Pitfalls and Strategies of Buying Distressed CRE

Property investors and owners eager to learn "What You Need to Know (But Nobody Will Tell You) About Buying Distressed Commercial Real Estate" filled the room at this recent seminar in New York.

Held at the law office of Herrick Feinstein LLC, the program featured three industry veterans who shared advice. David Tesler, CEO, Real Diligence LLC; Bruce Stern, principal, Red River Asset Management LLC; and Gary Eisenberg of Herrick Feinstein offered strategies for successful investing in today's volatile market and detailed ways to avoid costly errors.

In his opening presentation, Stern detailed the three biggest mistakes investors make when buying distressed commercial real estate.

He said many investors buy too early. "Rushing to pick up troubled assets before conducting thorough and comprehensive due diligence all too often leads investors to pay 'stupid prices' and lose money; cash-rich funds have been especially guilty of making this error," said Stern.

Rather than looking at the "new normal," investors too often accept underwriting that is based on past expectations. But, in today's economy, the past is no longer a predictor for the future, he said.

Another mistake is "not having multiple exit strategies." To avoid catastrophic failure, Stern said investors should know how they can get their money back in any scenario, whether they decide to keep, sell or refinance the assets.

As Tesler noted in his presentation, thorough financial due diligence is important for all real estate transactions but it is absolutely essential when acquiring distressed assets.

Whether purchased through short sale or by buying notes or bank-owned properties, every distressed asset is unique and requires a multistep process of examination, including valuing the note and valuing the real estate. The process also requires loan due diligence, seller due diligence, property due diligence and standard due diligence.

Tesler laid out the advantages and drawbacks of short sales, notes and REOs, concluding that short sales generally offered investors the most access to relevant documentation, with greater control over the borrower and advantages in pricing and timing.

Eisenberg discussed the legal pitfalls that threaten distressed property purchases, especially when buying notes.

He noted that standard precautions— —don't ignore warning signs, review all documents and communications, do proper searches, etc. —are always important but that investors should take extra steps today to avoid lender liability claims brought by a borrower in connection with a loan workout or default.

"Don't make any sudden moves that might jeopardize the borrower's project. Similarly, err on the side of providing a construction loan, albeit with rigorous documentation in place, so the borrower cannot later claim a waiver," Eisenberg said.

"Be careful of the tone of default letters. Avoid 'saber rattling' or tough talk that might alienate a jury. Replace outside counsel that closed the loan with outside counsel that is expert in workout and lender liability."

Always be truthful to third parties such as potential replacement lenders, he advised.

"That said, avoid contact with them as much as possible and provide no assurances. Above all, always operate in good faith—just be fair."