"Defaults have increased from their historic lows," reports Stacey Berger, EVP of Overland Park, KS-based Midland Loan Services. "And we'll continue to see them through 2005 as some of these large floating-rate loans mature. Typically, the loans had a two- or three-year primary term and one or two one-year options. But a lot of those borrowers won't be able to execute these plans, given the fundamentals. So once those options burn off and the loan matures, the ability to refinance out at a number that will pay off becomes more problematic."

That being said, the relative numbers are "still very low," says Berger. "The life insurance company portfolios have had very few delinquencies or defaults, and the same is true for Fannie Mae and Freddie Mac."

Ditto the public side of the equation, he adds: "Depending on how you measure it, CMBS delinquencies and defaults are somewhere between 2% and 2.5%."

Berger states that his own firm is currently working on "a little more than $900 million" in special servicing. And while he admits that this is a large chunk of troubled business, it pales in relative terms. "Keep in mind that our total portfolio is $80 billion." And even though it is possible that the number of defaults could double in the next 18 months, we're still not talking about a return to RTC levels. "Absolutely not," says Berger. "There is certainly no threat to investment-grade bonds."

Even with a conceivable doubling in the rate of defaults, the percentages will still remain well below 5%, agrees Roy Chun, managing director at Standard & Poor's in Manhattan. Workouts are "definitely going to increase, but not at a substantial rate," he states. "Do the math; everything that's in delinquency divided by everything that's outstanding. That percentage is not going to increase all that much in the next year or two."

That is due to a number of factors. First, says Lehman Bros. managing director Raymond Mikulich, "It's conceivable that people will be locking in rates," he says. "They'll give up a little to go from floating to fixed, and they're still going to have some attractive borrowing costs. Another thing that will mitigate the number of defaults is that an interest-rate rise will likely be tied to the economic rebound and an improvement in the fundamentals. People will be in a better position to cover their increased borrowing costs. Finally, this industry is simply not as leveraged as it once was. So we have more ability to withstand a move in interest rates. Given all of these factors, I'm not prepared to say we've got a huge pent-up trend of defaults and workouts coming at us."

Taking a look at specific numbers, the industry has performed very well over the past decade. S&P, in its recent Structured Finance Special Report , put the cumulative default rate over the past 10 years at 3.52%.

But, as Lehman's Mikulich points out, as fundamentals correct themselves over the next year, pockets of distress will still be trackable, and that will represent a lingering source of delinquencies. He cites San Francisco's office sector as one ongoing and obvious area of weakness.

What other locales will be the likely location for workouts? Wherever performance faltered is the short-form answer. Depending on the property sector, you can include Dallas and the Southeast in that number.

" Dallas was hit hard because of problems in the telecom sector," states John Maute, senior VP and managing director at GMAC Commercial Mortgage in Horsham , PA. "In San Francisco, it was the dot-coms. E veryone would agree that the office lease rates should not have gone up as high as they did in the dot-com era."

"Florida and Texas collateral continue to show the highest levels of delinquencies while consistently swapping the top spot over the past few months," states a recent report by RealPoint, a unit of GMAC Institutional Advisors. "They now reflect 19.6% of delinquent balance. Delinquent loans in Texas represented 9.9% of the delinquency total while Florida represented 9.7%." The report goes on to say that the problem in Florida was attributable to hotels (at 46%) and retail (at 33.4%). In Texas, multifamily (at 32%) and office (at 26%) were the prime culprits.

Taking a national look at product sectors, the default leader is a no-brainer. Hotels led the pack, according to S&P's Special Report. The lodging sector posted the largest 10-year cumulative default rate at a dismal 16.6%, a figure weighted heavily by post-Sept. 11 performance. Healthcare followed at 12.7%. The remaining sectors all kept below the 3.52% overall average. These are CMBS numbers, Chun reports. Private defaults ran lower.

According to RealPoint statistics, August 2003 figures veered away from the 10-year trends. While hotels still led in defaults (28%), this was followed by office and retail, which tied at 19%. Healthcare came in at 12%, followed by multifamily (11%) and industrial (5%). Miscellaneous properties accounted for 6%.

For owners facing workouts, Chun, GMAC's Maute and Midland 's Berger agree that the alternatives are endless. "It's all deal by deal," says the S&P executive. "It depends on the market situation and whatever condition that property is in." Within that broad context a resolution can be as simple as a workout directly with the borrower or, at the other end of the spectrum, foreclosure and liquidation.

"The workout strategy will be influenced by the type and complexity of the property and the borrower's commitment to the project," states Maute. "We prefer to work with the borrower, since they usually have the financial motivation to solve the problem."

Going in with that assumption, he continues, "The first step is to determine the problems that caused the default. If the borrower is both competent and committed to the property's success, there is the basis for a workout. Being committed includes the borrower's ability and willingness to invest additional capital in the property. If these qualities are not present, then a workout is more difficult to accept from a lender's perspective."

"It's much more art than science," adds Berger. "There is no handbook. As you look at circumstances and values and how this thing plays out over time, you go to your experience with similar assets. And the deal falls into place."

But certain essentials always hold true. "Getting control of the cash flow is right at the top of the page," he says. "This allows you to get leverage on the borrower as you continue to service the debt to the extent you can and it does not allow the borrower to scrape the money off and finance his fight against you. It's all a matter of leverage."

The Midland executive says that dual tracking procedures also allow the special servicer to pursue foreclosure while negotiating with the borrower. "It keeps the pressure on the borrower to work this thing out or lose the property," he explains.

In terms of real estate's overall recovery, that will have to be measured by market and product type, says Lehman's Mikulich, since various markets and products respond differently to changes in the economy. "The response of office assets with long leases will be slower, for example, than multifamily," he says, "which is tied more to economic conditions such as unemployment, or retail, which is tied to consumer spending. But as a whole, and despite the pockets of deep unemployment, we've seen a lot worse."