When slogging through individual workouts, special servicers often encounter unforeseen obstacles such as faux-bidders or contentious borrowers. Yet as the pipeline of defaults grows ever larger, special servicers are forging ahead and emerging as major sellers in the distressed market.

Four of the largest special servicers recently made offerings of debt/REO on a bulk basis. These deals may serve as an indicator of what long-patient buyers can expect in the months to come. For example, CWCapital Asset Management, which has already traded $500 million of defaulted CMBS loans, has another seven loans with a par value of$115.6 million being marketed through Mission Capital Advisors.

At the start of the year, New York City-based Centerline Capital Group Inc. marketed a $307-million portfolio of non-performing loans and REO through the Carlton Group's auction format. According to Fitch Ratings, the firm has the highest percentage of loan value recoveries, clocking in at 67.1 %.

"Response to the auctions has been good," says John D'Amico, senior managing director of Centerline. "Special servicing personnel have indicated that there are a number of strong national and regional buyers who are interested in their portfolios. They expect that the greatest value may be realized by bracketing the REO and loans into regional subgroups where prospective buyers have particular expertise or interest."

Indeed, for a number of servicers coupling assets seems to be the tool of choice, as does the auction platform. By way of their online auction site, Jones Lang LaSalle and Real Estate Dispositions are assisting ING Clarion with the auction of a $ 171-million portfolio. The advisors are also working with LNR Partners in the marketing of five loans with a par value of $17 million. LNR, the largest CMBS special servicer, has recorded the most recoveries by volume despite having the highest exposure to the toxic vintages.

The recovery rates on these deals depend largely on when the debt was originated. "Much of the more current vintages tend to contain the more complicated, highly structured loans," explains Fitch's Stephanie Petosa. These loans were originated during an aggressive underwriting period-namely 1998, 2005, 2006 and 2007. The value of collateral properties in these pools are, on average, worth much less today than during the height of the market.

Even if all parties agree on an appraised value, it might not hold over the length of the workout, Petosa explains. In some cases, appraisers have put expiration dates on their valuations like a carton of milk. The valuation disagreements can also lead to some foot-dragging, although in the cases of solid assets, banks can blend and extend, so long as the debt is being serviced in some manner. But after a default, the extra time becomes costly, adding interest, late charges, legal fees and the like. To skirt this issue, personal guarantees playa large factor in forgiving debt for the deed.

Debt forgiveness helps the bank avoid foreclosure, which could become an arduous process. "In New Jersey, for instance, it's probably 18 months in foreclosure, and if there's a pre-packaged bankruptcy, it could add another six months to a year," explains Nicholas Minoia, president of Diversified Realty Advisors in Summit, NJ. Staring down a two-and-a-half to three-year legal process, the lender will often take the deed and release the borrower's personal guarantee "with no deficiency judgment in case of a short fall." These bargains help farther down the line.

On the flip side, there is a more emotional driver in the market, where a borrower may simply refuse to let a property die, elongating the foreclosure process. Minoia tells the story of a Monmouth County, NJ borrower who defaulted but resisted turning over deed-in-lieu because his family invested in the asset. Despite the financial realities, "it's easier for him [emotionally] to let it go to foreclosure and say he tried everything."

"We call it being married to an asset," Diversified's managing partner, John Stein, elaborates. It might be an owner-occupied restaurant that's been in the family for years, as opposed to a situation where a corporation is looking to unload a headquarters.

Meanwhile, there are property types that have begun to crop up as likely candidates for the dry powder investors have accrued. D'Amico notes that there is a "mix of all property types" in Centerline's pool, but the portfolio is "dominated by retail assets."

Petosa concurs that retail, as well as hotels, will have a greater presence in servicer pools because "defaults on those assets have increased." By the end of January, 842 retail loans totaling $15 billion and 275 hotel loans totaling $11 billion were sitting in special servicing pools, according to Fitch. About 248 loans across all property types fell into special servcing in January alone, four times the balance that transferred during the same period a year prior.

Michael Sher, managing director of Minneapolis-based RSM McGladrey, says retail is so overbuilt that some needs to be demolished. He is bullish on hotels because they were correctly priced. Given the soaring delinquency rates for hotel properties-16.44% in January, compared to 9.13% in December-Sher may soon have a wide variety of assets to choose from.

Ken Cruse, CFO of Sunstone Hotel Advisors, says the downturn has led to a decline in operations and, subsequently, defaults. Many of Sunstones operators have recalibrated their business models to adjust to the recession. "The end result is a much more productive and profitable property." Cruse explains.

Still, when cash flows no longer support debt service and the value of the collateral property drops below the mortgage, Sunstone is obligated to renegotiate or, in less flexible scenarios, give back the asset to satisfy the debt. That's precisely what the company did in January, when it handed 11 hotels back to lender Mass Mutual, after failing to make payments on a $246-million, non recourse mortgage.

More owners are likely to contend with these types of decisions, increasing the possibility of more trades on the market. But buyers beware, as there can be further difficulties even after the right investment appears. "We've seen an inordinate number of pretenders to the throne that claim that they have dry powder to lock up a deal," Stein relates. But that kind of skullduggery goes only so far in a tight credit market.Previously, "if you tied up a property, you could almost certainly get the money." Stein explains. But lack of expertise in note deals and the current capital structure results in lenders being unwilling and unsupportive. "We're seeing a lot of churning of deals, but not a lot getting done."

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