Bridging the price gap

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A large-scale offloading of distressed assets can only take place once the price gap is bridged, writes Ari Danielsson

One need not have followed the real estate investment trade press or analyst reports and surveys for many consecutive years to notice a pattern. There is a sense of something imminent, something that everyone has been expecting, that has been just slightly delayed, but is bound to happen next year.

Around this time every year, various commentators – this one included – step forward and claim that the coming 12 months will be the year when European banks start to sell off their distressed and non-core assets. Buyers and advisers proceed to line up and await the flood of bank sell-offs that never seem to materialise – at least, certainly not at the level expected.

Several explanations for these delays have been posited: lack of liquidity pressure on banking institutions as central banks have stepped in aggressively; changes in the regulatory environment causing uncertainty and, consequently, deferring key decisions; a lack of provisions and price adjustments made by European banks so far; and the absence of a clear political agenda has also played a part. All of the above apply to different degrees depending on the jurisdiction and banks in question. But one of the overriding reasons is a price gap wide enough to separate all but the most determined (or pressured) sellers and buyers. But there is also the question of volume and scale.

In 2012, there were a number of distressed real estate-related loan portfolio transactions taking place on several fronts – the UK, Ireland and Spain included. The price range, reportedly, has been as low as 10-20% of the nominal outstanding exposure of the loans, often closer to the lower end of the range. This naturally leads to the conclusion that these must be the most heavily distressed asset classes in the most heavily distressed (or price-shifted) markets. An undeveloped piece of land in Ireland or a badly planned brownfield project in Spain come to mind.

The most determined bidders in these transactions have been both well-known and lesser-known opportunistic, often US-based, private equity fund managers, with a long tradition of doing such trades. These investors are ready and willing to step in where others refuse, and naturally have return requirements and a short timeline to match their risk profiles. However, these heavily distressed deals represent only a small fraction of a larger part of the European real estate debt market in need of a new home. The nature of distress can vary greatly, and often it is not the asset that is distressed but rather the sponsor or the lender. In other cases there is no real distress at all, but simply an asset location that falls outside of what is currently defined as prime and core.

One report estimates that in 2013 some €170bn of European real estate debt will require refunding. Looking over a longer period, the number rises significantly, but so does the uncertainty of the projection. A recent survey identified €2.5trn as non-core assets, or 6% of the total European banking assets, of which €1.7trn is said to be performing. The same survey also estimates that there to be €500bn of nominal value of illiquid real estate-related assets expected to be traded over the course of the next five to 10 years.

These assets are not only in need of a new capital provider but also a new asset manager, or, in the case of the distressed asset class, a new workout manager capable of successfully and efficiently resolving the issues, turning around the troubled assets and ultimately divesting or monetising them.

In only a few cases, the bidding investment managers encompass fully functional built-in or bolt-on workout teams. In some cases, the investors will go out on a limb and attempt to rely on the vendors’ capabilities, at least for the initial period, but this cannot be seen as a sustainable strategy. It is safe to say that a key element in a successful European banking and asset restructuring will be the continuing development and maturing of stand-alone and independent asset management and resolution capabilities.

Between private equity’s requirement for steep returns and European banks reducing their lending to meet balance-sheet reduction pressures, there is a large playing field for new entrants in the real estate debt market. This has already led to an array of debt fund managers into the field for capital raising among institutional investors.

Many of these have been successful, but often at a higher cost and a significant increase in the time and effort required to reach a final close (recent surveys indicate a rise from an average nine months in 2007 to 19 months). According to Preqin, some 123 funds are in the market, raising a target of €34.8bn for various EU property-focused investment strategies.

Despite these efforts it remains clear that Europe still lags well behind the US in terms of raised capital, size of individual funds, transaction volume and general institutional investor market participation. Although maybe not the best example, it is tempting to compare Blackstone’s new €10bn BREP VII fund to almost any EU-focused and EU-originated fund, all of them only a fraction of that size, most well below €1bn. In fact, some US-based limited partners’ commitments to the Blackstone fund in question, ranging in the hundreds of millions of dollars, are larger than many entire European funds being raised at this point.
It is tempting to conclude that the flood-gates can only be opened once the price gap has been bridged and the volume on the buy-side has been boosted to match the sell-side.
Both buyers and sellers need to move their attention away from the most heavily distressed asset class towards the opportunity that the overall European real estate debt refinancing offers. But none of this can take place without a strong involvement of European institutional investors.