Authored by RSM US LLP

Key takeaways

  • When projecting the cash flow for a distressed asset, investors will likely want to build a premium into pre-pandemic discount rates based on the risk and uncertainty of the current market
  • Acquiring a distressed deal at auction requires a frenzy of due diligence in a short time period, but can mean a quicker closing and more time to apply a development plan
  • Competition is lower for off-market deals, but there are fewer controls in place to weed out the root cause of the asset’s distress

The central question of distressed investing is, “How much should I be willing to pay for an asset that’s in trouble?” The answer depends on numerous factors, including the current state of the market, the projections for the future and what put the asset in distress in the first place.

By and large, owners of distressed assets are working to keep their deals afloat with the hope of a quicker recovery, while potential buyers are biding their time, waiting for pricing to come down on distressed assets and debt.

“You have to understand the rationale for the distress. Is it asset mismanagement, regressive capital structures, the market dislocation or a combination of the three? Once a buyer understands the rationale, they can focus on the areas where they can make changes,” said RSM Canada’s Transaction Advisory Services Leader Ben Gibbons,

In the early stages of the distressed market, buyers may look for deals off-market, scouring debt maturity records to find owners who may be unable to recapitalize their holdings. Searching for off-market deals can mean less competition than for assets at auction and a wider window for laying out a development plan—but these deals can take a very long time to materialize, according to RSM US Valuation Director John Marshall.

“Off-market deals are a less-controlled environment,” Marshall said. “In an auction setting, there are controls in effect. A buyer has to qualify for financing and there’s a structure to the relationship. In an off-market setting, the rules are really just between the seller and buyer.”

When they bring a distressed asset or debt to auction, a lender will likely provide a full picture of what has caused the asset to become distressed. But auctions may draw more competition than off-market deals, and may only give buyers a few weeks to undertake their own due diligence and underwriting in order to decide whether or not to make a bid.

Especially in such a tenuous and unpredictable market, the due diligence process will have to be exhaustive, including looking at the asset’s fundamentals, examining the creditworthiness of its tenants, ascertaining whether the asset has any outstanding liens or encumbrances and how demand for the asset will recover over the coming years.

“When assets were trading hands quickly a few years ago, an investor might have taken a cursory look at the tenants, and a select few might have looked at them with more depth,” Gibbons said. “Broad-based and deep NOI examinations were not usually part of due diligence. Now, with demand for every industry at risk, they are compulsory.”

Even on newly constructed assets in prime locations, Gibbons said that buyers will likely want to add a premium to pre-pandemic unleveraged discount rates. This premium allows them to offset some of the uncertainty surrounding the real estate market in general.

In real estate, discount rates typically range from 6%–14%, depending on the asset in question. For some of the harder hit asset classes like retail and hospitality, that discount rate may rise to 12%–25%. 

Investors may have a harder time than usual deciding what to bid for a property, since there are so few transactions to compare it to. Using a talented valuation team that can contextualize all the transactions in the marketplace can keep bids reasonable.

When projecting NOI into the future, investors cannot simply use pre-pandemic numbers, as some industries may have changed permanently. According to RSM US Valuation Director Patrick Guthrie, while industries like food and beverage may return to normal levels, others, like retail and hospitality, will likely have transformed for the long term.

Tipping point: While upping the discount rate for an asset can drive its price down, investors must ensure they can actually create something out of a distressed asset once they own it. Will demand for the asset return in the future?

This article was originally published in partnership with Bisnow.