Purgatory. It may be the best word to describe the commercial real estate world in 2009. Sellers weren't selling. Buyers weren't buying. Lenders weren't lending. And fear prevailed.

All that led to a defensive property management strategy. But the tide is turning in 2012. Indeed, there is more clarity in the market. Trend lines are visible. And commercial real estate professionals are better equipped to manage what's coming down the pike. The result is that asset management has become more forward thinking and proactive than fearful or defensive.

So the questions are, what is coming down the pike and what is the best response? How should opportunities in broken projects and debt be managed in 2012 compared to 2009? Where are the opportunities and what challenges remain to get the best return on eventual resales?

Despite the progress in clearing distressed assets off the books, there are still more questions than answers as 2012 unfolds. The good news, though, is there are more answers than in years past and wary optimism has replaced fearful skepticism, even with about $100 billion worth of CMBS loans coming due over the next 12 months.

"We've made a lot of progress over the past 24 months, but that doesn't speak to what's ahead of us," says Ezra Katz, CEO and founder of the Aztec Group, a Miamibased investment and merchant banker specializing in the real estate industry. "It's much more difficult to quantify what's ahead. The good news is a lot of the uncertainty has been eliminated and that should give rise to more transactions, loan sales and workouts in 2012. It has to be vibrant, because if it isn't, that portends something more ominous" than most industry members foresee.

On the distressed assets scene, the days of simply kicking the can down the road are over. Extend-and-pretend is largely a philosophy of the past. While some lenders continue to modify loans rather than accept a discounted payoff, those days are gradually concluding as banks' balance sheets firm up.

Although the notion that a rolling loan gathers no loss has been refuted, the can still gets kicked in a different way, says Norman Radow, CEO of the Radco Cos., an Atlanta-based national real estate development firm that has managed and repositioned more than $4 billion of distressed real estate. As the lenders have brought in receivers or taken charge of properties directly, without the experience or the internal support to maximize value for the lender, the can gets kicked inside the institution.

"There are limits to how long a lender will hold real estate assets on their books or loans that remain in limbo," Radow says, "whether the incentive is regulatory scrutiny, improved market conditions with certain asset types, or simply the time and staff required of lenders to continue putting out fires and working in areas outside of their core competency of lending money."

Katz says special servicers have been part of the problem and need to be part of the solution. With billions of dollars of assets under the control of special servicers, he sees the need to rethink how business is getting done—and get more proactive in moving assets. Some special servicers are limited by legal boundaries while others are limited by valuation boundaries. Still others are looking for opportunistic situations within their portfolios. But Katz says a new paradigm is a must.

"Current incentives for special servicers to move assets must be revisited," he says. "How can their interests be better aligned with bondholders'? It's a big question." Special servicers have no choice, he says, but to continue servicing the loans and try to be as creative as they know how. "But that puts them in an entrepreneurial role," he adds. Instead, the servicers' goal should be "to liquidate their positions so we can get rid of the overhang in the market that impacts values."

Unrelenting lenders were part of the purgatory in years past. But lenders and special servicers are more willing—and more able—to get problem assets off their books in 2012. Some industry watchers expect to see major housecleaning this year, but there is not total agreement on how quickly lenders will move in 2012 compared to previous years.

"First, all lenders have created the infrastructure to workout and/or dispose of their assets, which was not in place in 2009," says Radow. "Second, loans have already been extended and are now maturing. Three years ago, debt was generally unavailable to recapitalize projects and equity required higher returns than banks or lenders were willing to part with."

Stuart J. Boesky, president and CEO of Pembrook Capital Management, a real estate investment management company in Harrison, NY, agrees that the extend-andpretend trend is fading. But, he adds, a lender or special servicer's ability to get distressed assets off the books is still constrained by a lack of good alternatives.

"We see more opportunities to work with borrowers on distressed assets now than we did 24 months ago," Boesky says. "Also, there are more auctions and direct sales of loan pools today than before. However, caution will continue to prevail because the markets remain unsteady and lenders are still not being forced to divest."

Warren Weiser, co-founder of Continental Real Estate Cos., a Miamibased full service real estate firm that delivers custom workout solutions, expects to see an active market for dispositions in 2012. Specifically, he predicts less activity on the receivership end, yet with about $100 billion in CMBS loans coming due, he admits anything could happen. The X-factor: the stock market.

"If the stock market gets volatile again, 2012 could be a rough year," Weiser says. "But we should see slow growth and the doom and gloom feelings are disappearing. The lenders that are still standing are capable of restructuring and there is more collaboration with borrowers than we've seen in previous years."

Whatever else happens, Katz remains insistent that the market has to clear the bad debt in order to remove the overhang in real estate valuations. So long as nonperforming assets remain in the hands of non-real estate owners, he says, there is a superficial market. "The market has to find a better balance than we've seen over the past three years," he says. "We need stability and a belief in the appraisals that are being written on each transaction." He sees property appraisals becoming "less complex" this year and more normative thereafter.

While lenders are ready to deal, they are also more adamant that borrowers add value to troubled assets in exchange for loan modifications. This isn't exactly a new trend, but it's one that will be more pronounced in 2012 as lenders continue holding more on their balance sheets in a slower securitization market.

"New equity will obviously not invest unless returns are there," Radow says. "We see a lot of cases where operating profit cannot support the payroll necessary to properly manage, let alone to invest money to cover asset improvements. The result, he says, is a "death spiral" that further erodes values and lender collateral. "Some, but very few operators, still have the resources to devote to underwater assets, but they have to believe values will improve before they work for free for an extended period of time."

Steve Silverman, an attorney at the law firm of Kluger, Kaplan, Silverman, Katzen & Levine in Miami, says the borrower's transparency is part of the solution. Lenders want borrowers to, as he puts it, lift the kimono and reveal the entire financial picture of the property.

"Transparency allows lenders to make deals, even if the deals aren't attractive to anyone," Silverman says. The banks sometimes take a severe haircut, but lenders can perhaps get some money from the guarantors who may have had significant balance sheets five-plus years ago. The borrower's balance sheet may be severely curtailed, but they are writing checks. So we're seeing some give and take now that was absent a couple of years ago."

A prime example of the more proactive approach to managing troubled assets in 2012 is broken condo projects. The firsttime homebuyer's tax credit is no longer available to spur sales. That means property managers have to develop and execute strategies that help them compete in the market.

"With the capital markets improved, CMBS aside, and lenders willing to part with assets at lower prices, value-add strategies can now be implemented," Radow says. "Management focus can be expanded beyond great customer service and solid operating processes to such items as additional property amenities, higher quality staff and IT investment for better reporting and communication."

Silverman doesn't disagree with Radow. But he makes a noteworthy point: no one was talking about adding value three years ago. In fact, three years ago the "troubled projects weren't being managed—they were wasting away." With owners actively working to get assets back on line, he says, management can and is getting more creative and projects are rising from the ashes.

"The ability to get control of the asset quickly is critical to achieving success in the distressed arena," notes Boesky. "Because the courts in many jurisdictions are backlogged, and because some borrowers will use bankruptcy and other legal processes to their advantage, out-of-court restructuring is almost always preferable to resolving matters in a court of equity, like bankruptcy court, in which the outcomes are uncertain and time-consuming."

Katz views asset management as the operator's most important role in 2012. Creative asset management adds more value to transactions than property management. Although property management is crucial to paying the bills, he says it's asset managers that add the value.

"Good asset management and good asset managers are irreplaceable," Katz says. "Asset management has become much more of an entrepreneurial role and should continue to be, rather than an accounting function." The managers "need to know what options they have, set a direction and execute a plan."

Given this changed set of circumstances, how can investors come into the picture—and what do they need to do in order to asset-manage these properties for the best return in an eventual resale?

"Asset management is a game only experienced real estate people should play," says Boesky. "Traditional lenders are not necessarily equipped to be asset managers because they always thought they were in a secure part of the capital structure. To manage a broken project successfully, you have to think like equity and bring those skills to the table."

During the period from 2004 to 2007, Boesky says, many "questionable assets" were financed along with "good assets," and in many cases leveraging questionable assets led to depressed valuations that has resulted in both good and bad assets becoming over-leveraged and distressed. The key to identifying opportunities in debt restructuring is having the real estate expertise to recognize those distressed situations that involve a good asset at a favorable basis, and the ability to address any issues either with the real estate itself or with its capital structure.

"Pembrook recently refinanced two condo projects in order to improve the capital structure and allow the borrowers time to complete the sellouts," Boesky illustrates. "We also took control of a distressed, half-vacant office building in Manhattan, completed the redevelopment, leased it up and are now selling it at an attractive profit."

Radow agrees that investors need an experienced operator who can identify good opportunities—and has the infrastructure to execute upon them. Direct loan purchases from lenders provide the most favorable risk-adjusted returns, he explains, because a good buy should provide enough room to financially motivate the owner to either execute on a new business plan and make the necessary returns, accept a deed in lieu or foreclose.

"Buying loans provides potential strategies that fee investment does not, although it is very difficult and time consuming to get the right deal, and asset-level information is difficult to obtain, in our experience," Radow says. "With respect to asset management, we think the most important aspect is to balance the new money invested with the expected benefits."

Taylor Grant, a receiver at Real Estate Receiverships in San Francisco, sees a growing movement of reverting to real estate as a local business with product-specific local knowledge. He predicts investors that take this approach will outperform those that don't. He also expects to see more partnerships in 2012 as developers and investors adopt "partner first, real estate second" as their mantra.

"In the 1970s and '80s, you'd see experienced developers who had done a lot of work to attract capital," Grant says. "In this last cycle, we saw yesterday's superintendent become a developer and yesterday's broker become president of a new REIT even though they had never put a shovel in the ground. We need a return to discipline and local knowledge."

Whatever else the strategy calls for, getting the proverbial ducks in a row is vital. Paul Ellis, president of CNL Commercial Real Estate, a full-service firm headquartered in Orlando, stresses that the opportunity to invest in broken projects and distressed debt is still a long-term one. With just under $1 trillion of debt maturing over the next three years, the buying window remains open and the property management skills to drive profitable resales are vital.

"Each year the pool of acquisitions opportunities is going to get larger," Ellis says. "From an asset management standpoint, 80% of the value is created when you buy the asset and by what you pay for it. You can talk about creative strategies, but if you're not buying a functional asset you're going to have a problem. You have to understand why the asset is distressed and buy right. Some assets are just functionally obsolete."

The bottom line: the days of investors with gunslinger mentalities are over—at least during the current era of investment and property management. The difference between this commercial real estate bubble and bubbles past is the size of the bubble. The 2009 meltdown brought stress of an unprecedented order of magnitude. The only way out is patience and smart investing.

Radow concludes that the currency in today's market is bringing a deal that is priced correctly to investors. That means staying in front of potential sellers whose priorities change and perfecting internal processes to underwrite a lot of deals very quickly. It also means bearing risks of hard earnest money and deal-pursuit costs before an investor commits to the deal.

"Often this means taking advantage of the smaller opportunities while the biggest players are driving up pricing by bidding up the big stuff in core markets," Radow says. "So the real opportunity is going into smaller and medium-sized deals that the biggest players aren't looking at yet. That's where the opportunities are."