So far, all signals from commercial real estate investment analysts point to very low delinquency and default rates, particularly in the CMBS and CDO worlds. And with investment funds continuing to raise large amounts of capital to pursue value-added and distressed assets, such opportunities are proving hard to find.

And even when distressed assets do come to market, buyers are paying rich prices to gain access to these assets, based on an analysis of announced deals. Troubled regional markets such as southern California, south Florida and Michigan continue to lead the potential areas for available distressed deals, while the hotel and retail sectors lead the property types where scavenger investors are searching these days.

Air of caution

For now, loan servicing managers are not resting on these prevailing trends, but instead gearing up to deal with a market where more distressed assets may surface. Stacey Berger, executive vice president of Midland Loan Services, one of the largest servicers of commercial real estate loans, recently remarked that while there is not a significant amount of distress in CDOs and CMBS, there is anticipation of such a development.

“Even though there are selected assets and transactions that have issues, there is little by way of delinquencies to spark many distress transactions at deep discounts,” Berger says. “Similarly, on the CMBS side, there is an increase in delinquency and default, but this increase is coming from very low levels to begin with.”

The delinquency and default rate for CMBS is still at less than 1%, according to Fitch Ratings, which hammered home that point during a recent forecast conference hosted by the agency. Berger's conclusion may very well be right on the money.

But there are credit issues looming on the horizon, and the CMBS special servicers — loan servicing agents who specialize in managing troubled assets — are taking note. They are preparing for a turn in the market. These special servicers, often asset managers by trade, observe that real estate-backed deals are tracking the corporate debt market quite closely. Instances of delinquency and default are a bit higher in corporate debt, with defaults now standing at just about 2.6% and rising.

The air of caution among loan servicers and asset managers may be well-founded since the real estate-backed market has historically tracked corporate bonds quite closely, particularly high-leveraged deals.

In early June, for example, many corporate deals began to fall apart after financing for leveraged buyouts ran into funding problems. Cautious, high-yield investors began to demand higher compensation for the perceived risk in these deals. Commercial real estate investors then began to make similar demands. They wanted higher returns for perceived higher risks.

Pent-up capital

The availability of capital for distressed real estate deals is continuing to grow. On the investor side of the business, an enormous amount of funding has already been raised to pursue attractive deals. It's estimated that in 2007 hedge funds, venture capital and private equity firms matched or surpassed the level of capital they raised in 2006 — a previous record high.

According to estimates by Private Equity Real Estate News (PERE), $65 billion was raised in 2007, roughly 20% more than the $54 billion in 2006. During 2005, private equity real estate funds, or value-added and opportunistic real estate private partnerships, raised roughly $34 billion.

This war chest suggests that despite the cautious feelings among real estate investors and their financing partners, there is sufficient capital seeking a home in real estate to significantly affect how quickly distressed deals are snapped up, and at what price.

While the California Public Employees' Retirement System is considering a staff recommendation that the $255 billion pension fund raise its allocation in 2008 for real estate to 10% from the current 8%, according to PERE, private equity is slated to raise its allocation in 2008 to 10%, up from the current 6% level.

With such a high level of interest in real estate from institutional investors, it is little wonder that distressed deals are being valued rather richly in this market, or not done at all. Investors who are seeking deals at steep discounts will have to wait for a major breakdown in real estate fundamentals in order to realize their value investment strategies. Just when and how that breakdown in fundamentals will occur is still an unknown.

W. Joseph Caton is managing director of Waterbury, Conn.-based Hartford One Group, a real estate finance consultant.