Earlier this year, commercial real estate had all the hallmarks of a distressed asset sale of the millennium. Across America, hundreds of billions of dollars' worth of office buildings, hotels, apartment complexes and malls were tanked up with debt and rapidly tanking in value. They were so far under water, conventional wisdom had it, that there was no way they could be refinanced. Wholesale foreclosures would follow. Banks would be forced to unload properties at bargain-basement prices.

In response, distressed real estate funds began lining up for the kill, pumped up with billions of dollars of investment money, ranging from sovereign wealth funds to insurance companies. The culling was supposed to begin the second half of 2009 and last until 2012. That's the period when the crop of loans come due from 2005-2007, the height of the commercial real estate lending spree.

As the year comes to a close, defaults are rapidly growing in number. The amount of distressed real estate is massive, about $150 billion, according to estimates by Real Capital Analytics Inc. An index compiled by Moody's Investors Service shows commercial property prices fell almost 43% from their peak in October 2007 until September 2009, the latest month available. They continue to decline.

For many of these properties, there's little possibility of significant recovery. "Owners who purchased late in the game (2005-2007) and used copious debt (75% plus) are toast," writes a joint study by PricewaterhouseCoopers LLP and the Urban Land Institute. "Many developers and construction lenders for just-completed projects don't have a chance."

However, few properties have been foreclosed on -- perhaps 10% of the defaulted loans, according to some estimates. Even fewer distressed sales have taken place. Distressed investors "thought it would be like shooting fish in a barrel," says a lawyer who represents both financial institutions and real estate interests. "A year later, they can't find the fish."

What happened? Broadly speaking, we're witnessing an almost universal restructuring. "Lenders try to work out any loans that can be worked out," says David Barksdale, a partner at Ballard Spahr Andrews & Ingersoll LLP. From the vantage point of lenders, this approach has obvious benefits. They are attempting to delay whenever possible the need to fully write down bad loans. The best way to do so: Don't take over the real estate. "The overarching issue is that for many lenders, taking property back means a hit onto their capital ratios," says Steven Herman, a New York-based partner at Cadwalader, Wickersham & Taft LLP.

That impasse has frustrated the entire market in commercial property, which would like to begin cleaning up the mess, with repercussions echoing throughout the economy.

"The reality is, it's a holding pattern," says Dennis Yeskey, New York-based senior adviser at AlixPartners LLP.

Federal regulators have been accommodating to that holding pattern. In late October, an interagency panel including the Federal Reserve, the Federal Deposit Insurance Corp., the Comptroller of the Currency and others issued guidelines under the benign bureaucratic title of "Policy Statement on Prudent Commercial Real Estate Loan Workouts." The guidelines favor workouts, urge examiners to take a "balanced approach" when assessing risk management and promise financial institutions they won't be hammered for restructuring even weak loans, as long as borrowers have some financial standing. The new regulations urge lenders and debtors "to work constructively together."

The policy "acknowledges what is going on in the marketplace," says Herman. "It's almost a tacit endorsement of the government in what's happening."

What's happening in commercial properties may lack the popular drama and widespread pathos of collapsed residential real estate, but it's also critical to the country's well-being. The rash of bad commercial debt threatens many lenders. With so much capital tied up in these bad loans, the ability to make new loans is limited. That has implications for the economy as a whole. "Business investment in nonresidential structures is likely to be a substantial drag on U.S. growth in the near term," said Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, in remarks to the Virginia state legislature.

The result, says David Jones, a longtime real estate partner with K&L Gates LLP, based in Charlotte, N.C.: "There hasn't been anything approaching the dealflow people thought there would be. I don't think the regs change that. It's just more of the same."

Washington's current approach to commercial real estate debt is easy enough to understand. Forcing lenders to write down so many non- or barely performing loans in short order could trigger unprecedented bank failures. Once capital requirements dip below a certain level, the FDIC has no choice but to take over a bank. This year, more than 120 banks have failed. If hundreds more collapse in the near term, it would have catastrophic effects on the FDIC, not to mention the banking system as a whole. "The FDIC is pretty much depleted. It can't afford to take over these banks," says Hugh Hilton, who is the national head of Alvarez & Marsal Inc.'s real estate group. "This is really an effort to slow down the freight train."

That approach to distressed debt comes with a cost to the commercial real estate market, critics assert. "It retards the rate of recovery and prevents the pricing system from doing its work," says Randall Zisler, CEO of Zisler Capital Partners LLC, a real estate investment advisory firm. "It not only extends the period of uncertainty, but possibly enhances it."

Valuations remain stuck in a kind of price purgatory. A chasm lies between what is being offered and what investors are willing to pay. What is carried on lenders' books reflects only a partial write-down. Because banks haven't taken back many properties, they haven't shopped them either, so there are few properties on the market. Lack of deals means even professional appraisers come in with wildly divergent figures.

As a result, it's almost impossible to establish a floor for what commercial real estate is worth. "There's no price clarity. The market is frozen," says Christopher Grey, managing partner of Third Wave Partners LLC, which both invests in distressed real estate and advises investors.

The question now is whether all this changes the calculus for commercial real estate for the foreseeable future or merely postpones the inevitable. Opinions vary. "Extend and pretend is now the rule," says an angry Grey, using one of the favored rhymes of the trade. (Another is delay and pray.)

Some perhaps less-biased analysts agree the current market isn't ripe for a dramatic upturn. "I'm skeptical this will accelerate the trading of distressed assets," says Edward Casas, a restructuring specialist who heads Navigant Capital Advisors LLC. "It perpetuates some degree of delay."

Casas sees a more gradual process. Demand exists and the money is now out there to do deals. Banks are shoring up their reserves quarter by quarter and will eventually be strong enough to cut loose their bad loans. Eventually, says Casas, "there will be a crossing over."

This "can't go on indefinitely," agrees Zisler, who believes lenders must eventually take a hit on bad real estate loans and sell off properties.

John Strockis is executive managing director of asset services for Voit Real Estate Services, a large Western U.S. realty group. Strockis believes the wave of distressed sales is coming. It's just been delayed. "The shift is starting to happen with very large financial institutions," he says, predicting significantly heightened foreclosure activity in the next six to nine months. "A certain set of financial institutions is clearly out of denial. Now there's a reappraisal of the markets. They are going to foreclose."

This much everyone agrees on: The distressed asset pool is huge. The PricewaterhouseCoopers/Urban Land study estimates commercial mortgage-backed securities, or CMBS, alone have $250 billion to $300 billion a year in maturities or rollovers through 2015. Fitch Ratings Ltd. estimates that through October, CMBS loan payments at least 60 days delinquent total almost $18 billion.

Fitch also estimates the banks and thrifts in its universe hold between $120 billion and $140 billion in impaired commercial real estate loans, a figure some others believe to be far too conservative. Banks held $1.1 trillion worth of commercial real estate loans as of June 30, according to Fitch.

Given the sheer volume of distressed real estate, coupled with the continued increase in job losses and a fragile economic recovery, chances of a significant rebound in commercial real estate within the next three years are close to nil.

Stronger financial institutions are far more likely to push borrowers than weaker ones. Those on the cusp look like they're just trying to get another year's reprieve so they can stabilize further. The weakest banks -- the so-called zombie banks -- may well succumb before their borrowers do, leaving the FDIC to clean up the mess.

A lack of transactions hurts everyone. Distressed funds, especially those set up in late 2007 and early 2008, find themselves under increased pressure from limited partners to do deals, even if they have to sacrifice some of their promised rates of return.

In the first half of the year, those funds stayed on the sidelines. It was hard to get any credible offers, say those involved. Shannon Lowry Nagle, a New York-based partner at O'Melveny & Myers LLP, is debtor counsel for a bankrupt REIT called 2008 Asset Holding Corp. She describes unsuccessful efforts to sell mortgage-backed securities held by the REIT. For the first six months of the year, "we couldn't get a bid, not even at distressed values," she recalls. "Real estate had a big skull and crossbones painted on it."

That's changing, according to Voit's Strockis. Now the few pieces of distressed properties on the market are garnering multiple offers, he says, sometimes 10 or 20 bids. Cap rates, the favored trade indicator that measures the ratio of net operating income to capital cost, are beginning to decline, he says, adding that he believes the bid-ask gap will narrow next year.

The real upturn in activity is the trading of debt tied to real estate. "There's a tremendous amount," says Alvarez & Marsal's Hilton. "A lot of investors are trading out of debt. It's just the title hasn't changed hands."

While some of these traders are merely looking to profit from the debt itself, others have an eye on the underlying assets, Hilton believes. "Some of these guys trading debt are going to start foreclosing."

Some rumblings can be felt. Earlier this month, for example, Bank of America Corp. filed a court notice to foreclose on an office building in Irvine, Calif. The notice was directed against strapped REIT Maguire Properties Inc. The foreclosure notice was anything but unexpected. The only surprise is how long it took. In August, Maguire announced that it would stop mortgage payments on that particular office building, as well as on four other Orange County properties and one in downtown Los Angeles. Maguire acquired these properties as part of a huge transaction in April 2007, when it paid Blackstone Group LP $2.875 billion for a portfolio of Southern California real estate, part of Blackstone's Equity Office Properties cache.

That transaction demonstrated just how crazy the market had become two years back. By Maguire's own reckoning, it laid out no equity. The acquisition was completely financed by debt. Irvine hosted numerous subprime mortgage companies, all of which blew up. Office demand suddenly cratered.

The Maguire building may demonstrate some resolve on the part of banks. It also illustrates what a lost cause some of the company's holdings are and how developers are now willing to give back the keys to their most drowned-in-debt properties.

In the worst commercial markets -- Las Vegas, Phoenix, South Florida, to name the three most obvious ones -- developers are beginning to give up, say lawyers. Sometimes, borrowers are signing over the deed in lieu of foreclosure. Sometimes, there's a consensual foreclosure in which the developer agrees to give back the property but continues to manage it for a fee, and the borrower cancels any personal guarantees on the part of the borrower.

However, even the drop-the-keys-at-the-front-door option is circumscribed. "I'm not seeing tons of these," says K&L Gates' Jones. There are good reasons why. Canceling a loan can create a phantom gain and subject the borrower to huge tax liability issues. "This ties real estate developers to these properties longer than they would like," says Jones.

The last thing lenders want is to become property owners. Most importantly, taking over real estate through foreclosure -- termed "real estate owned," or REO in the trade -- means asset conversion from a loan to a piece of property. That necessitates a reappraisal of the property and, in this marketplace, the certainty of a substantial hit to capital reserves. Lenders have been writing down bit by bit their loan assets as they struggle to build up capital reserves. But few banks have bulked up enough to take the entire write-down on multiple assets.

Under current accounting rules, a reappraisal of one asset could have a knock-on effect on the value of others, the so-called tainting of assets. Proposed changes in international accounting standards would remove this problem and some related issues but aren't scheduled to take effect until 2013.

Even the strongest banks aren't thrilled about the prospect of owning office buildings, hotels and shopping centers. That's not what they do. They aren't equipped for it. It's an added cost, even when they form a joint venture with the likes of Voit, which is angling to pick up such business and to market the properties. Along with retail, hotels represent the most distressed part of the landscape, according to Real Capital. A&M's Hilton describes the dilemma banks face when they take over hospitality assets -- everything from having to make payroll to dealing with liability issues. "It's an operating company inside real estate and a veritable nightmare for banks," he says.

Some workouts have an element of give-and-take, say lawyers and workout specialists involved. Others might better be characterized more by a wink and a nod. Lenders often threaten to foreclose but rarely do. In one case, says a lawyer for a developer, lender lawyers have been saying to him, " 'We're going to file if we don't get more.' This has gone on for nine months," he says.

According to some lawyers, decisions could hinge on whether the lenders have confidence in the abilities of the borrower as a property developer and operator, not on cash flow. Lenders will agree to forbearance that might include face-saving minimal payments, slightly tougher covenants, more detailed reporting or higher interest, but all these don't fundamentally change the loan or the ability to get repaid.

The realities of this marketplace can create an almost paradoxical reversal of roles where the borrower can have the upper hand, despite drowning in debt. If banks don't negotiate some kind of forbearance, property owners threaten to walk away from the building. That's the last thing banks want, both in terms of their own loan books and their operations. "Lenders don't have much choice. Borrowers understand that," says Barksdale, who is the co-head of Ballard Spahr's distressed real estate initiative.

While lenders are in no rush to foreclose, borrowers aren't awash in options, either. Unlike in previous down cycles, Chapter 7 or 11 are no longer considered options. "Filing for bankruptcy doesn't do any good at all," says O'Melveny's Lowry Nagle. "The incentives just aren't there."

Most real estate is held in single-asset, special purpose entity vehicles. Under the 2005 revised bankruptcy law, a bankrupt single-asset real estate vehicle must propose reorganization within 90 days of filing that has a reliable chance of success. Otherwise, the automatic stay that prohibits action by creditors is lifted, and lenders can take over the asset.

What's more ominous for borrowers, under most agreements these days, filing for bankruptcy may trigger provisions that open the guarantor to liability. That means creditors could seize a parent's other assets as well as the bankrupt property itself. A developer could find itself wiped out.

If anything, commercial real estate backed by securitized debt such as commercial mortgage-backed securities, with its bundling of assets, multiple layers of debt and complex ownership scheme, is even more complicated to handle. "How do you deal with thousands of investors?" asks AlixPartners' Yeskey. CMBS "were never designed to deal with this kind of market."

In a securitized loan, lenders appoint a general servicer to handle and distribute loan payments. However, when the borrower defaults or is in danger of defaulting, a special servicer takes over. Under the most common arrangement, the most junior tranche has the right to appoint the special servicer, but that entity is charged with adhering to what is in the best interest of all tranches.

Conflicting interests among various lenders are obvious. The seniormost tranches might demand immediate action, since they get the first cut of sales proceeds. Junior tranches, on the other hand, know a distressed sale means their equity is wiped out and will fight to delay any kind of foreclosure until the property market picks up. "Servicers are between a rock and a hard place," says Hilton, who like many others believes dissatisfied investors will sue and the courts will end up determining how aggressive these agents should be in foreclosing.

However, there are signs of movement even among securitized properties. "I'm seeing more and more desire [by some investors] to obtain control," says Cadwalader's Herman.

"This is not your grandmother's market," concludes fellow Cadwalader partner Susan Neuberg. "It is very complex."