Institutional and hedge fund investors in distressed debt say real estate offers the greatest opportunities for investment this year, according to a new survey, the North American Distressed Debt Market Outlook 2010. Commercial real estate, in particular, was named a top investment choice. However, respondents note that as the market recovers, yields may not be as high as they were when distress was more severe.

A steady flow of workouts as commercial leases expire and investors fall into delinquency and default is expected to continue to provide distressed investment opportunities in commercial real estate, according to the survey. The largest group of respondents (41%) singled out real estate as offering the best investment opportunities, while the second-largest group (33%) gave equal weight to consumer products, financial services and the stock of large industrial companies.

The interest in real estate represents a departure from last year, when just 19% of respondents indicated they would focus on real estate investment.

“Commercial real estate and much of the debt attached to it have fallen in value to the point of being tempting for value players and distressed investors,” said Ron Greenspan, senior managing director of Baltimore-based advisory firm FTI Consulting. FTI, along with Bingham McCutchen LLP and Macquarie Capital USA commissioned the fifth annual market outlook survey of 100 distressed debt investors. Interviews were conducted in November and December.

Fully half of those polled described their core investment strategy as focusing on distressed debt. They referred to debt from various sources, including real estate. Among the respondents, 11% identified themselves as institutional investors, while 46% identified themselves as hedge funds. Banks, private equity and other organizations made up the remaining 43%.

Many investors said the massive market rally late in 2009 significantly reduced the number of distressed investment opportunities. In 2010, only about one-fourth of respondents (26%) planned to increase their overall spending on distressed debt of various kinds. However, the increased interest in commercial real estate shows that some institutions and other investors planned to shift their strategy to allocate more funds to real estate debt.

Last year, as the Dow Jones Industrial Average sank below 7,000 in March, investors expected to increase their allocation to the stock market, said Jeffrey Sabin, partner at Boston-based law firm Bingham McCutchen. “They saw an opportunity and they pounced on it. Now that we are back over 10,000, the respondents are no longer as bullish.”

This year, investors are more cautious toward all distressed assets. “Spreads on high-yield bonds and leveraged loans have now fallen more in line with historical norms amid an early economic recovery that is still very tenuous,” explained DeLain Gray, head of FTI Consulting’s corporate finance and restructuring segment.

“The upside left in a basic buy-and-hold strategy of distressed names seems rather limited at this point so it’s understandable that fixed-income investors are looking to derive returns in other ways,” said Gray.

Rising asset prices have also dimmed the chance for high returns, added Raoul Nowitz, senior vice president of Macquarie Capital USA. “The 2009 run up in secondary loan prices has driven distressed asset prices to what many investors perceive as close to fair value. Driving outsized gains from these assets will be challenging during 2010.”

Upcoming debt maturities will play an important role in providing new distressed investment opportunities this year, respondents indicated, since many borrowers will be unable to repay their debts. More than half of the investors polled (54%) said they expect to see an increase in mergers and acquisitions this year.

When it came to the question of whether the worst is over with regard to financially troubled companies and the need to restructure their debt because of loan defaults, about a third (36%) said the volume of restructurings had peaked by the time of the survey in the fourth quarter. However, the majority of respondents did not agree, and indicated that the highest volume of loan workouts and restructurings lies ahead. Some 30% expected the peak to occur by the end of 2010, but an even larger group (34%) said they do not expect the volume of restructuring to peak until 2011 or later.

Still, there was reason to be upbeat. A solid majority of respondents (61%) were optimistic about the availability of credit, saying they expected refinancing opportunities to be more available this year than last year. Only 15% expected credit to be more restricted.