Coming Wave of Capital and Distressed Retail Plays

An underappreciated strength of real estate is that well-located properties can be repurposed.

Businesses are a lot harder to change. Pretty sure that dying nail salon in your town is not going pivot into software development. But a building with great bones in a high traffic area has real value, even at 0% occupancy. This is why conservatively leveraged real estate firms rarely go bankrupt.

Below are a few interesting real estate investment niches that are starting to come across our desk.

Emerging Retail Conversion Strategies

  • Distressed retail to self-storage conversion
  • Distressed retail to cloud kitchen conversion
  • Distressed retail to last mile distribution facility (think Amazon branded sprinter vans, not semis with docks)

These deals are interesting on a case by case basis but are not all ‘no brainers’ yet. Retail pricing hasn't fallen to extreme distress levels. Investors might want to hold out for reduced pricing to justify the extra execution risk.

Sellers of distressed real estate will likely 'white knuckle it' until they've exhausted all options. I saw the same dynamic play out in 2009. We were all waiting for the fire sales, but they were slow to materialize.

Distressed real estate owners have stall options:

  • They can lobby their lender to use loan reserves to make debt payments.
  • They can secure mezzanine debt (a high yield second mortgage), which is a favorite loan-to-own strategy for vulture investors.
  • They can threaten to throw the asset into bankruptcy if the lender doesn’t modify the loan.

These strategies can work (our President was skilled at this in his real estate heyday), but often they just delay the inevitable. A few large hotel operators recently took 9-12% interest, PIK (Paid In Kind) loans from Oaktree Capital to try and survive this crisis. Paid in kind, means the borrower can pay the interest with more debt. Yikes, no thanks.

Market Considerations – Regulatory Concerns

Here are some quick thoughts on real estate market selection (for new investments). Two predictions:

1. Down on their luck cities are going to goose-up every tax they can think to shore up decimated budgets. This is especially true of cities facing negative net migration. This is a flawed strategy. High taxes are partly to blame for the mass exodus from major cities. Someone should tell these government officials that - thanks to the WFH trend / Zoom – their tax base is now mobile. People move, which causes cities to raise taxes, which causes more people to leave = vicious cycle. The increased tax burden in such states will disproportionally hit commercial real estate investors in the form of:

  • Increased property taxes – cities are revisiting property tax assessments across the board. In California, the voters will likely repeal our beloved prop 13, which have kept a cap on commercial property taxes.
  • Increased transfer taxes on large sales – Washington tripled their transfer tax rate to ~3% this year. Why? Because they could. Landlords pockets are the easiest to fleece. Here is a news headline you’ll never see: Landlords treated unfairly, voters demand justice!

This doesn’t mean such markets must be avoided. However, investors need to be compensated – by way of price discounts - for the

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