We’ve all been waiting for the wave of distressed assets to hit the commercial real estate market. Despite distress levels rising steadily since 2022, a surge in forced capital events has yet to materialize at significant scale. Distressed transaction volume is just now starting to rise. But how many properties are truly distressed, versus just value impaired? Determining the difference between the two is an important step for brokers and other stakeholders involved in the sales of challenged assets. While a change of ownership may potentially solve for simple cost-based stress, distress in the property’s fundamentals is not so easily turned around.

At a recent SIOR Chicago Speaker Series luncheon, Kirsten Bowersox, principal and COO of Xroads Real Estate Advisors Inc., a national full-service real estate asset management, property management and advisory firm; and Adam Toosley, lender attorney with Smith Gambrell & Russell, LP sat down with moderator Ryan Moen, SIOR for a candid discussion around the state of distressed assets, receiverships and special servicing.

The tidal wave of distress is beginning to swell

Investors anticipated a flood of distressed assets in the wake of the early pandemic, but according to a recent MSCI blog post, 2023 saw only a minor 1.7% share of investment attributed to distressed sales in the U.S. market, surprising many. However, according to PERE, the first quarter of 2024 experienced a 3.9% uptick in distressed commercial real estate transaction volume.

Many in the industry believed that skyrocketing office vacancies from impacts of COVID-19 would create an office sector apocalypse. However, the more imminent driver of distress has been the high interest rate environment, as noted by Bowersox and Toosley. Bowersox called out how unpredictable fluctuations in interest rates in addition to higher office vacancies, are fueling receiverships, foreclosures and other signs of market stress. She posed the property valuation existential question: is an asset genuinely distressed, or is its problem just stress in the financing?

Not all “stressed” qualify as “distressed”

During the SIOR luncheon panel, Bowersox emphasized that not all stressed assets qualify as distressed. Distinguishing between the two is a vital part of figuring out next steps for a property whose owner is in trouble. This is particularly true in the commercial mortgage-backed securities market, where servicers grapple with cash traps on performing assets strained by interest rate pressures.

A “stressed” property is generally cash flow positive and demonstrates a stable tenant mix—but its owners are pressured by the fact that their cost of capital has risen with the rise in interest rates. They may have a maturing loan, possibly with a capital call for more equity to refinance the loan (a “cash trap”). Stress in the financing may be solved by an asset sale to a buyer with a new, lower cost basis. For example, a fully leased retail center might be stressed because the owner can no longer afford its payments to its lenders due to a floating rate loan.

In some cases, these well-leased properties may also receive a lower valuation that triggers a transition into stress—even as tenants continue to pay their rent on time every month. Such a property may exhibit performance on par with or exceeding market standards yet receives a lower valuation due to lower prices similar properties are commanding in the market. These properties typically maintain stable occupancy, engage in active leasing, and command rents that meet or surpass market rates. In short, despite robust property-level performance, the asset's value is dampened by the elevated cost of capital and market conditions.

A fundamentally “distressed asset” on the other hand, is characterized by below-market occupancy, exacerbated by tenant exits and leases nearing expiration. In this scenario the ownership also struggles to fulfill its debt obligations—but the difference is that a simple change of ownership won’t solve the underlying problem. For example, an office building may have low occupancy and zero-to-little chance of attracting new tenants at the rents needed. Depending on the location and zoning, the building may be more likely to become candidate for adaptive re-use or demolition since new ownership alone will not do anything right away to resolve the underlying problem.

A distressed property can also be defined by an ownership group that does not have the capital to backfill a space or makes a conscience decision to not deploy more capital in cases when it does not make financial sense to do so.

Timing is everything: asset foreclosures take time

In either stress or distress, foreclosure can be the first step toward resolution. Asset foreclosure timelines can vary, with some lenders opting for swift foreclosure while others prefer placing them under receivership for longer periods. Toosley explained that the choice between expediting or delaying foreclosure depends on the lender’s objectives.

“Factors such as selling the note, stabilizing the property with tenants to increase its value, or ensuring adequate rental income for tax payments all play a role in this decision-making process. If there is a market for a particular stressed asset, lenders are inclined to reclaim and sell it promptly, minimizing their exposure,” he added. “Much of a lender’s strategy today revolves around whether the asset can be reintegrated into the marketplace as a viable property or if it requires demolition, a determination the bank may prefer to avoid.”

The receivership opportunity: strategies for acquiring distressed assets

Bowersox noted how receivership, appointed by court or lender, can be a powerful tool for rejuvenating distressed or stressed real estate. An impartial third party takes over management, handling rents, bills, repairs, and improvements. Many times, an asset is managed in receivership while the bank or private lender group that owns it seeks a buyer for the loan’s note. In this way, despite its complexity, receivership offers a path to revive troubled properties.

A strategic receiver will recognize that tenants must be well-managed during times of transition and prioritize retention on behalf of the lenders. For example, the receiver will manage lease agreements and proactive protections safeguarding their interests during ownership transitions.

When under stress (or distress), communication is paramount

Effective communication becomes one of the most important tools for all parties involved in distressed assets, particularly those stressed borrowers that are trying to find an exit from a bad investment.

“Persistence in reaching out and addressing concerns proactively can foster necessary engagement,” advised Bowersox during the SIOR luncheon panel. “However, dynamics vary depending on the asset nature and lender identity. Traditional lending scenarios may offer a straightforward path, while special servicers handling distressed assets demand swifter action.”

When an asset becomes stressed or distressed, the situation has far-reaching impacts on lenders, owners, investors and tenants, all with a unique set of priorities. One thing they have in common is that navigating the nuances of distressed assets demands an educated, patient and open-minded approach. When all parties work together, a property can be brought out of distress much more quickly and smoothly.