In recent weeks, investors have been returning to the stock market in droves as heavy losses in equity and corporate bonds during the fall of 2008 and early 2009 dissipate. At the same time, some are turning to weakness in the real estate investment world to make their fortunes. These investors continue to target distressed notes and high-yield portions of mortgage-backed securities.

But opportunistic real estate buyers have been running into roadblocks coming from two of the least expected sources — lenders and existing debt holders. As it turns out, some lenders and debt investors are not only unwilling to sell their secured real estate-backed loans, but their unsecured loans as well.

A brewing showdown

An old strategy has been driving this behavior of late, one in which parties are using their subordinated and unsecured debt positions to muscle their way into control of underlying properties.

In some cases, investors are buying up debt for pennies on the dollar, and so far the move has netted them control of trophy properties such as the Stuyvesant Town/Peter Cooper Village in New York, the John Hancock Tower in Boston, and the Sheffield57 in New York. As borrowers default on unsecured debt, this has spelled the demise of some otherwise secured deals.

Consider that Citigroup has put the kibosh on a deal in which opportunity investment fund Max Property is attempting to buy out a £232 million ($383 million) portfolio of UK industrial properties from the receiver of a joint venture called the Cambridge Place-Torre Asset Foundation.

The joint venture's real estate was placed into receivership with Ernst & Young. Citigroup provided a £38.9 million ($64.2 million) mezzanine loan in the original financing transaction, and believes it can best recover its investment by acquiring the entire portfolio.

As a subordinate lender in the structure, Citigroup stands to lose all of its investment, if Max Property is successful in a distressed discount purchase. So Citigroup is asking the receiver to allow it to put in a competing bid for the portfolio.

The fact that Citigroup is willing to go to such lengths to recoup its investment as a subordinated debt provider is proof positive that the battle lines are being drawn for control of distressed assets. And as a result the tsunami of distressed deals that many cash-rich investors are expecting to pick off on the cheap may be anything but certain.

With lenders and debt investors just as eager to gain access to distressed properties, there may be a showdown underway to pre-empt the fire sale of distressed properties — especially high-quality assets. That showdown will likely be between opportunistic investors and asset managers acting on behalf of lenders, portfolio holders, and even some securities investors.

Putting cash to work

There is precedent here from the equity and corporate finance investment business. The August 2009 Merrill Lynch Fund Managers Survey of 204 fund managers — with $554 billion under management — found that investors are eager to put cash to work. The survey showed the highest optimism among managers and investors since 2003.

One of the survey's measures is average cash balance held by these fund managers. These balances have fallen to 3.5% of total fund assets from 5.4% at the beginning of the year, according to the survey, and stands at its lowest level since July 2007. This trend is consistent with the mounting level of cash that real estate investors want to put to work.

Now that real estate fund sponsors have raised capital from partners and private investors, with a focus on buying distressed notes and properties, expect more confrontations like the showdown between Citigroup and Max Properties.

And by the way, a third party has entered the fray of late. Delancey Real Estate Asset Management Ltd., a London-based private equity firm, has joined Citigroup in its rival bid against Max Properties.

And with so many battles for control of distressed properties occurring, it is likely that some distress fund investors will be disappointed. The highly anticipated wave of real estate deals to be had — mainly the result of maturing loans that are having trouble getting refinanced — has so far turned out to be primarily lower-quality transactions sold mostly through the Federal Deposit Insurance Corp. Those deals are unlikely to attract major institutional investors.

On the other hand, well-capitalized lenders and institutional note investors like Citigroup and the asset managers they can deploy are keen to pre-empt the easy distress buyout opportunities. For this reason, the standoff between lenders and opportunity investors may only be getting started.

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

DISTRESSED MORTGAGE SALES AT A GLANCE

What follows is a snapshot of FDIC transactions in the second quarter of 2009.

Commercial Mortgages Sold:

$1.2 billion

Proceeds:

$650 million

Transactions:

171 deals

Price:

55 cents for each dollar

Recovery:

55% of the loans' balance

Sources: FDIC, Distressed Asset Coalition