People always underestimate how bad things can get. While we all know that trees don't grow to the sky, during a boom market the human spirit cannot believe that there will be an ultimate bust.

The commercial real estate market has entered a period of declining values with many properties overleveraged or encountering financial difficulty. The collapse of the housing market coupled with fuel and food price inflation are putting tremendous strain on the American consumer, the ultimate driver of our economy. This will likely result in recession and is affecting all sectors of the commercial real estate business, especially the financing of properties.

You could say that cheap real estate capital is like economic crack. The Federal Reserve created the perfect environment, while the lending community, Wall Street and the rating agencies generated rich fees. What happened?

To begin with, lenders detached risk from reward in a market where more money was made securitizing the loans than holding them. Demand for securitized loans forced lenders to sacrifice underwriting standards and reengineer loan products such as interest-only loans and low or no debt-service coverage requirements.

Financing at all levels of the capital stack created more asset demand. Cap-rate compression happened quickly, falling from 11% in 1995 on average to 6.29% in June 2007. Without leverage, investors would demand a higher return.

As with other sectors already hit by the credit crunch, these loans will cause problems that will find their way beyond the CMBS and CDO lenders — namely the banks — and hit the global fixed-income investors who invested in CMBS securities.

The market cleansing process

Ultimately, the CMBS market will rebound. Market recovery will happen by starting afresh with new, more conservative underwriting standards after the market participants have divested their poorly performing or distressed loans at discounts.

At the start of 2008, the capital markets are effectively closed for financing and most of the commercial banks and savings institutions are not making new loans or are limited to conservative loans for their best customers.

Overleveraged property investors undoubtedly will face loan defaults, workouts or foreclosures. This is the downside of overleveraging assets in a cyclical business, which forces property owners to go through a detoxification process so that the lending cycle can begin anew.

The cleanup process requires some specialists to enter the fray, including loan workout officers and distressed or vulture investors. We think of ourselves as the garbage men of Wall Street. Companies like Valhalla Financial Inc. buy distressed mortgages, or other securities that the market is mispricing from financial institutions, and find a way to fix the problem.

Distressed real estate 101

An owner facing a problem loan should consider the following questions before deciding on a strategy: Are the problems operational or financial? What is the compelling reason for the lender to work with you as an owner? How much equity is based on current market value? Let's consider the options:

Refinance — Obtain new debt or equity with a new lender or equity partner. This is often not easy to achieve due to a property's problems and a dysfunctional marketplace.

Negotiate — A discounted loan payoff may be agreed upon where the existing debt is repaid for an amount less than is owed. Alternatively, restructure the loan so that the owner adds value in exchange for the lender foregoing some right or payment. Lastly, a deed in lieu of foreclosure is an honorable way of handing over the keys. It is a negotiated relinquishment of the property to the lender in exchange for release of liabilities, as part of an overall settlement.

Foreclosure — If none of the above work, or if communications break down, the lender will file for foreclosure, a legal proceeding in which real estate secured by a mortgage or deed of trust is sold to satisfy the underlying debt. Check with your accountant and lawyer for specific advice on all of the above options.

It's going to be challenging in 2008. During the last downturn in the early 1990s, Sam Zell's mantra was “Stay alive till '95.” Those who weren't overleveraged survived — most didn't. Our new motto,“Till '12 before it's well.”

Jeff Gugick and Marc Schuster are managing directors with Valhalla Financial Inc. in New York and Santa Monica, respectively.