Investors looking for distressed multifamily opportunities haveso far had slim pickings. But the flow of deals may grow strongerin the second half of 2010 and into 2011. Distress transactionshave already started picking up for multifamily assets, sales ofdistressed properties accounted for 31 % of the nearly $1 billionof apartment assets that changed hands in April, according to thelatest data from Real Capital Analytics. Troubled assets took up a20% share of deal volume at year-end 2009.

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By comparison, RCA reports that distressed assets accounted for20% of the $700 million of retail deals that closed in April. Onlysix of the 30 hotel properties that sold in April were distressed,taking up $20 million of the aggregate $769 million in volume. Andin the office sector, which saw $763 million in volume, just two ofthe 26 properties that traded qualified as distressed.

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While the increase in distressed sales is promising, it's stillnot anywhere near the numbers most market watchers were expecting.Considering the total amount of outstanding distress in theapartment sector-some $33 billion at the end of the first quarter,according to RCA-the distressed sales that have taken place so farare a mere drop in the bucket.

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The deals that have been closing involve primarily class Aproperties where the owner cannot meet its debt obligations, orthose that banks, servicers and other lenders decide to part with,according to Mike Kelly, Denver based president and co-founder ofCaldera Asset Management, a multifamily consulting and turnaroundservices firm. Those deals have been moving at extremely aggressivecap rates, but there doesn't seem to be as much interest inproperties that are class B and below.

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And herein lies the quagmire. Most investors in the distressarena are seeking high-quality assets at discounts, and they don'tseem to mind waiting for those opportunities to arise. Meanwhile,lenders and servicers are putting only lower-grade product on thesales block. Add to that the issue of financing-the main sources ofcapital in the multifamily market, Fannie Mae and Freddie Mac, haveset lending criteria that would by default negate class B or Cproduct and one can see why deal activity has been lacking.

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A major factor behind the dearth of class A assets for sale isthe propensity of lenders and servicers to do workouts withborrowers. In March, for instance, the apartment market saw $963million in new distress, as per RCA. The real figure, however, wasmuch lower, since $957 million of the total was resolved orrestructured. It should be noted, though, that 64% of thoseworkouts consisted of two deals-the refinancing of River house inManhattan and Essex Property Trust's purchase of a 349- unit assetfrom iStar Financial that was left over from its 2007 acquisitionof Fremont Investment & Loan's commercial loan business.

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Distress, says Kelly, can be broken down into two categories:situations that are truly distressed financially and those withlooming maturities. While lenders and servicers will look toquickly shed nonperforming or lower-quality product, typicallythose with underwater loans, he explains, in the latter case, "youhave good borrowers, good business operators with good businessplans, but they're staring a maturity default in the face."

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In those scenarios, he says, if the properties are performingand are in good markets, an extension is the most logical solution."The markets are getting tighter across the country, occupanciesand rents are going to increase-it's just a matter of when," heexplains. "Foreclosing for a simple maturity default doesn't make alot of sense. The most successful approach we're seeing is if youhave a good operator with a good business plan, give it time toride the wave for the next 24 months. That would also benefit yourtrust holders because it minimizes your transaction costs.Generally, the person that's already in the deal has the bestvested interest in getting you through whole, rather than someoneyou'd bring in later."

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Lenders and servicers are more likely to sell if it isprofitable and, in some cases, the sales appetite isn't high enoughthat the workout won't be the more profitable solution, says DebbieCorson, a Chicago-based principal with Apartment Realty Advisorsand head of the firm's Distressed Asset Solution Group.

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It's actually a Catch-22. On one hand, there is so much capitalseeking multifamily deals, and particularly, distressed multifamilydeals, that there's a scarcity premium. "You're seeing cap rates atridiculously low levels to acquire 'nice' properties," she says."Even on the distress side of the business, we're seeing a lot moreactivity for projects that don't have any net operating income orhave value-add components, just because there are so many groupsthat have put funds together to go after that type of product."

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On the other hand, the buyers out there aren't aggressive enoughto convince asset holders that selling would be the best option."The frenzy is not high enough for investors to bid 100 cents onthe dollar, there is still some discount going on to where thesepeople are on their notes," explains Corson. "The question becomes,if someone will pay 70 cents on the dollar for the property ornote, will the borrower do that? So even if the borrower is goingto pay a little less than what the frenzied market would, it may bemore worth while for them to work something out with the borrowerthan it is to go through the year or two of a foreclosureprocess."

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Of course, she adds, it's market specific, since all states havedifferent foreclosure and bankruptcy laws. For instance, Corsonsays that Texas, which has some of the most relaxed foreclosurelaws in the country, is also seeing the most activity in terms ofdistress transactions.

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Another factor keeping deal activity at a minimum is thatlenders and servicers are being inundated with product, and are toobusy trying to get their arms around the assets they have, letalone come up with a plan to dispose of them. "A lot of the specialservicers are so bogged down with product coming in the door thatthey may be working on four assets and trying to put together aplan for those properties and, in the meantime, four more come in,"says Corson. "What I see is a bottleneck. All of us are workingvery hard to force something through that bottleneck, but not muchis happening." If it's any indication, that bottleneck will worsenas time goes on. In a recent study, Fitch Ratings reported thatinvestors are sending CMBS loans into special servicing at anincreasingly rapid pace. The volume of securitized loans in specialservicing grew to $81.7 billion at the end of the first quarter,and servicers are responding to the onslaught by adding additionalstaff and new technologies, or restructuring their organizations tobetter handle the growing load.

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That's not to say, however, that Corson and her counterparts aresitting idle. There is in fact a significant amount of activity,but "it's just not anything that's resulting in transactions at themoment," she says. "We're doing a ton of broker opinions of valuefor special servicers and lenders all across the country. Thespecial servicers are getting BOV s as well as appraisals andreviewing that information" to put together the appropriate gameplans for the assets they hold.

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Most observers agree that unclogging this bottleneck will be along term process. For now, the best way for investors to get theirhands on distressed multifamily assets is to enter the deal on thedebt side-an approach that many players have embraced. Thesignificant amounts of overleveraging have made outright propertysales prohibitive, so oftentimes investors' best option toultimately own an asset is to buy the debt it secures-the classicloan-to-own scenario.

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Right now, there are two classes of property, says J. KingsleyGreenland, president and CEO of DebtX in Boston. The product withperformance issues-that is, those in which borrowers can't meettheir debt obligations because the income from the property is toolow-constitutes only 10% to 15% of the current market, Greenlandpoints out. That's also the group of properties that has, for themost part, worked its way through the system.

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The remaining majority of assets, however, are performingproperties with large loans that will likely not obtainrefinancing. When there's structural overleveraging, "a del everingof that asset has to occur," says Greenland. "In many respects, aloan sale is the optimal way to handle a delevering, since it'sdifficult to foreclose on a performing property, and simplyforgiving the debt has its own issues." This trend will intensifyover the next couple of years, he adds.

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Yet investors may be disappointed with the pickings here, too,since the majority of deals these days have involved class Band Cassets. In recent weeks, DebtX, in a partnership with KEMA Advisorsdubbed KDX Ventures, auctioned off $306 million in nonperformingloans on behalf of the Department of Housing and Urban Development.That sale garnered 67 bidders and more than 200 individual and poolbids for the package, which consisted of paper backed by 25multifamily assets and one health care property. Proceeds from the12 winning bids accounted for more than 48% of the debt's unpaidprincipal balance.

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Though the debt side is where the deals are, Caldera's Kellypoints out that investors should be careful, since "the debt sideis a quirky business. People have to understand what they're doingto buy loans, and there are a lot of people who are trying to buyloans right now who aren't really prepared for all that's necessaryto be the buyer of a loan that has different terms and extensions.In that situation, you are a lender, not a buyer of real estate.It's tough for a lot of people to see the distinction."

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Generally, however, most observers believe the opportunities fordistress multifamily investment will grow over the second half ofthe year and especially in 2011 as the market finds its bearings.Lower-grade product will certainly dominate, and some investorswill eventually opt to reach for the low-hanging fruit.Interestingly, the Federal Deposit Insurance Corp. isn't seen to bea major source of distressed deals, be

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it on the real estate side or debt. "I can probably count on onehand the number of deals that have been FDIC driven," says Kelly.And although the agency can certainly take over more failedbanks-the FDIC put 73 new banks on its "problem list," bringing thetotal roster to 775 banks as of the first quarter-it's anyone'sguess as to whether that would bring more distressed multifamily tomarket.

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It's likely that we'll see more offerings from HUD, by virtue ofthe size of their portfolio, says Greenland (KDX Ventures is theagency's exclusive loan sale advisor). But, he adds, while HUD willbe "a significant player, it won't be dominant since the market isso fragmented." Lenders and servicers will still make up the bulkof sellers. At press time, ARA had more than 50 distressedapartment listings, primarily REO properties, and the majority wereeither unpriced or priced below $10 million. But Kelly points outthat he wouldn't be surprised to see some developers on the sceneas more loans reach maturity. "If you look back, there were astaggering amount of development deals that were started in 2005through the middle of 2007," he says. "The developer is probablyalready riding a construction extension now, and the banks aren'tgoing to do much better. If they sold a year ago, they would havelost a lot of money. But if they sold today, they'd probably breakeven and live to fight another day."


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