The vultures are circling commercial real estate. But are they too numerous and too early?

These are the questions troubling a new generation of commercial real estate investment trusts as they try to benefit from the problems in retail and office property.

Later to develop than the residential mortgage crisis, commercial real estate is in turmoil. Defaults have been rising as vacancies soar and rents tumble on both retail and office leases. Office property values are down by 40%-45% in most large markets.

Delinquency rates on commercial loans are at 4.6%. By the end of next year, they may be at 7.5%, estimates Matt Anderson, partner with Foresight Analytics.

All that mounting distress could mean buying opportunities for REITs hoping to snatch retail and office loans, securitized mortgages and properties at sharp discounts.

At least 10 new REITs with plans to attack the moribund commercial market are in the works, notes Wendy Worcester, chief financial officer of TNP Strategic Retail Trust. TNP Strategic Retail is a privately traded REIT raising funds from retail investors to buy into malls anchored by grocers and pharmacies in the West.

"Tens" of such privately traded REITs are looking for retail investors, notes Darren Tangen, CFO of Colony Financial (NYSE:CLNY - News), which did an IPO in September.

The rush to new REITs began on a promising note in August when Starwood Property Trust (NYSE:STWD - News) raised $800 million. Since then, IPOs by Colony, Apollo Commercial (NYSE:ARI - News) and CreXus Investment (NYSE:CXS - News) have fallen far short of their capital-raising targets. Other REIT IPO plans have been put on hold.

So what's the problem?

As Sterne Agee analyst Henry Coffey sees it, buyers outnumber opportunities. "You've got all these buyers sitting there in their yellow raincoats with their black umbrellas and galoshes. ... There's a lot of money out there waiting on the sidelines," Coffey said.

No Consensus On The Bottom

Other analysts note investors are wary of investing in vulture funds with no track record.

And nobody is quite sure where the market bottom lies.

"There's some consensus that we're seeing stabilization in the residential market. That really hasn't happened yet in the commercial market," said Nick Einhorn, an analyst with Renaissance Capital who has been tracking the REIT IPOs.

For all the problems of troubled borrowers, banks have been hesitant to foreclose on properties. Selling at current prices would require write-downs the banks are reluctant to take. "We haven't had the disgorgement process," said Coffey.

Mercer consultants David Nix and Michelle Reuter have been following commercial real estate developments. They were asked why the new REITs seem to be having trouble attracting investors.

"Transaction volumes remain light and many of the new public vehicles have been unable to identify attractive investment opportunities. Investors are simply growing hesitant to commit fresh capital without seeing a pipeline of opportunities," the Mercer consultants wrote in response.

Jeffrey Rogers, president of Integra Realty Resources and a board member of the TNP REIT, sees opportunities for buyers willing to do the legwork and research.

"The reports out there that there are no transactions are not true," said Rogers. He added, "You need to kind of hunt for deals."

Commercial real estate REITs can buy existing loans or securitized debt, as well as property. Despite rising default rates, spreads on high-quality commercial mortgage-backed securities have compressed in recent months. Spreads on AAA-rated CMBS have tightened from 1,000 basis points over Treasuries down to 500 basis points, notes Anderson. For REITs, which distribute 90% or more of income to investors, the best CMBS deals may already have been made.

"The lowest-hanging fruit is gone," said Anderson. Still, he points out that current spreads are historically high. As recently as early 2007, AAA CMBS spreads stood at just 30-50 basis points.

Most observers think the tightened spreads reflects the support of the Fed's TALF program, which has offered low interest rate credit to some buyers of distressed mortgage securities.

Rogers believes the effect of TALF will wear off.

"Over time, the marketplace gets used to the liquidity," he said. "The spreads will widen." This, he contends, will create further opportunities in commercial real estate debt.

What will it take for distressed properties to come to market?

Recent regulatory guidelines make it easier for banks to extend loans on many properties, says Anderson. This will further delay foreclosures.

At the same time, he adds, regulators seem to want banks held accountable for the worst-performing loans. These are "loans where the borrower does not have the cash flow to make interest payments," Anderson said. He estimates that "clear nonperformers" amount to $110 billion; in most cases, banks will wind up selling the troubled loans at a discount. In some cases, they'll sell the property.

All that should provide a richer target environment for the new REITs. Still, they face a couple of problems.

Colony Financial CFO Tangen notes that the REITs went public before assembling a portfolio of assets. The IPOs gave them the capital to start buying. Until they deploy that capital, it's hard for investors to be confident in the returns they'll see. "The market does not like these blind pool offerings. Investors don't know what the portfolio will look like," said Tangen.

Cash-Rich REITs

Further clouding the outlook is that established REITs, already publicly traded, have also been raising fresh capital. Through October, established REITs had raised over $20 billion this year from secondary equity offerings, the National Association of Real Estate Investment Trusts reports. Some of that will surely go toward buying distressed assets.

These REITs have track records and cash to capitalize on the depressed commercial market. But they are burdened by existing portfolios that may continue to bleed.

"The new REITs certainly have the benefit of not having legacy issues in their portfolios," said Anderson.

At the same time, investors' wariness of blind pools is understandable. "It's not a sure thing the market will be awash in distressed opportunities," he explained.

Colony's Tangen argues that the opportunities for investing in distressed commercial assets have only just begun.

"There's going to be huge opportunity," he said. "There's a massive restructuring and deleveraging that has to happen in commercial real estate. And it's going to happen over a number of years."