The first signs of distress in the commercial real estate market emerged in September 2007. With the exception of the retail and condo markets, fundamentals remained strong; sales velocity and property fundamentals were stable. As 2008 unfolded, however, the freezing of interbank lending and the commercial paper market catalyzed the recession into a full-blown global financial crisis.

Through 2008, most stress was tied to maturing debt, but deteriorating fundamentals will further compound issues this year. At the end of 2008, there were more than $25.7 billion in distressed assets, with another $80.9 billion at risk. Over the same period, roughly $4.7 billion were in the retail sector, with another $23.5 billion at risk, according to Marcus & Millichap Research Services.

Even when occupied by high-credit tenants, retail properties in secondary and tertiary markets are generally at the most risk since these locations can be more vulnerable to sudden shifts due to a lack of economic diversity. For example, both large- and small-sized retail properties in Las Vegas, the Northeast, Florida, Southern California, Phoenix, Texas, the Pacific Northwest and Midwest are at risk.

The Federal Deposit Insurance Corp. (FDIC) and other government entities will be the biggest sellers of distressed commercial properties in 2009 and 2010. The Legacy Loans Program (LLP) announced in the first quarter by the FDIC and the Treasury Department is designed to cleanse bank balance sheets of distressed loans and other assets and reduce the associated market overhang.

With no clearly established parameters, the LLP will remain subject to change by the Treasury and Obama administration as 2009 progresses. For instance, there is no centralized list of troubled assets, unlike in the early 1990s when the Resolution Trust Corp. created a master list. This time around, investors will have to visit virtually every courthouse in the country to assess the amount of troubled assets and notes in existence.

The marketplace is fraught with uncertainty and perceived risk, tied to the asset quality and whether the investor is buying the note or the foreclosed real estate. Asset pricing remains inconsistent. Many properties are trading at deep discounts, especially weakly tenanted properties located in secondary and tertiary markets, where investors are underwriting deals on replacement costs. Urban in-fill properties with national credit tenants have retained the most value.

When an entity goes to market to purchase a note from trading desks at financial institutions, they often face risks. Most investors believe that these institutions have conducted appropriate due diligence, which is not always the case. Investors should make certain a term sheet or e-mail acceptance exists to ensure that pricing and values hold firm.

Many lenders are extending loan terms or disposing of assets on a one-off basis as the government debates a strategy to clear bank balance sheets. Investors will be best served by formulating strategies based on market selection and the type of retail that fits their value-creation goals, and then look for attractively priced buying opportunities.

With the increasing number of distressed assets, buyers have begun to expect deep discounts, even for properties operating soundly. Outside of top-tier assets in prime locations, the gap between buyer and seller expectations remains fairly wide, although it appears to be closing. Interest rates ultimately will rise as the government finances the more than $2 trillion of economic stimulus already pumped into the system, and the $787 billion recently signed into law.

Retail assets with assumable or seller financing are attractive to investors. While lenders have tightened requirements for new borrowers on loan assumptions, this segment accounted for half of all retail transactions last year, compared to virtually none prior to the credit crunch.