Despite promising signs that the two-year credit crunch is easing, small doses of debt can't soothe the suffering commercial real estate industry. Buyers and sellers remain paralyzed by a gap between bids and asking prices, and anemic sales volume is compounding the stalemate by depriving investors of sales data needed to set pricing.

Transaction volume across property types totaled just $2.1 billion in May, a fraction of the $9 billion in deals closed in May 2008, according to New York-based Real Capital Analytics.

A wave of distressed asset sales could break the spell by providing data that can be adjusted to help close deals on healthier properties, but those liquidations will come at the expense of owners and lenders who must purge assets in order to survive.

“There are going to be buying opportunities coming that we've never seen in our lifetime, and the long-term result will be a huge transfer of wealth,” predicts Gary Mozer, principal and managing director at Los Angeles-based real estate investment banking firm George Smith Partners. “But a lot of pain has to be felt, and that's going to be in foreclosures and bank failures.”

When will distress reach a breaking point and usher in renewed investment activity? And when will demand for commercial space boost occupancy and bring rent growth back to the market?

The answers to those questions lie in an elusive economic recovery, one that will support rent growth while it bolsters lender balance sheets to handle losses they must realize in liquidation sales.

Pain before gain

Landlords are certainly suffering. The longest recession since the Great Depression has knocked the legs out from under property fundamentals while investors are still grappling with deflated prices. Asset values had fallen 29.5% through April since their peak in October 2007, according to the Moody's/REAL Commercial Property Price Index.

Shrinking income has left many investors unable to keep up with payments on loan balances that may well exceed their property's value. The volume of commercial real estate in foreclosure, owner bankruptcy and other crises more than doubled to $108 billion during the first six months of 2009, according to Real Capital Analytics.

The reason swarms of distressed owners haven't sold their properties is that today's conservative underwriting for acquisition loans requires adequate debt-service coverage from the outset. In other words, investors can't get loans to buy properties with no cash flow.

Unless a non-performing property carries an assumable loan or the seller can provide financing, buyers must use cash or equity to close. Buyers expect double-digit returns on equity to reflect their risk, but the sums they bid are too small to help borrowers out of their troubles. “On a broken asset, there's hardly any financing available,” Mozer explains. “So buyers have to earn equity-like returns on the majority of their money.”

By the same token, lenders have been reluctant to sell foreclosed properties, which would force them to realize losses. More than 525 U.S. office properties representing almost $18 billion have fallen into distress since February 2008, according to Real Capital. In the first half of 2009, banks sold just 13 of those real estate owned (REO) office properties to third-party buyers.

“The bank will want to get 60 or 80 cents on the dollar of its loan amount and the buyers want to pay 30 to 50 cents, so we're seeing very few deals transact,” Mozer says. “Most of the banks aren't strong enough right now and that's why we've seen this stalemate. They don't have enough profits to offset their losses.”

Lenders will open the floodgates to investment sales when they are strong enough to stomach the losses that will come with selling their real estate owned properties at depressed prices. And thanks in part to government loans to lenders under the Troubled Asset Relief Program (TARP) and other measures to stimulate lending, many banks are beginning to heal.

Credit comeback?

Through the first week of July, the Federal Deposit Insurance Corp. had closed 48 lending institutions, nearly double the 25 it closed in all of 2008. Lenders are growing stronger as a whole, however.

FDIC-insured institutions posted $7.6 billion in net income during the first quarter, the strongest performance of the past four quarters and a dramatic comeback from the fourth quarter's $32.1 billion net losses. While individual performance varied, four out of five banks profited in the first quarter. Troubled loans are weighing on the industry, but net interest income, non-interest income and gains on securities all rose, according to the FDIC.

The London Interbank Offered Rate (LIBOR), which banks charge to lend to one another, fell to 0.6% in June from its peak of 4.8% last October. That shows that lenders perceive diminishing risk, says Jamie Woodwell, vice president of commercial real estate research at the Mortgage Bankers Association (MBA).

Gradual loosening of credit hasn't boosted commercial mortgage origination volume, which continues to fall, albeit at a slowing pace. Origination fell 26% in the first quarter of 2009 after falling 65% in the fourth quarter, according to the MBA. Year-over-year, lending was down 70% from January through March.

Demand for acquisition loans is down and declining asset values have made refinancing difficult, especially for borrowers with maturing debt arranged in the investment flurry of 2006 and 2007. Today's loan-to-value ratios at approximately 60% don't provide enough proceeds to pay off balloon maturities on loans arranged at 90% loan-to-value.

Rather than foreclose on borrowers unable to make their balloon payments, lenders are granting short-term extensions on loans in hopes that healthier fundamentals and asset values down the road will enable their borrowers to refinance.