But these modifications were not for every property, even as a first try. The workable assets needed to have a number of things in place before a modification could be accomplished. The asset had to have a positive cash flow, for one, and in many cases, the lender had to have a good relationship with the borrower.

This, needless to say, is still true today, but "if you have an asset that's in the hands of the special servicer or receiver and seems to be languishing and losing value, those are the compelling opportunities" for purchase, explains Larry Kestin, founding partner and managing principal of Manhattan-based Glenmont Capital Management.

Of course this couldn't have happened in a vacuum. "One of the principal facilitators of the modifications has been the very low interest-rate environment," Chandan says (see cover story). Essentially, lenders used the low rates to modify loans into lower interest-only loans or longer amortization schedules, enabling the borrowers, in many cases, to cover the debt service.

New Day, Same Strategy

Naturally, this is not the only reason that lenders will continue to modify loans. The same market that caused the problem is turning, creating value for future asset sales. "The strategy doesn't really change," explains Al Pontius, national director of special assets for Encino, CA-based Marcus & Millichap. "It's all about value preservation and recovery, but market conditions are allowing for a better environment now." RCA notes that by the end of the third quarter of 2010, there was $68 billion of distressed office, industrial and retail properties in workouts with servicers, plus another $14 billion in lender held properties that "will eventually have to be sold," Kestin points out. The market's viability is helping, "but even an optimistic lender ultimately has to know when the mountain is too big. If the option is to support the debt service, lenders can actually extend and pretend as long as the market supports it. Since the market is moving in the right direction, you expect they can extend until it's performing."

But a bank can extend only so many times. Even with robust growth, which the economy has not shown yet, many properties will never regain their full value, and the lender will have no choice other than to accept some kind of a loss on the sale, minor or major.

That's if the market is as good as it seems. With access to large amounts of cheap capital, REITs are driving the market in a dominant way, pushing distressed prices higher and bullying smaller investors. "There's a dichotomy in the marketplace, which is stabilized assets and cash flow, which is what REITs want to acquire," notes Joseph C. Smith, a partner of Glenmont Capital. There is a sense that prices are unnaturally inflated versus market fundamentals.

"The market continues to be dynamic in nature," says Pontius. "Everybody just has to figure out where they stand on the forecasts and, consequently, people are making bets." He points to some positive economic indicators, such as corporate profitability and corporate revenues, as well as the slow crawl of employment figures.

"There are plenty of people willing to bet that the bottom is clearly behind us," he continues, "and while it might be harder to predict exactly when a significant upswing occurs, there is a feeling that if I acquire today on a lower cost basis-maybe not a higher yield-it is a good position to find yourself in."

Fundamental Improvement

Despite the economic uncertainty, the turnaround is happening. Kestin points to the hotel market as an indicator of recent growth. "You're seeing increased occupancy, room rates and NOI, along with banks that are a little healthier in their balance sheets and can afford to take a loss on some assets." He notes that it's not as much of a flood as everyone predicted, but transactions are beginning to tick up. These sales, however, are still on a mostly one-off basis. "It's not a wholesale opportunity," Kestin says. "There's nowhere for a bank to go with an asset, so they have to put it back into the market. They don't have a strong borrower or ways to recapitalize, but ultimately they want finality."

Pontius looks for a high volume of restructurings, particularly in the CMBS market. Commercial mortgages alone will account for roughly $500 billion in 2011 and 2012, according to RCA. So the practice will persist as long as it works. But there are concerns that it will not work quite as well.

For one, there are those interest rates again. As Chandan explains, the heavy reliance on low rates makes modifications more difficult if those rates rise. "Only in a few cases have lenders actually adjusted the principal down to write-off some of the principal balance of the loan," the RCA executive explains

And treasuries are in danger of rising, which slims the margin for cap rates across the board. "The 10-year Treasury has run pretty hard compared to what we've seen these past couple of years," Pontius says. "Spreads have come back in to moderate the impact of the 10-year rise versus the borrowing rates. But there's no doubt that, if interest rates continue to run up, it will change the underwriting characteristics and, at least in the short-term, it will have a softening impact on valuations."

Global Volatility

Moreover, the volatile state of international politics will play a large role in how treasuries are valued. "The baseline expectations are that we'll see the 10-year Treasury move below 5% for 2010, so we know that the risk for the interest-rate market is very unpredictable," Chandan explains. "A significant increase in geopolitical instability abroad can drive capital into the US and result in the Treasury falling again. But if conditions stabilize, there will be less flight to treasuries." So should lenders be rooting for instability abroad? Pontius is not as concerned with treasuries as they stand right now. "The market doesn't react to the daily movement of interest rates," he says. "If they continue to settle where they are today, we're in a historically favorable environment for borrowing rates. And we're certainly seeing improvement in an expanded debt market and a great availability of debt solutions."

Given the new era of growth we are entering, loan modifications should coexist with a growing arc of transactions. The losses will be less for banks that continue the extend-and-pretend model, as long as the economy stays positive. However, even if a lender caves to the sale, the buyer is not always winning the battle. "Not everyone buying distressed is going to be a winner," notes Glenmont's Smith. "Some people are buying assets that should probably never have been built in locations that are no longer valid. Make sure it's generally a good asset that as a troubled balance sheet."

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