With more than $1.6 billion in second-quarter losses and plans to sell off its most viable business operations, Capmark Financial Group Inc. provides a painful example of the turmoil plaguing many large lenders to the commercial real estate industry.

In its second-quarter report published in September, the Horsham, Pa.-based commercial real estate finance company disclosed an agreement to sell its mortgage banking origination and servicing businesses to Berkadia III, a partnership owned by Warren Buffett's Berkshire Hathaway Inc. and Leucadia National Corp., for $450 million. Later that week, rating agencies lowered Capmark's credit ratings to reflect the company's likelihood of defaulting on its cumbersome debt.

“This has been long coming,” says Edward Mermelstein, managing partner at Manhattan-based law firm Edward A. Mermelstein & Associates. “Anyone who has a good overview of the market has been expecting Capmark, as well as other companies of the same size, to either head into bankruptcy or somehow be repositioned or acquired.”

Selling Capmark's mortgage-origination and loan-servicing units will enable those businesses to retain their value while the remaining banking and investment business units are wound down, sold piecemeal or stabilized, according to analyst Jeff Zaun, associate director at Standard & Poor's. The rating agency left Capmark's commercial mortgage servicer rankings unchanged when it lowered Capmark's long-term credit rating to CC from B-minus on Sept. 4.

“In our view, the originate-to-distribute model is still viable,” Zaun says. “Large funds are going to want real estate exposure and they are not going to want their own origination shops.”

The $375 million in cash and $75 million note that Berkadia III is expected to pay for Capmark's mortgage platform won't be enough to satisfy the company's primary debts, however. And according to analyst Christopher Wolfe of Fitch Ratings, the exclusion of Capmark's banking and management businesses from the pending deal suggests that the remaining business units don't appeal to potential buyers right now.

The next step

What will happen to the rest of the company, then? Most likely, Capmark will either file for bankruptcy protection or will hammer out agreements with its lenders outside of bankruptcy court. If bankruptcy or an out-of-court restructuring reduces leverage sufficiently, it is possible that Capmark will be able to stabilize the remaining parts of the business, which include banking and asset management. The more likely outcome is an eventual sale of the remaining business, however, according to Zaun.

As of late September, Capmark's corporate or unstructured debt amounts to about $8.5 billion. Even if the company comes to an agreement with lenders, however, those lenders won't be getting their full return under original terms, so the company is expected to default on its debts to some degree either in or out of bankruptcy. That likelihood is reflected in recent downgrades by Standard & Poor's, Moody's Investors Service and Fitch.

Although Capmark has made progress this year toward restructuring, deteriorating commercial real estate fundamentals and a spike in loan delinquency rates have overshadowed improvements in the company's structure.

In its second-quarter report, Capmark explains that growing numbers of its borrowers have been unable to obtain financing to satisfy maturing loans, resulting in a rising number of defaults. Commercial real estate fundamentals, too, are eating away at property values and accelerating the rate of default, with a corresponding devaluing effect on loan values.

Default pressure

Capmark isn't alone in its struggles to deal with crippling defaults. On Sept. 11, government regulators closed down Chicago-based condominium construction lender Corus Bank. Earlier this year, parent company Corus Bankshares reported that it had roughly $2 billion in non-performing loans.

According to a Fitch report published Aug. 18, the agency assigns a negative credit outlook to nearly half of the 20 largest U.S. lenders it rates, and a major concern contributing to those negative outlooks is the potential for further deterioration in loan portfolios with a specific emphasis on commercial real estate.

Capmark and many lenders like it depended on a high-volume, steady stream of loan originations to generate fees and a margin of profit from the resale or syndication of completed loans. That's in contrast to a balance sheet lender that makes loans and collects principal and interest as its primary source of revenue.

Capmark has loans on its balance sheet that it has been unable to sell, but is not geared to survive on loan payments alone. Experts say that Capmark was overleveraged going into the recession, making its current problems more acute than the troubles of many other large commercial real estate lenders.

As lenders seek liquidity through distressed sales, and bankruptcies mount, private buyers are circling to snatch up deals. Mermelstein has clients that are already poring over some of Corus' properties in Miami and other markets where condominium development burned hottest. “You have billions if not trillions of dollars from high-net-worth individuals that have been sitting out of the market in treasuries for over a year, and that money needs to be placed,” he says.

Mermelstein offers a simple system for investors who want to determine which lenders are most likely to join the ranks of distressed sellers or be forced into bankruptcy liquidations. The writing is on the wall — or on the fence, to be exact.

“Lenders that are highly exposed in Miami, New York and other areas of the country that have had a tremendous amount of new construction in the last couple of years are the lenders that are most exposed,” he says. “You can drive from unfinished project to unfinished project, and looking at the names of the lenders on the gates, you basically know who's in jeopardy of going under.”