Preparing for the flood
Research predicts a surge in troubled asset sales in Germany. Ralph Winter examines the prospects for European distressed investing
Pension funds across the world are, on average, suffering from poorer performance, higher costs, less transparency and liquidity as a result of investing directly in bricks and mortar or non-listed funds rather than REITs and listed property stocks. This is the headline conclusion of a study of the performance of pension fund property portfolios over two decades by the Maastricht University.
In virtually every market across Europe, real estate investors and fund managers can find distressed opportunities. The highest degree of property distress is found in the peripheral EU countries, such as Spain, Greece and Ireland, where the excesses of the previous cycle were the greatest and current macroeconomic headwinds are exacerbating the situation. Economies in a severe state of recession coupled with crippling levels of unemployment, which in Spain currently stands at 25%, have created swathes of distressed owners and assets.
A shortage of buyers in these countries means that investors potentially can cherry-pick the very best of these opportunities, but the risk premium attached to the overarching economic climate in these countries means that anyone willing to deploy capital in these areas requires returns at the very highest end of the achievable spectrum.
That said, even in core European countries, where the excesses and retrenchment is less acute, a potent mixture of upcoming loan maturities, the residual effect of poor asset management, and the continuing need for banks to bolster capital ratios, has led to a steady stream of distressed opportunities in markets such as the UK, Scandinavia and Germany. They provide investors with the prospect of participating in distressed scenarios and chance to generate value-add and opportunistic-type returns with the additional support of a sound underlying economy.
Many market participants expected to see a deluge of distressed opportunities, even within core markets such as Germany. But, to date, there have been few large portfolio disposals by banks, due to their unwillingness or inability to accept large write-downs. Where loans have been performing, banks have been content with ‘extending and pretending or amending’, as well as selling down assets on a piecemeal basis to preserve capital values. Nevertheless, we are detecting in the markets an increasing perception that banks have become more willing to dispose of distressed loans at discounted levels or to force owners to sell their properties.
This has been confirmed in the recent findings of our research into German distressed real estate debt, undertaken in conjunction with the European Business School Real Estate Management Institute (EBS REMI). Despite the hard work of European banks over the past few years to improve their capital ratios, further work is required to meet the stringent targets of Basel III, in which at least 6% of risk-weighted assets must be backed with T-1 capital, compared with 4% at present. In addition, a so-called capital conservation buffer of another 2.5% also needs to be created, as well as a counter-cyclical buffer varying between 0% and 2.5%, depending on macroeconomic conditions.
At best, loan extensions were only a temporary respite to many refinancing problems. Basel III, however, provides a real impetus for banks to deleverage and generate capital from their distressed loan book. The European refinancing situation is extreme in terms of the absolute numbers. It is estimated that €170bn of real estate debt in Europe requires refinancing in 2013 alone, of which €43bn is in Germany.
The vast majority of these loans were originated in the early-to-mid 2000s, when loan-to-value (LTV) ratios of over 80% were the norm and, although interest rates were higher during this period, the overall burden of servicing debt was reduced through the banks’ ready acceptance of covenant-light structures and bullet repayments.
Findings of our research, in which banks representing 65% of the asset value of the entire German banking system were polled, indicate that the quantum of debt banks are willing to provide is likely to reduce over the next 12-24 months, as are the LTV ratios upon these facilities. The majority (60%) of banks polled would not lend over €50m on individual deals and the majority of LTV ratios they are willing to lend against are between 50% and 60%.
This creates a problem when former 80% LTV loans require refinancing, a situation we are increasingly seeing in the market. The interest may have been serviced throughout the life of a loan but, due to the general risk aversion of banks and their need to deleverage, refinance is only provided at 60% LTVs, leaving the owner to come up with the residual amount, or default on the loan repayment. In many cases, this leads to a distressed sale of a performing asset.
The short-term effect of distress coming to the market is a downward pressure on pricing of non-core assets. While the process of balance sheet repair continues, banks are only likely to cherry-pick the best core assets to lend against, exacerbating the dearth of finance for non-core property. This continues to dampen demand for these non-core types of assets while simultaneously increasing overall supply. Consequently, this leads to excellent opportunities for well-funded investors to acquire such assets at competitive prices in a market with overall stable macroeconomic conditions, provided they have the local market knowledge and capabilities to properly underwrite and asset-manage the properties.
In our view, while the process will take three to five years and maybe longer, banks ultimately will restore their balance sheets to a point where accessibility to debt will improve, albeit on more conservative terms, to a broader cross-section of the market, facilitating an increase in demand and property prices. With the strongest European economies set to provide plenty of distressed opportunities, timely investment into these markets provides excellent value-add and opportunistic-type returns for those investing with a longer investment horizon – but without the exposure to volatile peripheral countries of the euro-zone.
Ralph Winter is founder and chairman of Corestate Capital