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CRE Insights Blog

Last updated on Mar 29, 2023

8 min read

by Jeff Hamann

The Advantages and Risks of Buying Distressed Properties

Distressed properties can offer excellent opportunities for savvy investors, but you've got to be careful. Read our guide and a couple case studies to understand what you could be in for.

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The world of real estate investment is diverse, and one particular niche that has attracted the attention of savvy investors is distressed properties. These properties can offer significant advantages to investors who are willing to navigate the risks and complexities involved.

In this blog post, we'll go through the ins and outs of distressed properties, including the top advantages and risks associated with investing in them. Then, we’ll take a tour of two distressed investments — one successful, the other not — and see what went right or wrong. Finally, we’ll explore financing options and provide a suitability questionnaire, of sorts, to help you determine if this type of investment is right for you.

What Is a Distressed Property?

A distressed property is a property that is in financial or legal trouble, often due to the owner's inability to meet mortgage payments, tax obligations, or maintenance requirements. This can result in foreclosure, short sales, or properties being sold at a significant discount.

Distressed properties can include residential, commercial, and industrial real estate — any property type, really — providing a wide range of investment opportunities for those who are interested in this niche.

Top 3 Advantages of Investing in Distressed Properties

#1: Lower Purchase Price

One of the main reasons investors are attracted to distressed properties is the opportunity to acquire them at a lower purchase price than comparable non-distressed properties. This can happen when banks or other financial institutions are eager to offload these properties to recover their losses, leading to discounted prices.

These lower costs can translate into higher profit margins for investors who are able to successfully rehabilitate and sell or lease the property.

#2: Less Competition

Another advantage of investing in distressed properties is that there is often less competition compared to traditional real estate investments. Many investors are hesitant to enter the distressed property market due to the potential risks and complexities involved. This means that those who are willing to navigate these challenges can often find more opportunities and less competition when it comes to sourcing and acquiring properties.

#3: Value-Add Potential

Distressed properties often come with the opportunity for investors to add value through renovations, repairs, or redevelopment. This can help increase the property's value, allowing investors to profit from capital appreciation or rental income once the property is improved. Additionally, the value-added potential of distressed properties can sometimes result in higher returns on investment compared to more traditional real estate investments.

3 Biggest Risks of Investing in Distressed Properties

#1: Uncertain Property Condition

One of the main risks associated with investing in distressed properties is the uncertainty of the property's condition. Distressed properties are often in poor shape due to neglect, deferred maintenance, or even vandalism. This can lead to costly repairs and renovations, which can erode your profit margin if not accurately assessed and budgeted for during the acquisition process.

#2: Legal and Financial Complications

Distressed properties can come with a variety of legal and financial complications, such as liens, title issues, and outstanding taxes. These issues can add time and cost to the acquisition process, and in some cases, may even prevent you from successfully purchasing the property. It's essential to conduct thorough due diligence to identify and address these potential complications before moving forward with an investment.

#3: Market Volatility

The distressed property market can be more susceptible to fluctuations in economic conditions than the traditional real estate market. This means that investors may face increased risk in terms of property values and demand for rental properties. It's essential to carefully analyze the local market and be prepared for potential market shifts when investing in distressed properties.

Distressed Properties: 2 Case Studies

To provide a better understanding of the potential outcomes when investing in distressed properties, let's take a look at two case studies: one representing a successful value-add project and the other illustrating the challenges of a troubled investment.

The Turnaround Warehouse

Meet Alex, a real estate investor based in Atlanta. He decided to invest in a distressed property, specifically a warehouse in an industrial park near Hartsfield-Jackson Airport. Alex saw the potential in the property despite its current state, which included a damaged roof, outdated electrical systems, and neglected landscaping.

He purchased the property at a significantly discounted price due to the property's distressed status. Alex then invested in repairing the roof, upgrading the electrical system, and improving the property's overall curb appeal. He also hired a property management company to help lease the warehouse to a reputable tenant.

Within six months, Alex successfully transformed the distressed property into a fully leased, income-producing asset. The property's value increased significantly due to the improvements, and Alex was able to refinance the property with a lower interest rate, further increasing his cash flow. The turnaround warehouse project proved to be a successful value-add investment for Alex.

The Troubled Office Building

On the other hand, meet Emily, a real estate investor from Phoenix. Emily decided to invest in a distressed commercial property: a vacant office building in downtown St. Louis. She believed that the property's prime location would attract tenants once the necessary renovations were completed.

Emily purchased the property at a discounted price, but soon discovered that the building required much more extensive renovations than she had initially anticipated. The building had outdated HVAC systems, asbestos issues, and significant water damage that had gone unnoticed during the initial inspection.

As renovation costs began to spiral out of control, Emily struggled to secure additional financing due to the property's distressed condition and the mounting expenses. Despite her best efforts, she was unable to attract quality tenants, as the local office market had become oversaturated, with many businesses opting for more flexible, remote work arrangements.

Ultimately, Emily's troubled office building investment led to significant financial losses, as she was forced to sell the property for less than she had paid (the combination of acquisition and renovation costs).

This case study highlights the potential risks and challenges associated with distressed property investments, emphasizing the importance of thorough due diligence and a solid understanding of the local market conditions.

How to Finance a Distressed Property Acquisition

Financing a distressed property acquisition can be more challenging than securing a traditional real estate loan, but there are several options available to investors. Some of the most common financing options for distressed properties include the four listed below, but depending on the investor and property, many more options may be available.

Hard Money Loans

These short-term loans are provided by private lenders and are typically easier to qualify for than traditional bank loans. Hard money loans often have higher interest rates and shorter repayment terms, making them more suitable for investors looking to quickly acquire, rehabilitate, and sell a distressed property.

Private Money Loans

Similar to hard money loans, private money loans are provided by individuals or small groups rather than institutional lenders. These loans can offer more flexible terms and potentially lower interest rates than hard money loans, but may require a stronger personal relationship with the lender.

Bridge Loans

Bridge loans are short-term loans designed to help investors finance the acquisition and renovation of a distressed property before securing more long-term financing. These loans can be useful for investors who need to move quickly to take advantage of a distressed property opportunity.

Traditional Bank Loans

Some banks may be willing to finance the acquisition of distressed properties, particularly if the investor has a strong track record and a well-defined exit strategy. However, traditional bank loans may have more stringent qualification requirements and may not be suitable for all distressed property investments.

Are Distressed Properties Right for Me?

Before diving into the world of distressed property investment, it's essential to consider whether this type of investment aligns with your goals, risk tolerance, and experience.

Here's a list of questions to think through to help you determine if distressed property investing is right for you.

What's Your Risk Tolerance?

Are you comfortable with the increased risks associated with distressed properties, including uncertain property conditions, legal and financial complications, and market volatility? If you're risk averse or prefer more predictable investments, distressed properties may not be the best fit for you.

How Much Experience Do You Have?

Do you have experience in real estate investing, property management, or renovation? While it's possible to learn on the job, having some background knowledge can help you navigate the complexities of distressed property investments more effectively.

Can You Shoulder the Time Commitment?

Are you prepared to dedicate the time required to source, acquire, and manage distressed properties? This may include conducting due diligence, attending auctions, managing renovations, and overseeing property management. If you're looking for a more passive investment, distressed properties may not be the best choice.

How Is Your Financial Situation?

Do you have the financial resources to cover the costs associated with distressed property investments, such as acquisition, renovation, and carrying costs? Keep in mind that financing options for distressed properties may be more limited or have less favorable terms compared to traditional real estate loans.

Do You Have Access to a Helpful Network?

Do you have access to a network of professionals who can help you navigate the distressed property market, such as real estate agents, attorneys, contractors, and lenders? Building a strong team can be crucial to your success as a distressed property investor.

Wrapping Things Up

Investing in distressed properties can offer significant advantages, such as lower purchase prices, less competition, and value-add potential. However, these investments also come with inherent risks and complexities that should not be overlooked.

By carefully considering your suitability for distressed property investing and conducting thorough due diligence, you can make informed decisions and potentially reap the rewards of this unique real estate niche.