Banks may at last be gearing up to tackle problem loans, with a mix of solutions depending on the borrower, says Lynn Strongin Dodds

After the financial crisis exploded in 2008, there were fears of distressed properties deluging the market. The doomsday scenario did not happen thanks to low interest rates and steady cash flows to cover the debt payments. The days of reckoning may be approaching against the spectre of higher interest rates and an uncertain economic environment, although few expect to see the floodgates open.

Not surprisingly, secondary properties are the most vulnerable. Doug Hardman, CEMEA Investment director at DTZ, says: "At the height of the last cycle the pricing gap between prime and secondary assets narrowed alarmingly. Pricing for secondary assets has now rapidly unwound and is unlikely to repair in the short to medium term. Investors and funding banks now face the reality that some weaker assets may never regain their former value, and quickly become impossible to ignore once they require additional asset management and capital expenditure.

"Our experience to date has been that banks are taking a very pragmatic approach and are unwilling to face potential losses on a weak market for secondary assets. Active management of relationships with borrowers, often with the support of third party consultants, has been effective as long as all parties believe the asset has a realistic chance of recovery."

The latest survey of The Royal Institution of Chartered Surveyors (RICS) also shows that while distressed sales are increasing, banks generally only foreclose on properties as a last resort. They have preferred to ignore a breach if a borrower continues to pay interest.

However, Oliver Gilmartin, senior economist at the RICS noted that "distressed property listings are likely to become a bigger feature of the global property landscape in the coming year as loan refinancing and improved pricing in some markets provide a window of opportunity for banks to manage down some of their property loan exposure."

The RICS survey found that over 80% of the 25 countries surveyed reported a rise in the number of distressed sales in the third quarter, with South Africa leading the way, followed by the US, Portugal and France. Although the figures have not been published, the survey expects Russia, the US, Spain and Ireland to show the most activity in the fourth quarter, while the UK is also expected to see a rising number of distressed commercial property sales.

To date, the largest default in the UK has been the £1.1bn (€1.26bn) White Tower securitisation, with properties backed by the debt such as 60 Victoria Embankment and Aviva Tower being lined up for disposal. Meanwhile, Paul Kemsley's collapsed property empire's trophy assets, which include the Burberry headquarters, are on the market while the Silverburn shopping centre in Glasgow was sold to real estate company Hammerson, in partnership with Canada Pension Plan Investment Board, for about £300bn. Its owner Retail Property Holdings, an offshore firm headed by Paul Green, fell into receivership.

Industry participants believe that the Silverburn deal may be at the tip of the shopping centre sell-off. A recent report from DTZ reveals that £10bn or one in every five shopping centres in the UK is at risk of defaulting on loans due to the falls in value and income. Many of these are also seeing the end of leases agreed some 20 years ago, and there are far fewer buyers for their outdated store sizes and designs which were a legacy of the 1980s development boom.

Overall, though, whittling down the mountains of leverage will be a monumental task and take several years. Estimated property debt outstanding across the US and Europe stands at an eye-watering £3trn, according to industry reports. About $1.6trn (€1.18trn) of commercial mortgage debt is estimated to mature in the next five years in the US and a further €366bn in Europe. In the UK, the figure is projected at roughly £100bn over the next three years.

The latest report from De Montfort University revealed that UK banks are sitting on a massive £224bn of outstanding debt, although some estimates put the figure higher at £300bn. Two of the country's largest banks account for half of the burden. Lloyds, carrying the loans that HBOS aggressively made during the boom, has around £60bn outstanding to the commercial property and construction sectors, while the Royal Bank of Scotland is estimated to have a UK commercial property loan book of about £50bn.

Peter Cosmetatos, director of finance and investment at the British Property Federation, says: "Banks are slowly working through their loan books and gradually getting to grips with what they have. There are many loans that are under water and have breached their covenants. Borrowers have been treated with a certain degree of flexibility and sympathy but banks also do not want to crystallise their losses. One of the biggest questions is what will the economy do. The picture is quite mixed and uncertain as to when interest rates will rise - that will impact on borrowers' ability to service their debt."

Philip Cropper, executive director of CBRE Real Estate Finance, says: "I think it is worthwhile to look back and understand why the banks have not really dealt with the issue until now. The banks could not dispose of the properties on their loan books too quickly because they did not have control of the assets and because they could not afford to take the write-downs. They needed time to develop solutions while, from an investment point of view, the income was still being paid and interest was covered, and therefore the loans remained current despite breaches of loan to value or interest cover ratio (ICR) covenants.

"However, it is a different picture today. Last year we saw signs of improvement in banks' balance sheets. They are generating revenues in other parts of their business and there is recognition from the banks that they will have to take more write-downs in the future, at a time when they should hopefully be better placed to absorb these losses."

Alex Jeffrey, chief executive of MGPA's European operations, adds: "While it is difficult to generalise, banks did turn a blind eye to the loan to value breaches as long as the debt service payments were being met. They also did not have the resources to deal with the problems, but over the past year they have increased their internal capabilities to work through their loans. As a result, I think we will start to see a gradual pick-up of foreclosures."

Barry Osilaja, director in Jones Lang LaSalle's Corporate Finance team, agrees: "Banks definitely needed to repair their balance sheets before they could deal with their loan books. They also need to hire specialists to help them understand the problems and develop solutions."

In fact, many believe that the lack of restructuring experience in the industry has been one of the main factors hampering the process. While there are no concrete figures published, there is anecdotal evidence that suggests Lloyds has now over 200 people working in this area while RBS is thought to have more.

As Jon Digby-Rogers of Cushman and Wakefield, puts it: "This is a huge task and it will be a long, tortuous process. Banks were looking across their restructuring departments for age and experience and realised that there were few people to choose from who understood the issues. This is because there are not that many people left in the industry who worked in the last property crash in the early 1990s. It takes time to recruit and train them before the banks could logically start working through their loan books."

In general, this has means reviewing their relationships, categorising the different types of loans as well as borrowers.

Ahsan Ellahi, co-head of Eurohypo's London office and head of its loan restructuring group in London, believes that banks will adopt different courses of action depending on individual situations. "On the whole Eurohypo has been able to restructure its loans and we have only had a few situations where the borrowers could not continue to be involved. One of the problems for other banks is that due to their size they are like huge tankers and it is not easy to turn them around in the way they deal with loans in difficulty.

"They need to take decisive action and work much more quickly in identifying the problem loans and focus on which borrowers are defaulting on the loan terms, particularly potential ICR breaches - whereby the interest on the loan may not be covered by rental income. There also needs to be clear reporting lines within the organisation and the ability to work as a team to make quick decisions."

According to Ellahi, restructuring the loan may include an injection of fresh equity capital or the inclusion of new, debt-free properties in the security pool. If this is not possible, then borrowers might be asked to change the term and duration of the original financing. In addition, negotiations will be needed around increasing the price of the debt to cover both the cost of the additional regulatory capital required as well as the higher risk incurred with higher-level LTVs and thinner ICRs.

Cropper also believes that banks need to start segmenting their loans into categories. "There will be the core, quality assets and borrowers that can be extended for another two to three years in the hope that the recovery will come through and that the existing management team will develop a clear business plan. There will also be cases where banks will decide to end their relationship with the current management and look for joint ventures with third parties who are willing to inject new capital and specific asset management skills to improve the value of the property."

He continues: "We may also see banks start to package the senior loans and sell the secure tranches to investors through securitisation. We have seen this with the German banks which are using the Pfandbriefe market. We also expect banks to consider selling loans and passing on the economic interest to third party investors leaving the new investor to recover the loan over a period of time."

Andrea Pavelka Schimmler, director within the investment strategy team at LaSalle Investment Management, also believes that banks will be working much more closely with asset management groups: "I think one of the issues is that some portfolios have been left alone during the turmoil and they were not looked after. There is now scope for an asset manager that has core skills to step in and maximise the value of that property. This means renegotiating the terms of the leases as well as upgrading the property."

While solutions are being developed, reaching a consensus may not always be easy, particularly when there is a syndicate of banks. Simon Farnsworth, chief operating officer, Strategic Partners UK, CBRE Investors, says: "Syndication is totally dependent on how the deals are structured. If there is a majority voting structure then it can be easier to have an extension or amendment to the key provisions. However, if you need everyone to agree to the new terms, then there could be a problem."

The same applies to the collaterised mortgage backed securities, where groups of loans were packaged and sold to investors in tranches offering different levels of risk and profit. Moody's has warned that commercial mortgage-backed securities (CMBS) issued during the boom time are set to incur significant default rates, given an average fall in values of 43% since the peak in the US. The holders of certain riskier bonds are already expected to have had their investments wiped out.

The rating agency estimates that up to $153bn of CMBS will come to maturity by the end of 2012 and $100bn will face refinancing difficulties. The US government has already been forced in effect to underwrite the CMBS market.

Fitch, another rating agency, has warned of similar pressures in Europe, where CMBS worth as much as €66bn are due for maturity before 2014. About 40% of the instruments issued between 2004 and 2008 were in the UK or Germany. The US and UK, which are thought to have better restructuring processes than the rest of Europe, have already started to tackle these problem loans as witnessed by the impending disposal of White Tower.