WASHINGTON, DC-Last month, DiamondRock Hospitality acquired $69million in debt from Wells Fargo, backed by the landmark Chicagohotel Allerton. The Maryland hotel firm bought the senior mortgageloan on the 443-room hotel after its owner, Chartres Lodging Group,was unable to repay it. DiamondRock said in a news release that itexpected to own the fee title of the hotel upon completion of theforeclosure. That plan hit a bump in the road shortly afterwards,though; according to the Wall Street Journal, a tusslebroke out between it and mezzanine lender, New York-based PetraCapital Management, with both firms vying for control.

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Welcome to the new face of real estate distress: after a deeprecession, with the pain particularly acute in commercial realestate, there are still few viable distressed properties or notesavailable for sale. In short, the deals that are being done nowentail investors, such as DiamondRock, chasing after defaultedborrowers to offer capital solutions.

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The pickings are so slim that many investors who had originallythought they would pursue distressed opportunities are beginning tobow out, says Gary Eisenberg, a partner with Herrick, Feinstein.“Potential bidders would underwrite conservative offers and thenfind themselves losing by an order of magnitude,” he tellsGlobeSt.com. ”There is always someone willing to pay more, itseems.”

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There are a number of reasons behind this situation, startingwith government policies put into place to combat the recession,explains Bruce Prigoff, partner with Cox Castle & Nicholson.The Troubled-Asset Relief Program, for instance, propped up thebanks so they could continue to exist without mass closures. Also,the FDIC has placed great emphasis in selling assets through astructured transaction format in which the agency retains amajority of the ownership interests in the loans of failedinstitutions, coupled with substantial ultra-cheap FDIC guaranteedfinancing to the venture that acquires the loans in partnershipwith the FDIC.

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Those two developments are unlikely to shift in the foreseeablefuture. However, a third factor— bank loan accounting rules—willchange.

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At the start of the crisis, loan accounting rules were changedto permit banks to carve off portions of loans in an A/B Noterestructure so that the portion of the loan that could be supportedby current cash flow and was not too far under water from avaluation standpoint could be held by the bank as a modifiedperforming loan, Prigoff explains. “This allowed the banks toretain large portions of their portfolios that otherwise would havebeen classified as nonperforming,” he says.

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Now, the Financial Accounting Standards Board is proposing achange to the accounting standards that required banks to bookloans at their current market value. The rules are not an immediatepanacea—they won’t go into effect until 2013 for the largest banksand 2017 for smaller institutions.

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But will their eventual arrival finally lead to the traditionalor typical—or, at least, market-priced—distressed deals thatopportunistic investors had originally been expecting? Don’t holdyour breath, Prigoff advises. “The forces weighing against clearingthe cloud over the real estate market through mark-to-marketaccounting remain very strong…regulatory pressure to move assets ofthe books of the banks is rumored from time to time, but is nothaving great effect at this time.”

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The concept that the overall economy is going to improvesufficiently to outrun the collapse in the real estate markets andallow the US government and banks to avoid massive losses is thereal problem, he says. “Also, continuing to hold most of the realestate loans on the books of institutions with a low cost ofcapital is designed to minimize the losses that would be incurredif the assets were shifted to investors that have a high cost ofcapital and high yield expectations. In a market where newfinancing for real estate assets is scarce, the cost of capitalrises dramatically when an asset is moved off a bank’s books intothe hands of a third party opportunistic investor, absent bankseller subsidized financing of the purchase. Accordingly, I do notanticipate a major change in US government policy that would bringlarge numbers of assets to market at this time.”

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Integra Realty Resources’ president and COO, Jeffrey Rogers,says more patience is required on the part of distressed investors,some of which are beginning to disband funds set up for thispurpose. “Memories tend to be short, but those of us who werearound during the RTC days remember that the distressed assets didnot begin to flow immediately. There was a process and it tookyears. This real estate downturn is different in many respects, butit still takes time before distressed assets are flushed throughthe system,” he tells GlobeSt.com.

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He also doesn’t think a change in mark-to-market accountingregulations will have much impact. “First, the proposed rulesregulate when a financial institution has to recognize a loss on aloan asset. The institution is not forced to sell the asset becauseit has lost value,” Rogers explains. “Financial institutions couldstill decide to keep the loans until they increase in value. Theywill certainly choose this option if the borrower is covering debtservice.”

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