Last year's hyped deluge of distress has materialized into a drip. Yet, the promise of 2009 was that the lemons of 2005, 2006 and 2007 would finally be ripe for the squeezing and investors readied their capital accordingly. The result is a highly competitive market with, perhaps, inflated pricing. The question is whether or not a price can be considered too high on assets that are in the process of price discovery.

"People are referring to it as a scarcity premium," explains Stath Karras, executive managing director of national investment sales at Cushman & Wakefield. "And many believe that the prices being paid have been pushed unusually high" for this point in the cycle. With more than a few funds on expiring deadlines to spend capital, the money ready to bid-especially on class A properties-is increasing demand rapidly, not necessarily consistent with the cash-flow valuation of the assets themselves.

"We can observe a large number of bidders when properties do become available," notes Real Capital Analytics global economist Dr. Sam Chandan. "That has naturally led to upward pressure on pricing, which reflects the supply/demand conditions in the market, but not a sustained improvement in fundamentals. And that's the definition of an emergent bubble."

Banks' pretend-and-extend has been a major culprit in the market's current situation, as banks in particular struggle with disposing of non-performing or under-performing assets for a multitude of reasons. Rhyne Brown, EVP at NAI Global, indicates poor operating conditions as a major hurdle for many banks when dealing with overleveraged or underperforming properties, the type that has not seen a market yet. The death spiral of falling rents, defaulted maintenance and skyrocketing vacancies decimated the value of a property, with the added headache of property-liability resolution lowering returns and often pushing back an appraisal process. To properly value an asset within this kind of scenario is a futile endeavor and the banks view it, Brown explains, like trying to catch a falling knife.

The focus on class A is leaving B and C assets with an empty dance card and so creating a greater distinction between the market tiers. However, that's likely to change down the road. Eventually, the pricing for class A will drive bidders to classes Band C-at inflated prices. "I see the early signs of people trying to reach for yield," notes Mesa West Capital co-CEO Mark Zytko. "It's very hard to find. With Treasuries coming in at 2% to 3%, and Libor showing roughly 3%, a 6% or sub-6% yield on a performing property looks pretty good in the short term, even at inflated prices."

The danger comes over time. "On a historical basis they're accepting low yields, but the question of whether they're overpaying in the class A market is determined by where yields go," Zytko says. "If Treasuries are 7%, in a couple of months people are going to get hurt."

Sandy Monaghan, managing director of C&W's resolutions group, says it

is premature to view the AlB split as a harsh dichotomy. "It's not so much that people have over-paid for the core assets," he says. "It's that the next wave of assets is going to be priced differently, just given the nature of the risk of those assets." Zytko agrees, noting this yield-chasing will bring liquidity back into classes Band C, mitigating any supply-and-demand issues currently dominating the market.

Monaghan also points out that a two-tier market will truly occur only if some of the product doesn't sell at all, but receivers and managers can work to turn properties around and get them back to investment-grade over a longer timeline. A slow-moving economy will also help stem over-zealous investors, keeping pricing more rational.

"The underlying trends in the domestic economy suggest that we will ultimately see a sustained but modest growth in employment," Chandan says. And as the economy grows, expectations are fulfilled for the investors, therefore justifying higher pricing. However, he notes that if the economy has a more protracted recovery, or even a slight dip, the investors will reassess their bids, moderating any bubble. Karras concurs, saying the next 30 to 60 days should telegraph if to day's bids are on the right track. There are, as always, some concerns to keep an eye on. Zytko says that if a property was bid with an expectation of a V-shaped recovery, then those bids will be in trouble as the economy grinds through the next two years. However, if a property was purchased with a bid anticipating flat NOI and flat job growth, those properties will end up on the winning side of the expectation game. Overall, the greatest danger comes from a rise in interest rates, which would demolish the emaciated margins. While there are indications of an emerging bubble and a rush of bubble boys to drive it, job growth and underlying weakness in the current economy will help slow price drivers. "If those jobs don't pan out, then investors will start thinking more carefully about valuations and expectations for fundamentals even in these best markets," Chandan explains. "So that will ultimately limit how far this can go."

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