A year ago the fear was that a glut of distressed sales would drive down prices. But now the opposite seems true as too much money goes after too few prime opportunities and banks hold on to their assets. Christine Senior reports

What a difference a year makes. This time last year the fear - based on past history - was that a tidal wave of distressed properties would hit the market, destroying prices. In the event those fears have been proved unfounded. Distressed sales have been few and far between.

But this recession is different from the experiences of the early 1990s. The lack of distressed sales can partly be attributed to the current low cost of debt. Low interest rates mean that borrowers have been able to continue servicing their debts out of rental income, and banks have been tolerating breaches of loan-to-value covenants while hanging on for the market to improve.

"What is most important for banks is that loans are being serviced on a monthly basis," says Alessandro Bronda, head of global investment strategy at Aberdeen Property Investors. "If banks can find a basis of trust with borrowers, if they are confident borrowers will be able to pay back loans, that gives them some comfort. I think banks are establishing more personal relationships with their big clients."

Few examples of true distressed sales have been seen in the UK. It little profits banks to foreclose, forcing properties onto a fragile market, driving prices down and crystallising their own losses. By hanging on, working the assets, value is created and sales can be fed at regular intervals into a rising market.

"For a vast swathe of the loan book in the UK this isn't about distress, it's about maximising recovery proceeds, whether by marketing a property correctly or working out that property or portfolio over time in the company of people you trust to get back the whole or a significant proportion of your original loan proceeds," says Tony Edgley, head of corporate finance at JLL.

Banking sector professionals with long memories can look back to the early 1990s to learn from past experiences, to avoid the pitfalls that tripped them up then. They well remember the losses suffered and want to avoid a repeat experience.

"Banks remember the late 1980s early 1990s when they sold out at the bottom of the market to the private sector, and wrote down the losses, then saw the private sector recover the losses and profit over the next five to 10 years," says Joe Froud, head of real estate ventures at Schroders. "They are keen not to repeat that. I think banks are doing everything possible to hang on until the market improves and they can write back impairment charges and benefit from the upside."

Neville Pritchard, head of business recovery at King Sturge, says that another reason why a lot of good quality distressed property has yet to come to market is because it is bound up in structured finance vehicles, which prove difficult to unravel. Pritchard says: "Unbundling those structured finance situations is extremely difficult, because loan note holders have differing agendas. An A loan note holder will hopefully still have their value maintained, but a subordinate loan note holder's value is lost rapidly. There is a vast difference in approach between those who have lost everything already, and the people trying to maintain what value they still have."

Prime assets are attracting buyers, while investors have little interest in the secondary and tertiary assets which carry the greatest risk. For the next couple of years it is income-producing assets in prime markets that investors are likely to seek. But the problem for the banks is they own few of this kind of asset. The onus is on them, through skilled management, to turn less than first rate assets into something that appeals to buyers.

"There is a disconnect between what the banks are holding and what the market wants to buy currently," says John Knowles, managing director, corporate finance, at DTZ. "The challenge for the banks will be to reposition those assets, whether through redevelopment, fixing the income, or the asset management over the next three years, to get them into a space where the investment market is."

The secondary market, on the other hand, is likely to present problems for the banks, says George Tindley, director of investment at Cordea Savills.

"With the secondary market banks haven't got an easy market to sell properties into. It's difficult because there are shorter leases and weaker tenants and it's those properties where there is much less demand from investors. Banks will probably have to wait until the tenant market recovers. In the prime market there is a lot of demand from overseas investors, from UK institutions and from recovery funds that are setting up."

Ironically the banks have benefited from the time it has taken them to organise their affairs. Pools of liquidity have flowed into the public markets but failed to find suitable assets to buy, so demand is driving prices up. Capital values have risen significantly over the past three months simply because there is nothing to buy, says Edgley.

"Through banks doing nothing the value of the underlying assets and correspondingly the recovery prospects for loans have got better," he says. "But there is a limit to that - the market will eventually get bored and go off and buy gold, oil or stocks instead. What banks need to do is to feed the market at an appropriate level where it remains hungry."

UK banks are likely to want to reduce their exposure to real estate over the next few years. That will be achieved by selling assets, and refinancing loan packages. UK banks with substantial taxpayer support have to toe the government line on their lending policies and this will affect their exposure to real estate.

"Strategically the UK banks, particularly those controlled by the government, are told they need to focus on new lending to UK businesses," says Knowles. "Partly because of that and partly because of the unwinding of their forays into non-domestic markets where they have done quite badly, I imagine they will want to reduce exposure much faster in non-core markets."

Similarly, Irish banks are likely to come under pressure to pull out of eastern Europe, where they built up big loan books on property in the boom times, as they come under pressure from their government, which bailed them out and which is imposing tax rises and public spending cuts on the population.

Problems are likely to arise when borrowers find themselves with reduced cash flows and unable to service loans. King Sturge reports being asked to review portfolios that are getting to the point of distress, which are likely already to be outside their loan-to-value covenants and perhaps struggling to meet interest rate payments. The first wave of distress has involved development properties which have no income to cover interest repayments.

"Banks hit the development and residential side first because there is no income there, there is no interest cover at all," says Pritchard. "Many developments are not viable. There is an unwillingness from banks to commit further funds without a clear exit route."

As distress hits other types of real estate, it is the secondary and tertiary properties whichare suffering most due to higher leverage and greater falls in value. Prime market properties on the other hand offer more chance of a favourable exit.

"The prime market has begun to make a comeback," says Pritchard. "These assets are becoming much more liquid and banks are starting to consider sales of more prime, better-quality assets. There is no intention to dump secondary stock into a market that isn't very strong but as the market rises better-quality assets can be sold. As markets improve properties which were in distress are now becoming saleable."

One example of this is the Silverburn shopping centre in Glasgow, which went up for sale after its developer went into receivership, and its value plummeted below the level of outstanding debt. Strong interest from a number of buyers is thought to have pushed the price well above the £250m (€277.6m) offer price quoted by Lloyds, the main lender. Another successful outcome was the purchase by Max Property of a portfolio of industrial buildings in the UK from the collapsed Industrious Group.

Increasingly banks are setting up teams of specialists to work out the assets, making improvements and biding their time to sell them off as the market improves. Unlike in the recession of the early 1990s, current low interest rates allow them to work the assets without excessive holding costs. Sometimes in concert with the bank the original owners are continuing to manage assets, earning performance-related rewards if they increase value over a period of time. In other cases banks have entered into partnerships with asset managers or property investment companies that inject new capital and take over the management of the assets.

"A number of banks are working with people they know and trust," says Pritchard. "These asset managers are often able to bring equity into the situation. The bank reduces its exposure while at the time taking a good slice of the upside if the right result comes through."

It is the UK real estate market that has suffered the greatest amount of distressed activity. In western European markets, where the use of leverage was lower, the situation has been less acute. But central and eastern Europe (CEE) has certainly suffered the inevitable consequences of a high level of development funded by borrowing in the boom years. Much of the lending came from Austrian, German, UK and Irish banks. Offloading development property into a non-existent market in the CEE is likely to be well nigh impossible for these banks for the foreseeable future.

"Where there has been no underlying market in real estate, there is no point in foreclosing," says Knowles. "You need to have some market recovery in these places to have a workout plan. Otherwise banks will have to sit there for a while."

Of course the UK economy is not out of the woods yet, and even if it climbs out of recession in the last quarter of the year, the lingering effects will continue to hit businesses and employment for some time to come. The property market is likely to be subject to continuing tenant bankruptcies and defaults and downward pressure on rents. But it appears rising asset prices could also be a threat.

"Prices are going up too quickly," says Froud. "If the economy gets worse some banks may get in a position where they can't afford to hold on to property or keep it on their balance sheet. That could force more sales in the market, and if supply got sufficient that could force values down again and we could see a double dip."

Bronda also fears setbacks: "If there is another external shock, if values start to fall further, more than anticipated, it is possible that banks then will start to force owners to sell at distressed prices. I would view that more as a risk."

The Royal Institution of Chartered Surveyors (RICS) reported a rise in specialist funds focusing on distressed commercial properties in its latest report for Q2. Activity was greatest, it says, in Italy and the UK, closely followed by Germany, the US, Hungary, Spain and Ireland.

But Anne Breen, head of property research at Standard Life Investments, says a lot of capital raised to target potentially distressed assets will struggle to find something to invest in. Breen says: "Our view is banks will not produce large amounts of stock to market at one time. It will be a continual flow over the next few years. If you look at the last cycle post early 1990s when banks built up quite big exposure to the sector the reduction took place over five or six years. It may be slightly shorter than
that this time."

Threadneedle has raised £1bn over the past 12 months in its three UK opportunities funds, and has invested half of that. But the source of distressed properties has not been the banks.

"The fear was the banks would act as they did 20 years ago and foreclose and distress sell," says Don Jordison, managing director of Threadneedle property business. "The actual sellers were open-ended fund managers. Up till recently we were buying predominantly from open-ended managers with liquidity issues but now they are generally not having outflows."

Interest in the Threadneedle funds, says Jordison, has come from a wide range of investors - high-net-worth individuals to pension funds, and from across the globe.