Between Wells Fargo and special servicer LNR Property Corp., the two entities are unloading some $1 billion of distressed U.S. commercial real estate loans and properties. These developments should serve as confirmation that commercial real estate is recovering despite some lingering doubts.

The San Francisco-based bank and the Miami-based special servicer are among those that studiously avoided selling distressed loans and repossessed properties at fire-sale prices during last year's price declines. Their decisions have surely led to a buildup of shadow inventory stemming from the inability of borrowers to refinance maturing loans, as well as a steady rise in delinquencies.

Today, however, as both liquidity and buyer demand increase, more sales are materializing. And the fact that most banks and special servicers are pursuing “private auction” sales is a telling sign. It shows that sellers now believe they can fetch higher prices for troubled loans with fewer, higher-quality bidders.

Luring B-piece buyers

As the FDIC and other banking regulators toss around the buzzwords “risk retention,” the chase is on to engage the elusive B-piece investor, the one who buys the riskiest portion of a pool of commercial real estate loans. CMBS issuers are seeking buy-and-hold, B-piece investors to make their new bonds more attractive to an audience of otherwise skittish investment-grade investors.

And since the amount of distressed assets on the books of banks and other lenders can now be better quantified (due to higher liquidity), issuers can now structure transactions that will draw B-piece buyers off the sidelines. Banks and special servicers hold about $185 billion in distressed loans, reports Oakland, Calif.-based Forrester Research. And based on data from analysts at Bloomberg, Wells Fargo had $12.9 billion in non-performing commercial property loans in the first quarter alone. LNR, a B-piece investor itself, is special servicer to some $24 billion of delinquent assets.

Roughly 60% of the non-performing assets on Wells Fargo's books alone stem from the bank's rather hasty October 2008 acquisition of Wachovia Corp. Banks and special servicers hope a drop in property values of about 42% from their peak in October 2007 will entice these risk-retaining buyers.

Falling delinquencies

While the nascent CMBS recovery is still searching for B-piece buyers, another underlying trend is emerging. Delinquencies among the riskiest portions of securitized loans (CDOs) are falling. They are impacting securitized commercial real estate loans, the bane of the market's recovery thus far.

Fitch Ratings confirms that delinquency rates in the commercial real estate CDOs it tracks have declined for two straight months. CDOs, which are not in the same class as most CMBS, are super risky, and B-piece buyers are usually their intended customers. Fitch's May 2010 delinquencies fell to 11.6% from 12.1% in April and 12.8% in March.

Thus, the emerging trend surely supports the decisions by lenders and servicers like Wells Fargo and LNR to market more assets for sale. And even though deals from Royal Bank of Scotland, Bridger Commercial Funding, and JP Morgan have all moved forward in the absence of B-piece buyers, analysts expect these issues to be well subscribed.

Falling delinquencies may also be behind a recent decision by GE Capital Real Estate to cut its massive $80 billion portfolio by half. GE confirms that the value of its commercial buildings alone declined by almost 40% since 2008, but the company was not willing to dispose of its assets during that period. Delinquency reports like Fitch's will influence decisions from investors and financial institutions like GE Capital.

Finally, as banks and other lenders seek to sell off assets, one fund investment player, Fortress Investment Group, hopes to pick up these unwanted assets. The New York-based private equity firm's co-chairman, Peter Briger, recently referred to his firm's real estate fund as the “financial services industry garbage collector,” and said he expects a steady increase of assets coming out of the FDIC during the next three to four years.

New sales appear to be heating up, but with the exception of a few special situations not many transactions are emerging in which buyers pick off top-tier assets at steep discounts. Both banks and servicers are looking forward to seeing their “extend-and-pretend” strategy pay off as they fetch better prices at private auctions.

Joe Caton is a South Florida journalist who provides training and development services to real estate finance professionals.