The Risks and Rewards of Investing in Distressed Properties
By Michelle Clardie on 11/04/2023.
Reviewed by Josefin Gatsby
Distressed properties are a special category of real estate investments, coming with their own challenges and benefits. In this article, we’re exploring the risks and rewards of investing in distressed properties. Plus, we’ll tell you how to minimize your liability while maximizing your return potential!
What is a Distressed Property?
A distressed property is any property that is either in physical or financial trouble. For example, a neglected structure with heavy deferred maintenance could be considered a property in distress. As could a property that is at risk of being foreclosed on. In most cases, properties at risk of foreclosure are also experiencing some form of physical distress. This is because homeowners who are struggling to make their mortgage payments typically don’t have funds available to invest in maintaining the property.
So, is a distressed property a good investment? Let’s look at the potential risks and rewards associated with distressed properties so you can decide if this is a good investment strategy for you.
The Rewards of Investing in Distressed Properties
Here are the primary rewards of this investment type.
Less Buyer Competition
Many buyers lack the time, knowledge, or cash to rehab a distressed home. This means there are fewer buyers in the market for this type of property. Lower competition not only grants you more time to consider the details of the deal, but it can also lead sellers to offer incentives for any would-be buyer.
Negotiating Power
Owners of distressed properties are often looking for a quick sale. Particularly if a foreclosure is looming. The sellers may want to find a buyer and close the deal before the property can be foreclosed on. This would prevent them from having a foreclosure on their credit report, which can have devastating effects on future loan applications.
This means you may have more negotiating power on a distressed property. You might be able to negotiate a quicker closing, a lower purchase price, or to have personal property (like salvageable furnishings) included in the deal.
Buying at a Discount
Because distressed properties typically have motivated sellers and a smaller buyer pool, it’s easier to purchase these properties below market value. Even when accounting for the cost of the work to be completed, you can often save money by purchasing distressed properties.
Forced Appreciation
Forced appreciation is when you actively add value to a property to immediately increase its worth (as opposed to market appreciation, which is when assets grow in value on their own over time). The key benefit here is that you can potentially turn a profit by selling the renovated property in a short time frame. Alternatively, you might use the increased value to borrow against the equity for the down payment on your next property.
Renting the Renovated Property for Ongoing Income and Tax Benefits
The Risks Associated with Investing in Distressed Properties
In addition to the many benefits of investing in distressed properties, here are a few of the potential risks to consider.
Unknown Condition
Distressed properties are often sold in as-is condition. This means that the seller will not make any repairs or offer any financial assistance to help the buyer make necessary repairs. It is entirely up to you to confirm the condition of the property before finalizing the purchase. A licensed home inspector can provide a report of the property’s condition to help you make an informed decision. You might also wish to have additional inspections for any specialty features or unique concerns. For example, you might choose to have a supplemental fireplace, pool, or plumbing inspection.
Fluctuations in Real Estate Values
While home prices always trend up over the long term, they are constantly shifting up and down over the short term. If you plan to fix and flip a distressed property, you might find that values are slightly down when you’re ready to sell. This can eat into your profit margins, or potentially cost you money on the deal.
A careful local housing market analysis should be conducted before purchasing any investment property. But this is particularly important when planning a short-term flip project that relies on the market as a whole maintaining its value.
High Renovation Costs and Unforeseen Expenses
Renovation costs are notoriously difficult to accurately predict. You never know when you’ll come across an unexpected complication or need to order more materials than you originally budgeted. There’s also a risk of requiring more hours of paid labor than originally estimated, which can quickly add to the renovation costs.
Building Permit Issues
Many distressed properties need extensive renovations that require building permits. Failing to understand the permitting process (or underestimating the timelines) can lead to costly delays.
Legal Complexities
Distressed properties may come with additional legal considerations. For example, there might be liens against the property for unpaid taxes or other liabilities. If the current owner can’t pay these liens from the proceeds, you may need to pay the liens to allow the owner to complete the sale. There might also be renter issues. For example, if a pre-foreclosure property is occupied by renters, you could potentially need to file eviction paperwork to have the renters removed. Invest some time in researching any potential legal liabilities before purchasing a distressed property.
How to Easily Invest in Distressed Properties
If you are interested in investing in a distressed property, but you have concerns about the potential risks, consider investing through a crowdfunded project.
Real estate crowdfunding is a growing investment strategy in which multiple investors contribute funds to a real estate project, which allows each investor to access a deal for much less than they would pay as an independent property owner. And, because crowdfunded projects are professionally managed by development sponsors, you can invest hassle-free and earn passive returns!
Here’s how crowdfunding mitigates the risks of investing in a distressed property:
Risk 1: Unknown Condition. The project’s sponsor can have their trusted team of inspectors confirm the condition of the property before purchasing. In fact, because crowdfunding sponsors have more resources available, they might have the option of demolishing the existing structure and replacing it with a brand-new higher-value building.
Risk 2: Fluctuating Real Estate Conditions. A good crowdfunding sponsor will have a team of expert real estate analysts to track local market trends and create contingency plans for expected market shifts.
Risk 3: High Renovation Costs and Unforeseen Expenses. In addition to the increased due diligence capabilities of sponsors, which allows for more accurate budget forecasting, good sponsors will have reserve funds or lines of credit ready to cover unexpected expenses.
Risk 4: Building Permit Issues. A good sponsor is familiar with the local permitting process and has contacts at the local permit office. They may even be able to fast-track permits to complete the build faster.
Risk 5: Legal Complexities. Good crowdfunding sponsors have insider knowledge of potential legal risks associated with distressed properties. They may also have attorneys on retainer, ready to professionally address any legal issues that come up in a deal.
Gatsby Investment is a real estate sponsor with years of experience in distressed property investing. With a stellar track record of high returns, refreshing financial transparency, and an innovative online dashboard for monitoring investments, Gatsby is among the most reputable development sponsors in the industry.
