Five Red Flags Distressed Property Investors Often Ignore

Every distressed property looks like an opportunity.

Sometimes it is.

Sometimes it's simply someone else's expensive problem.

The best investors know the difference. Unfortunately, even experienced investors occasionally become so focused on purchase price that they overlook warning signs capable of turning a bargain into a financial disaster.

Here are five of the most common red flags.

1. A Cheap Purchase Price Doesn't Cure a Bad Location

Investors love buying at a discount. Unfortunately, buying a bad property in a bad location simply means you own it cheaper.

Ask yourself why the property became distressed.

Did the owner overpay? Did management fail? Or has the surrounding neighborhood changed permanently?

Look beyond the building itself.

• Are nearby businesses closing or nearby rentals vacant?
• Who are the other tenants on the street? A nuisance property—or worse, a known drug house—two doors away may make it difficult to attract and retain quality residential tenants.
• Is traffic declining? Or has it increased dramatically, making ingress/egress difficult?
• Have major employers left the area?
• Has a magnet shifted the center of activity? A new WalMart often pulls everybody towards itself.
• Is the property in a flood plain? That will affect your insurance costs and could also affect commercial tenants, reducing the amount they can pay in rent.

Cosmetic problems can usually be fixed. The location usually can’t.

2. Deferred Maintenance Is Usually Worse Than It Appears

Every seller says, "It just needs a little work."

Rarely does it stop there.

When owners postpone maintenance because they cannot afford repairs, they usually postpone everything but perhaps spend a little money on cosmetics. That resurfaced parking lot might be covering up something that needs to be replaced entirely. New roof shingles could be hiding structural problems, mold, and compromised fire walls.

Build a contingency budget that assumes you'll discover additional problems after closing. Then add another contingency.

Experienced investors aren't pessimists.

They're realistic.

3. Occupancy Doesn't Equal Income

A property may appear healthy because it's full and tenants are current on their rent.

That doesn't mean it's profitable.

Ask questions like:

• Are tenants actually paying, or have large past due balances been forgiven to ready the books for a sale?
• How much is/was delinquent?
• How many leases are expiring in the near future? That might be good or bad, depending on your strategy.
• Were rents discounted to create occupancy?
• Are there tenant improvement obligations coming due, such as a commercial tenant entitled to a large TI allowance when it renews its lease?
• Are below-market leases about to expire—or above-market leases?
• For commercial properties—what is the health of the tenant’s business?

Cash flow pays the mortgage. You have to predict it accurately.

4. Legal Problems Can Cost More Than Construction Problems

Many investors spend weeks estimating renovation costs and only minutes reviewing legal issues.

That's backwards.

A property may have:

• Boundary disputes (almost never covered by title insurance)
• Easement problems (your rights; other people’s rights across your property)
• Side agreements (tenant estoppel letters will help)
• Code violations
• Environmental issues
• Pending or threatened litigation
• Zoning restrictions that interfere with your business plan
• Pending or current bankruptcy—seller or tenant

Physical problems are often visible.

Legal problems usually are not.

They deserve just as much attention during due diligence.

5. Don't Underestimate the Cost of Time

Time is one of the most expensive items in any investment.

Every month spent waiting on permits, financing, contractors, utility approvals, rezoning, or lease-up costs money.

·       Interest continues.

·       Insurance continues.

·       Taxes continue.

·       Utilities continue.

·       Opportunity costs continue.

·       Every month a property sits on the market without a lease changes the conversation. Prospective tenants begin wondering, "What's wrong with this place?" They assume previous prospects discovered something they didn't. Even if there's nothing that would actually affect them, the property's reputation may begin working against you.

When evaluating a distressed property, don't simply ask, "How much will it cost?"

Also ask, "How long until this property begins producing income?"

That answer often determines whether a deal succeeds or fails.

Final Thoughts

Distressed properties can produce exceptional returns.

They can also produce exceptional headaches.

Successful investors don't make money because they buy distressed properties.

They make money because they correctly identify which problems can be solved—and which ones should send them looking for the next opportunity.

Sometimes the smartest investment decision isn't buying the bargain.

It's walking away.

Every distressed property is discounted for a reason. Before you invest, make sure you understand why.

If you're considering a distressed residential or commercial property, contact Denise Evans, JD, CCIM. With decades of experience in real estate, law, and investment analysis, I help buyers identify risks, uncover opportunities, and negotiate from a position of knowledge.

205-310-3799 (mobile)
Denise@ButlerEvansRealEstate.com