Commercial Real Estate Bargain-Hunting Makes Bargains Scarce...extend and pretend (WSJ)

By Prabha Natarajan Of DOW JONES NEWSWIRES

At a bankruptcy auction in Washington late last month, the winning bidder paid almost 90 cents on the dollar for the mortgage on the Shops at Georgetown Park even though the developers are suing each other over who actually owns the property, the current operator has defaulted on its mortgage and the original lender is bankrupt.

Such high prices and long lines for such a distressed property are not unusual these days despite rising delinquencies and surging vacancies in commercial real estate. Sometimes it seems that so many investors are cruising for so few bargains in this troubled sector that they are making true bargains hard to find.

Many investors had raised billions of dollars to create opportunity funds to buy such troubled assets. They had envisioned a scenario similar to the early 1990s when through the Resolution Trust Corp., banks and savings and loans sold distressed properties at 5 cents on the dollar, and buyers booked stupendous gains within three years. They have been disappointed, with many closing down such funds.

"This market is different," said Jack Taylor, a managing director and head of Prudential Real Estate Investors' global high-yield debt group, adding some hyperbole about buyers' enthusiasm: "There is no such thing as distressed asset."

There is, however, some hope of a flood of troubled assets coming to market, and these are expected to trade at more reasonable prices.

Taylor and other market participants say overlevered properties and distressed sellers are likely to emerge in the next few months and peak next year as banks and lenders start looking to clean up their books.

The paucity of troubled assets for sale is mainly due to the practice of lenders not forcing owners into foreclosure, preferring instead to "pretend and extend" - an industry term to describe lenders' preference to extend maturing loans by a year or two in the hope that both the economy and the property's finances will improve during that time.

This, in turn, has helped maintain status quo in commercial real estate despite a 10% delinquency rate. Typically, delinquency rate averages below 1% in this sector.

"The pig in the python has now grown to elephant size, and only small bits of it has been digested," Taylor said, describing the volume of dodgy assets banks have been forced to swallow.

The bits that have been digested are mostly loans backed by high-end or trophy properties in large metro areas.

"Demand has exceeded supply, and as a result, the pricing is just not appropriate for the risks still there," said Maury Tognarelli, president and chief executive of Heitman LLC, a real estate investment management company with $22.9 billion in assets globally.

Not only that, it also creates an illusion of normalcy.
"This makes some investors think a rapid, broad-based recovery is underway; but these transactions don't paint a good picture of what's happening for a substantial segment of the industry, where properties remain under-capitalized," said John Murray, a senior vice president and a portfolio manager at PIMCO, while talking about the company's extensive study on commercial real estate released in June.

Market participants say that delinquent properties that are slowly creeping into defaults and foreclosures are likely to hit the market later this year.

"We are at the start of the period when banks start looking at their balance sheets, and try to repair them, while the economy stabilizes," said Taylor of Prudential.

This period of resolution is likely to extend until 2013, and during that time "commercial real estate will see a slow recovery, where the returning capital is met by deleveraging at banks and CMBS levels," Murray of PIMCO said.