The stymieing effect the credit crunch has had on the flow of capital has been well chronicled. But until recently, commercial real estate had virtually escaped the fallout. The primary reason for the resilience was the ability of savvy asset managers to step in and cure delinquent and defaulted loans through buyouts and workouts.

Since most of the loans running into repayment difficulties to this point have been short-term and high-leverage transactions, pools of commercial real estate collateralized debt obligations (CDOs) have been the hardest hit. By any industry measurement, fading liquidity appears to be the greatest contributing factor.

Fitch Ratings' most recent commercial real estate loan CDO delinquency index, for instance, shows that 15 newly delinquent loans — mostly for retail properties — led to an increase in its reading to 5.4% for February, up from 3.8% in January.

The reading represents the largest one-month increase since the inception of the index. The pools of some 1,100 rated loans and 370 rated securities with balances totaling $23.8 billion are a good snapshot of what investors face when looking for buying opportunities.

Critical liquidity

What's significant about this development though, is that as recently as late 2008, Fitch reported the delinquency rate in its CDO pools was below 3%. The rating agency previously tied the low delinquency rate to asset managers exercising their right to repurchase the poorer performing loans in their pools.

“However, with the continued illiquidity in the commercial real estate capital markets, asset manager repurchases have diminished, with none reported in the past two months,” says Karen Trebach, a senior director for Fitch.

Trebach notes that loan extensions had also helped to keep the delinquency rate low as they often serve as the early stages of workout. “Nevertheless, extensions are becoming harder to justify as the deepening recession has continued to impact real estate fundamentals over the last few months.”

Loan extensions in some structures are causing a rift between some securities investors and the asset managers who service these loans. For instance, extending troubled loans in a CDO structure can benefit the asset manager since a fee is collected for every extension.

Consequently, many investors — particularly those in the higher tranches of the structure — remain on the hook longer for loans that may eventually default anyway.

This is causing some investors to question the motives of the asset managers who may already have been wiped out financially, but due to special servicing contracts continue to profit from the loan and asset administration process.

Buying control

It is common knowledge that capital has moved to the sidelines to await opportunities in distressed notes and properties. If asset managers are losing access to this capital, something significant is happening beneath the surface.

Delinquent loans are now remaining in CDOs instead of being purchased through asset managers. So these CDO bonds could become the vehicle of choice for some opportunity investors to buy distressed real estate assets today.

A significant shift has already taken place to this end as seen among institutional investment funds. In the past, general partners, or fund sponsors, usually reserved the higher investor preference in structured funds and securities like CDOs for themselves.

However, in recent weeks several reports have surfaced that general partners are now taking a backseat to limited partners in their new funds by agreeing to absorb first losses before their limited partners are ever affected.

This shift emphasizes the need to attract eager capital that would otherwise go to ventures such as asset managers seeking to buy troubled loans out of securitized pools.

So the chase is on to find liquidity amid an unprecedented credit crunch while both delinquencies and defaults continue to rise. Investors who buy distressed debt and properties now control much of the capital flow, and this is adding to the reality of wide differences between bid and ask prices today.

Rating agency analysts have been busy these past weeks downgrading pools of loans and securities that they follow. As a result, asset managers today must work harder than ever before to resolve troubled loans and properties while having lost access to critical capital sources. Now is the time for the true stars in the asset management world to shine.

W. Joseph Caton is managing director of Oxford, Conn.-based Hartford One Group, a real estate finance consultant.