Opportunistic investors have been scanning the European real estate markets for distressed opportunities for some time, but the euro-zone crisis has made the picture even more complicated, finds Lynn Strongin Dodds

Last year, private equity firms and hedge funds swooped into the UK and Europe in anticipation of a steady stream of property deals on the back of impending banking regulation. Transactions, not surprisingly, have stalled as the uncertainty over the ongoing euro-zone debt crisis continues. Market participants are waiting as events unfold, but regulatory pressures will force banks to start seriously unwinding their loan portfolios in 2012. The big question, of course, will be pricing, but no one is willing to predict how the land will lie.

Over the 12 months, leading lights such as Blackstone, Lone Star Funds, Oaktree, Starwood Capital Group, Pramerica Real Estate Investors, Centerbridge and Baupost, which specialise in distressed situations, have either opened new offices or expanded their existing premises in Europe. They were all hoping to have their pick of assets as banks started the painful process of not only meeting the Basel III capital adequacy requirements but also the more recent European Banking Authority (EBA) edict to bolster their core tier-1 capital ratios to more than 9% of risk-weighted assets by the middle of 2012.

In fact, in the first half of 2011 a bountiful crop of private equity funds was raised, however, market conditions put a damper on the third quarter. According to figures from data provider Preqin, 17 private equity real estate funds raised $11bn (€8.43bn) globally in the third quarter, a 16% drop on the previous quarter when $13.1bn was raised by 27 funds. North America remained the hot spot, with six funds raising $5.5bn, followed closely by Europe, with nine funds raising $4.8bn. Asia and the remaining regions were lower down the list, amassing $1bn.

As Simon Dunne, director of Savills Capital Advisors says: “There is pent-up demand from private equity, hedge funds and special situation funds. They are sitting on dry powder and although banks will need to de-leverage, it has not happened as fast as buyers would have liked. There is a mismatch between buyers and sellers over price, and as a result this has made it difficult to get the deals across the finishing line.”

“The euro is in a state of flux,” says Barry Osilaja, director, Jones Lang Lasalle Pan-European Corporate Finance. “There is a lot of money, especially in the mezzanine debt space, but it is a struggle to get deals done while meeting return requirements. Some European banks will need to recapitalise due to Basel III and the EBA capital requirements, but the other major issue is: what will the impact be if the euro-zone itself has to be restructured?”

Joe Valente, managing director, head of research and strategy for JP Morgan Asset Management’s European real estate group, says: “There has been a lot of hype, and while private equity firms are back pushing debt there haven’t been that many deals. I have seen the best part of 30 funds come across my desk, but only five have done anything. It is just the tip of the iceberg and they are tinkering at the edge. The activity has been miniscule versus what is required to tackle the problem.”

Estimates from Deloitte reveal that the total value of non-core and non-performing assets held by European banks is a staggering €1.7trn, with the UK accounting for the largest chunk - €536bn. Around €500bn of real estate loans will need to be refinanced in Europe over the next four years, of which around €125bn alone will be German loans, according to Ralph Winter, founder and chairman of Swiss-based private equity group Corestate Capital. The group recently joined forces with Germany’s European Business School to identify and analyse the key issues with regard to distressed real estate assets and non-performing loans.

In the past 12 months, around 100 or so portfolios of loans and other assets have been brought to market, with actual sales totalling around €60bn. One of the most notable has been Royal Bank of Scotland’s (RBS) Project Isobel, which had been plagued with problems since Blackstone was selected to take a 25% stake in the vehicle at the beginning of last July. Deteriorating market conditions combined with falling swap rates led to protracted negotiations over the split of the additional costs. In addition, bank funding costs and capacity to lend were squeezed. The deal teetered on the brink of collapse as RBS and Blackstone sought third-party lending and eventually RBS, as well as external parties, provided around 60% of the debt.

In the end, a white knight emerged in the form of China’s sovereign wealth fund China Investment Corporation (CIC), which has assets of $409bn. CIC agreed to buy a 12.5% stake valued at about £50m (€59.4m). It is the first time a sovereign wealth fund has invested in a UK distressed property banking deal.

Another high-profile deal currently on the block is Lloyd Bank’s Project Royal. Lone Star is thought to be the front-runner for the £900m portfolio, having fought off competition from rival bidders Cerberus and Colony Capital. The loans form part of the state-owned bank’s business support unit, which manages a vast £24bn portfolio of loans that need restructuring and comprise approximately 30 borrowers secured against more than 200 office, retail and industrial properties across the country. All eyes are on the pricing which is thought to be at a discount of between £500m and £550m.

Market participants are also waiting for the National Asset Management Agency (NAMA) to make a meaningful dent in the €75bn portfolio of loans it bought from main Irish banks at an average discount of 58%. The state agency, which is now one of the biggest property companies in the world, hopes to turn a profit by selling the loans or properties linked to the loans over a period of 10 years. This has not been an easy task as commercial and residential property prices have plunged by 60% in parts of Ireland and are still dropping due to the challenging economic climate.

Many believe that future deals could follow a Project Isobel path and be structured with different types of players. Although each deal may differ, there is no doubt that banks will play a smaller role. They started retreating four years ago after incurring €526bn of losses due to the credit crisis and ensuing property slump, according to industry calculations. However, the withdrawal has continued; in 2011 stalwarts, such as French bank Société Générale and German firms Eurohypo AG, Commerzbank AG’s real estate arm, put a halt to new lending.

“Banks are not capable of covering financing demand due to the capital requirements imposed on them,” says Winters. “They have cut back severely on credit financing deals, focusing on core, stable income-producing assets, although 97% of German real estate is not core. Finance today is more of a hybrid of equity and debt, but there needs to be much more work on the asset management side in order to create value. This is only achievable if you have the right mix of skill sets, which I am sure that not all the large US private companies have.”

We are in a period of transition, according to Ari Danielsson, managing director at Reviva Capital. “Financing property in its old form - whereby banks provided about 80% to 85% of the funding in the market followed by around 10% from the CMBS market and the rest from alternatives such as mezzanine and insurance companies - is gone. Now we are in a state of flux, but in three or four years’ time banks could provide only about 60% of the overall market, with insurance companies and alternatives contributing as much as 20% or more of funding. Then there is a new and simplified generation of structured financing referred to as CMBS 2.0, which is also expected to play a role, although a smaller one in Europe than in the US.”

CMBS 2.0 is the post-bubble adaptation of the commercial mortgage-backed securities market, which focuses on smaller-size transactions. In the halcyon days, CMBS would raise around $2-3bn, comprised of at least 150 loans, but today they would include around 50 loans to make it easier for due diligence teams to review and inspect the collateral pool. Its shelf life, though, might be short-lived in the wake of S&P’s pulling its ratings on the $1.48bn deal from Goldman Sachs and Citi last summer. The offering had an aggressive capital structure that did not sit well with investors, particularly as the outlook for the economy turned.

As a result, an updated version, CMBS 3.0, was slotted into place, offering a hefty credit enhancement of 30% for an AAA-rated super-senior class. By contrast, CMBS 2.0 deals typically were structured with just one senior class, with the enhancement levels in the mid to high-teens range. The Goldman and Citi deal was initially marketed at a 14.5% enhancement.

Industry experts also agree with Danielsson and expect to see insurance companies making greater inroads. They are not newcomers to the property game, having been major participants 20 years ago before the investment banks usurped their position. Solvency II is one of the main drivers and over the past year AXA Real Estate, Allianz Real Estate, Canada Life, Aviva, Met Life and Legal & General have thrown their hats into the ring. The new rules, which are expected to come into force in January 2014, make lending to property an attractive option because it proposes capital charges of less than 5% on property loans compared with the proposed 25% charge for equity investments.

Research from DTZ predicts that these organisations could lend around €60bn in European commercial real estate over the next three years. Recent figures from CBRE reveal that insurers in 2011 provided the most competitive real estate debt terms on the market. With maximum loan-to-values (LTVs) of 69% and typical margins of 2.4%, insurers were offering deals around 20-30bps below the market average of 66.2% and 2.6 % respectively.

In the UK, they account for roughly 14% of all real estate lenders, but Eleonora Pulci, a specialist in CBRE’s debt advisory team, believes this figure could rise to 20% over the medium to longer term. “They are competitive and active, but insurance companies alone will not fill the funding gap in Europe, nor will they replace mainstream lenders. They will have an important but niche role.”

As Ben Stirling, head of continental Europe real estate at Aviva Investors, says: “There is a real lack of liquidity in the senior debt end of the capital structure, where we mainly focus. This business is also efficient from a Solvency II perspective, plus the returns are more attractive than government yields. I think there will be opportunities in 2012 because banks will be forced to restructure their portfolios and will have to stop extending and pretending.”

For now, though, European banks are sitting tight. Fearful of additional heavy write-downs on sovereign debt, they are keen to avoid further capital erosion resulting from a widespread fire sale of cheap loans. “The current situation is that there is a lot of money chasing opportunities but there are not yet enough transactions in the market,” says Pulci. “Banks have to shift assets off their balance sheets, but they can’t afford to sell at such big discounts and they need time to generate profits in other areas of their businesses to offset the losses. Meanwhile, investors are waiting because they do not want to pay too much.”

Osilaja adds: “One of the biggest problems is that private equity firms require big returns - in the mid teens - and a quick turnaround. Today the discounts are not there with loan-to-values of 60-65%. I think we will see activity next year, especially on the loan sales side, due to banks having to strengthen their balance sheets, and I do not think there will be a floodgate of transactions but a slow and steady stream.”