Secrets for Buying Distressed Commercial Real Estate - Part 1 of 3

I am frequently amazed when I see what the effect of cheap money has on people.  The case in point that spurred this series is an article on MSNBC.com from the New York Times.  It’s called As Simmons sank, buyout firms prospered.  Simmons is that famous bed company you’ve seen on TV for decades.  Several lines from that article could be applied completely to commercial real estate.

Simmons is one of hundreds of companies swept up by private equity firms in the early part of this decade, during the greatest burst of corporate takeovers the world has ever seen.

“From my experience, none of the private equity firms were building a brand for the future,” said Robert Hellyer, Simmons’s former president, who worked for several of the private equity buyers before being asked to leave the company in 2005.  “Plus, the mind-set was, since the money was practically free, why not leverage the company to the maximum?”

But in the mid-1980s, Simmons caught the attention of a new type of investor.  The businesses that stormed corporate America in recent years under the banner of private equity were not always called private equity firms.  In the 1980s, they were known as leveraged buyout shops.  Their strategy is essentially unchanged, however: they try to buy undervalued companies, using mostly borrowed money, fix them up and sell them for a fast profit.  Because they pile debt onto the companies they buy, the firms free up their own cash, allowing them to make additional investments and increase their potential profits.

I’m not going to rag on the flipping that private equity firms have done with companies, although it sure sounds a lot like what happened in some residential neighborhoods.  I am also reminded of numerous conversations I’ve had with investors who wish to buy distressed commercial real estate and I find the mindset to be surprisingly similar.

Secret #1 – Forget About the Triple Digit Return on Investment

There is still plenty of wide-eyed, dyed-in-the-wool optimism about there by investors and prospective small-time commercial property purchasers.  It’s like they’re looking for that single pot of gold in the pottery market.  It’s kind of like putting all your money on the money wheel and hoping that the needle stops on that 20 to 1 slice.  It’s understandable… the dollar value of commercial real estate is so much compared to residential real estate that if they catch it right, it will make them rich.  That worked for Donald Trump who had a letter of credit for $50 million to buy and renovate his first hotel, but I’m sorry to say I don’t know anyone else with that much luck straight out of the gate.

Sure, appreciation expectations aren’t what they used to be… the optimism has shifted to cash flow.  By that I mean that there are still way too many investors who believe they can take the existing cash flow and improve it by substantial amounts.  Maybe they can, but I wouldn’t bet on it.  Why?

• What do you bring to the table that the existing owner did not?  Is it really going to translate into more _____ (sales, operating cost savings… you fill in the blank)?
• It seems that reconstructing the true operating statements for lots of real estate is nothing more than throwing darts at a dart board.  For instance, last week I get a call from a Texas lender who is repossessing this four-unit building and doesn’t have leases or financial statements on the property.  How accurate do you think their estimate of income, expenses and net operating income is?  Better yet, how accurate would your estimate be?  Unless you put the due diligence into the deal like we appraisers have to (i.e. one to three weeks labor), your net operating income estimate will be incorrect.  Basing further increases in revenue on a false assumption is…. well…. compounding an error.
• Any thought about “cashing out” or getting financing is highly optimistic today.  If you’ve done any reading in the press, many people are only now just getting on the “commercial real estate is failing” or “the next domino is commercial real estate” bandwagon.  Like lenders really want to lend on commercial real estate when they think it will go down in value.  What that means is deals today are “all equity”, so without the ability to get positive leverage, forget about getting a great return.
• Is there a business integrated with the real estate?  Take the example of the marina.  If you think you can run a business better than the last owner, you’ll have to work hard to make me a true believer.  The same applies to many forms of commercial real estate such as car washes, nursing homes and many others.

Given the lack of deals going on out there and the disconnect between buyers and sellers, even double digit returns on investment are about as scarce as finding a wheat back penny on the ground.  Speaking of disconnect, that’s the focus of Part 2.

John Simpson, MAI