Another reason that distressed asset specialists like Nicoletti and Levy expect note sales to grow even more popular is that values achieved, especially for larger assets in major markets, have equaled or approached the value that the institution might otherwise have achieved by taking the asset back as REO. Nicoletti points out that, in the 1980s and 1990s, lenders were "more amenable to taking the properties back and holding the loans on their balance sheets." Today, however, "They're realizing that there is a very liquid market on the note-sale side," he says.

Levy also cites the efficiency of note sales compared with other approaches to distress. The government is one of the biggest note sellers because of this, and there are banks selling pools as well, directly to buyers and through brokers.

"We see that continuing because it is efficient, the value is there and the originating institution does not have the risks and costs associated with taking back an asset through REO," he says. For smaller office assets, selling pools of notes is an efficient means of disposing of large numbers of assets at one time. "Several special servicers have sold pools of several hundred million dollars' worth of notes, and those loan pools have disproportionately been smaller assets," Levy says. "Pooling was a more efficient method from their standpoint than to go through the time, energy and risk of taking them as REO."

The expectation of increasing note sales comes at a time when opportunities in distress, overall, are likely to reach their highest totals yet for the current cycle, according to New York City based Real Capital Analytics. A report from RCA says 2011 "is poised to see the highest levels of distressed sales for the cycle, which is good news for the opportunistic investor." The prediction stands despite a gradual slowing in the amount of new distress. "The market has reached an inflection point, from which the mountain of distress will begin to erode." RCA's report explains that although inflows to distress have started to slow, reversing a three-year trend, "Much of that distress remains unresolved, to the great frustration of many opportunistic buyers." What's in store for 2011, however, might relieve some of that frustration. RCA says that sales of distressed office assets increased both as a share of market activity and in absolute dollar volume in the second half of 2010, a trend that it says foreshadows an increase in office distress investment opportunities in the new year.

Nicoletti lists other reasons for an increase in note sales in the office sector: In general, the volume of office properties lapsing into distress has lagged other sectors because, in many cases, office rents have not rolled back to market levels. However, more office product will shift to the distress side of the ledger as leases expire and building owners remain hard-pressed to fill the space especially at comparable lease rates. In addition, many building owners will not have the capital for TIs or leasing commissions that they need to fill space.

Also, many office loans that were restructured on a short-term basis in 2009 will mature. "These short-term loans were reset in the hope that the market would get better, but only a few office markets have shown any real improvement, so we are going to see a lot of these resets come back to the market," Nicoletti says.

Levy points out another factor that foretells more distress in the office sector is the long-term nature of the leases. He contrasts office properties with hotels, which are recovering faster because "you get to reset rents every day," he says.

Levy also points out that, despite the growing popularity of note sales, there will still be more opportunities in short sales and REOs this year. "We have already seen a rise in short sales where the borrower cooperates with the lender," he says, and he expects that increase to continue as lenders become more comfortable with the short-sale process. REO opportunities will be case-by-case.

Whether the lender pursues foreclosure and an REO sale "is dependent on the strategy of the bank or the special servicer," Nicoletti explains. "A lot of the larger money-center banks will foreclose if they have the asset management teams and the other infrastructure in place, and we expect that will continue."

Levy adds that, on a percentage basis, special servicers are accounting for more REO sales than the banks. "The trend of 2010 will continue; the predominant way to get to the larger, institutional-grade assets is going to be through the note sale, particularly from banks." In cases where opportunities arise to acquire larger, more institutional- grade distressed office properties via an REO sale, those opportunities will come largely from servicers, he says.

However, investors in 2011 will also be tracking where the opportunities are geographically. Based on figures from RCA, the most office distress will be found in the Northeast, which closed 2010 with nearly $14 billion in distressed office assets. That's followed by the West, where office distress totaled more than $12.8 billion at the end of the year, even though in terms of overall distress in all property sectors, the West leads the nation with nearly $57 billion in troubled assets. Yet another factor suggesting opportunities in office distress is that the $48-billion national total of troubled office properties is the largest among the commercial sectors, followed by apartments at $37.9 billion, according to the latest RCA figures.

As outlined in an article in DAI's January issue (Go West, Investor), properties can migrate from the "distressed" column to "no longer distressed" or "less distressed" when industry and property fundamentals improve. This has occurred in the hotel market over the past year as RevPAR rose, although it's questionable whether office is likely to improve enough to rescue troubled properties from their distressed states. "The challenge we have in office is that, while we've seen increased leasing velocity in the major markets, what we haven't seen is an increase in rents or occupancy, at least not in any material way," Levy says. Th at means that, until and unless fundamentals improve, a huge volume of assets will remain distressed, and those who want to acquire them will do so by way of note sales.

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