With the banking sector continuing to lick its wounds and slowly return to health, more distressed multifamily assets are expected to hit the streets next year.

In the second quarter of 2010, the banking sector saw an aggregate profit of $21.6 billion, its highest quarterly earnings since the third quarter of 2007 and a $26 billion improvement over the second quarter of 2009, when the sector saw a $4.4 billion net loss.

This movement out of the red and into the black means that banks can more readily absorb some losses through asset liquidation. And today, they may not have to take too much of a hit: As cap rates continue to compress for quality assets in major metros, the recovery rates on REO are improving.

“The combination of more stable fundamentals, improving price discovery on the investment sales market, and a desire of regulators and banks to see a decline in the pool of REO will result in an increase in sales out of distress next year,” says Sam Chandan, global chief economist for New York-based market-research firm Real Capital Analytics.

That’s good news for all of those multifamily opportunity funds positioned to capture a wave of distress that never materialized in 2009 or 2010. Their long wait on the sidelines was mostly attributable to the FDIC’s policy of tiered bank failures—a slow bleed that critics say delayed price discovery, but that proponents say staved off a greater economic collapse.

“The disconnect relates to the difference between borrowers' financial distress and the timeframe over which that distress is resolved,” Chandan says. “Regulators have been mindful that rapid movement of distressed assets into the marketplace may not be ideal for the bank, or, by extension, the broader health of the financial system.”

The Good and the Bad
In many ways, the pace of failures has overwhelmed the FDIC, resulting in further delays in closing “zombie” banks, some of which probably should’ve been shuttered a year ago. The number of banks failing this year will likely exceed last year’s total of 140. As of the mid-September, 125 had already gone under with another quarter left in the year. What’s more, the number of “troubled banks” on the FDIC’s watch-list grew to 829—the highest total since 1993 in the wake of the Savings & Loan scandal.

Yet things are getting better for the sector. The number of bank loans 90 or more days past due has declined for the first time since 2006. And the banks that are failing these days are smaller.

There are almost 8,000 FDIC-regulated banks in the United States, so while 829 on a watch-list accounts for more than 10 percent of the total, that watch-list is filled with smaller regional and community banks, which represent a much smaller share of total outstanding credit. 

“The largest banks, where there were some potential systemic issues, are more stable and healthy now,” Chandan says. “But many of the smaller community and regional banks, where concentrations of commercial real estate loans are very high, are facing continued challenges.”

Distress Drivers
The word on the street is that the subsequent release of more distressed assets into the marketplace has already begun. Anecdotally, brokers are reporting more REO sales and lenders are seeing more requests for financing of distressed acquisitions.

“As banks regain their health, they’ve been more willing to let the assets go out into the market, whether it’s a note sale, a discounted payoff, or just an asset sale,” says Kirk Booher, senior vice president of Chicago-based lender BB&T Real Estate Funding.

But the jury is still out on the availability of construction debt in 2011. Smaller banks account for an inordinate share of the overall market for construction debt, and their continued problems will likely help the FHA continue its reign of popularity.

As the recession began to take hold at the end of 2007, commercial banks with less than $10 billion in assets accounted for about half of all construction and development loans, and about half of all commercial real estate loans, in the nation. Yet those same banks held only a quarter of all loans outstanding across all of the nation’s banks, according to a recent report by Standard & Poor’s.