Reducing the risks and avoiding the pitfalls of buying distressed comm'l. R.E. in today's market

While risk is an unavoidable element in any commercial real estate purchase, in today's erratic market, the stakes are even higher. How can a buyer be sure that they are getting the benefit of their bargain? How can a buyer avoid the financial and legal pitfalls that lie at every stage of the process? While risk may be unavoidable, there are varying degrees of risk. In today's real estate market, it is imperative to limit the risk by conducting adequate financial due diligence on the asset. Rushing to purchase troubled assets before conducting thorough and comprehensive due diligence all too often leads investors to pay inflated prices and lose money. Cash-rich funds have been especially guilty of this mistake. Although financial due diligence is important for all real estate transactions, it is absolutely essential when acquiring distressed assets. Whether purchased through short sale or by buying notes or bank-owned (REO) properties, every distressed asset is unique and requires a multi-step process of examination, including valuing the note, valuing the real estate and conducting due diligence on the (i) loan, (ii) property and (iii) seller. The market has drastically changed. The assumptions utilized in the past are no longer as indicative of the future (and possibly never were). Instead of accepting underwriting based on past expectations, it is important to discover the "new normal" of the market. The primary task, then, is to gain a clear financial picture of the asset today, uncovering any current or potential trouble spots. This is accomplished through a comprehensive financial due diligence review and an honest and conservative market analysis. It is a process that few companies are qualified and staffed to conduct in-house. In addition to the market analysis, the financial examination should involve a thorough review of all relevant documentation including an income and expense verification, CAM reconciliation and validation, financial modeling/cash flow analysis, and IRR analysis of leveraged and non-leveraged returns. Armed with this data, investors are far better qualified to negotiate from a position of strength in order to strike the most advantageous deal. When specifically conducting due diligence on a distressed note, it becomes necessary to conduct multi-layered due diligence. The first step is to organize and abstract the loan documents to ensure a clear understanding of the rights, obligations and responsibilities of all parties under the loan documents. Next, a financial review of the underlying property is needed, to the extent that access to available documentation allows. There is simply no other way to properly evaluate the value of what is being acquired. Proper and accurate due diligence can also be helpful post acquisition with the complex organizational and logistical issues that arise should the investor need to take ownership of a foreclosed property. The purchase of notes on distressed properties also has many legal pitfalls to avoid. Investors should hire qualified counsel to ensure the enforceability of the loan documents and protect against any potential lender liability claims brought by a borrower in connection with an acquisition. For any individual investor or fund looking to acquire distressed real estate, the goal is always to minimize risk and maximize return. In today's changing market, upfront financial due diligence of the asset can minimize the risk and maximize the return on distressed properties and notes. David Tesler, Esq., is the CEO of Real Diligence, LLC and LeaseProbe, LLC, New York, N.Y.