In Strockis' view, lenders' choice to thumbs-up or thumbs-down an extension is determined largely by size; smaller borrowers generally face a higher risk of default. "The small business owners who bought at the height of the market and are now struggling with their business are where we're seeing the highest percentage of defaults," he tells DAI.

More so than in the heyday of extend-and-pretend, lenders are likely to turn to foreclosure "if there's a significant spread between the loan balance and the market value," Strockis says. With bigger-credit borrowers, even those with vacancies of 50% or more, "there's likely to be a substantial effort to work it out any way they can." The low interest-rate environment (see cover story), he explains, gives lenders the leeway to do this, along with the healthier balance sheets of many banks compared to the depths of the capital markets crisis.

Pumper agrees that bigger-balance loans will likely avoid foreclosure, but not due solely to negotiations between borrower and lender. "If they're high quality assets, you're going to see a lot of recapitalizations taking place, a lot of recovery capital coming to the borrower," he says. "They're going to try to work out some discounted payoff s with the lender. So the best of the best will have several investors trying to get in and help the borrower out."

But Strockis doesn't foresee lenders granting extensions indefinitely, even for bigger borrowers. "Some of the larger money-center banks are, on a quarterly basis, taking write downs on the margin," he explains. "They're going to do this over a two-year period, not all at once. At some point the lines are going to cross between market and book value, and they're going to dispose of the note."

The past six months have seen an uptick in note sales, representing an opportunity for investors because of the dearth of quality assets, says Strockis. For lenders, he says, note sales can mean "getting 80% of par on some of the better-located credits. They don't want to put up with the risk of bankruptcy or foreclosure, and some of those legal fees can be substantial. If they're getting a high recovery value just by selling the note, why not do that?"

And even among borrowers with quality portfolios, Pumper says that workouts may entail selling some of their assets "to delever their positions with the lenders" and demonstrate the borrowers' good will. "You're seeing that happen with some of the best companies and some of the better portfolios." Especially with cap rates compressing for core assets, this represents an opportunity both for the borrower and for would-be investors "because there's a scarcity of product on the deal side and pent-up demand for equity placement. And, quite frankly, there's pent-up demand on the debt side of the equation for the better stuff ."

Although bigger borrowers may have the advantage of drawing on rescue capital from debt and equity investors, "you're going to find quality assets that have leasing issues; that, in my estimation, will be the types of assets that increasingly come to the marketplace," says Pumper. "You can't lose 8.5 million jobs between 2007 and 2009 without it having an impact on commercial space, whether it be office, retail or industrial."

Pumper says the market needs to have providers of capital on the debt side that will enable investors to start buying these lease-challenged assets, "then start to put in some energy and capital improvements so they will be viable when the market improves." He predicts that as 2011 moves on, "you'll see more lenders step into that space."

It's not only that fundamentals may be shaky at the asset level; there's also the little matter of hundreds of billions of dollars in maturing debt this year and next. In testimony during February's Congressional Oversight Panel hearing on the "Commercial Real Estate Market in the US and Its Impact on Bank Stability," Matt Anderson, managing director at Trepp, said his firm estimates that commercial real estate debt maturities will climb to "approximately $350 billion per year between 2011 and 2013."

Solely within the US CMBS sector, there will be $22 billion of loans coming due this year, according to Fitch Ratings. About $12 billion of that total was originated between 2005 and 2007, at the peak of both the market and optimism about growth in rents and income. "Borrowers of maturing five-year interest-only loans will need to contribute additional equity to reduce debt levels." Adam Fox, senior director at Fitch, says in a release. "Five-year loans will face more difficulty in refinancing, especially office loans with significant upcoming lease rollover."

In February, Fitch reported a 36-basis-point increase in US CMBS delinquencies, with a trio of large multifamily defaults leading the way. The apartment sector now has the highest percentage of delinquent CMBS at 17.4%, while delinquencies for hotels-formerly the hardest-hit sector-are decreasing as lodging fundamentals improve. Fitch puts 2,935 CMBS loans totaling $35.8 billion on its delinquency list, out of 38,000 CMBS loans totaling $416.1 billion. Further, Anderson told Congress, Trepp estimates that "as much as half of the loans maturing between 2011 and 2015 are currently underwater, and as much as $251 billion is underwater by 20% or more." The CMBS data researcher also puts the peak-to-trough decline in commercial property values on par with those seen during the Great Depression, and Anderson testified that although occupancy and rents are stabilizing in the basic food groups, NOI is still off 15% from pre-recession levels. Given these factors, Strockis says commercial mortgage defaults are in the range of 8% to 9%, including securitized as well as balance-sheet loans.

Along with distressed assets-which Real Capital Analytics put at $179.1 billion nationally as of mid-February, more than half the global tally of $245.7 billion-there's also what Delta Associates terms "the looming volume of stressed assets." These are properties that, while current on their mortgages, have warning signs: "maturing loans, bankrupt tenants, under-performance, financially troubled owners or other significant obstacles that could potentially lead to distress in the future."

As for actively distressed real estate, Delta notes that it not only has begun to plateau but actually has ticked down a bit. The real question, though, is when it will recede as a sustained trend, and Delta doesn't foresee meaningful progress until next year. Trepp predicts the process of deleveraging banks' balance sheets will take "several more quarters."

Longer term, Anderson testified in February, "Continued high demand for refinancing from loans originated during the commercial real estate debt boom of the 2000s will constrain real or inflation-adjusted growth in the commercial mortgage market over the next decade." He predicted that growth "will more closely resemble the 1990s, when annual growth was 0.8% in real terms, rather than 2000 to 2008, when annual real growth was 9.4%." Off setting the new normal of slower growth is a thawing in the credit markets and, in particular, a revival in the CMBS arena. Will securitization ramp up rapidly enough to off set some of the anticipated pain? "It will definitely help," Pumper says, although he notes that it's rebounding from "a historic low."

CMBS issuance went from $150 billion in 2005 to $250 billion in 2007 to just $5 billion two years later, Pumper notes. "Last year, it was north of $15 billion, and this year, it will probably be $40 billion to $50 billion," he says. "When things find their appropriate water level, CMBS lenders will play in that $50-billion-to-$100-billion debt sector on an annualized basis domestically, and that's good for the industry." The much-vaunted "CMBS 2.0," generally describing the new wave of mortgage-backed securities, may be a misnomer unless 2.0 means keeping it simple. "When things heated up in the go-go days of 2005 to early 2008, there was such a focus on placing both debt and equity that the underwriting suffered," says Pumper. Based on the fallout from that era, he says, "we've gone back to the basics of very strong underwriting, leaning a little more toward the conservative. If you look at the CMBS that was issued last year, there were a lot of single issuances."

Thus far, Pumper describes the resurgent CMBS market as "putting our toe back into the water; I don't see us getting out of control for the foreseeable future. There's going to be a lot more transparency in the CMBS sector, and a watchful eye." The result, he says, will be "better underwriting and better CMBS product. It fills a necessary role in the debt stack."

Pumper agrees that this greater scrutiny could have a snowball effect: more investor confidence, and therefore more demand and greater issuance. Already, for example, Deutsche Bank and UBS have broken the $2-billion barrier with an issue that priced in February. Nonetheless, he says, if new CMBS issues exceed the projections of $40 billion to $50 billion for this year, "it won't be by a wide margin. If you look at overall investment-sales volume, $522 billion was the peak in 2007. I don't see us going anywhere near that for the foreseeable future." Having said that, Pumper adds that investment sales have begun rebounding from their 2009 trough of $54 billion. "Last year, we were at $110 billion, so we doubled, and this year we're right around that $180-billion range," he says. "It could be $160 billion on the low side, it could be $200 billion on the high. That would put us pretty much in line with what we experienced from 2002 through 2004, which is a very healthy number."

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