When asked about the latest trends in distressed real estate investment, Wayne B. Heicklen tells about the back-and-forth negotiations between a troubled bank and an eager private-equity investor over a few distressed assets.

The firm had its eye on certain assets in a portfolio of non-peforming loans held by a financial institution on Long Island, recounts Heicklen, co-chair of the real estate group of New York City-based law firm Pryor Cashman. It quickly found, though, that the bank's price expectations were too stringent, so it gave up.

Then the bank merged with another, so Heicklen's client tried again and found the new ownerships more amendable to a sale. But the private equity company's original idea of acquiring just the group's best assets? Nice try, but no cigar. And no sale. "The private-equity company started out bidding on the particular assets it wanted but was quickly pushed into the direction of buying the whole portfolio," Heicklen says.

In many ways this failed deal is telling about current trends in the industry, starting with the power that holders of distressed assets still wield in the market. That equation, though, can change as more troubled banks seek out acquiring partners to keep them solvent. However, the most recent and interesting change is illustrated by Heicklen's client's original desire: to buy just a few assets from the bank.

It is a trend that is gaining traction in a number of markets such as Georgia, according to Maxine Hicks, a member of Epstein Becker Green in Atlanta. "We are seeing this more and more," she says. "Companies trying to cherry-pick certain branches of distressed regional banks."

The FDIC is still seen as the main, or a main, channel through which to acquire distressed assets, she says. But a mindset is developing among some real estate investors, such as private equity funds, that the best way to get the highest value in distress investing is to cherry pick, rather than take the entire portfolio.

The approach certainly makes sense from a pricing standpoint. Distressed assets are viewed by many as overpriced and investors are not being adequately rewarded for the risk they are taking.

Spencer Garfield, managing director at Hudson Realty Capital, a real estate fund manager headquartered in New York City, has opted to shun distressed debt investing for this reason. Given the prices at which they are trading, especially in auctions, he says, it is difficult to see how some funds are meeting their IRRs. "Eighteen percent to 20% is what the opportunistic funds are targeting, but I am not sure how they are getting it based on what they are bidding," Garfield says.

Some of this may change if Treasuries start to rise. Right now they are priced so low that the spread is very compelling. "But on an absolute basis returns are very low," says Bill Lindsay, a partner in the Los Angeles office of PCCP LLC, a balance sheet debt and equity provider. "It is hard to tell an opportunistic investor 'well, I got you a good relative return at 10%: " At such prices, the risk of acquiring just a few distressed assets is lower than an entire portfolio.

But putting this practice into affect is not easy, starting with the fact that banks and the government are well aware of what the investor is trying to do as it cherry-picks the best loans, Heicklen says. "Many of these loans are losers, with only a couple of diamonds in the rough. Believe me, both banks and private equity have a feel for that." The environment is still skewed to the holder of the distressed loans, he says. Buyers, in other words, do not have that much negotiating power. In some cases, the investor may be better off taking the entire load. Or put another way, it may be that the investor doesn't have a choice if it wants really wants those assets.

None of this is to say that banks are in iron-fisted control of the market or the negotiations. Depending on the scenario, the process of acquiring assets from a failed or failing bank is either a complete mess or a methodical process, says Matthew C. Sullivan, managing director of the Investment Services Group at Lee & Associates in Los Angeles.

"Oftentimes a community bank can't do much until it is sold or seized because it can't absorb the loss," he explains. "They are stuck until another acquiring bank comes along. Once the bank has been acquired there is a loss-sharing agreement that is implemented." In such cases the system works pretty much as intended, providing transparency and new opportunities to would-be investors.

In other cases, prior to the bank being acquired or seized by the FDIC, Sullivan says, it might not even have its loans classified properly because it is afraid of being shut down sooner. Here, too, opportunities exist for a private-equity investor but only for those with steely nerves. "You don't really know what you may be getting and you often don't have time to conduct the necessary due diligence," Sullivan says.

Banks and private-equity investors have been reaching deals through one of two ways. One has been for the bank to sell the portfolio in bulk and clean up its balance sheet. The other has been a recapitalization by another institution. "A private-equity company will buy a small healthy bank, capitalize it and use it to buy the troubled institutions," Sullivan explains.

But some equity players attempting to become cherry pickers are meeting with only limited success, Sullivan says. He is also seeing some entities trying to buy banks and separate them into a good operating bank and one holding the bad loans. "There are a lot of challenges to doing that, however. As far as I know it hasn't happened yet," he states.

Buyers' tactics have also hindered deals, says Matthew Zifrony, a director with Tripp Scott in Fort Lauderdale, FL. In some cases buyers are waiting for the bank to fail because they believe they can get a better deal from the FDIC.

"I am seeing a lot of frustration by community banks over this tactic," he says.

A year ago, even six months ago, he says, private-equity players were negotiating with struggling banks in better faith. "Now it is clear there is another element in play: their calculations about what a property could be worth after the bank is taken over." This strategy is not necessarily a slam dunk and much depends on the assets in question. The FDIC will try to unload certain assets right away, he says. Nevertheless, there is logic to this approach, says Louis Archambault, a partner with Pathman Lewis, a real estate law firm in South Florida.

"The advantage of buying an asset after the FDIC has shepherded the transaction is that the buyer has an agreement with the bank to guarantee a certain amount of loss," he says. "It allows for the vehicles of the failing bank to be transferred to the purchaser and places the assets back on the market in an attractive package for the buyer."

Archambault has a number of clients currently trying to buy individual assets from banks in distressed situations, many of them foreign. They are not finding the process easy and some are waiting for the assets to move to FDIC control. Still, though, waiting for the FDIC to step in can be frustrating, considering the potential of a private trade.

There are some good deals available on banks' books, says Pryor Cashman's Heicklen. "Properties that used to trade at $400 per square foot now can be had at $200 per square foot via a bank note."

Also, banks are becoming more concerned about mark-to-market rules, which show every indication of becoming tighter. So far it has been easier on their books to sit back and wait, Heicklen says, but they know they can't do that forever. A more fluid, transparent market for distressed assets would be a welcome alternative to banks when they are finally forced to push troubled assets off their balance sheet. "The banks have to realize that they need to move forward, he says. "I do see that happening more than it had been but it is still a major problem in recognizing losses."

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