We're now observing increased levels of capitulation. Stakeholders are acknowledging that the real estate world has changed for the long term. Capital availability will remain tight for the foreseeable future. Rents are dropping. Vacancy is rising. Most expect fundementals to deteriorate further.

But this new paradigm is a difficult pill to swallow. Furthermore, the rules of the game are not yet fully defined. So each person's description of "reality" varies widely, and their perspective tends to be biased.

While the oft-predicted "tidal wave" of commercial foreclosures is still just a ripple, work-out activity is showing a marked up-tick. Herein we share observations about conditions that are influencing distressed real estate work-outs.

Market Factors

Obviously, the two major factors driving works outs are the deterioration of market fundementals (rents and occupancy), and illiquidity in the capital markets. However, a number of less obvious sub-set issues may directly impact efforts to "work-out" a troubled asset, as follows.

Appraisals – By definition, appraisals are backward looking. Thus, appraised values typically lag the market. In a market with such thin transactional activity, appraisers must consider older comps from a wider field, or extrapolate extensively. This seems to generate appraised values that are significantly out of step with buyer sentiment. We use appraised values with skepticism in work-out negotiations.

Absorption – Conservative rents and occupancy projections are obvious, but slow absorption rates must also be considered. Even at lower rents, achieving stabilization may take a lot longer than it used to.Cap Rates – Nobody can describe cap rates with authority in this market. But the weighted average cost of capital is clearly dramatically higher today, so cap rates must move with it. Loosely speaking, investors seem to see a 150-200 basis point run-up in cap rates, and look for stable NOI/costs percentage that is 200 basis points higher than the going in cap.

Return Expectations – Where a fresh capital infusion is required, investor return expectations influence the structure of a work-out. Stated hurdles of passive equity investors have not changed significantly, but the underwriting assumptions they use have, which nets a tectonic shift in implied values. In addition, investors demand a return premium just to "get off the fence". Most consider alternative investments (bonds, convertible securities, etc) offering attractive yields with low risk. They also note that early movers have been punished recently, so all-else-equal, they'd rather wait.

Deal Dynamics

As always, deal circumstances vary widely; this simple fact is critical in work-out negotiations. Real estate is once again a localized expertise. It cannot be managed remotely, and it is certainly not a passive investment. Capital providers are fully aware of the value of good asset management.

This acknowledgement significantly advantages skilled operators. Practical, applied, boots-on-the-ground experience differentiates performers from bubble-riders. Execution cannot be outsourced. Capital sources in a work-out situation have a stake in the asset – lenders are now equity partners. As such, they want to keep good operators, particularly those that already know the asset.

Lender Conditions

CMBS – CMBS loans will not constitute the lion share of work-out activity in 2009. Performing loans that are maturing can (and will) be extended by the servicer for 12-24 months; only non-performing loans will see much servicer attention. CMBS loans often enjoy low fixed-rates of debt service with term, so may weather the storm for a while longer. Furthermore, servicer's are tightly restricted from creative restructuring. Securitized loans cannot legally be "modified" before an Event of Default, because modifications trigger problems with the REMIC ownership structure. Moreover, many Special Servicers also hold a deeply subordinated tranche of the mortgage pools they service, so they may have a conflict of interest in co-operating with a modification that impairs the value of their investment. Thus, we expect that most non-performing CMBS loans will ultimately face foreclosure, rather than modification.

Banks – Government sponsored bail-out activities have stalled efforts to clean-up bank balance sheets. Many institutions are so underwater that "clean-up" (i.e. selling assets or writing-off losses based on current market-clearing values) would imply insolvency; so they wait and hope for rescue – whether in the form of government help or economic recovery. They've ducked losses (with optimistic appraisals) and avoided foreclosures (by protracting default proceedings). But that game is coming to an end. We observe a number of banks ramping up to take action and realize the inevitable. At the same time, their options are limited and foreclosure implies an immediate diminution in value, so work-outs are the logical next-step. We expect significant work-out activity with banks in the second half of 2009.

Portfolio Lenders (Life Cos & Pension Funds) – Portfolio lenders underwrote relatively conservatively even in the up-market, so they generally don't have acute real estate loan problems. They may face broader problems of stock price or fund allocation imbalances, but that's not immediately relevant to work-outs. Their greatest real estate risk seems to be maturing loans that no longer meet the lender's own hurdles for re-finance or extension. Certainly adjustments may be made, but the volume and significance of portfolio lender work-outs should remain low.

Investor/Borrower Considerations

Balance Sheet - The elephant in the room in most work-out negotiations is that the borrower's balance sheet is probably worse than the lender's. Most real estate investors loaded up on assets and leverage in recent years. So when capital disappeared and fundementals deteriorated, their portfolio got hammered.

Incentives - Some investors are slow to accept the massive drop in value the market implies for their assets, and hold out hope of "jumping the chasm" by holding on to the asset until capital markets are more liquid and fundementals improve. However most are realistic; they just don't have much incentive to accelerate resolution. If their balance sheet is evaporating and the lender is in denial, they punt on major decisions in order to maximize option value.

Capitulation - When pressed, investors are starting to capitulate. Deal circumstances vary. In many instances, we're seeing investors decline to meet capital calls. Healthy recourse borrowers may meet lender demands for pay-downs, but probably demand extensions, forbearance, write-downs or guaranty releases. Non-recourse borrowers are more likely to just walk-away.

It is difficult to make strong directional bets about such trends, but we are observing increased activity on work-outs. Lenders and borrowers are running out of ways to defer decisions. Normal refinancing is often impossible for borrowers, and foreclosure is unappealing to lenders. Collaboration (that is, shared losses) is often in best interests of all stakeholders and the asset. If the capitulation trend continues to grow, it should help reset values, clear balance-sheets, and establish a floor on which to rebuild normal market activity.