There was blood in the streets last year. More than 130 banks failed in 2009. Fundamentals, from effective rents to occupancy levels, declined to record lows. There were fewer sources of debt all around. A number of large multifamily owners—including Fairfi eld Residential, Babcock and Brown, and Bethany Holding Group —went under. And a wave of loan defaults had vulture funds salivating as they hunted for easy prey at wholesale discounts.

Yet, while a new opportunity fund seemed to close every week in '09, the pace of distressed acquisitions was slow, to say the least. Distressed sales only accounted for about 15 percent to 20 percent of the overall multifamily sales volume through December 2009, according to New Yorkbased market research firm Real Capital Analytics (RCA). This is despite the fact that the volume of distressed apartments reached $30.8 billion in December, according to RCA.

Although the pace of distressed acquisitions is expected to pick up in the coming years, “it won't be the bloodbath that a lot of people expect,” says Linwood Thompson, managing director of Encino, Calif.-based broker Marcus & Millichap. “The amount of money being raised for distressed asset purchases is going to be a lot harder to place than most people think.”

Take Alliance Residential. From the start of 2008 to November 2009, the Phoenix-based company had underwritten more than $4 billion of potential distressed transactions—but only closed on $100 million. “The level of distress is certainly as much if not greater than we ever thought it would be,” says Jay Hiemenz, CFO of Alliance. “But the level of dispositions are not.”

That's a common refrain. Most of the opportunity funds were expecting returns of around 25 percent. But as more buyers enter the market chasing the same few opportunities, those return expectations are falling fast.

As the industry enters 2010, the question is: When will all of those distressed assets emerge from limbo? Better yet, when will the peak of opportunity (or the pit of despair, depending on your point of view) reach its zenith?

“You can't time an absolute bottom, and people who try are going to miss the opportunities,” says Dan Fasulo, managing director of RCA. “We're still in the early innings of the distress cycle—a lot of opportunity-focused investors will be disappointed.”

For the past year, several factors have kept the floodgates of distress closed. The availability of agency capital has helped to prop up values. The London Interbank Offered Rate, the benchmark upon which most construction loans are based, was low throughout 2009, which has also been a boon. But the willingness of lenders to modify loans is the biggest factor staving off distress.

“The issue right now is one of valuation. There are a lot of properties that continue to cash flow, but if you value it today, there would be a substantial discount,” says Craig Butchenhart, president of Minneapolisbased Northmarq Capital. “As long as a property continues to cash flow, the lenders will extend a year or two and hope that things get better.”

But how long can lenders continue to amend and extend? Several investors believe that the peak of opportunity is right around the corner. It's just a question of simple math, they say. Five-year, aggressively-underwritten CMBS loans done at the height of the market—from 2005 to 2007—should come due starting in 2010. “The next three years are going to be great,” says Eric Silverman, managing director of Boston-based investor Eastham Capital, which is raising a $50 million opportunity fund. “Many loans coming due in 2010 and 2011 will have difficulty refinancing and will have to re-trade.”

A Different Floodgate

Where will all of these maturing CMBS deals find refinancing capital? Fannie Mae and Freddie Mac obviously continue to be active lenders in the space, but they're generally only doing 70 percent loan-to-value (LTV) loans on higher-quality deals. And regional banks aren't big on nonrecourse long-term loans. “Ultimately, there isn't enough regional bank capacity to bail those guys out,” says Mike Kelly, president and co-founder of Greenwood Village, Colo.- based Caldera Asset Management. “If you look at the maturity schedules, there's only so much time that people can delay the inevitable.”

Indeed, these are boom times for special servicers. For instance, CWCapital Asset Management has been inundated with business—its portfolio of assets grew from $3 billion a year ago to $11 billion now. The division nearly doubled its staff in the first half of 2009, mostly for the distressed debt and REO groups. “I haven't seen any kind of financing source enter the market on a broad basis to finance a lot of these properties,” says Brian Hanson, managing director of Washington, D.C.-based CWCapital Asset Management.

But just as lenders are extending loans based on sunny projections, many special servicers are now opting to asset-manage their way through the downturn, trying to stabilize or increase the NOI of an REO and wait a couple of years before selling.

“I don't think the wave is coming. I don't believe that the maturity defaults are nearly as scary as we thought six months ago,” says David Rifk ind, principal and managing director of Los Angeles-based George Smith Partners. “If the fundamentals and underwriting are there, extensions are granted fairly easily. The headlines we saw six months ago about the maturity tsunami—that's all bullshit.”

Rifk ind's firm offers a lender services group, which advises lenders on maximizing the value of their distressed assets. And based on what he's seen, the majority of lender sales are going to be driven by measured strategic decisions, not the panic dumping that investors assumed would occur. The quality assets will generate serious bids at a pretty high level, he says.

Sandy Pockets

Not all markets are created equal, though. Caldera's Kelly points to the large number of units that recently came online in some markets as further proof that a wave of distress is coming. Consider Phoenix, where builders delivered about 5,000 units in 2009, adding 2 percent to the existing stock. That doesn't bode well for a market that ended 2009 with a vacancy rate above 12 percent, according to Marcus & Millichap.

“From a global view, the supply-anddemand balance of the apartment market looks good,” Kelly says. “But it's all about submarkets: You start going down from 30,000 feet, and it's a different story.”

In hard-hit states such as Florida, there's no denying that more distress deals will take place in 2010. More than half of the deals that NAI Tampa Bay has processed since the beginning of 2009 have been distressed—a trend they see increasing this year.

“We're seeing a dramatic slowdown in the pace of transactions,” says T. Sean Lance, president of the Troubled Asset Optimization Team of NAI Tampa Bay. “But the banks are starting to get comfortable with where some of the values lie, and they'll start disposing. The drip might turn into a faster drip, but it's not going to be the tidal wave everyone is talking about.”

Big Fish in a Small Pool

The size of deals currently at play has also changed. The vast majority of the distressed acquisitions closed in 2009 were smaller (less than $20 million), but larger deals emerged in the fourth quarter. For instance, Chicago-based Apartment Realty Advisors (ARA) marketed an ING portfolio of 10 assets located mostly in Texas and received more than 200 offers. The assets were mostly Class B- and C-quality.

“We are seeing people coming off the sidelines who were quiet six months ago; there's been a real change in the number of offers we get on transactions now,” says Debbie Corson, who heads ARA's Distressed Asset Solution Group. “These larger guys with equity are really coming out of the woodwork.”

Opportunity funds that hoarded cash for much of 2009 are starting to realize that the discounts won't be as jaw dropping as they once believed and are starting to engage the market. Addison, Texas-based Behringer Harvard has been the most active buyer, closing deals in the $80 million to $90 million range. Chicago-based Equity Residential has also been active, recently paying $100 million for a 326-unit property in Arlington, Va. These acquisitions signal that it's not just older assets that are hitting the distress auction block—larger deals constructed in the past 10 years are also at play, many of which have solid occupancy rates.

NAI Tampa Bay marketed a Class A REO asset of less than 100 units recently and received several full-price offers. “Six months ago, it wouldn't have been the case, but now people are starting to realize they're missing the boat,” Lance says. “They're willing to pay a little premium now as opposed to having to compete for deals when prices go up.”

The 12-property Bethany portfolio deal in Phoenix attracted 50-plus offers, though deals of that size were few and far between at the end of 2009.

“There are only a handful of deals out there that the entire buying community is looking at, so it's sort of an artificial feeding frenzy,” Kelly says. “There's not a giant, deep bench of qualified buyers. You've got a couple of REITs and a handful of highnet- worth guys who can close deals.”

The distressed assets Caldera sees generally fit into two categories. The majority are Class C assets, but on the flip side is a growing number of construction loans going south. “We know the quality assets are there; it just takes time for them to come through the snake,” Kelly says. “It's like what happened in '07 and '08 when it took so long for single-family homes to roll through the foreclosure process.”

RTC Redux?

When the Great Recession began, many expected a second coming of the Resolution Trust Corp., the government program of the 1990s that sold off troubled properties after the Savings & Loan scandal. Back then, the pace of dispositions was swift and orderly. But this cycle won't behave like the last one. Why? For one, the assets of 20 years ago were facing severely-overbuilt markets. Throughout the 1980s, developers delivered about 4 percent of the existing apartment stock annually. But from 2000 to 2009, only 1 percent of existing stock came online annually, according to Marcus & Millichap.

Today's culprit is unemployment. “This is not caused by overbuilding; it's not a problem with the industry,” says Thompson of Marcus & Millichap. “As the economy strengthens, then the problems will go away rather quickly.”

Another major difference is the owners themselves: In the late '80s, the industry was highly fragmented. Today, a larger percentage of units are owned by well-capitalized firms.

Additionally, the type of loans backing these properties is different today as well: Twenty years ago, unwinding a balance-sheet loan was easy. But CMBSbacked loans pose a much more difficult knot to untangle. “It's like taking a building down floor by floor,” Thompson says. “You've got a mezz lender, a CMBS loan with four stacks in it, some [of which] has been syndicated across 15 different investors. It's more time consuming because nobody wants to get out of the way.”

Kicking the Can to 2012

By 2012, the multifamily sector should be in full-recovery mode, but getting there is the hard part.

Most economists don't see a return to significant job growth until the end of 2010. The 10-year Treasury rate is expected to rise in 2010, pushing up prices on fixedrate debt. And rising concessions and vacancies will produce more negative NOI growth in most of 2010.

“It's going to be a slow, tough climb out of the recession,” Thompson says. “We're still going to be bouncing around the bottom for another 12 to 18 months. But attitudes have already started to shift; people are less concerned about it getting substantially worse.”

Several factors complicate this forecast. Congress plans to debate the future of Fannie Mae and Freddie Mac in the spring, and any disruption in the flow of GSE funds could have serious ripple effects on the level of distress.

“It's a false sense of security that there's an efficient market for multifamily,” says Rifk ind of George Smith Partners. “How the GSEs operate could upset the fragile efficiency of multifamily finance, which is holding the market together.”

The Competition

As more distressed assets shake loose, transaction velocity will accelerate. “I think the competition will be intense once things start hitting the street,” says Robert E. Hart , CEO and president of KW Multifamily Management Group , a Beverly Hills, Calif.- based apartment owner with 10,000 units in the U.S. “There will be a few players to take it down. There's a huge desire on the sidelines to get stuff.”

In fact, if you have been selling apartment properties during the past five years, you may not recognize the people bidding on assets today. On distressed deals, Bill Shippen, principal of the Atlanta office of ARA, says only about 50 percent of the current bidders were active in the last real estate cycle. The other half either hasn't been bidding for deals in awhile or has stuck with retail and office investments.

“It's a lot of new people. A lot of those people were players back in the early '90s,” Shippen says. “They're coming back in. They bought in 1992 to 1995, hung out, sold in 2001 and 2004, and have been sitting on the sidelines. Now they're ready to do it again.”

The other new faces that Shippen sees come from the remaining commercial real estate sectors. They actually see more potential in multifamily distress than the battered retail and hospitality markets. And not only are they new to the multifamily sector, these groups also share a common thread—they're private.

“There are a lot of private funds out there; it seems that everybody has got a joint venture these days,” says Eric Bolton , CEO of Mid- America Apartment Communities , a Memphis, Tenn.-based REIT with 42,252 units.

The reason for the private interest is easier to understand. High-net-worth individuals don't have to get an investment board to sign off on their deals. They can take chances pursuing risky distressed deals. “Private capital and high-net-worth individuals are the most active,” says Joe Leon , a partner at Hendricks & Partners , a broker based in Phoenix. “Family trusts and high-net-worth buyers are nimble and can be more aggressive. That's a big issue with a bank or a seller that's motivated to get a transaction closed.”

And the smaller, private buyers also often have significant local market knowledge. “Every city has buyers who will buy more challenged deals with all cash,” says Caldera's Kelly. “They know they can manage this rough clientele for x per door. That will be a local guy who has local management [expertise] and is not afraid of the submarket and economic risk.”

Waiting on the REITs

While the private buyers are often the first to bid on distress assets, many people predict they won't be alone for much longer. “Generally, the private buyers are the first to buy and sell,” says Lili F. Dunn, senior vice president of investments at AvalonBay Communities, a REIT based in Alexandria, Va. “They also represent the majority of the buyers. They usually have more of a tolerance for risk. Until recently, most of the buyers have been small, private buyers or regional companies.”

Pat Barber, president and CEO of Encore Enterprises, a Dallas-based commercial real estate firm with 436 units, knows the institutions will eventually be players in the distressed (or, at least, discounted) space. That's why he's trying to make his move now.

“In the early stages, there's always a lot of private money,” Barber says. “Then the institutional capital will come in when there's a lot of money transacted on the private side.”

What's more, the REITs seem to be focused on bigger moves than just buying one-off deals. “We could see the acquisition of entire companies,” says Nicholas Michael Ingle , director of capital markets for Hendricks & Partners. “Developers get bought. There's an opportunity for deal making, but people haven't gotten their head around it yet. That's where I would see the institutions get an upper hand on the private guys.”

But Ingle doesn't expect all institutions to become suitors for distressed apartments or their notes. Right now, both life companies and pension funds are more focused on selling.

“They're pretty scared and burnt from losing so much money over the past five years,” Ingle says.

One thing is certain: People are anxious on both sides of the coin—hungry investors on offense and struggling owners playing defense—to just get it over with, to find a resolution. And nobody really disputes whether things will get worse before they get better. The falling knife is a foregone conclusion. The question on everybody's mind is, how deep will it cut?


Through the fourth quarter of 2009, the volume of distressed multifamily properties was more than three times greater than reported at the end of 2008.


The amount of multifamily loan maturities across all investor types will nearly double in five years' time.