“Perhaps the best strategy for dealing with distressed properties is to forestall them by watching for early warning signals. The difficulties of most problem properties usually can be traced to one of the following factors: poor management, operating deficits, lack of capital improvements, or owners who need greater liquidity. Sometimes the problems are physical–deterioration of interiors and exteriors, problem tenants, neighborhood deterioration, functional obsolescence, adverse changes to frontage, increased traffic congestion, or worsened access in and out of the property…Fixing these problems before they become major obstacles can save everyone a lot of grief. It helps the equity investor because he or she may be able to avoid foreclosure. Working hard to turn around a property may also allow the equity investor to borrow again another day” (Shilling, 2002, p. 190 – 191).
Assessing Risk is an Important Part of Conducting Due Diligence
We are having a very interesting class discussion regarding assessing and mitigating the risks that surround real estate investing. A very important point was made that an assessment of risk should be conducted as part of the due diligence process. As cited above, the best way to avoid becoming a distressed statistic is to take preemptive and preventative measures; for example, establishing quality management, ensuring that cash flow is sufficient to cover expenses and yield a positive return, establishing and maintaining reserves for capital improvements and maintaining greater liquidity, etc. These are all things that are within an investors’ control; however, there are some factors that go beyond the control of an investor; for example functional obsolescence and neighborhood deterioration. These uncontrollable factors will have a direct and significant impact on the quality of tenants, and thus quality of the investment; which in turn raises the risk of the cash flows and risk of the investment in the long-term.
The Greater the Risk, The Greater the Expectation of a Return
For the average real estate investor, these conditions are best uncovered during the due diligence period and avoided. However, for an experienced investor with vision, resources, local knowledge, and community backing, there could be a tremendous opportunity to re-develop deteriorating communities; to be sure, it is a specialty not for the faint of heart. In the case of deteriorating neighborhoods, these investors are buying up whole blocks of homes for pennies on the dollar, eradicating the neighborhood of criminal element, demolishing old vacant homes, and then re-developing / re-building clean affordable homes and rentals. When the market recovers, their hard work will have paid off handsomely, because they properly assessed the risks, created a preemptive plan of action, and followed through with all things considered. Since they assume a greater level of risk, they can expect to earn greater returns, and rightly so. These investors are angels–in my opinion–because they are the ones that revitalize and renew ailing neighborhoods; they encompass what it means to be “green” in the quest for sustainability and the triple bottom line of, “people, planet, and profit.” These Angels have my undying respect and admiration for the good that they do for people in their pursuit of profit; they are social entrepreneurs to the core. Spectacular!