EquityMultiple offers investors access to commercial real estate investments through several types of investments. Investors are likely most familiar with debt and equity investments that come with various types of returns. Our sponsors purchase properties, renovate them, and then can resell the property once it is leased-up.
A unique way for a sponsor to acquire these assets is through a non-performing loan. The returns from these investments can often present a highly attractive entry point and risk-adjusted return potential.
What is a Non-Performing Loan (NPL)?
A non-performing loan is a loan where the borrower has defaulted. There are many ways for a default to occur. Not every default provision will lead to a foreclosure, and not every default can make a loan non-performing. That said, typically commercial loans are considered non-performing if the debtor has made zero payments of interest or principal within 90 days or is 90 days past due.[1]
An NPL can be purchased at a fraction of its original value, giving investors favorable terms after foreclosure such as potentially high cash flow and overall return due to acquiring at such a discount. Through the foreclosure process, a sponsor can then acquire the underlying real estate asset.
Types of Non-Performing Loans
Non-performing loans can be categorized into several types based on their characteristics. Understanding these types can help investors identify potential opportunities and risks associated with NPL investments.
Substandard Loans
Substandard loans are those that show signs of weakness or contain deficiencies, making it likely that the borrower will default on the loan. These loans may still be generating some income but have a high probability of becoming non-performing in the near future.
Doubtful Loans
Doubtful loans are a step beyond substandard loans, where it is highly probable that the borrower will default and there is little to no prospect of recovering the principal or interest. In these cases, the collateral securing the loan may not be sufficient to cover the outstanding debt.
Loss Loans
Loss loans are those where there’s little to no chance of recovering any funds from the borrower or through the liquidation of collateral. The loan is considered a loss for the lender, and they may choose to write off the debt completely.
Restructured Loans
Restructured loans occur when a lender agrees to modify the original terms of a loan due to financial difficulties faced by the borrower. This could involve lowering interest rates, extending repayment periods, or even forgiving a portion of the principal balance. While restructured loans can sometimes regain performing status, they carry an increased risk as borrowers have already demonstrated financial distress.
Knowing different types of non-performing loans can help investors choose which NPL investments are best for their risk tolerance and investment objectives.
Current Market Forces
Our Real Estate team sees the recent volatility in the economy as an opportunity to capitalize on potential opportunities in commercial real estate. Primary markets like New York are becoming more attractive as prices have fallen. Although the drop in values in these markets for asset classes like office buildings can be disconcerting, patient investors can find attractive entry points.
Population shifts and new working trends from the pandemic continue to play out and crystallize into a new normal. As the dust settles there are several areas where real estate sponsors may be challenged. These challenged or “distressed” assets are the basis for NPLs.
For example, given that workers are less likely to use office space with work-from-home (WFH) trends persisting, income from rents has declined. In turn, these property values have diminished, too. You can also find NPLs in other asset types, such as residential, hospitality, and retail. In many cases, these asset types have been hit particularly hard by the pandemic, as people are less likely to travel, shop in retail stores, or buy homes. Thus, prior owners and borrowers are faced with potential defaults when they can’t meet their debt service requirements. Specifically, recent office building transactions in San Francisco, Chicago, and New York have showcased the weakness of this asset class in recent years. However, at the right acquisition basis — the price that is paid for the property — the property can be attractive during this market.
How do investors benefit from NPLs?
Since the NPL can often be acquired at a significant discount to its face value, the cost basis of the investment can be much lower than the original purchase price of the property. A lower price to acquire the asset can potentially lead to a return when the property appreciates in value.
Most often investors purchase NPLs with the intention of foreclosing on the loan. When a sponsor forecloses they are able to obtain the underlying asset. Once the sponsor owns the property they can renovate the property, lease up the property to new tenants, and sell to a new owner upon stabilization.
The most beneficial aspect of an NPL acquisition is the significantly lower acquisition cost for an otherwise attractive property. With the proper business plan a seasoned sponsor can potentially find, acquire, and turn around these assets for a potentially attractive return. The risk in acquiring NPLs is that the loans may be non-performing for various reasons. The sponsor must understand the underlying asset and its market value before an acquisition. This will allow the sponsor to determine a suitable purchase price and assess the potential return. Additionally, the sponsor must be mindful of any additional costs associated with the acquisition and any potential legal matters related to the property. With careful consideration and proper due diligence, a sponsor can find value in the NPL market and create a strong
Key Takeaways:
- A non-performing loan is a loan where the borrower has defaulted, typically occurring when the debtor has made zero payments of interest or principal within 90 days.
- The most beneficial aspect of an NPL acquisition is the significantly lower acquisition cost for an otherwise attractive property, giving investors favorable terms after foreclosure.
- With the sponsor able to obtain the underlying asset, they can renovate the property, lease up the new tenants, and sell to a new owner once it is leased-up.