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Welcome to the Commercial Real Estate Mastery podcast, where you'll learn the correct way to identify, negotiate, perform due diligence on, renegotiate, finance, turn around and operate real estate in today's market -- a market in which volatility creates opportunity, and sound principles defeat fads and bubbles. And your host is a 25-year commercial real estate veteran and co-owner of over $1 billion in real estate assets, Frank Rolfe.
If there's one topic I know really well, it's buying properties in distress. 'Cause I'm old enough that I've been through not one, not two, not three, but four different recessions. And I'm fully aware of the opportunities that can come from buying properties when times are bad. This is Frank Rolfe with the Commercial Real Estate Mastery podcast. Let's talk about distress. What makes properties go into distress? Well, there's several different groups of distress when it comes to commercial real estate, each of them a little different, with the opportunities of how to play that hand of cards a little different. Let's start off with my favorite type of property in distress, and that's called the term default. So what in the world is a term default distress play? Well, here's the situation. Real estate always comes with a loan. That's how you get the higher yields is you use leverage. Leverage is a big tool. So normally, most commercial properties are bought using 20 or 30% down, with the balance coming from typically a bank or maybe a CMBS lender, or if it's housing-oriented, Fannie Mae, Freddie Mac. Or it could just be a seller note.
But those notes all have a window on them. Typically, bank loans are five years, CMBS loans are 10 years, Fannie Freddie loans can go out to 12 years, and mom and pop can be whatever they want to set. But you rarely, if ever, see a commercial loan that goes to full maturity, unlike your typical home loan that'd be a 30-year fixed amount. Commercial real estate loans don't go 30 years. They typically go a third or less of that number. And when the loan comes due, some properties can't get a new loan. Now, why can't they get a new loan? Well, maybe they can't get the new loan because the property is not occupied enough. But one way they can't get a new loan is if the borrower, not the property but the borrower, has gotten screwed up during the time of that loan.
Let me give you an example that occurred a lot after 2007, 2008 in the Great Recession. You would have a borrower that had over-leveraged themselves with their business. Let's say that they had a day job of owning something or running something, and then they had their hobby job, which was the commercial property. And because of things they did with their day job, they no longer were creditworthy. Maybe they had declared bankruptcy, for example. So what happens? Well, they can't get the loan renewed, but not because the property isn't doing well. They can't get the thing renewed because they're not doing well. And that means when a property comes on the market because of a term default, you can often buy something in really good shape at a really low price that doesn't need a whole lot of work. It's probably the best way to buy things in distress when that happens.
We once bought a property, a mobile home park, that was in term default, and it was almost eerie. The property was immaculate. There was nothing to improve on. The sign at the front, brand new, very well done. Landscaping, everything was great. The mowing was fine, the roads were terrific, the occupancy was great. That mobile home park only had one problem, and that was the borrower. They couldn't get a loan. They had over-leveraged themselves, and during the Great Recession, they had a giant house, multi-million dollar house, that went into default, and ultimately they declared bankruptcy, and therefore no bank would give them a loan. So when you find a property that's in term default, those are absolutely some of the best.
Now, you will have to remember the one wild card on a term default, which is you still have to get a loan on it. And some people get spooked when a property is in distress. But on the term default, you can explain to lenders, "Look, the property isn't the issue here. The issue was the borrower. I don't have a problem, and therefore you should do me a loan." And normally they will. Now, another type of distressed property, a lot harder than the term default, is a property that's losing money and it can't cover the negative. You see that every day when you're out and about, right? If you go to the shopping mall, at least in the St. Louis area where I am, malls are typically about half occupied by actual tenants. They'll throw some kind of weird stuff in some of the vacant storefronts to make them look occupied, but we all know they're really not. And I bet if we looked at the books on those big malls, those malls are hemorrhaging money like you would never believe. And so often the owner of that big mall, he can't make up the difference. Often that thing is losing so much money that if he tries to cover the negative month after month for a whole calendar year, he would go bankrupt. So people then get desperate. "I got to sell this property because it's not working properly." That's a whole different issue than term default because now the property itself is flawed.
So how do you buy something like that? How do you buy a park in distress where, heck, it's not working anymore as an ongoing property? Well, obviously the first thing is, can you fix it? In the world of shopping malls, the problem is you can't. There just aren't that many retailers these days. There's almost no retailers going in. You have Saks Fifth Avenue shutting all their outlet stores and some of their main department stores. How will you fill those Saks Fifth Avenue spaces? Well, I don't know, but probably you won't. But a lot of other industries, things can be fixed. If you're looking at an RV park, for example, that's got massive vacancy, assuming the market is decent, maybe all you got to do is get that thing onto SEO, get it onto the internet, and start renting things online. But can you fix the problem? That's the first step in a distress deal where a property is failing.
And another big issue is can you finance it? That can often be a giant obstacle because financing is essential. That's the tool. Leverage is what makes the yields big. And if a property is struggling, how are you gonna buy it? How are you gonna finance it? Sometimes you can finance it by going to the existing lender and saying, "Hey, lender, this guy doesn't know what he's doing. Let me step into their shoes and I can turn it around." And we've done that many times successfully. But you got to find a way to get it financed. Remember that when the bank looks at, for example, the last three years of profit and loss statements, it may say, "Wait, what the heck? I can't finance this thing. This thing doesn't have an adequate amount of cash flow to make it happen." Remember that lenders are always focused on coverage ratio. Coverage ratio can be 1.2 or 1.25 times, and what it means is you've got to have more money than is necessary to pay the mortgage with an ample cushion, and otherwise they're not gonna make the loan. So that's the big deal on those properties if you want to buy them in distress: can you fix it and can you get it financed?
The final type of distress, and this falls completely on the seller, are health problems, divorces, deaths. This launches people into a panic mode to unload the property. And again, this is one where you can do really, really well in the event of distress. Because when people have to sell 'cause of a health issue, divorce issue, or settling of an estate, they tend to really discount prices to get things out the door. And it's not really a problem with the property. It's kind of like the default distress. The problem is with them. And it's not a problem that they created. They may be a wonderful commercial real estate manager, but they simply suddenly have to do something quick for some ulterior reason that has nothing to do at all with the property. The bottom line is that buying properties in distress is not an impossible, unattainable goal. Sometimes the property isn't even the issue causing the distress, and other times the property is not performing simply because of bad management or improper positioning.
So when you see a property that's in foreclosure, you see a property being marketed by a broker as something that's in distress and make offers, don't feel like, "Oh, well, I don't want that property. That property is a loser." Because it's not necessarily a loser. Henry J. Kaiser, the steel magnate, once said that problems are only opportunities in work clothes. Ponder that for a moment. He was a guy that went around buying up all the steel companies in America all the way back into the 19th century, and he loved recessions and he loved distress because he always saw that as an opportunity to make good buys. This is Frank Rolfe with the Commercial Real Estate Mastery podcast. Hope you enjoyed this. Talk to you again soon.