When most people think of distressed real estate, they picture a run-down property with peeling paint and deferred maintenance. That's one type of distress. But in commercial real estate, physical condition is actually the least common source of it.
Distress in commercial real estate can look very different from deal to deal. It can range from a simple value-add situation where a property needs renovation, to a defaulted subordinate equity position in a fully occupied high-rise. Understanding where distress actually originates is one of the most useful frameworks a passive investor can carry into any deal evaluation.
Distress can be found in four main areas of a real estate deal.
The Debt: 60%
The majority of distress in commercial real estate, roughly 60%, originates within the debt side of the capital structure. Overleveraged deals don't always reveal themselves immediately. Sometimes it takes several years for a structural debt problem to surface, particularly when markets are forgiving and interest rates are favorable. When conditions shift, the weakness becomes visible. Common examples of distressed debt include maturity defaults, term defaults, and bank regulatory stress on the lender side.
The Operator: 25%
The operator runs the show, and 25% of distress in commercial real estate can be traced back to the operating team. This typically stems from one of three causes: an inexperienced team that is in over their heads on a deal type or market they don't know well, a weak team that lacks the execution capacity to manage the business plan, or an absentee team that is not actively managing the asset. All three lead to the same outcome - a deal that underperforms or fails not because of the property or the market, but because of the people running it.
The Asset: 10%
Only 10% of distress originates within the asset itself. Most investors assume this number would be much higher, but physical distress is far less common as the primary cause of a deal going wrong than debt or operator failure. When distress is found within the asset, it typically involves key events that failed to occur, a property that is functionally obsolete or unattractive relative to competing supply, or insufficient market demand for the asset type in that location.
The Equity: 5%
The smallest source of distress, at roughly 5%, is the equity structure itself. This usually occurs when a property is overleveraged and a default cascades into the subordinated equity positions. It can also occur when limited partners lose confidence in a weak operator and attempt to exit their positions, creating friction in the capital structure at a time when the deal can least afford it.
The Bottom Line
Most people have the distress picture backwards. They focus on the asset, where only 10% of distress is found, and underweight the debt structure and the operator, which together account for 85% of everything that goes wrong in commercial real estate.
That inversion is significant. It means that with a properly structured capital stack and a strong operator, a mediocre asset can still produce a good outcome. And conversely, with an overleveraged capital structure and a weak operator, an exceptional asset in a great market can still fail.
This is why the 9-Point Checklist prioritizes operator evaluation and debt structure above physical due diligence. The building matters. The people and the structure matter more.
Download the P10 9-Point Checklist to see how each of these risk categories fits into a complete investment evaluation. Get the Checklist
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