What Investors Need to Know About Distressed Funds

There’s nothing that excites right estate investors quite like distressed assets or debt. Many businesses were built on buying a troubled asset cheaply and eventually selling at a higher price.

But distressed debts are assets that can also get investors into a lot of trouble. “You can’t just run in, buy distressed and make a billion dollars,” says Carol Faber, co-chair of Akerman’s distressed property practice. “You can’t just say, I can get it for X percent of what its value is, and I’m going to come in and I’m going to make a killing.”

Before someone buys distressed debt, they need to know the entire picture—about the loan, the asset and the ground under it. “You really need to understand the business side, the economics, the asset type, where it is located, and what you can do with the property,’ Faber says.

Faber says it is also essential to understand the legal side of distressed deals. “If the loan is going to fail, you need somebody that knows how to look at those loan documents and knows what to look for,” she says.

And another important question is who controls the money. You need to know, “is there cash management in place? Is it provided for in the loan documents? If it’s provided for, is it being followed? Is it already set up? And is it in place?” she says.

If the cash management isn’t in place, Faber says it’s challenging to get a borrower about to default to cooperate. “The the key in a lot of these distressed deals is controlling the cash and controlling the property,” Faber says. “That’s important.”

An investor in distressed debt also needs to know who is in the capital stack. “It’s not just the mortgage lender,” she says. “You could have a senior mortgage loan, junior loan, mortgage or mezz debt. You’ve got to see which way you’ve got people involved, and you’ve got to be really careful and figure out where you are.”

Faber says borrowers have gotten a lot smarter since the last downturn and have negotiated strong positions in private loans that can’t be freely assigned.

There are also brick-and-mortar real estate issues to consider, such as the condition of the property. If it’s a development deal, distressed buyers need to know if there is an environmental issue and the status of entitlements, approvals and land use. Buyers should also find out if the entitlements are transferable.

“I’ve been involved in several deals recently where the entitlements are not transferable,” Faber says. “So, what does that mean if a lender forecloses? Can they take that over?”

Then there are fractured condos, which were prevalent in Florida during the Great Recession. They can bring a host of new issues. “You’ve got to be very careful how you handle those when you’re the buyer,” she says.