Long term, Standard & Poor's predicts that the peak of defaults will be farther in the future than in previous downturns. "Unemployment is expected to remain elevated in the near term, at levels higher than we've seen in the two previous recessions," says S&P's Larry Kay, the New York City-based director of structured finance ratings. "That, coupled with the high vacancy rates and the severity of the recent recession, means it could take even longer" than the 25-month lag between the end of the 2001 recession and the peak of annual loan defaults.

Fitch Ratings said in December that property fundamentals and CMBS loan performance will begin to diverge in 2011. "While fundamentals are likely to enter a period of stabilization, loan performance will remain plagued by the effects of asset-specific tenant rollover and high leverage," according to Fitch. That will lead to a continuing, albeit moderating, stream of term defaults throughout the year.

One factor contributing to this growing divergence is the quality of the real estate backing the bulk of CMBS issues, notwithstanding large deals such as the Extended Stay portfolio. "CMBS consists largely of B- and C-quality underlying real estate," says William David Tobin, principal at Mission Capital Advisors in New York City. "A-quality tends to gravitate toward insurance companies. The recovery is sort of an emergence of the haves and have-nots."

Investment-grade properties with class A tenants "tend to do okay, with capital seeking those out and pushing down cap rates and bumping up trade prices," Tobin says. "It's the B- and C-quality retail centers, office and industrial, where the recovery hasn't taken hold. They had lower fundamentals to begin with, and the flaws in those sorts of properties get exposed a little more when you really have a marginal recovery."

The bifurcation exists not only between investment-grade and second-tier assets, but also between gateway markets and the rest of the US. "That tends to skew the figures," says Tobin. "You hear about these buildings trading at aggressive cap rates in New York; San Francisco; and Washington, DC, and maybe in Los Angeles and Chicago. But when you move out into the other primary cities, and the secondary and tertiary markets, there's still a lot of distress. So you've got a barbell effect in geography and asset quality. Those two factors are weighing heavily on CMBS."

Moving out beyond the realm of CMBS and into the larger sphere of commercial mortgages, Real Capital Analytics reported in December that the third quarter's nine-basis-point rise in the commercial mortgage default rate marked the 17th consecutive quarterly increase. In early 2006, the default rate bottomed at 0.58%, whereas the current rate is just 19 bps shy of 1992's record high of 4.55%, RCA says.

"Since banks have worked through only a subset of the $46.8 billion in bank held defaulted commercial mortgages, the potential for losses related to resolutions of distress remains a key feature of the marketplace," according to RCA. Tom Melody, Chicago- based executive managing director of Jones Lang La- Salle's real estate investment banking business, told GlobeSt.com in November that lenders currently hold over $33 billion of REO inventory due to soured legacy loans from the last cycle. Melody's colleague, managing director of the special asset services division at JLL Peter Nicoletti, said, "Although the current outstanding level of troubled and REO apartment, industrial, office and retail properties appears to be leveling at approximately $120 billion, forced sales will continue to be a significant feature on the capital markets landscape."

Against this backdrop, Eisenberg says the era of extend-and-pretend is coming to a close. "There's been a recognition that long-term extend-and-pretend can't work, because assets need investment of capital to keep them up to date," he says. "Who's going to invest capital if they don't know whether they're going to be the asset's owner long term?"

Certainly not borrowers, Eisenberg says, while lenders would prefer not to make the outlay, "because if they're under-secured, their likelihood of recovering what they put in is reduced."

From a lender's perspective, "it's time for what I call ‘die and fry:' you enforce your rights and remedies under the mortgage and see where the pain shakes out," says Eisenberg, who is based in Newark. This can mean opportunities for buyers of distressed debt, he says. In situations where prospects of the property's value recovering are slim, "losses are going to continue to accumulate and selling now could mean a better return and a better outcome."

As a result, Eisenberg says, "You're seeing a lot more activity in terms of potential note buyers stepping into the mix, purchasing notes and then turning around and enforcing rights and remedies under the mortgages." Because they are buying at a discount, they're in a better position to enforce those rights and remedies while seeing upside potential if they take those steps.

Would-be investors of all stripes are taking notice. At the NYU conference, a panel of private equity experts suggested that they're looking more seriously at opportunistic plays. "Everybody got so burned by the downturn that they want safety and liquidity," said Jonathan Gray of Blackstone Real Estate Advisors. Partly because everybody is chasing those same few deals in key markets, there are more opportunities in properties that are high quality yet impaired, said Gray, the New York City-based senior managing director and co-head of real estate at Blackstone. His fellow panelist, Paul Galiano, Tishman Speyer's co-head of acquisitions, dispositions, equity capital markets and joint-venture transactions, predicted that the current bifurcation between core and value-add opportunities will continue well into 2011.

Similarly, a panel of lenders, all of whom spoke of their organizations' conservative underwriting, also expressed a willingness to push the envelope just a little. "We're starting to look for opportunities where we can get a little more yield and take a little more risk-but not too much more risk," said New York City based Richard Coppola, managing director and head of commercial mortgage investments at TIAA-CREF.

Deutsche Bank Securities' John Nacos, managing director and global head of real estate debt, sees value in "unstabilized, broken assets." However, the New York City-based Nacos noted that this comes with higher-priced debt -interest rates of 10% or more-along with leverage of no more than 60% to 65%.

The resulting rise in distress-related transactions is "a slow climb, but what's not apparent when looking simply at transaction volume is the number of loan deals," says Mission Capital's Tobin. "That really is growing pretty aggressively. You have a lot more announced loan sale transactions this year versus last."

As of November 2010, Tobin says, there were about $24 billion in loan-sale transactions year-to-date compared to $17 billion for all of 2009. That tally didn't include all results from the fourth quarter, and a $30-billion total by year's end was likely. "That's about a 70% increase in announced volume alone," he says. "There are a lot of unrecorded private deals." Fitch predicted that lodging as well as multifamily, hardest hit by the downturn, would be the first to stabilize. Certainly that assessment is borne out by both Jones Lang LaSalle Hotels' third-quarter investor sentiment survey and by actual asset sales.

"We've rounded the bottom, so now people can start applying their newfound buoyancy and move forward on transactions," says Gregory Rumpel, Miami-based executive vice president at JLL Hotels. "Of course, it still requires lending to come back and sellers to meet the market. But we've seen it already. The third quarter's been very good for us in terms of volume, certainly in the US."

However, Rumpel notes that while the select-service market has been buoyed by larger portfolio transactions as lenders clear their books of non-performing loans, the full-service segment sees the bifurcation prevalent across the investment sales landscape. "If we have a gateway market, we're seeing significant investor interest, whereas if it's a secondary or tertiary market, there is interest, but it's definitely tempered," he says.

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