Distressed lending is making loans to people or companies in financial distress. For lenders, this can be an excellent way to earn high yields on your investment capital while reducing risk compared with traditional asset classes like stocks and bonds.
For borrowers, event-driven investing can provide access to much-needed capital when they need it most. However, distressed lending is also a very specialized area with its risks and rewards, so you should be careful about who you choose as a partner for this investment strategy.
What Is Distressed Lending?
Distressed lending is asset-based lending in which you lend money to people or businesses with financial difficulties, such as those in bankruptcy proceedings.
Distressed lending is risky because you may not obtain adequate collateral, and your loans may not be repaid if the borrower cannot offer anything of value as security. However, it can also be lucrative if you choose wisely and find candidates with assets worth more than their debts.
Distressed companies are often good candidates for distressed lending because they have valuable assets that could help pay back your loan. These include real estate, equipment, inventory, accounts receivable, and other property types.
Distressed investing is considered a niche specialty in the lending industry. However, it can be very profitable if you have the right expertise and access to distressed assets. With proper training and education, you can become familiar with the process of making loans to those who are in financial trouble.
What Are the Benefits of Distressed Lending?
When it comes to distressed borrowers, there are several benefits. The first is high yields and returns. Because loans in the distressed category tend to be high risk, the interest rates are also high. As a result, you reap substantial rewards if your investment pays off.
Another benefit of investing in distressed debt is low competition. Since it’s less common for institutions to lend money on this kind of collateral, you don’t have as many competitors vying for your investment dollars.
Additionally, because most people avoid buying into this type of loan due to its complexity and high-risk factor (which makes sense), there’s plenty of room left over for those who want something different from their portfolios—and an excellent way “diversify” might just be buying some distressed assets!
Assets Under Management in San Diego
The amount of money invested in distressed lending depends on how much time and effort you’re willing to put into finding suitable investments. You’ll need to do extensive research before deciding whether or not to invest in distressed lending.
You will likely need to spend at least one day per week looking through public records and researching potential opportunities. This includes searching court documents, bankruptcy filings, and company reports.
Perhaps most importantly, though: by investing in something unique compared to a more traditional investment like stocks or bonds, you can often earn higher returns on your investment.
What Are the Risks of Distressed Debt Investing?
- Risk of default: The borrower could miss payments and face foreclosure, leaving you without investment.
- Risk of not being paid: The borrower may not pay you back the money they owe you under the loan terms.
- Risk of losing your investment: If the borrower does not repay the loan, then there’s a chance that they will lose possession of their property and sell it for less than what they owe on it—meaning that your original investment would be lost forever.
- Legal action: You could face legal action from both sides—the lender (who may try to collect what’s owed) and investors who invested in similar loans (looking for repayment).
The above list is just a taste; many other risks are associated with opportunistic credit!
These risks are why it’s essential to do your homework when investing in this type of loan. Make sure you know what you’re getting into and that the borrower has a decent chance of repaying the loan before you invest.
Private Equity Firms
Another option is private equity firms. These companies buy up distressed debt, usually from banks, and then use that money to make new investments.
They have a lot of flexibility regarding where they choose to invest their funds, so you can find them all over the country. They also tend to focus on smaller deals, so you won’t have to look far to find suitable candidates.
However, these types of investments come with some risks as well. Private equity firms typically take on a large portion of the risk themselves, but if things go wrong, they could take a big hit.
What Are the Types of DIP Loans?
Distressed lending encompasses a variety of investment types. It can be broken down into three main categories: hard money, private equity, asset management company (AMC) lending, and commercial real estate (CRE) lending.
Hard money loans are short-term loans that are collateralized by real estate or other assets the borrower holds. These do not have to go through the traditional bank approval process because they are made with a minimal personal guarantee or collateral from the borrower; instead, these are secured against the value of an asset already owned by the borrower.
Leveraged loans are long-term loans backed by a combination of cash and assets. Leverage means that the amount borrowed exceeds the current market value of the collateral approving the loan, allowing lenders to borrow more money than they otherwise could.
Asset Management Companies (AMCs) lend money to borrowers based on the value of their properties. AMCs purchase loans from banks at discounted prices, which gives them access to a broader pool of potential borrowers.
Commercial Real Estate Loans (CREs) are used to finance commercial real estate projects such as office buildings, shopping centers, hotels, etc. CREs are often funded with multiple layers of debt, including mortgages, bonds, and lines of credit.
How to Get Started With Distressed Securities
Getting started with distressed lending is simple. Here’s how it works:
- Find a property you want to buy and use as collateral for the loan. You can find these opportunities by looking at your local newspaper or Craigslist or asking friends or family if they know anyone with a property they’d like to sell quickly.
- Talk with a bank that specializes in distressed lending and explain your situation. They’ll help you determine whether or not it’s possible for them to make financing available for your purchase of this property as soon as possible (ideally within 24 hours).
- If the bank says yes, promptly complete their paperwork, so they have all their information about their clientele interested in buying these homes from distressed owners!
Larger loans require larger down payments, and the minimum down amount varies depending on the loan type. For example, a conventional mortgage requires 20% equity, while an FHA mortgage only requires 3%.
The minimum down payment required varies according to the type of loan being discussed. For example, a traditional mortgage requires 20% equity, whereas an FHA mortgage only requires three percent.
A good rule of thumb is to start with 10% down if you can come up with the remaining funds needed; great! Otherwise, you may be forced to pay private mortgage insurance (PMI), which will cost you anywhere between 1%-3% of the total loan amount. PMI protects the lender against loss should the borrower default on their obligation.
Distressed Investments Can Be an Excellent Way for Lenders to Achieve High Yields
Distressed lending can be an excellent way for lenders to achieve high yields. But this niche market isn’t for everyone.
Distressed lending refers to lenders who lend money to borrowers in financial distress, generally through loan modifications, debt restructuring, or foreclosures.
In most cases, distressed loans are not made by the same type of lender that makes traditional mortgage loans. Instead, they’re often made by investors with plenty of cash but don’t want the headache or risk associated with owning real estate.
Investment opportunities can be appealing because they offer higher returns than traditional bank products such as certificates of deposit (CDs) or money market accounts—if you can stomach some risk in exchange for those returns. If you’re willing to take on some risk and have sufficient capital, distressed lending could be right up your alley!
These commercial loans are typically used for large-scale projects like shopping centers, office buildings, hotels, industrial parks, warehouses, and other similar properties.
The collateral of the property itself usually secures commercial loans. If the borrower defaults on the loan, the lender can take possession of the property and sell it at auction to recoup any losses.
However, there are also non-secured commercial loans, which do not require the security of the property itself. These include construction loans, equipment leases, and revolving lines of credit.
When looking into commercial loans, keep in mind that the interest rates tend to be higher than residential loans.
Commercial loans are typically offered at fixed rates, meaning that the rate won’t change throughout the life of the loan.
Distressed loans are not for everyone. If you’re considering this type of lending, make sure you understand the risks and can afford to lose some or all of your investment if things go south.
Restructuring Distressed Loans
Now, a new wave of funding options is available to help businesses survive and thrive during these tough economic times.
One option is restructuring distressed loans. This involves taking over a loan that’s already delinquent and renegotiating its terms.
Another option is buying out a company’s assets at a discount. These include equipment, real estate, intellectual property, and other tangible assets.
Both options offer companies access to capital and liquidity. And both options allow lenders to avoid losses and preserve value.
But which option is better? Both options have pros and cons. So it depends on the situation.
The distressed lending market is still ripe for the picking, and there are many opportunities to find a good deal. Many challenging clients need loans and have bad credit scores.
If you are looking for a good investment that will help you build your portfolio, then this should be considered by anyone looking for that opportunity.