has a DSCR of 1.25, just clearing what the lender wants to see. The time to refinance comes about and now rates are up to 7%. That makes the debt service 75% more expensive. To maintain the 1.25 DSCR, NOI would also have to jump by 75%, which, let’s be honest, is probably a sucker’s bet to make. More likely, NOI remains static and DSCR has now dropped to about .71. And, bang, the project defaults on the loan terms.

That leaves the owners with a short list of stark choices. One, go back to the investors and get additional money to pay down more of the loan, restoring an ongoing manageable ratio. Probably unlikely as it cuts the IRR the investors expect. Two, renegotiate with the lender, which might be possible but if so, only for a short amount of time. Three, get bridge funding and hope that market conditions turn around within a year or two, which in our view seems unlikely. Or, four, sell right away, which is the more likely and prudent outcome.

If you’re an investor or owner/operator of properties, someone’s bad luck or planning can work to your advantage. After all, the property ultimately will need a different owner because the lenders won’t want to operate it themselves.

You could wait until something hits the market and craft a bid among a throng of competitors all looking to snap up opportunities. That probably drives the eventual price up and your return down. Or you could identify some of these properties, make discrete inquiries, and pay a more reasonable sum, improving the financial metrics.

We’d opt for the latter. The question then is how to identify which properties might be a good fit. Here’s the beginning of a rough general approach that we would take with our data and analytic tools. First, look at value-add deals that went under contract in the last several years, specifically closings from January 2019 through March 2022, before the Fed started the rate race. Next, overlay the requirement that the properties were built from 1980 through 2005. Now you have reasonable criteria to identify the buildings most likely to be in distress and still have enough financial room for improvements and rent increases.

That’s only the first step. Then you’d want to add other criteria that suit your business model: location, size, class of building, and so on. This is the sort of analysis we do in our acquisition work for clients and will be happy to help you reach your goals more effectively and economically.