Defaults on commercial properties are rising in New York, and experts think they may herald a larger wave of bankruptcies. If the local economy begins to plateau or even head into a downturn, the NYC market could fill up with distressed properties being sold below their perceived values.

“Historically, these economic conditions have drawn out real estate investors interested in acquiring distressed assets,” said Jack Rose, leader of the reorganization and bankruptcy department at real estate law firm Rosenberg & Estis. “While there are certainly opportunities, investors need to be aware of the potential pitfalls.”

With land at a premium in the five boroughs, deeply discounted properties may seem like a dream come true. But without a seasoned expert in the world of bankruptcy on the team, acquisitions can quickly devolve into protracted legal battles, or worse, money pits that can swallow investors whole.

Here are five of the dangers that investors face when they go after distressed properties, and how to avoid them.

1. Hidden Liabilities

Buying a distressed property is not like buying any other building. Often the reason these properties come at a discount is because there are liabilities that the new owners will have to take on themselves and that could cost a great deal to resolve. These liabilities can take innumerable forms, from liens or legal barriers to messy environmental cleanup efforts.

Some investors will attempt to negotiate a purchase price for distressed properties outside of bankruptcy court in order to avoid a bidding war, but Rose said those negotiations can cause investors to overlook the expensive liabilities.

“Out of court, you can’t scrub the property or divorce it from all the underlying liabilities,” he said. “If it goes through court, you can transfer the property free and clear of liens, claims and encumbrances, resulting in clean title.”

Rose also noted that buyers should beware of prices that look too good to be true. Investors may acquire a distressed property directly from its owner for a great price, only to find later that a bankruptcy trustee or other party has a claim to the property and wants to unwind the deal and hold the buyer accountable for a much larger sum than they initially paid.

2. Lack Of Yield

For a distressed property to make sense as an acquisition, the yield can’t just be equivalent to other comparable assets. It has to be superior.

“The old saying holds true: If you look around the table and can’t figure out who the sucker is, it’s probably you,” Rose said. “You have to have good professionals on your side: an experienced broker and a lawyer who’s seasoned in the distressed market.”

Auctions for distressed properties, which can result in bidding wars, may drive up the initial price and turn an acquisition from a smart investment into a loser. A smart distressed investor should find a property in an area they think still has potential for growth, Rose said. Too late to a submarket and the acquisition may not be worth the trouble.

3. Falling In Love With The Deal 

At a certain point, all investors need to know when to stop throwing good money after bad. Rose described having tough conversations with his clients about exiting a deal even after months of planning. Sometimes, even when it makes sense to walk away investors have hung on, intent on making the deals happen.

“I offer my 30 years of experience and give the best advice I can, but they’re the client, and I represent them to the best of my abilities,” Rose said.

He added that while he has occasionally seen investors salvage deals he thought they should abandon, much of the time, investors eventually back out only having expended more time and money than they ought to have chasing after a deal they loved. Many times, Rose said, if an investor walks away early, the deal will return to them down the road with a better price and fewer liabilities.

4. Failing To Adapt

Above all else, distressed property deals are volatile. Teams on both sides of a distressed deal may need to overhaul their negotiation strategy at a moment's notice. Especially because debt and loans are now regularly traded, creditor teams can change at the drop of a hat.

“On Friday, you might be hashing it out with a loan servicer from a bank, and on Monday, you're negotiating with three hedge funds who bought the loan,” Rose said. “Their goals might be totally different — while a bank might be looking to extend the loan or be bought out with a refi, the hedge funds may want to push to own the property.”

Changes are just as common on the other side of the transaction, too, and property owners could be facing a brand-new set of buyers from one day to the next.

“If you are expecting a stable environment, you shouldn’t go after distressed properties,” Rose said. “Don’t assume the group that is there on day one will be there two months later, let alone years later.”

5. Waiting Too Long

Even real estate professionals who aren’t interested in acquiring distressed assets should be concerned about the growing number of bankruptcies. Office landlords with tenants that may be in danger of declaring bankruptcy should bring in legal advisers as soon as possible, Rose said.

“Everybody hopes that things will get better, but most of the time, they get worse,” he said. “Usually, by the time people like me get called in, the situation is pretty dire. The earlier we arrive, the more help we can provide.”

Rose said that negotiations between a landlord and a distressed company require a delicate hand. Landlords have a vested interest in not seeing their tenants go bankrupt, of course, but at the end of the day, they still need to get paid.

“The world of bankruptcy is always a balancing act, especially for real estate,” Rose said. “You want to make sure you have an experienced team on your side, no matter where you sit.”

This feature was produced by Bisnow Branded Content in collaboration with Rosenberg & Estis. Bisnow news staff was not involved in the production of this content.